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The Gross Profit Method for Estimated Ending Inventory Most companies would like to prepare interim financial statements such as monthly, quarterly or semiannually. Physical count inventory is made at the end of year. For this reason the companies use some methods to calculate its ending inventory, one of these methods called "The Gross Profit Method". The Gross Profit Method (sometimes called "the Gross Margin Method") means "a way to estimate the value of ending inventory on the base of percentage of gross profit"; therefore, companies must determine the percentage of gross profit at the end of year after preparing the financial statements. The percentage of gross profit is calculated as follows: Whether as a percentage of sales or net sales: The gross profit percentage = gross profit /sales Or, a percentage of cost of goods sold or cost of sales: The gross profit percentage = gross profit / cost of goods sold To compute the ending inventory by the Gross Profit Method, there are five steps: 1. To determine the gross profit rate whether as a percentage of sales or a percentage of cost (cost of goods sold ) , if the percentage was of cost , you must convert this percentage to a percentage of sales because the cost of goods sold is variable , convert the percentage from cost to sales as follows : Gross profit on sales =percentage markup on cost / (100% + percentage markup on cost). For example if the % was 25% of cost, to convert this percentage from cost to sales as follows: Gross Profit on sales =0.25/ (1+0.25) ×100=20%. Note: The computed gross profit of sales must equal the computed gross profit of cost. To illustrate this problem assume the following information that related to XY Company:- Beginning Inventory $20,000; Purchases $160,000; Sales $190,000 and Gross Profit percentage 25% of cost. Solution:- Gross Profit on sales =0.25/ (1+0.25) ×100=20%. Gross Profit =$190,000 *20% = $38,000 Cost of goods sold =$190,000-38,000= $152,000 Gross Profit on Cost = $152,000*25%= $38,000 2. Compute the Total cost of goods available for sale. The cost of goods available for sales consist of Beginning Inventory + Net Purchases + Fright in ; (Net Purchases = Purchases –Discount , Returns & Allowances Purchases) 3. Compute the estimated Gross profit by multiplying Sales ×Gross Profit percentage. 4. Compute the cost of goods sold by subtracting the Computed Gross Profit from Sales. 5. Compute ending inventory by subtracting the computed cost of goods sold from cost of goods available for sale. To illustrate that ,assume the following information:- Beginning Inventory $30,000;Net Purchases 120,000; Net Sales 185,000; Fright in 25,000; Gross Profit 30% of sales . Compute ending inventory? Solution: 1. The percentage of Gross Profit is 30% of sales revenues. 2. Cost of Goods available for sales =$30,000+120,000+25,000=$175,000 3. The estimated Gross Profit =$185,000*30%=$55,500 4. Cost of Goods Sold = $185,000-55,500=$129,500 ,or $185,000*70%=$129,500 5. Ending Inventory =$175,000-129,500= $45,500 Uses of Gross Profit Method: Gross profit method is used in both commercial and manufacturing companies; the gross profit method is used: 1. To test the reasonability of an inventory valuation determined by some other means, such as a physical inventory count or from perpetual inventory records. For example, assume the company submits to an auditor an ending inventory valuation of $ 10,000 .The Gross profit method provides an approximation of $ 7,000 which suggests that the ending inventory may be overvalue and should be examined. 2. To estimate the ending inventory for interim financial reports or internal reports prepared during the year when it is impractical to count the inventory physically and perpetual inventory system is not used. 3. To estimate the cost of inventory destroyed by an accident, such as fire or storm. Valuation of inventory lost is necessary to account for the accident and to establish basis for insurance claims and income taxes. 4. To develop budget estimates of cost of goods sold, gross profit and inventory consistent with sales revenues budget. Evaluation of Gross Profit Method:- The gross profit method is not normally accepted for financial reporting purposes because it provides only an estimate. A physical inventory needs an additional verification that the inventory indicated in the records is actually on hand. Therefore the disadvantages of gross profit method are as follows: 1. It depends on determine gross profit on past percentages ,on other hand it uses the past percentage on determining the gross profit and neglects any changes happen on the current period. This procedure is not correct because this percentage does not reflect the actual changes of the current or future period. Therefore the past percentages should be adjusted to reflect the actual changes. 2. This method provides just an estimate. This procedure doesn't normally acceptable for external financial reporting purposes. 3. The gross profit rate may vary widely on different types of inventory. Most companies carry a number of different types of merchandise; each one has different gross profit rates. Changes in the relative quantities of each types of merchandise sold affect the reliability of the gross profit results. Solved Problems P 1) Reese Co. prepares monthly income statements. Inventory is counted only at year end; thus, month-end inventories must be estimated. All sales are made on account. The rate of mark-up on cost is 20%. The following information relates to the month of May. Accounts receivable, May 1 $21,000 Accounts receivable, May 31 27,000 Collections of accounts during May 90,000 Inventory, May 1 45,000 Purchases during May 58,000 Instructions Calculate the estimated cost of the inventory on May 31. Solution 9-108 Collections of accounts $ 90,000 Add accounts receivable, May 31 27,000 Deduct accounts receivable, May 1 (21,000) Sales during May $ 96,000 Inventory, May 1 $ 45,000 Purchases during May 58,000 Goods available 103,000 Cost of sales ($96,000 ÷ 120%) (80,000) Estimated cost of inventory, May 31 $ 23,000 P2). On December 31, 2007 Carr Company's inventory burned. Sales and purchases for the year had been $1,400,000 and $980,000, respectively. The beginning inventory (Jan. 1, 2007) was $170,000; in the past Carr's gross profit has averaged 40% of selling price. Instructions Compute the estimated cost of inventory burned, and give entries as of December 31, 2007 to close merchandise accounts. Solution 9-110 Beginning inventory $ 170,000 Add: Purchases 980,000 Cost of goods available 1,150,000 Sales $1,400,000 Less 40% (560,000) 840,000 Estimated inventory lost $ 310,000 Sales.............................................................................. 1,400 000 Income Summary................................................. 1,400,000 Cost of Goods Sold....................................................... 840,000 Fire Loss....................................................................... 310,000 Inventory.............................................................. 170,000 Purchases............................................................. 980,000 ************** The_Gross_Profit_Method_for_Estimated_Ending_Inventory.doc