Definition of Gross Profit Method
The gross profit method is a technique for estimating the amount of ending inventory. The gross profit method might be used to estimate each month's ending inventory or it might be used as part of a calculation to determine the approximate amount of inventory that has been lost due to theft, fire, or other reasons.
The gross profit method of estimating ending inventory assumes that the gross profit percentage or the gross margin ratio is known. For example, if a company purchases goods for $80 and sells them for $100, its gross profit is $20. This results in a gross profit percentage or gross margin ratio of 20% of the selling price. Therefore, when the company has sales of $50,000 it is assumed that its cost of those goods will be $40,000 (80% of $50,000 in sales; or sales of $50,000 minus $10,000 of gross profit).
Example of Gross Profit Method
Assume you need to estimate the cost of a company's July 31 inventory. The last time the inventory was calculated was seven months earlier on December 31 when it had a cost of $15,000. Since December 31, the company purchased goods having a cost of $42,000; its sales were $50,000; and the gross profit percentage has remained at 20% (hence its cost of goods sold would be 80% of sales). The inventory at the end of the day on July 31 is estimated as follows:
- Inventory cost at December 31 was $15,000
- Purchases between December 31 and July 31 had a cost of $42,000
- Cost of goods available: $57,000 ($15,000 + $42,000)
- Cost of goods sold: sales of $50,000 X 80% = $40,000
- Ending Inventory at July 31 at its estimated cost: $17,000 ($57,000 cost of goods available minus $40,000 of cost of goods sold)