The gross profit method of estimating inventory is a method of calculating the ending inventory of a business in the absence of a physical inventory count at the end of an accounting period.
It is similar to the retail inventory method, and is sometimes referred to as the gross margin method.
Gross Profit Method Process
The gross profit method involves the following for steps.
- Calculate the historical gross profit percentage
- Calculate the cost of goods available for sale
- Estimate the cost of goods sold
- Calculate the ending inventory
Gross Profit Method Example
By applying these four steps an estimate of the cost of the ending inventory can be arrived at as follows:
Calculate the Historical Gross Profit Percentage
The gross profit percentage, sometimes referred to as the gross margin, is calculated using the following formula.
Gross profit % = Gross profit / RevenueFor example, suppose the historical accounts of a business show revenue of 120,000 and a gross profit of 72,000, then the gross profit percentage is given as follows:
Gross profit % = Gross profit / Revenue Gross profit % = 72,000 / 120,000 Gross profit % = 60%Calculate the Cost of Goods Available for Sale
The cost of goods available for sale is the beginning inventory plus any goods purchased during the accounting period.
Goods available for sale = Beginning inventory + PurchasesFor example, if the beginning inventory is 18,000, and the purchases during the period are 65,000, then the cost of goods available for sale is as follows:
Goods available for sale = Beginning inventory + Purchases Goods available for sale = 18,000 + 65,000 Goods available for sale = 83,000All the amounts used in this step are at cost.
Estimate the Cost of Goods Sold
The cost of goods sold can now be calculated by applying the gross profit percentage to the revenue for the period using the following formula:
Cost of goods sold = Revenue x (1 - Gross profit %)In our example, suppose the revenue for the accounting period was 150,000, with an estimated 60% gross profit percentage, the cost of goods sold is estimated as follows:
Cost of goods sold = Revenue x (1 - Gross profit %) Cost of goods sold = 150,000 x (1 - 60%) Cost of goods sold = 60,000Calculate the Ending Inventory at Cost
Finally, the ending inventory at cost can be estimated using the following formula:
Ending inventory = Cost of goods available for sale - Cost of goods soldIn our example, the ending inventory at cost is calculated as follows:
Ending inventory = Cost of goods available for sale - Cost of goods sold Ending inventory = 83,000 - 60,000 Ending inventory = 23,000The four steps used in the gross profit method are summarized in the table below.
Gross profit method example summary1. Calculate Historical Gross Profit %Revenue120,000Gross profit72,000Gross profit %60%2. Calculate Goods Available for SaleBeginning inventory18,000Purchases65,000Available for sale83,0003. Estimate Cost of Goods SoldRevenue150,000Gross profit %60%Cost of goods sold60,0004. Calculate Ending InventoryAvailable for sale83,000Cost of goods sold60,000Ending inventory23,000
Our gross profits method calculator is useful for estimating the ending inventory using the four steps described above.
Gross Profit Method Formula
Combining the four steps above results in the gross profit method formula which can be stated as follows:
Using the data from the previous example and the gross profit method formula, the ending inventory is calculated as follows:
Ending inventory = Beginning inventory + Purchases - Revenue x (1 - Gross profit %) Ending inventory = 18,000 + 65,000 - 150,000 x (1 - 60%) Ending inventory = 23,000Despite its apparent accuracy, the method relies on an estimated gross margin percentage based on historical information and assumes it will be the same in the following accounting periods. Any significant shift in the type of ending inventory and its gross margin percentage will cause inaccuracies in the calculation. While suitable for monthly management accounts, the profit method is generally not appropriate for use in the year-end financial statements, when a full physical inventory count should be carried out.
Last modified November 19th, 2019 by Michael Brown
About the Author
Chartered accountant is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.