Gross Profit Method of Estimating Inventory

The gross profit method of estimating inventory is a method of calculating the ending inventory of a business in the absence of a physical inventory count at the end of an accounting period.

It is similar to the retail inventory method, and is sometimes referred to as the gross margin method.

Gross Profit Method Process

The gross profit method involves the following for steps.

  1. Calculate the historical gross profit percentage
  2. Calculate the cost of goods available for sale
  3. Estimate the cost of goods sold
  4. Calculate the ending inventory

Gross Profit Method Example

By applying these four steps an estimate of the cost of the ending inventory can be arrived at as follows:

Calculate the Historical Gross Profit Percentage

The gross profit percentage, sometimes referred to as the gross margin, is calculated using the following formula.

Gross profit % = Gross profit / Revenue

For example, suppose the historical accounts of a business show revenue of 120,000 and a gross profit of 72,000, then the gross profit percentage is given as follows:

Gross profit % = Gross profit / Revenue
Gross profit % = 72,000 / 120,000
Gross profit % = 60%

Calculate the Cost of Goods Available for Sale

The cost of goods available for sale is the beginning inventory plus any goods purchased during the accounting period.

Goods available for sale = Beginning inventory + Purchases

For example, if the beginning inventory is 18,000, and the purchases during the period are 65,000, then the cost of goods available for sale is as follows:

Goods available for sale = Beginning inventory + Purchases
Goods available for sale = 18,000 + 65,000
Goods available for sale = 83,000

All the amounts used in this step are at cost.

Estimate the Cost of Goods Sold

The cost of goods sold can now be calculated by applying the gross profit percentage to the revenue for the period using the following formula:

Cost of goods sold = Revenue x (1 - Gross profit %)

In our example, suppose the revenue for the accounting period was 150,000, with an estimated 60% gross profit percentage, the cost of goods sold is estimated as follows:

Cost of goods sold = Revenue x (1 - Gross profit %)
Cost of goods sold = 150,000 x (1 - 60%)
Cost of goods sold = 60,000

Calculate the Ending Inventory at Cost

Finally, the ending inventory at cost can be estimated using the following formula:

Ending inventory = Cost of goods available for sale - Cost of goods sold

In our example, the ending inventory at cost is calculated as follows:

Ending inventory = Cost of goods available for sale - Cost of goods sold
Ending inventory = 83,000 - 60,000
Ending inventory = 23,000

The four steps used in the gross profit method are summarized in the table below.

Gross profit method example summary
1. Calculate Historical Gross Profit %
Revenue 120,000
Gross profit 72,000
Gross profit % 60%
2. Calculate Goods Available for Sale
Beginning inventory 18,000
Purchases 65,000
Available for sale 83,000
3. Estimate Cost of Goods Sold
Revenue 150,000
Gross profit % 60%
Cost of goods sold 60,000
4. Calculate Ending Inventory
Available for sale 83,000
Cost of goods sold 60,000
Ending inventory 23,000

Our gross profits method calculator is useful for estimating the ending inventory using the four steps described above.

Gross Profit Method Formula

Combining the four steps above results in the gross profit method formula which can be stated as follows:

Ending inventory = Beginning inventory + Purchases - Revenue x (1 - Gross profit %)

Using the data from the previous example and the gross profit method formula, the ending inventory is calculated as follows:

Ending inventory = Beginning inventory + Purchases - Revenue x (1 - Gross profit %)
Ending inventory = 18,000 + 65,000 - 150,000 x (1 - 60%)
Ending inventory = 23,000

Despite its apparent accuracy, the method relies on an estimated gross margin percentage based on historical information and assumes it will be the same in the following accounting periods. Any significant shift in the type of ending inventory and its gross margin percentage will cause inaccuracies in the calculation. While suitable for monthly management accounts, the gross profit method is generally not appropriate for use in the year-end financial statements, when a full physical inventory count should be carried out.

Gross Profit Method of Estimating Inventory November 6th, 2016Team

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