Gross Profit Method: Definition, Working, Uses, And Example 

While running a company, buying inventory is one of the most crucial parts. But sometimes, it happens when it becomes impossible to keep in count the amount of inventory purchased. This makes the price estimation really tough. Hence, you need to estimate the cost of the inventory. 

But if that is becoming something of an inconvenience, there are two ways in which you can estimate the inventory value. They are the gross profit method and also the retail inventory method. 

Gross Profit Method: A General Overview 

In this section, you will learn about the Gross Profit Method and how you can calculate using the formula. 

The gross profit method is a method of counting an amount of endless inventory within a reporting period. This method is helpful for monthly financial statements, where physical counting of inventory is not possible. Or in certain cases, fire damage, theft, or other disasters. 

You must use this calculation method only for an interim period and not a year-end inventory. This method does not find acceptance for certain tax purposes or even as annual financial statements. 

Gross Profit Method Formula

In order to calculate the gross profit formula, you need to abide by the following steps:

• You must add the cost of the inventory at the beginning. Also, you must add the cost of goods purchased in between that are available for sale. 

• You need to take into account the expected profit percentage of the total sale during that period of selling of goods to get the cost.
• Lastly, you have to estimate the cost of goods that are available for sale. Now subtract the estimated cost of goods to be sold after the inventory ends.

Therefore, the gross profit margin of a company is equal to the gross profit divided by the net sale.

Let?s say,

Net sales of a company are – $4,000,000.

The cost of goods sold that year was – $2,600,000.

The gross profit was – $ 1,400,000.

So, the gross profit margin was 35%. Let me show you how. 

Gross Profit Margin= $1,400,000/ $4,000,000 = 35%.

So if your gross profit margin is 35%, then the cost of your goods sold is 65%.

What Are the Uses of the Gross Profit Method? 

The gross profit method is the amount of profit that a company makes after it deducts the costs of production and sales. This amount is also known as gross income or sales profit. Here, you can calculate it by subtracting the cost of goods from the revenue of the organization. 

In general, gross profit helps isolate product/ service performance. Once the company does not need to pay for the administrative or operating costs, it can think strategically about improving the performance of the product or service. 

Basically, with the gross profit of the company, you can find out whether the pricing of the product is appropriate or not.

What Are the Problems with the Gross Profit Method? 

Realistically, there are several issues regarding the gross profit method. It sometimes makes this method unreliable for determining the exact value of the inventory over a long span of time. 

Let?s see what these problems are with the gross profit method. 

1. The Historical Base Can Be Wrong 

The percentage of gross profit method is the main part of the calculation. The percentage depends on the company?s history. It is highly possible that historical facts are wrong, and then the percentage can come out wrong.

2. It Includes Inventory Losses 

This calculation assumes that in the long term, the reasons for losses are theft, fire damage, or something else. You can include all these losses in the gross profit percentage history. 

However, if you do not account for these losses or calculate them, then the whole calculation is going to be wrong. 

3. It Has a Limited Application 

This type of calculation is most suited for retail chains, where companies are selling and buying different merchandise. 

However, if a company manufactures the goods as well, then you can add overhead and labor charges. This usually makes the gross profit method very simple and yields a more reliable result. 

4. You Can Use It Only for A Short Term 

Ordinarily, you must use any of these inventory calculation methods only for a short time. Only a cycle counting calculating program is superior enough to keep on giving an accurate inventory record with high accuracy. 

You must use anything else for a shorter period of time only. If not, you can always go for physical inventory counting after the end of every reporting year. 

Read More: How Inventory Scanners Can Benefit Businesses

Question!

Suppose you are given the question, which statement is true about the gross profit method of inventory valuation?

Also, you have the following options, 

1. The gross profit method is very complicated to use for inventory calculation.

1. You can use the method to calculate the inventory at year-end for the accounting of the finances. 

1. The gross profit method is a perfectly acceptable method that you can use to determine the cost of the inventory damaged by some cause.

1. The retail inventory method is not as accurate for inventory cost estimation as the gross profit method.

If you are faced with such a question, then without hesitating, you can say that option number C is the correct answer.

FIFO And LIFO Methods: What are They? 

The FIFO, or the First-In, First-Out, is a method that takes into account that the oldest products in the inventory should be sold first. 

The LIFO, or the Last-In, First-Out, is a method that takes into account that the unit that arrived in the inventory should be sold first. 

If someone asks you whether FIFO reports higher gross profit and net income than the LIFO method when the price increases.

Then, you should know that the statement is true. 

Read More: Conjoined Triangles Of Success ? What Are Conjoined Triangles Of Success?

Frequently Asked Questions!! (FAQs)

The following are some of the most common questions about the gross profit method.

Wrapping Up!

You must note that you can use any inventory cost estimation method for a shorter period of time. If you are able to do the inventory by yourself, great; if not, there are financial experts who might help you out.

The gross profit method is a very effective method of calculation, but if continued for a long time, it may give inaccurate results and calculations. This may hamper the whole inventory process. Though this is not the most effective way of doing inventory, it still helps in completing the work. 

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