Browse Accounting Lessons Here Accounting Terms & Definitions Accounting for Merchandising Activities Debits and Credits (Double Entry Accounting) Business Valuation Formulas Time Value of Money & Present/Future Values Complex Debt & Equity Instruments Common Stock & Shareholder's Equity Accounting & Finance Ratios Valuing Common Stock Corporate Income Taxes Lower of Cost or Market (LCM) & Inventory Valuation Chart of Accounts & Bookkeeping Bonds Payable & Long Term Liabilities Capital Assets GAAP, Accrual & Cash Accounting, Information Commodity, Internal Controls & Materiality What category of browser are you on this website? Accounting student (homework help) Finance professor (university research) Accounting manager (at work) Other Explore Careers in Accounting and Finance Visit our section on Careers in Accounting & Finance to explore vast opportunities in this industry.

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

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:

 i) The beginning inventory + purchases = the cost of goods available for sale that must be accounted for: ii) Goods not sold must be on hand in ending inventory (logically) iii) When net sales (reduced to cost) are deducted from cost of goods available for sale, the result is net ending inventory.

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:

 Beginning inventory at cost \$80,000 Purchases at cost \$300,000 Goods available for sale (cost) \$380,000 Sales (at selling price) \$400,000 Less: Gross profit (30% x \$400,000) (\$120,000) Sales at Cost (Estimated Cost of Goods Sold (\$280,000) Estimated Ending Inventory (at cost) \$100,000

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.