Chapter 9 Inventories: Additional Valuation Issues

Because selling price exceeds cost, and with the gross profit amount the same for both,
gross profit on selling price will always be less than the related percentage based on
cost. Note that companies do not multiply sales by a cost-based markup percentage.
Instead, they must convert the gross profit percentage to a percentage based on selling
price.
Evaluation of Gross Profi t Method
What are the major disadvantages of the gross profit method? One disadvantage is that
it provides an estimate. As a result, companies must take a physical inventory once a
year to verify the inventory. Second, the gross profit method uses past percentages in
determining the markup. Although the past often provides answers to the future, a current
rate is more appropriate. Note that whenever significant fluctuations occur, companies
should adjust the percentage as appropriate. Third, companies must be careful in
applying a blanket gross profit rate. Frequently, a store or department handles merchandise
with widely varying rates of gross profit. In these situations, the company may
need to apply the gross profit method by subsections, lines of merchandise, or a similar
basis that classifies merchandise according to their respective rates of gross profit. The
gross profit method is normally unacceptable for financial reporting purposes because
it provides only an estimate. IFRS requires a physical inventory as additional verification
of the inventory indicated in the records. Note that the gross profit method will
follow closely the inventory method used (FIFO or average-cost) because it relies on
historical records.
ILLUSTRATION 9-16
Application of Gross
Profi t Formulas
Gross Profit on Selling Price Percentage Markup on Cost
Given: 20%
.20
1.00 2 .20
5 25%
Given: 25%
.25
1.00 2 .25
5 331/3%
.25
1.00 1 .25 5 20% Given: 25%
.50
1.00 1 .50 5 331/3% Given: 50%