The financial accounting term gross profit method refers to an approach to valuing ending inventory which is based on an assumption the gross profit ratio on the items held in inventory remains consistent from one accounting period to the next.
While larger companies may have sophisticated electronic systems that track items held in inventory, smaller companies may not be able to afford such systems. Instead, these companies rely on physical counts of items, which can be burdensome. Companies may elect to conduct these physical inventories only at year end due to their cost.
The gross profit method allows these companies to estimate the value of their inventories each accounting period. This method assumes the gross profit per item remains fairly consistent throughout the year.
Companies can verify the accuracy of the gross profit method by comparing the result of their estimate with those obtained during the year end physical inventory.
Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet. Inventory errors also have an effect on net income. For example, if the beginning inventory is understated, net income in that period will be overstated.
Company A's inventory on January 1 was $175,000. Additions during the first quarter of the year were $72,500. Company A's revenues in the first quarter were $125,000 and the historical gross profit margin for this product is 40%. The inventory at the end of the first quarter would be:
|Cost of Goods Available for Sale||$247,500|
|Less: Estimated COGS (60% of $125,000)||$75,000|