Question

Describe the gross profit method of estimating ending inventory values.

a) Provide an overview of the process used to estimate ending inventory.

b) List the three assumptions on which the method relies.

c) Given a firm that has $1,000,000 in sales; purchases $750,000 of items for resale; has a beginning inventory of $215,000; and a gross profit percentage of 27% calculate ending inventory and cost of goods sold.

d) Given a firm has gross profit on selling price of 37%, what is their percentage markup on cost?

e) Given a firm has a percentage markup on cost of 28%, what is the gross profit percentage on selling price.

f) Describe the major disadvantages of the gross profit method.

g) Given the disadvantages, why and when is it used?

Answer 1

Answer to (a)

Overview of process of gross profit method for valuation of inventory :

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.

Answer to (b)

Three assumptions are

1.The beginning inventory + purchases = the cost of goods available for sale that must be accounted for

2. Goods not sold must be on hand in ending inventory (logically)

3. When net sales (reduced to cost) are deducted from cost of goods available for sale, the result is net ending inventory

Answer to (c)

cost of goods available for sale = value of opening inventory + value of purchases

= $215000+$750000

=$965000

Cost of goods sold= sales * (1- gross profit ratio)

=$1000000*(1-0.27)

=$730,000

Value of ending inventory = $965,000-$730,000

=$235,000

Answer to (d)

Gross profit on sales = 37% of $1,000,000=$370,000

Markup on cost =$370,000/$730000=50.685%

Answer to (e)

Markup on cost = 28% of $730,000=$204,400

Gross profit on sales = $204,400/$1,000,000= 20.44%

Answer to (f)

disadvantage of gross profit method are as follows

Historical basis. 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.

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).

Answer to (g)

considering the disadvantages this method is used 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.