Differences Between Using the Gross Profit Method & Retail Inventory Method
A physical count of inventory is expensive and not always possible. It is usually done once at the end of the fiscal year. However, interim reports usually require an inventory estimate, and fire or water damage may also require an inventory estimate for insurance claims. The two common ways to estimate inventory levels in a periodic inventory system are the gross profit method and the retail inventory method.
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Facts
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The gross profit method estimates the inventory value by using the company's historical gross profit margin, which is the gross profit expressed as a percentage of sales. Gross profit equals sales minus cost of goods. The retail inventory method is often used by retail businesses who determine monthly gross profits but do one annual physical inventory count. It uses current period cost-to-retail ratios -- ratio of cost to retail value -- to estimate the ending inventory at cost. It also produces estimates of ending inventory and actual physical inventory at retail prices, thus possibly helping identify inventory shortages resulting from theft or other causes.
Calculation
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The gross profit method uses the historical gross profit margin to estimate the inventory. It assumes that items not sold remain in inventory. For example, if a company's historical gross profit margin is 20 percent and it has sales of $500,000 in a period, then the cost of goods sold equals $400,000: $500,000 x (1.00 - 0.20). If the physical inventory at the start of the period is $200,000 and purchases of $250,000 occurred during the period, then the ending inventory using the gross profit method equals $50,000 (200,000 + 250,000 - 400,000).
The retail method tracks the cost and retail prices of inventory and uses the cost-to-retail ratio to get the ending inventory at cost. For example, if the cost and retail sales values of beginning inventory are $25,000 and $40,000 and that of purchases are $10,000 and $20,000 respectively, then the cost and retail values of goods available for sale are $35,000 (25,000 + 10,000) and $60,000 (40,000 + 20,000) respectively. The cost-to-retail ratio of the goods available for sale, expressed as a percentage, is about 58.3 percent: 100 x (35,000 / 60,000). If retail sales are $45,000 for the period, then the estimated retail value of the ending inventory balance is $15,000 (60,000 - 45,000) and the cost value is $8,745 ($15,000 x 0.583).
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Historical Vs. Current
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The gross profit method uses historical gross profit rates and the retail method uses data from the current period. This means that the retail method is more likely to capture changes in the external environment -- for example, changing market prices, increased competition and changing customer preferences -- than the gross profit method.
Considerations
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The gross profit and retail methods of estimating inventory are not substitutes for a physical count. Because both methods apply global averages to inventory valuation, ending inventory estimates may be inaccurate if the company sells products that have higher or lower profits than the average.
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References
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