Gross Profit Inventory Method
Companies need to have an estimate of ending inventory at the end of each accounting period. The gross profit method is a tool to estimate ending inventory that can greatly reduce the time and effort required to produce an ending inventory figure. This method is useful when a company cannot conduct a physical count of the firm's inventory. Historical financial information is used to estimate profit margins which are then applied to estimate inventory.
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Estimate the Gross Profit Percentage
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Companies can mine historical data to estimate the firm's gross profit percentage. An accountant could search through the last few years of financial records and compare sales dollars against the costs of goods sold. The sales subtracted by the costs leaves a gross margin. This figure divided by sales equals the gross margin percentage. For example, if sales were $1,000,000 in 2009 and costs of goods sold were $700,000 the same year, the gross margin would be $300,000. The gross margin divided by $1,000,000 is 30 percent; this is the gross profit percentage.
Multiply the Gross Profit Percentage to Sales to Estimate Costs
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After calculating the gross profit percentage based on historical performance, this figure can be used to project costs of sales. An accountant would multiply the current sales figure by the estimated gross profit percentage to get an estimated cost of goods sold. For example, if the gross profit percentage based on historical data is 30 percent, and sales for the current year are $2,000,000, then the estimated cost of goods sold is $600,000. A spreadsheet can be useful for this task because the information can be saved and also quickly updated in the future.
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Subtract the Cost Estimate From Cost of Goods Available to Calculate Estimated Ending Inventory
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The cost of goods sold estimate is deducted from the cost of goods available for sale to create an estimated inventory level. For example, if the cost of goods sold is $600,000 and the costs of goods available for sale is $4,000,000 then the estimated inventory equals $3,400,000. While this is not the actual inventory level, the value is a safe, logical estimate based on historical trends. A good estimate can provide enough information for managers to make decisions.
Tips and Tricks
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Profit margins are often stable, but an accountant must make sure estimated values are reliable. If a company's sales mix has dramatically changed or if the raw materials or labor costs have significantly changed, then relying on historical ratios will yield inaccurate estimates. In addition, a company should have a rule to automatically check the historical data when there are large swings in profit margins, to ensure accuracy.
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