Definition of "Gross Profit Accounting"
Gross profit accounting is one of the methods that provide an estimate of the value of a company's inventory. Alternative methods include the retail inventory method, which uses store price markups to estimate profit, and the actual pricing method, an actual count of each item that the company owns. Gross profit accounting is so called because the company can calculate the average gross profit that it makes compared to its total revenue, and use this ratio to estimate its cost of goods sold.
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Time Frame
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Gross profit accounting requires the company to have sales and profit information going back several years. For example, if the company received $50 million of revenue in the last five years, but its cost to produce its inventory was $30 million, the company has a gross profit of $20 million. The company then predicts that if it makes $55 million this year, its cost to produce the inventory should increase by the same proportion, giving it a cost of goods sold of $33 million and a gross profit of $22 million.
Comparability
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Gross profit accounting provides an estimate, so the company should only use it if the financial data it has from earlier years are comparable to the expected revenue and expenses this year. It is reasonable to expect that an increase of 10 percent in sales will produce about a 10 percent increase in manufacturing costs, but if sales increase by 100 percent, a gross profit accounting estimate may be inaccurate.
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Benefits
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Convenience and cost are the main reasons to use the gross profit accounting method. The company does not have to hire an employee to physically go and count every product in the warehouse. The company can even use the gross profit accounting method if a disaster, such as a fire or a flood, destroys its inventory records.
Warning
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When a company uses the gross profit method to estimate the value of its inventory, it still has to have an employee count the individual items periodically to confirm the accuracy of the estimate. According to the Securities and Exchange Commission, a company cannot use the gross profit method on a financial report if a physical count of products at one location shows that the gross profit method will estimate that the company owns many more products than the company's count reports.
Reporting
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Some companies use the gross profit method to estimate inventory each quarter, and then perform a full physical count of the inventory once a year when they release their yearly financial statements. According to the Securities and Exchange Commission, a company must estimate the specific quantity of each product it owns when it uses the gross profit method to produce a quarterly report. The gross profit method only gives the overall inventory value; it doesn't estimate the number of individual products of each type that the company owns.
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