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 using which you can estimate the inventory value. They are the gross profit method and also the retail inventory method.
Gross Profit Method
Today we are going to discuss what the gross profit method is? And how it is calculated?
The gross profit method is a type of calculating method to count an amount of endless inventory within a reporting period. This method is used for the monthly financial statements, where physical counting of inventory is not possible. Or in certain cases, fire damage or theft or other disasters.
This method should only be used for an interim period and not a year-end inventory. It is not accepted 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 need to add the cost of the inventory at the beginning and 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.
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 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 The Inventory Losses.
This calculation assumes that in the long term, loses the reason are theft, fire damage or something else. All these losses are included in the history of gross profit percentage.
But if these losses are not accounted for or calculated, then the whole calculator 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.
But if a company is manufacturing the goods as well, then the overhead and labour charges are added. This usually makes the gross profit method very simple for it to yield a more reliable result.
4. Used Only For A Short Term.
Ordinarily, any of these inventory calculation methods should be used 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.
Anything else should be used for a shorter period of time only. If not, you can always go for physical counting of inventory after the end of every reporting year.
Suppose you are given the question, which statement is true about the gross profit method of inventory valuation?
And you are given the following options,
- The gross profit method is very complicated to use for inventory calculation.
- The gross profit method is usually used to calculate the inventory at year-end for the accounting of the finances.
- The gross profit method is a perfectly acceptable method used to find out the cost of the inventory damaged by some cause.
- 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
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 you are asked if FIFO reports higher gross profit and net income than the LIFO method when the price increases. If the statement is true or false.
Then you should know that the statement is true.
Frequently Asked Questions (FAQs):
The gross profit method is used to estimate the monthly ending of inventory. Or to determine the amount of the inventory that has been damaged due to some incident.
The gross profit of a company is found by simply subtracting the costs which are related to the selling and manufacturing of its services or products.
In the retail method, the ending inventory is balanced by just measuring the total cost of inventory that is related to the price of the products.
Other than calculating the inventory and sales of a product, this method also uses the cost-to-retail ratio factor.
It should be noted that any inventory cost estimation method only be used 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 out inaccurate results and calculations. This may hamper the whole inventory process. Though this is not the most effective way of doing inventory, it gets the work done.
Sreya Bhadra is an ardent writer who excels in genres like entertainment, Technology, lifestyle, and current affairs. Belonging from a journalism background, she believes in the power of the pen in conveying any message.