Small business owners can avoid frequent inventory counts and save time by using the gross profit method to estimate inventory. The gross profit method is the easiest inventory estimation technique wherein the company uses historical gross profit rates to determine cost of goods sold (COGS) and estimate ending inventory. By assuming a constant gross profit margin, you can convert actual sales to estimated COGS, which can then be used to estimate ending inventory.
Use our free gross profit method calculator below to compute your estimated ending inventory:
Gross Profit Method Calculator
Gross Profit Method Formula
The core formula in the gross profit method is the COGS formula. But instead of determining COGS, we will estimate it based on historical gross profit rate. Take a look at the example below:
| Sales | 100% |
|---|---|
| Cost of goods sold | ? |
| Gross profit | 40% |
In our example, our gross profit rate is 40%. To arrive at this figure, our COGS should be 60% (100% – 40%). Therefore, we derive COGS based on the historical gross profit rate without determining ending inventory. For instance, if our actual sales figure is $100, then we can estimate that our COGS is $60.
We can then calculate estimated ending inventory by applying estimated COGS to actual purchases and beginning inventory.
| Beginning inventoryPurchases or Production | xxxxxx |
|---|---|
| Cost of goods available for saleLess: Estimated COGS | xxxxxx |
| Estimated ending inventory | xxx |
Gross Profit Method Example
Let’s assume the following information:
- Beginning inventory: $100
- Net purchases: $3,000
- Historical gross profit rate: 40% of sales
- Net sales: $3,400
Since the gross profit rate is 40% of sales, we derive COGS as 60% of sales.
| Beginning inventoryPurchases or Production | $100$3,000 |
|---|---|
| Cost of goods available for saleLess: Estimated COGS ($3,400 x 60%) | $3,100($2,040) |
| Estimated ending inventory | $1,060 |
If gross profit rates don’t change significantly, the actual ending inventory cost must be near the estimated cost of $1,060.
When To Use and Who Is It Best For
ADVANTAGES | DISADVANTAGES |
|---|---|
|
|
- Businesses using a periodic inventory system: Periodic inventory systems require an ending inventory valuation to calculate COGS. The gross profit method provides an easy way to estimate inventory value during the middle of year purposes.
- Businesses with a little workforce: Counting inventory takes time and effort. It’s inefficient to count inventory every month, especially if the business has a limited workforce. Using the gross profit method is more convenient because it only requires short and easy calculations to determine estimated ending inventory.
- Businesses with a stable gross profit margin: The gross profit method can report the best estimate of ending inventory if the business has a stable gross profit margin. Hence, we also don’t recommend this method if gross margins change frequently during the year.
- Businesses with high volumes of small inventory items: If you sell small items and stock them in bulk, counting these inventory items is inefficient, even if you have a sufficient workforce. It’s best to use the gross profit method to estimate ending inventory then perform periodic inventory counts at the middle or end of the year.
Gross Profit Method vs Normal Periodic Method
The gross profit method is an alternative to the normal periodic method that is available for midyear reporting, with the major advantage of eliminating the need for a physical inventory count. However, you’ll still have to perform a physical count at the end of the year and adjust your mid-year estimates to the actuals determined under the normal periodic method.
| Gross Profit Method | Normal Periodic Method | |
|---|---|---|
| Best for Businesses With | High volumes of small inventory items | Low volumes of inventory |
| Cost of Inventory | Estimated amount | Actual cost |
| Way of Determining Inventory Cost | Based on historical gross profit rate to derive COGS and ending inventory | Cost flow assumption, such as last-in, first out (LIFO), first-in, first-out (FIFO), or average cost |
| Measurement of Inventory | Based on derived amounts | Actual cost based on physical count and cost flow assumption |
| Physical Count | Not required | Required |
Alternatives to the Gross Profit Method
The major disadvantage of the gross profit method is its reliance on historical data in using estimations. Since historical data doesn’t necessarily reflect current period conditions, you might want to consider gross profit method alternatives in determining ending inventory.
Using the perpetual inventory system is by far the most comprehensive and accurate method of tracking inventory. It eliminates the need for estimation and keeps inventory data updated for every purchase and sale.
However, the perpetual system requires the use of special software designed to track inventory from purchase requisitions to delivery and ultimately when it is sold to customers. Read our article on perpetual vs periodic inventory to learn the advantages and disadvantages of each system.
The retail method is an estimation technique, just like the gross profit method. However, the former is more sophisticated because it uses cost and retail data to determine the estimated ending inventory. It is best for large retailers that store inventory in warehouses.
Moreover, retailers with inventory stored in multiple locations will benefit from the retail method in determining ending inventory. For a detailed discussion of this method, read our article on retail accounting. It includes a free calculator for figuring your estimated ending inventory at cost.
The best way to determine ending inventory is to count it. However, physical counts pause business operations and add more work to employees. A regular physical inventory count is only feasible if the inventory can be counted easily. Such inventory is usually high-value items, such as jewelry, consumer appliances, and luxury apparel. But if you hold large quantities of inventory, a physical count is inefficient, and using either the retail or gross profit method is highly recommended.
Frequently Asked Questions (FAQs)
Why is the gross profit method used?
For ease of computation, the gross profit method is a quick solution for determining COGS and ending inventory for interim reporting. Since interim reports are usually for internal use, it is acceptable to use this method.
What is the gross profit formula?
The gross profit formula is: Sales – Cost of Goods Sold = Gross Profit
Bottom Line
The gross profit method is a convenient and easy way to estimate ending inventory. As an easier alternative to the retail method, the gross profit method has limitations in use due to the use of historical gross profit rates in estimation. However, it is still an acceptable method when making interim reports for internal use.
