What is the disadvantage of using the gross profit method when estimating ending inventory?

The gross profit method is a way of calculating the amount of ending inventory in a reporting period. It is used for monthly financial statements when a physical inventory is not possible, for interim periods between physical inventory counts, and when inventory has been destroyed by fire, theft, or other disaster and you need to estimate your losses for the purpose of insurance.

However, a gross profit method should not be used to determine year-end inventory, nor is it an acceptable method for tax purposes, or annual financial statements.

Gross profit method formula

To calculate the gross profit method, you need to follow these steps:

• Add together the cost of beginning inventory and the cost of goods purchased during a period to get the cost of goods available for sale

• Take the expected gross profit percentage of the total sales figure during a period to get the cost of goods sold

• Then calculate the estimated cost of goods available for sale minus the estimated cost of goods sold to get the ending inventory

It can be helpful to compare the cost of goods sold as a percentage of sales with the recent trend line for the same percentage to see if the outcome matches.

Gross profit method example

Madison runs a large boutique jewelry shop in Los Angeles and is calculating her month-end inventory for September. Her beginning inventory was $25,000 and her purchases during the month were $40,000. Therefore, her estimated cost of goods available for sale is:

$25,000 beginning inventory + $40,000 purchases = $65,000 cost of goods available for sale

Madison knows her gross margin percentage across the last 12 months was 30%, which is considered a reliable long-term margin. Her sales during September were $70,000. Therefore, her estimated cost of goods available for sale is:

30% gross margin percentage of $70,000 total sales during September = $21,000 cost of goods sold

Then she takes $65,000 cost of goods available for sale minus $21,000 cost of goods sold in the period = $43,000 ending inventory

Gross profit method practice problems

As outlined earlier, the gross profit method is not appropriate for annual reports because it only estimates what the ending inventory balance may be and is not conclusive.

However, another issue lies with the gross profit percentage. This is key to the overall calculation, but is based on a company’s historical experience and not fact. A reduction of prices or unforeseen costs could yield a different percentage and make the gross profit percentage found in the calculation incorrect.

Also, if the long-term rate of losses due to theft, obsolescence, or any other causes are not recognized in the historical gross profit percentage, then the ending inventory will probably be an inaccurate estimation.

This calculation is applicable if the company – like Madison’s jewelry shop – is a retailer that simply trades in buying and reselling merchandise. But if a business manufactures its own goods then components of the inventory would need to include labor and overhead costs, making the gross profit method too basic to produce reliable results.

Overall, any inventory estimation technique should only be used for short periods of time. A well-run cycle counting program is a better method for routinely keeping inventory record accuracy at a high level. On the other hand, a physical inventory could be counted at the end of each reporting period manually.

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The gross profit method of estimating ending inventory assumes that the percentage of gross profit on sales remains approximately the same from period to period. Therefore, if the gross profit percentage is known, the dollar amount of ending inventory can be estimated. First, gross profit is estimated by applying the gross profit percentage to sales. From this, cost of goods sold can be derived, namely the difference between sales and gross profit. Cost of goods available for sale can be determined from the accounting records (opening inventory + purchases). The difference between cost of goods available for sale and cost of goods sold is the estimated value of ending inventory.

To demonstrate, assume that Pete’s Products Ltd. has an average gross profit percentage of 40%. If opening inventory at January 1, 2019 was $200, sales for the six months ended June 30, 2019 were $2,000, and inventory purchased during the six months ended June 30, 2019 was $1,100, the cost of goods sold and ending inventory can be estimated as follows.

The estimated ending inventory at June 30 must be $100—the difference between the cost of goods available for sale and cost of goods sold.

The gross profit method of estimating inventory is useful in situations when goods have been stolen or destroyed by fire or when it is not cost-effective to make a physical inventory count.

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Why would a company use the gross profit method to estimate ending inventory?

What is the gross profit method of estimating inventory?

Which of the following is an important limitation of the gross profit method?