Definition
The financial accounting term gross profit method refers to an approach to valuing ending inventory which is based on an assumption the gross profit ratio on the items held in inventory remains consistent from one accounting period to the next.
Explanation
While larger companies may have sophisticated electronic systems that track items held in inventory, smaller companies may not be able to afford such systems. Instead, these companies rely on physical counts of items, which can be burdensome. Companies may elect to conduct these physical inventories only at year end due to their cost.
The gross profit method allows these companies to estimate the value of their inventories each accounting period. This method assumes the gross profit per item remains fairly consistent throughout the year.
Companies can verify the accuracy of the gross profit method by comparing the result of their estimate with those obtained during the year end physical inventory.
Accurate inventory valuation will ensure the proper reporting of assets on the company's balance sheet. Inventory errors also have an effect on net income. For example, if the beginning inventory is understated, net income in that period will be overstated.
Example
Company A's inventory on January 1 was $175,000. Additions during the first quarter of the year were $72,500. Company A's revenues in the first quarter were $125,000 and the historical gross profit margin for this product is 40%. The inventory at the end of the first quarter would be:
Beginning Inventory | $175,000 |
Net Additions | $72,500 |
Cost of Goods Available for Sale | $247,500 |
Less: Estimated COGS (60% of $125,000) | $75,000 |
Ending Inventory | $172,500 |
Related Terms
The financial accounting term inventory is used to describe the balance sheet line item that includes the value of raw materials, work in process, finished goods ready for sale, and returned goods that can be resold.
Moneyzine EditorJanuary 22nd, 2024
The financial accounting term gross profit is used to describe a subtotal line item appearing on the income statement. Gross profit is the money left over after the cost of goods sold (COGS) is subtracted from revenues.Moneyzine EditorJanuary 19th, 2024
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The financial accounting term first-in, first-out refers to one of several approaches to inventory valuation. The first-in, first-out method assumes the oldest items held in inventory are the first items to be sold when determining the value of inventory appearing on a company's balance sheet.Moneyzine EditorJanuary 18th, 2024
The financial accounting term last-in, first-out refers to one of several acceptable approaches to inventory valuation. The last-in, first-out method assumes the newest items held in inventory are the first items to be sold when determining the value of this asset as it appears on a company's balance sheet.Moneyzine EditorJanuary 23rd, 2024
The financial accounting term lower of cost or market refers to an inventory valuation rule that states items should be valued at their original cost or their current market cost, whichever is lower.Moneyzine EditorJanuary 24th, 2024- The financial accounting term retail method refers to an approach to valuing inventory in a retail business setting. The retail method assumes the relationship between the cost of goods in stores and their retail price is consistent in the current period.Moneyzine EditorSeptember 21st, 2023
The gross profit index is an operating performance measure that allows analysts to understand if the gross profit margin is changing significantly over time. When the gross profit index varies considerably from 1.0, it may indicate irregularities in the reporting of profits.Moneyzine EditorJanuary 19th, 2024
