The gross profit method of estimating ending inventory assumes that we know the gross profit percentage or gross margin ratio. For example, if a company purchases goods for $80 and sells them for $100, its gross profit is $20 and it has a gross profit percentage or ratio of 20% of the selling price. When this company has sales of $50,000 it is assumed that its cost of those goods will be $40,000 ($50,000 minus 20% of $50,000; or 80% of $50,000).
Let's assume we need to estimate the cost of the July 31 inventory. The last time the merchandise inventory was counted was seven months earlier on December 31 and it had a cost of $15,000. Since December 31, the company purchased merchandise with a cost of $42,000; its sales were $50,000; and the gross profit percentage has remained at 20%. We can estimate the July 31 inventory as follows:
Inventory cost at December 31: $15,000
Purchases between December 31 and July 31 at cost: $42,000
Expected cost of goods available: $57,000 ($15,000 + $42,000)
Cost of goods sold: $50,000 of sales x 80% = $40,000
Estimated Inventory at July 31 at cost: $17,000 ($57,000 - $40,000)
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