Which of the following is not a basic assumption of the gross profit method?

The gross profit method estimates the amount of ending inventory in a reporting period. This is of use for interim periods between physical inventory counts. It is also useful when inventory was destroyed and you need to estimate the ending inventory balance for the purpose of filing a claim for insurance reimbursement. The gross profit method is not an acceptable method for determining the year-end inventory balance, since it only estimates what the ending inventory balance may be. It is not sufficiently precise to be reliable for audited financial statements.

How to Use the Gross Profit Method

Follow these steps to estimate ending inventory using the gross profit method:

1. Add together the cost of beginning inventory and the cost of purchases during the period to arrive at the cost of goods available for sale.

2. Multiply (1 - expected gross profit %) by sales during the period to arrive at the estimated cost of goods sold.

3. Subtract the estimated cost of goods sold (step #2) from the cost of goods available for sale (step #1) to arrive at the ending inventory.

In addition, it is useful to compare the resulting cost of goods sold as a percentage of sales to the recent trend line for the same percentage, to see if the outcome is reasonable.

Example of the Gross Profit Method

Amalgamated Scientific Corporation (ASC) is calculating its month-end inventory for March. Its beginning inventory was $175,000 and its purchases during the month were $225,000. Thus, its cost of goods available for sale are:

$175,000 beginning inventory + $225,000 purchases = $400,000 cost of goods available for sale

ASC's gross margin percentage for all of the past 12 months was 35%, which is considered a reliable long-term margin. Its sales during March were $500,000. Thus, its estimated cost of goods sold is:

(1 - 35%) x $500,000 = $325,000 cost of goods sold

By subtracting the estimated cost of goods sold from the cost of goods available for sale, ASC arrives at an estimated ending inventory balance of $75,000.

Problems with the Gross Profit Method

There are several issues with the gross profit method that make it unreliable as the sole method for determining the value of inventory over the long term, which are noted below.

Historical Basis Could Be Incorrect

The gross profit percentage is a key component of the calculation, but the percentage is based on a company's historical experience. If the current situation yields a different percentage (as may be caused by a special sale at reduced prices), then the gross profit percentage used in the calculation will be incorrect.

Assumes Inclusion of Inventory Losses

The calculation assumes that the long-term rate of losses due to theft, obsolescence, and other causes is included in the historical gross profit percentage. If not, or if these losses have not previously been recognized, then the calculation will likely result in an inaccurate estimated ending inventory (and probably one that is too high).

Limited Applicability

The calculation is most useful in retail situations where a company is simply buying and reselling merchandise. If a company is instead manufacturing goods, then the components of inventory must also include labor and overhead, which make the gross profit method too simplistic to yield reliable results.

Short-Term Usage Period

In general, any inventory estimation technique is only to be used for short periods of time. A well-run cycle counting program is a superior method for routinely keeping inventory record accuracy at a high level. Alternatively, conduct a physical inventory count at the end of each reporting period.

Merchandising and manufacturing companies generate revenue and earn profits by selling inventory. For such companies, inventory forms an important asset on their company balance sheet.

Merchandisers, including wholesalers and retailers, account for only one type of inventory, that is, finished goods as they purchase the ready for sale inventory from manufacturers.

On the other hand, manufacturers first purchase raw materials from suppliers and then transform these raw materials into finished goods. Therefore, manufacturers classify inventory into three categories: raw materials, work-in-progress, and finished goods Work-in-progress inventory is nothing but the inventory that is still under process and is not yet converted into finished goods to be sold to customers.

Now, in order to record the cost of inventories in the books of accounts, manufacturers can either record the amounts of raw materials, work-in-progress and finished goods separately on the balance sheet or simply showcase the total inventory amount.

Therefore, we can say that inventories and cost of goods sold form an important part of the basic financial statements of many companies.

International Financial Reporting Standards (IFRS) has stipulated three cost formulas to allow for inter-company comparisons. These include Specific Identification, First-In-First-Out (FIFO), and Weighted Average Cost Methods.

Thus, the type of method used by a company to value its inventory has an impact on its ending inventory and cost of sales. So in this article, let us try to understand what is the Cost of Goods Sold, COGS Formula, and different Inventory Valuation Methods.

Which of the following is a basic assumption of the gross profit method?

Which statement is true about the gross profit method?

When should the gross profit method of inventory valuation not be used because it is invalid?

In which of the following instances would the use of gross profit method in estimating inventory be not useful?