What is the consequence of using the gross profit method to provide an estimate of inventory amount?

The gross profit method is a way of calculating the amount of ending inventory in a reporting period. It is used for monthly financial statements when a physical inventory is not possible, for interim periods between physical inventory counts, and when inventory has been destroyed by fire, theft, or other disaster and you need to estimate your losses for the purpose of insurance.

However, a gross profit method should not be used to determine year-end inventory, nor is it an acceptable method for tax purposes, or annual financial statements.

Gross profit method formula

To calculate the gross profit method, you need to follow these steps:

• Add together the cost of beginning inventory and the cost of goods purchased during a period to get the cost of goods available for sale

• Take the expected gross profit percentage of the total sales figure during a period to get the cost of goods sold

• Then calculate the estimated cost of goods available for sale minus the estimated cost of goods sold to get the ending inventory

It can be helpful to compare the cost of goods sold as a percentage of sales with the recent trend line for the same percentage to see if the outcome matches.

Gross profit method example

Madison runs a large boutique jewelry shop in Los Angeles and is calculating her month-end inventory for September. Her beginning inventory was $25,000 and her purchases during the month were $40,000. Therefore, her estimated cost of goods available for sale is:

$25,000 beginning inventory + $40,000 purchases = $65,000 cost of goods available for sale

Madison knows her gross margin percentage across the last 12 months was 30%, which is considered a reliable long-term margin. Her sales during September were $70,000. Therefore, her estimated cost of goods available for sale is:

30% gross margin percentage of $70,000 total sales during September = $21,000 cost of goods sold

Then she takes $65,000 cost of goods available for sale minus $21,000 cost of goods sold in the period = $43,000 ending inventory

Gross profit method practice problems

As outlined earlier, the gross profit method is not appropriate for annual reports because it only estimates what the ending inventory balance may be and is not conclusive.

However, another issue lies with the gross profit percentage. This is key to the overall calculation, but is based on a company’s historical experience and not fact. A reduction of prices or unforeseen costs could yield a different percentage and make the gross profit percentage found in the calculation incorrect.

Also, if the long-term rate of losses due to theft, obsolescence, or any other causes are not recognized in the historical gross profit percentage, then the ending inventory will probably be an inaccurate estimation.

This calculation is applicable if the company – like Madison’s jewelry shop – is a retailer that simply trades in buying and reselling merchandise. But if a business manufactures its own goods then components of the inventory would need to include labor and overhead costs, making the gross profit method too basic to produce reliable results.

Overall, any inventory estimation technique should only be used for short periods of time. A well-run cycle counting program is a better method for routinely keeping inventory record accuracy at a high level. On the other hand, a physical inventory could be counted at the end of each reporting period manually.

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Businesses that sell goods need to implement effective inventory control to keep track of assets. Businesses use two primary methods to calculate the ending inventory value: the gross profit or the retail inventory method. These two methods of inventory control have practical applications for business that cannot perform physical inventories on a regular basis. Performing a physical inventory is not always possible for a variety of reasons, including a lack of manpower, natural disasters and other inventory issues.

The Retail Method

1. When a retail merchandiser wants to value or estimate the ending inventory, she can choose to use the retail method. The application of this method will only work, however, for businesses that sell merchandise with a consistent markup. This inventory method calculates the ending inventory by subtracting the actual sales from the goods available for sale at a retail level. The retail method is not a very accurate method of inventory evaluation because this method does not account for merchandise lost at the retail level.

Disadvantages

1. When calculating inventory using the retail method, the best a business can hope for is a realistic estimate. If the business has price fluctuations at the retail level due to sales or promotions, the retail method of inventory becomes ineffective. The retail method also makes historical assumptions about the pricing of the merchandise at the retail level. Additionally, when using the retail method, a business will eventually have to take a physical inventory to balance the actual inventory levels and the inventory levels recorded in the company’s books.

Gross Profit Method

1. The gross profit method uses the company's gross profit percentage to come up with the ending inventory. Just like the retail method, the gross profit method does not require a physical inventory. This method relies on the historical average gross profit to calculate the ending inventory. Typically, a company will use its income statement to calculate gross profit and average the results over time.

Reliability

1. A business should not use either the gross profit or the retail inventory method if the goal is to obtain an accurate evaluation of inventory levels. The gross profit method uses historical bases and inventory losses to calculate an approximation of ending inventory levels. Too many variables can affect the total outcome when using this method. The gross profit method can, however, have a beneficial use for merchandise resellers where unit costs are not a factor in assessing inventory valuation.

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