Gross Profit Method
Use of Estimate in Inventory
Valuation
The most common reasons for making an estimate of
the cost of the goods on hand are:
A. The inventory is destroyed by fire and other
catastrophe, or theft of the merchandise has
occurred and the amount of inventory is
required for insurance purposes.
B. A physical count of the goods on hand is
made and it is necessary to prove the
correctness or reasonableness of such count by
making an estimate.
C. Interim financial statements are prepared
and a physical count of the goods on hand is not
necessary because it may take time to do so.
Two widely accepted procedures for
approximating the value of inventory:
A. Gross profit method
B. Retail inventory method
Gross Profit Method
Gross profit method is based on the
assumption that the rate of gross profit
remains approximately the same from
period to period and therefore the ratio of
cost of goods sold to net sales is relatively
constant from period to period.
Basic formula under the gross profit
method:
Goods Available for Sale
xxx
Less: Cost of Goods Sold
xxx
Ending Inventory
xxx
Goods Available for Sale
Beginning inventory
xxx
Purchases xxx
Add: Freight in xxx
Total xxx
Less: Purchase return, allowance and discount xxx
xxx
Goods available for sale
xxx
Cost of Goods Sold
The cost of goods sold is computed as
follows:
A. Net sales multiplied by cost ratio
B. Net sales divided by sales ratio
Illustration
Beginning inventory
100,000
Net purchases
500,000
Net sales
700,000
Gross profit rate based on sales
40%
The ending inventory is computed as follows:
Beginning inventory 100,000
Net purchases 500,000
Goods available for sale 600,000
Less: Cost of goods sold
Net sales 700,000
Multiply by cost ratio 60% 420,000
Ending inventory
180,000
Illustration
Beginning inventory
200,000
Net purchases
1,000,000
Net sales
1,260,000
Gross profit rate based on cost
40%
The ending inventory is computed as follows:
Beginning inventory
200,000
Net purchases
1,000,000
Goods available for sale
1,200,000
Less: Cost of Goods Sold:
Net sales 1,260,000
Divide by sales ratio 140%
900,000
Ending inventory
300,000
Computation of Gross
Profit Rate
The gross profit rate is expressed as a
percent of sales or a percent of cost of
goods sold.
The gross profit rate on sales is
computed by dividing the amount of
gross profit by the net sales.
The gross profit rate on cost is
computed by dividing the gross profit by
the cost of goods sold.
Gross Profit Rate on Cost to Gross
Profit on Sales
If the gross profit rate on cost is 25%, the gross
profit rate on sales is computed as follows:
Net sales 125%
Cost 100%
Gross profit on cost 25%
Gross profit on sales ( 25/125 )
20%
Gross Profit Rate On Sales to Gross
Profit on Cost
If the gross profit on sales is 20%, the gross
profit on cost is computed as follows:
Net sales
100%
Cost of goods sold
80%
Gross profit on sales
20%
Gross profit on cost ( 20/80 )
25%
Illustration
Inventory 600,000
Purchases 2,530,000
Purchase return 15,000
Purchase allowance 5,000
Purchase discount 10,000
Freight in 50,000
Sales 3,100,000
Sales return 100,000
Sales allowance 50,000
Sales discount 150,000
Requirement:
A. Computation of ending inventory – gross profit rate is 25%
on sales
B. Computation of ending inventory – gross profit rate is 25%
on cost
Gross Profit Rate Based
on Sales
Inventory – beginning 600,000
Purchases 2,530,000
Add: Freight In 50,000
Total 2,580,000
Less: Purchase return 15,000
Purchase allowance 5,000
Purchase discount 10,000 30,000 2,550,000
Goods available for sale 3,150,000
Less: Cost of Goods Sold:
Sales 3,100,000
Sales return ( 100,000)
Net sales 3,000,000
Multiply by cost ratio 75% 2,250,000
Ending inventory
900,000
Gross Profit Rate Based
on Cost
Goods available for sale
3,150,000
Less: Cost of goods sold
Sales 3,100,000
Sales return (100,000)
Net sales 3,000,000
Divide by sales ratio 125%
2,400,000
Ending inventory
750,000
End of
Presentation
