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What is the gross profit method?

The gross profit method is a technique used to estimate the amount of ending inventory. The technique could be used for monthly financial statements when a physical inventory is not feasible. (However, it is no substitute for an annual physical inventory.) It is also used to estimate the amount of missing inventory caused by theft, fire or other disaster.

Here's how the gross profit method works. First you must determine the gross profit percentage (gross profit margin) that your company is currently experiencing. For example, if a retailer buys its merchandise for $0.70 and sells the merchandise for $1.00, it has a gross profit of $0.30. The gross profit of $0.30 divided by the selling price of $1.00 means a gross profit margin of 30% of sales. This also means that the retailer's cost of goods sold is 70% of sales.

Next, compute the sales value of the merchandise sold since the last time an inventory amount was known. Let's assume that the sales amounted to $100,000. Given the sales value of $100,000 the cost of the goods sold should be approximately $70,000 (70% from above times $100,000).

Add the cost of the goods purchased since the last inventory to that inventory amount. Let's assume that previous inventory amount was $15,000 and that there were purchases of $75,000. That means the cost of goods that were available for sale totals $90,000 ($15,000 + $75,000). Since the estimated cost of goods sold was $70,000 (from above), the estimated cost of goods in inventory should be approximately $20,000 ($90,000 minus $70,000).

Be certain that the gross profit percentage is indicative of reality and remember that the resulting amount is an estimate.