The Gross Profit Method for Estimated Ending Inventory
Most companies would like to prepare interim financial statements such as monthly,
quarterly or semiannually. Physical count inventory is made at the end of year. For this
reason the companies use some methods to calculate its ending inventory, one of these
methods called "The Gross Profit Method".
The Gross Profit Method (sometimes called "the Gross Margin Method") means "a
way to estimate the value of ending inventory on the base of percentage of gross profit";
therefore, companies must determine the percentage of gross profit at the end of year after
preparing the financial statements.
The percentage of gross profit is calculated as follows:
Whether as a percentage of sales or net sales:
The gross profit percentage = gross profit /sales
Or, a percentage of cost of goods sold or cost of sales:
The gross profit percentage = gross profit / cost of goods sold
To compute the ending inventory by the Gross Profit Method, there are five steps:
1. To determine the gross profit rate whether as a percentage of sales or a percentage
of cost (cost of goods sold ) , if the percentage was of cost , you must convert this
percentage to a percentage of sales because the cost of goods sold is variable ,
convert the percentage from cost to sales as follows :
Gross profit on sales =percentage markup on cost / (100% + percentage markup on
cost).
For example if the % was 25% of cost, to convert this percentage from cost to sales
as follows:
Gross Profit on sales =0.25/ (1+0.25)× 100=20%.
Note: The computed gross profit of sales must equal the computed gross profit of
cost. To illustrate this problem assume the following information that related to XY
Company:Beginning Inventory $20,000; Purchases $160,000; Sales $190,000 and Gross Profit
percentage 25% of cost.
Solution:Gross Profit on sales =0.25/ (1+0.25)× 100=20%.
Gross Profit =$190,000 *20% = $38,000
Cost of goods sold =$190,000-38,000= $152,000
Gross Profit on Cost = $152,000*25%= $38,000
2. Compute the Total cost of goods available for sale. The cost of goods available for
sales consist of Beginning Inventory + Net Purchases + Fright in ; (Net Purchases =
Purchases –Discount , Returns & Allowances Purchases)
3. Compute the estimated Gross profit by multiplying Sales ×Gross Profit percentage.
4. Compute the cost of goods sold by subtracting the Computed Gross Profit from
Sales.
4‫ من‬1 ‫صفحة‬
Prepared by: Ali Salim Wabraan
5. Compute ending inventory by subtracting the computed cost of goods sold from
cost of goods available for sale. To illustrate that ,assume the following
information:Beginning Inventory $30,000;Net Purchases 120,000; Net Sales 185,000; Fright in
25,000; Gross Profit 30% of sales .
Compute ending inventory?
Solution:
1. The percentage of Gross Profit is 30% of sales revenues.
2. Cost of Goods available for sales
=$30,000+120,000+25,000=$175,000
3. The estimated Gross Profit =$185,000*30%=$55,500
4. Cost of Goods Sold = $185,000-55,500=$129,500 ,or $185,000*70%=$129,500
5. Ending Inventory =$175,000-129,500= $45,500
Uses of Gross Profit Method:
Gross profit method is used in both commercial and manufacturing companies; the gross
profit method is used:
1. To test the reasonability of an inventory valuation determined by some other means,
such as a physical inventory count or from perpetual inventory records. For
example, assume the company submits to an auditor an ending inventory valuation
of $ 10,000 .The Gross profit method provides an approximation of $ 7,000 which
suggests that the ending inventory may be overvalue and should be examined.
2. To estimate the ending inventory for interim financial reports or internal reports
prepared during the year when it is impractical to count the inventory physically and
perpetual inventory system is not used.
3. To estimate the cost of inventory destroyed by an accident, such as fire or storm.
Valuation of inventory lost is necessary to account for the accident and to establish
basis for insurance claims and income taxes.
4. To develop budget estimates of cost of goods sold, gross profit and inventory
consistent with sales revenues budget.
Evaluation of Gross Profit Method:The gross profit method is not normally accepted for financial reporting purposes because
it provides only an estimate. A physical inventory needs an additional verification that the
inventory indicated in the records is actually on hand. Therefore the disadvantages of gross
profit method are as follows:
1. It depends on determine gross profit on past percentages ,on other hand it uses the
past percentage on determining the gross profit and neglects any changes happen on
the current period. This procedure is not correct because this percentage does not
reflect the actual changes of the current or future period. Therefore the past
percentages should be adjusted to reflect the actual changes.
4‫ من‬2 ‫صفحة‬
Prepared by: Ali Salim Wabraan
2. This method provides just an estimate. This procedure doesn't normally acceptable
for external financial reporting purposes.
3. The gross profit rate may vary widely on different types of inventory. Most
companies carry a number of different types of merchandise; each one has different
gross profit rates. Changes in the relative quantities of each types of merchandise
sold affect the reliability of the gross profit results.
Solved Problems
P 1)
Reese Co. prepares monthly income statements. Inventory is counted only at year
end; thus, month-end inventories must be estimated. All sales are made on
account. The rate of mark-up on cost is 20%. The following information relates to
the month of May.
Accounts receivable, May 1
Accounts receivable, May 31
Collections of accounts during May
Inventory, May 1
Purchases during May
$21,000
27,000
90,000
45,000
58,000
Instructions
Calculate the estimated cost of the inventory on May 31.
Solution 9-108
Collections of accounts
Add accounts receivable, May 31
Deduct accounts receivable, May 1
Sales during May
$ 90,000
27,000
(21,000)
$ 96,000
Inventory, May 1
Purchases during May
Goods available
Cost of sales ($96,000 ÷ 120%)
Estimated cost of inventory, May 31
$ 45,000
58,000
103,000
(80,000)
$ 23,000
P2).
On December 31, 2007 Carr Company's inventory burned. Sales and purchases
for the year had been $1,400,000 and $980,000, respectively. The beginning
4‫ من‬3 ‫صفحة‬
Prepared by: Ali Salim Wabraan
inventory (Jan. 1, 2007) was $170,000; in the past Carr's gross profit has
averaged 40% of selling price.
Instructions
Compute the estimated cost of inventory burned, and give entries as of December 31, 2007
to close merchandise accounts.
Solution 9-110
Beginning inventory
Add: Purchases
Cost of goods available
Sales
Less 40%
Estimated inventory lost
$ 170,000
980,000
1,150,000
$1,400,000
(560,000)
840,000
$ 310,000
Sales .................................................................................... 1,400 000
Income Summary .....................................................
1,400,000
Cost of Goods Sold ............................................................. 840,000
Fire Loss ............................................................................. 310,000
Inventory ..................................................................
Purchases ..................................................................
**************
4‫ من‬4 ‫صفحة‬
Prepared by: Ali Salim Wabraan
170,000
980,000