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