Gross Profit Method

Gross profit method (also known as gross margin method) is a technique used to estimate the value of ending inventory and cost of goods sold of a period on the basis of the historical or projected gross profit ratio of the business. Gross profit method assumes that gross profit ratio remains stable during the period.

This method is an alternative to the retail method of inventory estimation and it is usually used to estimate the value of inventory when the retail values of beginning inventory and purchases are not available.

A summary of steps in the gross profit method is given below:

  1. Calculate the cost of goods available for sale as the sum of the cost of beginning inventory and cost of net purchases.
  2. 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.
  3. Multiply sales made during the period by gross profit ratio to obtain estimated cost of goods sold.
  4. Calculate the cost of ending inventory as the difference of cost of goods available for sale and estimated cost of goods sold.

Example

Cost of Beginning Inventory $23,000
Net Purchases at Cost 482,000
Freight Cost on Purchases 25,000
Cost of Goods Available for Sale 530,000
Less: Estimated Cost of Goods Sold:  
Sales$860,000 
Less: Estimated Gross Profit 40%−344,000 
Estimated Cost of Goods Sold 516,000
Estimated Cost of Ending Inventory 14,000

Written by Irfanullah Jan