Gross profit method of estimating inventory

Gross profit method of estimating inventory uses the historical gross profit margin ratio to estimate the cost of goods sold. Opening balance of inventory is the previous period’s closing balance of inventory and purchases are available from the company’s records (such as purchase ledger). Opening inventory, purchases and estimated cost of goods sold are inserted in the following formula of cost of goods sold to work out the closing inventory.

  USD
Opening inventory balance xxx
Add: Purchases xxx
Total inventory balance available xxx
Less: Closing inventory balance ??
Cost of goods sold xxx

 

Let’s take a look at the following example to understand the gross profit method of estimating inventory.

Example – Gross profit method of estimating inventory

ABC Company is preparing quarterly financial statement for the three months ended 31 March 20X1. As the company uses periodic system of inventory record keeping and stock counting is done only at year end, it needs to estimate closing inventory. Relevant information extracted from the financial statements for the year ended 31 December 20X0 is given below:

  • Sales revenue of $200,000
  • Cost of goods sold of $150,000
  • Gross profit of $50,000
  • Closing inventory of $30,000

Following additional information related to the current quarter is available from the company’s records:

  • Sales made during the current quarter of $65,000
  • Purchases made during the quarter of $60,000
  • There is no significant change in operations from last year, so the gross profit margin of last year is a reasonable estimate of the gross profit margin of current quarter.

Estimate the closing inventory on 31 March 20X1.

Answer

The company’s gross profit margin of last year is 25% (50,000/200,000 x 100). Using this gross profit margin, we can work out the cost of goods sold.

Sales during the quarter = $65,000

Gross profit @25%          = $16,250

Cost of goods sold           = $65,000 – $16,250 = $48,750

Alternatively, cost of goods sold can also be calculated by multiplying 75% with sales, i.e. 75% x $65,000 = $48,750.

Now, let’s insert the estimated cost of goods sold, opening inventory and purchases in the below formula:

  USD
Opening inventory balance 30,000
Add: Purchases 60,000
Total inventory balance available 90,000
Less: Closing inventory balance ??
Cost of goods sold 48,750

 

Cost of goods sold = Total inventory available – Closing inventory

Closing inventory  = Total inventory available – Cost of goods sold

Closing inventory  = $90,000 – $48,750

Closing inventory  = $41,250