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What is the Gross Profit Method?The gross profit method estimates the amount of ending inventory in a reporting period. This is of use for interim periods between physical inventory counts. It is also useful when inventory was destroyed and you need to estimate the ending inventory balance for the purpose of filing a claim for insurance reimbursement. The gross profit method is not an acceptable method for determining the year-end inventory balance, since it only estimates what the ending inventory balance may be. It is not sufficiently precise to be reliable for audited financial statements. How to Use the Gross Profit MethodFollow these steps to estimate ending inventory using the gross profit method:
In addition, it is useful to compare the resulting cost of goods sold as a percentage of sales to the recent trend line for the same percentage, to see if the outcome is reasonable. Example of the Gross Profit MethodAmalgamated Scientific Corporation (ASC) is calculating its month-end inventory for March. Its beginning inventory was $175,000 and its purchases during the month were $225,000. Thus, its cost of goods available for sale are: $175,000 beginning inventory + $225,000 purchases = $400,000 cost of goods available for sale ASC's gross margin percentage for all of the past 12 months was 35%, which is considered a reliable long-term margin. Its sales during March were $500,000. Thus, its estimated cost of goods sold is: (1 - 35%) x $500,000 = $325,000 cost of goods sold By subtracting the estimated cost of goods sold from the cost of goods available for sale, ASC arrives at an estimated ending inventory balance of $75,000. Problems with the Gross Profit MethodThere are several issues with the gross profit method that make it unreliable as the sole method for determining the value of inventory over the long term, which are noted below. Historical Basis Could Be IncorrectThe gross profit percentage is a key component of the calculation, but the percentage is based on a company's historical experience. If the current situation yields a different percentage (as may be caused by a special sale at reduced prices), then the gross profit percentage used in the calculation will be incorrect. Assumes Inclusion of Inventory LossesThe calculation assumes that the long-term rate of losses due to theft, obsolescence, and other causes is included in the historical gross profit percentage. If not, or if these losses have not previously been recognized, then the calculation will likely result in an inaccurate estimated ending inventory (and probably one that is too high). Limited ApplicabilityThe calculation is most useful in retail situations where a company is simply buying and reselling merchandise. If a company is instead manufacturing goods, then the components of inventory must also include labor and overhead, which make the gross profit method too simplistic to yield reliable results. Short-Term Usage PeriodIn general, any inventory estimation technique is only to be used for short periods of time. A well-run cycle counting program is a superior method for routinely keeping inventory record accuracy at a high level. Alternatively, conduct a physical inventory count at the end of each reporting period. The gross profit method is a technique for estimating the amount of ending inventory. The gross profit method might be used to estimate
each month's ending inventory or it might be used as part of a calculation to determine the approximate amount of inventory that has been lost due to theft, fire, or other reasons. The gross profit method of estimating ending inventory assumes that the gross profit percentage or the gross margin ratio is known. For example, if a company purchases goods for $80 and
sells them for $100, its gross profit is $20. This results in a gross profit percentage or gross margin ratio of 20% of the selling price. Therefore, when the company has sales of $50,000 it is assumed that its cost of those goods will be $40,000 (80% of $50,000 in sales; or sales of $50,000 minus $10,000 of gross profit). Assume you
need to estimate the cost of a company's July 31 inventory. The last time the inventory was calculated was seven months earlier on December 31 when it had a cost of $15,000. Since December 31, the company purchased goods having a cost of $42,000; its sales were $50,000; and the gross profit percentage has remained at 20% (hence its cost of goods sold would be 80% of sales). The inventory at the end of the day on July 31 is estimated as follows: Which is not valid about the gross profit method?The GP method will be invalid in the case where GP margin on sales differs from the margin on closing inventory. This states that on a notable difference in the GP margin, this method will be invalid since the primary assumption to use it is that the GP margin will not change.
What is the gross profit method of estimating inventory?The gross profit method estimates the value of inventory by applying the company's historical gross profit percentage to current‐period information about net sales and the cost of goods available for sale. Gross profit equals net sales minus the cost of goods sold.
What is the ending inventory under the gross margin method?Multiply the gross profit percentage by sales to find the estimated cost of goods sold. Subtract the cost of goods available for sold from the cost of goods sold to get the ending inventory.
In which of the following instances would the use of gross profit method in estimating inventory be not useful?d. In estimating the amount of inventory that should be purchased for the upcoming year. No, the gross profit method cannot be used to make projections.
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The gross margin method of estimating ending inventory may be used for all of the following, except
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