The gross margin method of estimating ending inventory is frequently used

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.

The gross profit method estimates the amount of ending inventory in a reporting period. This is of use for interim periods between physical inventory counts. It is also useful when inventory was destroyed and you need to estimate the ending inventory balance for the purpose of filing a claim for insurance reimbursement. The gross profit method is not an acceptable method for determining the year-end inventory balance, since it only estimates what the ending inventory balance may be. It is not sufficiently precise to be reliable for audited financial statements.

How to Use the Gross Profit Method

Follow these steps to estimate ending inventory using the gross profit method:

  1. Add together the cost of beginning inventory and the cost of purchases during the period to arrive at the cost of goods available for sale.

  2. Multiply (1 - expected gross profit %) by sales during the period to arrive at the estimated cost of goods sold.

  3. Subtract the estimated cost of goods sold (step #2) from the cost of goods available for sale (step #1) to arrive at the ending inventory.

In addition, it is useful to compare the resulting cost of goods sold as a percentage of sales to the recent trend line for the same percentage, to see if the outcome is reasonable.

Example of the Gross Profit Method

Amalgamated Scientific Corporation (ASC) is calculating its month-end inventory for March. Its beginning inventory was $175,000 and its purchases during the month were $225,000. Thus, its cost of goods available for sale are:

$175,000 beginning inventory + $225,000 purchases = $400,000 cost of goods available for sale

ASC's gross margin percentage for all of the past 12 months was 35%, which is considered a reliable long-term margin. Its sales during March were $500,000. Thus, its estimated cost of goods sold is:

(1 - 35%) x $500,000 = $325,000 cost of goods sold

By subtracting the estimated cost of goods sold from the cost of goods available for sale, ASC arrives at an estimated ending inventory balance of $75,000.

Problems with the Gross Profit Method

There are several issues with the gross profit method that make it unreliable as the sole method for determining the value of inventory over the long term, which are noted below.

Historical Basis Could Be Incorrect

The gross profit percentage is a key component of the calculation, but the percentage is based on a company's historical experience. If the current situation yields a different percentage (as may be caused by a special sale at reduced prices), then the gross profit percentage used in the calculation will be incorrect.

Assumes Inclusion of Inventory Losses

The calculation assumes that the long-term rate of losses due to theft, obsolescence, and other causes is included in the historical gross profit percentage. If not, or if these losses have not previously been recognized, then the calculation will likely result in an inaccurate estimated ending inventory (and probably one that is too high).

Limited Applicability

The calculation is most useful in retail situations where a company is simply buying and reselling merchandise. If a company is instead manufacturing goods, then the components of inventory must also include labor and overhead, which make the gross profit method too simplistic to yield reliable results.

Short-Term Usage Period

In general, any inventory estimation technique is only to be used for short periods of time. A well-run cycle counting program is a superior method for routinely keeping inventory record accuracy at a high level. Alternatively, conduct a physical inventory count at the end of each reporting period.

Ending inventory is the total unit quantity of inventory in stock or its total valuation at the end of an accounting period. The ending inventory figure is needed to derive the cost of goods sold, as well as the ending inventory balance to include in a company's balance sheet. You may be unable to count the amount of inventory on hand at the end of an accounting period, or cannot assign a value to it. This situation can arise when there is too much shipping activity at month-end to conduct a physical count, or because the counting process is too labor-intensive, or when the staff is too busy to take the time to conduct a physical count.

If so, there are two methods available for estimating the ending inventory. These methods are not foolproof, since they rely upon historical trends, but they should yield a reasonably accurate number, as long as no unusual transactions occurred during the period that might alter the ending inventory.

The Gross Profit Method

The first method is the gross profit method. The basic steps are:

  1. Add together the cost of beginning inventory and the cost of purchases during the period to arrive at the cost of goods available for sale.

  2. Multiply (1 - expected gross profit %) by sales during the period to arrive at the estimated cost of goods sold.

  3. Subtract the estimated cost of goods sold (step #2) from the cost of goods available for sale (step #1) to arrive at the ending inventory.

The trouble with the gross profit method is that the result is driven by the historical gross margin, which may not be the margin experienced in the most recent accounting period. Also, there may be inventory losses in the period that are higher or lower than the long-term historical rate, which can also vary the result from whatever the actual ending inventory may turn out to be.

The Retail Inventory Method

The retail inventory method is an alternative approach that is used by retailers to calculate their ending inventory. Rather than using the gross margin percentage as the foundation for the calculation, this method uses the proportion of the retail price to cost in prior periods. The calculation is:

  1. Calculate the cost-to-retail percentage, for which the formula is (Cost / Retail price).

  2. Calculate the cost of goods available for sale, for which the formula is (Cost of beginning inventory + Cost of purchases).

  3. Calculate the cost of sales during the period, for which the formula is (Sales x cost-to-retail percentage).

  4. Calculate ending inventory, for which the formula is (Cost of goods available for sale - Cost of sales during the period).

This method only works if you consistently mark up all products by the same percentage. Also, you need to have continued to use the same markup percentage in the current period (discounts for periodic sales can cause incorrect results). Thus, a series of discounts to clear out stock after the main selling season of the year can impact the outcome of this calculation.

The Need for Physical Counts

Note that the methods described here can only be used to estimate ending inventory - nothing beats a physical count or cycle counting program to obtain a much more accurate ending inventory valuation. Increased accuracy can also be obtained with a proper reserve for obsolete inventory and consideration of the effects of any inventory cost layering methodologies, such as the LIFO or FIFO methods.

A company that needs a precise ending inventory figure, as is common for audited financial statements or a pending acquisition, will probably need to complete a detailed physical inventory count, rather than using either of the estimation methods noted above.

What is the gross margin estimation method?

June 16, 2022. To calculate gross margin, subtract Cost of Goods Sold (COGS) from total revenue and divide that number by total revenue (Gross Margin = (Total Revenue – Cost of Goods Sold)/Total Revenue).

What is the gross profit method used for?

Gross profit method. The gross profit method estimates the value of inventory by applying the company's historical gross profit percentage to current‐period information about net sales and the cost of goods available for sale. Gross profit equals net sales minus the cost of goods sold.

What methods are used to estimate ending inventory?

The basic formula for calculating ending inventory is: Beginning inventory + net purchases – COGS = ending inventory. Your beginning inventory is the last period's ending inventory. The net purchases are the items you've bought and added to your inventory count.

In which of the following instances would the use of gross profit method in estimating inventory be not useful?

d. In estimating the amount of inventory that should be purchased for the upcoming year. No, the gross profit method cannot be used to make projections.