GROSS PROFIT

METHOD
DAX AARON L. UCAT, CPA,
CFMP
INSTRUCTOR
Technical Knowledge
a. To identify the methods of estimating
inventory value
b. To understand the rationale for making an
estimate to inventory value
c. To apply the gross profit method of
estimating inventory value
d. To understand the gross profit rate based
on sales and profit rate based on cost
Use of estimate in inventory valuation
In many cases, it is necessary to know the
approximate value of inventory when it is not
possible to take a physical count, or even if
possible, the same may prove costly, difficulty
or inconvenient at the moment.

There are two widely accepted procedures for

approximating the value of inventory, namely
the GROSS PROFIT METHOD and RETAIL
INVENTORY METHOD
Common reasons for approximation or estimation of
inventory:
a. The inventory is destroyed by fire and other
catastrophe, or theft of the merchandise has occurred
and the amount of inventory is required for insurance
purposes
b. A physical count of the goods on hand is made and it is
necessary to prove the correctness or reasonableness
of such count by making an estimate
c. Interim financial statements are prepared and a
physical count of the goods on hand is not necessary
either because it may take time to do so or because
only estimate is required to fairly present the financial
position and performance of the entity.
GROSS PROFIT METHOD
-is based on the assumption that the
rate of the gross profit remains
approximately the same from period to
period and therefore the ratio of cost of
goods sold to net sales is relatively constant
from period to period.
BASIC FORMULA UNDER GROSS PROFIT METHOD
Beginning inventory xx
Purchases xx
Add: Freight in xx
Total xx
Less: Purchase return,
allowance and discount xx xx
Goods available for sale xx
Less: Ending inventory xx
Cost of Goods Sold xx
Gross profit method is so called because the
cost of sales is computed through the use of
the gross profit rate.
COST OF SALES is computed as follows:
a. Net sales multiplied by cost ratio
- this formula is used when the gross
profit rate is based on sales

b. Net sales divided by sales ratio

- this formula is used when the gross profit
rate is based on cost
ILLUSTRATION 1
Beginning inventory 100,000
Net purchases 500,000
Net sales 700,000
Gross profit rate based on sales 40%
ILLUSTRATION 2 : The following data relate
to the current year:
Beginning inventory 200,000
Net purchases 1,000,000
Net sales 1,260,000
Gross profit based on cost 40%
Comprehensive Problem: The following data are
gathered for the current year:
Inventory, beginning 600,000
Purchases 2,530,000
Purchase return 15,000
Purchase allowance 5,000
Purchase discount 10,000
Freight in 50,000
Sales 3,100,000
Sales return 100,000
Sales allowance 50,000
Sales discount 150,000
The ending inventory is computed under each of
the following assumptions:
A. Gross profit rate is 25% on sales
B. Gross profit rate is 25% on cost
SALES ALLOWANCE and SALES DISCOUNT
Sales allowance and sales discount are ignored,
that is not deducted from sales. The reason is that
while these items decrease the amount of sales, they
do not affect the physical volume of the goods sold.
Sales allowance and discount do not increase the
physical inventory of goods, unlike in sales return
where there is an actual addition to goods on hand.
Deducting such items from sales would result to
overstatement of inventory which will understate the
COGS and leads to overstatement of profit.
Comprehensive Problem: The following data are
gathered for the current year:
Inventory, beginning 600,000
Purchases 2,530,000
Purchase return 15,000
Purchase allowance 5,000
Purchase discount 10,000
Freight in 50,000
Sales 3,100,000
Sales return 100,000
Sales allowance 50,000
Sales discount 150,000
QUIZ TIME!!!
PROBLEM 1: On June 30, a fire destroyed Intense
Company’s entire inventory. The inventory on
January 1 totaled P6,600,000. From January 1
through the time of the fire, the entity made
purchases of P3,000,000 incurred freight in of
P300,000 and had sales of P7,800,000. The rate
of gross profit on selling price is 30%. What is the
approximate cost of the inventory destroyed?
SOLUTION:
(*) Sales 7,800,000
GP on Sales x 30%
Gross Profit 2,340,000
Cost of Goods Sold 5,460,000
SOLUTION:
(*) Beg. Inventory 6,600,000
Purchases 3,000,000
Freight in 300,000
GAFS 9,900,000
Ending inventory (4,440,000)
Squeezed!
Cost of Goods Sold 5,460,000
PROBLEM 2: Keepsake Company estimated the
cost of its physical inventory on March 31 for use
in interim financial statement. The rate of
markup on cost is 25%. The inventory on January
1 was P5,500,000. During the period the entity
had purchases of P4,300,000 purchase returns of
P200,000 and sales of P7,500,000. What is the
estimated cost of inventory on March 31?
SOLUTION:
(*) Sales 7,500,000
Divide by: Sales ratio 125%
Cost of Goods Sold 6,000,000

(*) Beginning inventory 5,500,000

Purchases 4,300,000
Purchase return (200,000) 4,100,000
GAFS 9,600,000
Ending inventory (3,600,000)
Squeezed
Cost of Goods Sold 6,000,000
PROBLEM 3. Hard Company provided the following
information:
June July August
Sales on account 7,200,000 7,360,000
7,600,000
Cash Sales 720,000 800,000
1,040,000

All merchandise is marked up to sell at invoice cost

plus 20%. Inventory at the beginning of each month
is 30% of cost of goods sold for that month
a. What is the Cost of Goods Sold for June?
b. What is the amount of purchases for July?
SOLUTION
June July August
Total sales 7,920,000 8,160,000
8,640,000
Divide: Sales ratio 120% 120%
120%
Cost of Goods Sold 6,600,000 6,800,000
7,200,000
SOLUTION
June
Beg. Inventory (6,600,000x30%)
1,980,000
Purchases 6,660,000
GAFS 8,640,000
Ending inventory (6,800,000x30%)
2,040,000
Cost of Goods Sold
6,600,000
SOLUTION
July
Beg. Inventory (6,800,000x30%)
2,040,000
Purchases 6,920,000
GAFS 8,960,000
Ending inventory (7,200,000x30%)
2,160,000
Cost of Goods Sold
6,800,000
THANK YOU!