Chapter 3.7® - Gross Profit Method of Estimating Inventory - Using the Gross Margin Method, Annual Inventory Counts, Gross Profit on Selling Price Method

• Part 3.1 - Inventory Valuation & Estimation – Lower of Cost or Market, Example & Illustration of Net Realizable Value, Market Replacement Cost
• Part 3.2 - Example of Net Realizable Value less a Normal Profit Margin, Market equals = Net Realizable value or Market equals net realizable value minus a normal Profit Margin
• Part 3.3 - How Lower of Cost or Market Works - Acceptable Historical Cost Flow Method & Comparisons of Market versus Cost, US Designated Market Value
• Part 3.4 - Methods of Applying Lower of Cost and Market - Item by Item Basis, Category Basis & Total Inventory Basis
• Part 3.5 - Recording Inventory Valuation at Market instead of Cost - Direct & Indirect Methods assuming Periodic & Perpetual Inventory Systems
• Part 3.6 - Income Statement Presentation - Direct & Indirect Method and Advantages & Disadvantages of Using Lower of Cost and Market
• Part 3.7 - Gross Profit Method of Estimating Inventory - Using the Gross Margin Method, Annual Inventory Counts, Gross Profit on Selling Price Method
• Part 3.8 - Glossary of Important Inventory Valuation Terms

We must realize that the basic purpose of counting physical inventory at year-end or twice a year is to verify the amounts stated on the perpetual inventory records and if no perpetual records exist, to calculate the final inventory amounts (as done on periodic inventory systems). However sometimes, taking a physical inventory count is very costly, sometimes impossible. Then, estimation methods are used to approximate the total inventory on hand to be reported on the balance sheet. One method of estimating on hand inventory is the gross profit method. It is most often used when an interim financial report needs to be prepared and on hand inventory number is to be derived. Other cases when it is used include when inventory is destroyed by fire or some natural disaster, and the amount of inventory destroyed in the catastrophe is to be estimated for insurance purposes.

The gross profit method of estimating inventory is based on three assumptions:

As an example, consider that IRA Corp. has a beginning inventory of $80,000 and purchases of $300,000, both recorded at cost. Sales at selling price amount to $400,000 and gross profit on selling price is 30%.

The gross margin method is applied as follows:

Note that we calculated gross profit as 30% x $400,000 and subtracted this from $400,000 to arrive at estimated cost of goods sold. We could have automatically derived cost of goods sold as (100% - 30% = 70%) x $400,000 = $280,000

This chart above shows the breakdown of the costs included in estimating the inventory at gross profit method. The costs included are the beginning inventory costs, purchases for the year to arrive at goods available for sale, and the sales of the company less a gross profit of 30% to arrive at Sales at Cost (Estimated Cost of Goods Sold). This helps us finally arrive at our answer of $100,000 for the ending inventory.