Gross profit method

From Wikicpa

The basic purpose in taking a physical inventory is to verify the accuracy of the inventory records or, if no records exist, to arrive at an inventory amount. Sometimes substitute measures are used to arrive at the same answer. One substitute method of verifying or detergmining the inventory amount is called the gross profit method. This method is widely used by auditors in situations where only an estimate of the amount of the company’s inventory is needed (for example, for determining monthly or quarterly inventory amounts) or where both inventory and inventory records have been destroyed.

The gross profit method is based on the assumptions that:

• The beginning inventory plus purchases equal total goods to be accounted for;
• The goods not sold must be on hand;
• If the sales, reduced to cost, are deducted from the sum of the opening inventory plus purchases, the result is the goods on hand or, in other words, the inventory.

Illustration

To illustrate, assume that a department has a beginning inventory of $160,000 and purchases of $300,000, both at cost. Sales at selling price amount to $480,000. The average rate of gross margin on selling price for that department is 30%. The gross profit method is applied as follows:

Beginning inventory, at cost			$160,000
Purchases, at cost			$300,000
Good available, at cost			$460,000
Sales, at selling price		$ 480,000
Less gross margin ($480,000 x 30%)		$(144,000)
Sales, at cost			$336,000
Estimated inventory, at cost			$124,000

When the inventory is approximated by this method, care must be taken in applying a blanket rate of gross margin. Frequently a store or department handles merchandise with widely varying rates of gross margin. In these situations the gross profit method may have to be applied by subsections, lines of merchandise, or a similar basis that classifies merchandise according to rates of gross margin.

The gross profit method is not normally acceptable for financial reporting purposes, because it is only an estimate, and a physical inventory is needed as additional verification that the inventory indicated in the records is on hand. The gross profit method also uses past percentages for determination of the markup, and although the past can often provide answers to the future, a current rate is more appropriate. The gross profit percentage is an average rate, and whenever several different items are sold, it is best to make separate gross profit calculations for each line of items. If a composite approach is used, a change in the quantity of one line relative to another, or a change in the markup of one line could lead to an inaccurate final inventory value.