How is the gross profit method used in relation to inventory

Valuing Inventory

An inventory valuation allows a company to provide a monetary value for items that make up their inventory. Inventories are usually the largest currentasset of a business, and proper measurement of them is necessary to assure accurate financial statements. If inventory is not properly measured, expenses and revenues cannot be properly matched and a company could make poor business decisions.

A company will chose an inventory accounting system, either perpetual or periodic. In perpetual inventory the accounting records must show the amount of inventory on hand at all times. Periodic inventory is not updated on a regular basis.

Methods Used to Estimate Inventory Cost

While the best way to value inventory is to perform a physical inventory, in certain business operations, taking a physical inventory is impossible or impractical. In such a situation, it is necessary to estimate the inventory cost. There are two methods to estimate inventory cost, the retail inventory method and the gross profit method.

Both methods can be used to calculate the inventory amount for the monthly financial statements, or estimate the amount of missing inventory due to theft, fire or other disaster. Either of these methods should never be used as a substitute for performing an annual physical inventory.

Gross Profit Method

The gross profit (or gross margin) method uses the previous year's average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory. Keep in mind the gross profit method assumes that gross profit ratio remains stable during the period.

Inventory.

The gross profit (or gross margin) method uses the previous year's average gross profit margin (i.e. sales minus cost of goods sold divided by sales) to calculate the value of the inventory.

To prepare the inventory value via the gross profit method:

• Calculate the cost of goods available for sale as the sum of the cost of beginning inventory and cost of net purchases.
• Determine the gross profit ratio. Gross profit ratio equals gross profit divided by sales. Use projected gross profit ratio or historical gross profit ratio whichever is more accurate and reliable.
• Multiply sales made during the period by gross profit ratio to obtain estimated cost of goods sold.
• Calculate the cost of ending inventory as the difference of cost of goods available for sale and estimated cost of goods sold.

Example

The following is an example on how to calculate ending inventory using the gross profit method.

Furniture Palace has cost of goods available for sale of $5000. Sales were $1000. 

The company has projected a gross profit ratio of 25%.

The estimated cost of goods sold on the income statement for the period is $$1000\cdot.25 = $250$.

The ending inventory on the balance sheet is $$5000 - $250=$4750$.

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One sure-fire way to determine exactly what your business has in its inventory is to go in and count every single item. However, taking a physical inventory isn't always practical or even possible, so a business needs a reliable way of estimating the value of its inventory. Two of the most common methods for doing that are the gross profit method and the retail inventory method.

Purpose

1. Taking a physical inventory is necessary, but it's also time-consuming and expensive. You may have to close your business for a day or part of a day to "freeze" the inventory for counting, or you may have to pay employees overtime to come in during non-business hours to conduct the count. These considerations limit how often you can perform a physical inventory. However, between these "hand-counts," you still need information to plan your budget and prepare financial reports. In some cases, such as after a fire or robbery, a physical inventory is impossible because the items are gone, but you still must be able to estimate the value of the lost inventory to put in an insurance claim or deduct the loss on your taxes. In situations like these estimation methods come into play.

Choosing a Method

1. Each method depends on knowing the difference between how much it costs you to obtain or produce the items you sell and the price at which you sell them to customers.

   The gross profit method uses your company's current profit margin. If your company operates with a profit margin of 25 percent on sales, for example, it means that for every $1 in sales, 75 cents goes toward producing or purchasing the items you sell and 25 cents is gross profit. To determine your current margin, you must examine your recent sales and costs to determine exactly how much profit you're making. The retail inventory method uses markup -- the specific amount your company adds to the wholesale cost of goods when pricing them for retail. If you mark up goods 25 percent, for example, then an item you buy wholesale for $80 would sell for $100 -- that is, $80 plus a 25 percent markup, which is $20.

   Which method you choose depends largely on how you run your business. If you sell products with a consistent and equal markup, retail inventory is your simplest choice. However, if you sell a range of products, each of which has a different markup, gross profit would be better, although it entails the extra step of determining your current margin

Gross Profit Method

1. The gross profit method calculation starts with the value of the goods in your inventory the last time you performed a physical count. Remember that the "value" of inventory represents the cost to you, not the retail price. Say you had inventory worth $50,000 the last time you did a hand-count. Now add the amount you have spent on goods since that count. If you've spent $30,000 since then, the total cost of goods available for sale is $80,000. Next, look at your sales revenue since the last inventory. This amount will reflect the retail price of the goods sold. Say you had $60,000 in sales. Apply your gross profit margin to your sales revenue to determine the cost of the goods you sold. If your margin is 25 percent, then that $60,000 in sales represents $15,000 in profit and $45,000 in costs. Subtract that cost figure from the total cost of available goods: $80,000 minus $45,000 gives you an estimated current inventory value of $35,000.

Retail Inventory Method

1. The calculation for the retail inventory method works much the same as that for the gross profit method. Start with the inventory cost at the last hand-count and then add to that the cost of goods purchased since the count. Say these two add up to $80,000. Now take your sales revenue since the last inventory, and calculate how much of that was the cost of the goods and how much was markup. If you had $60,000 in sales and your markup is 25 percent, then those sales represent $48,000 in costs and $12,000 in markup ($12,000 is 25 percent of $48,000). Subtract $48,000 from $80,000, and your estimated current inventory is $32,000.

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