Regardless of the cost flow assumption or valuation method a company uses to record inventory on the balance sheet, the company must take a physical inventory. The regularity of this physical inventory varies based on company policy and the type of business.
However, sometimes it’s just not feasible to take a physical inventory. After all, closing down a mom-and-pop grocery store every time a set of financial statements is prepared to take a count of inventory will have a strong negative impact on sales. To work around this problem, companies use methods to come up with as good a guess as possible to approximate actual inventory.
One estimation method that’s pretty easy to use is the gross profit method. Now, you know what gross profit is, right? It’s the difference between net sales and cost of goods sold (COGS). Putting this in very basic terms with round numbers, if net sales are $100,000 and COGS is $75,000, gross profit is $25,000 and, stated as a percentage of selling price, the gross profit percentage 25 percent ($25,000 / $100,000).
Now you can use that same 25 percent gross profit percentage to estimate ending inventory using another set of facts and circumstances. In addition to the 25 percent gross profit percentage, you need to know that there are goods available for sale at cost, totaling $155,000, and that sales at selling price equal $125,000. Whip these figures around, and the following figure gives you approximate inventory at cost.
The gross profit method is certainly more accurate than throwing a dart at a number board, but it’s only an estimate to be used until the physical inventory can be taken. Often inventory taking is a once-a-year extravaganza, so the gross profit percentage in use is based on past performance. Using stale sales and COGS figures may not provide truly reliable figures.
However, GAAP allows the gross profit method for interim statements, which are financial statements for less than one year, such as monthly or quarterly statements, as long as the company discloses the use of this method.