Definition: The gross profit method is a way to estimate the cost of ending inventory during a period without doing a physical inventory count. At the end of every accounting period an inventory count should be taken to accurately calculate the cost of the inventory that was sold along with the amount of inventory that is left over at the end of a period.
What Does Gross Profit Method Mean?
Counting inventory is usually time consuming and extremely tedious. What happens when some inventory that wasn’t sold during the year is missing at the end of the year and an insurance claim must be filed immediately? There usually isn’t time for an exact physical inventory count. Plus, how are some of the stolen or destroyed goods counted?
This is where the gross profit method is used to calculate the actual cost of ending inventory. It is a two-step process.
First, the net sales are multiplied by the inverse gross profit ratio. This calculates an approximate cost of goods sold for the period.
Second, the estimated cost of goods sold is subtracted from the goods available for sale calculating the estimated ending inventory for the period.
Let’s look at an example.
Jane’s Clothing, Inc. needs to get an inventory estimate to its banker immediately to finalize some loan documents for the upcoming season. The banker doesn’t care whether or not Jane does an inventory count, so Jane uses the gross profit method.
Jane reports these numbers at the end of the period.
- Net sales 100,000
- Gross profit ratio .3
- Goods available for sale 150,000
Jane’s ending inventory is $80,000.
- Step one: 100,000 x .7 = 70,000
- Step two: 150,000 – 70,000 = 80,000
If a physical inventory count was performed at the end of a period, the GPM also acts like a double check to makes sure a physical inventory check is reasonable.