INTERMEDIATE ACCOUNTING 1

CHAPTER 13:
GROSS PROFIT
METHOD
VALIX, PERALTA, VALIX
Objectives:
To identify the methods of estimating
inventory value.
To understand the rationale for making an
estimate of inventory value.
To understand the gross profit rate based on
sales and profit rate based on cost.
ESTIMATE IN INVENTORY VALUATION
In many cases, it is necessary to know the approximate value of inventory
when it is possible to take a physical count.

There are two widely accepted procedures for approximating the value of
inventory, namely:

A. Gross Profit Method

B. Retail Inventory Method

The approximation or estimation of inventory is made for varied reasons.

COMMON REASONS FOR MAKING AN ESTIMATE OF THE
COST OF THE GOODS ON HAND ARE:

a. The inventory is destroyed by fire and other catastrophes, 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 the physical count by making an
estimate.
The approach of conducting a physical count is known as "the gross profit
test" in accounting parlance.

c. Interim financial statements are prepared and a physical count of the

goods on hand is not necessary because it may take time to do the same.
GROSS PROFIT METHOD
The gross profit method is based on the assumption that the rate of 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 THE GROSS PROFIT METHOD

GOODS AVAILABLE FOR SALE (GAS) xx

Less: COST OF GOODS SOLD xx
ENDING INVENTORY xx
GOODS AVAILABLE FOR SALE
The usual items affecting the goods available for sale are normally
considered:

Beginning Inventory xx
Purchases xx
Add: Freight In xx
Total xx
Less: Purchase return, allowance, and discount xx xx
Goods available for sale xx
COST OF GOODS SOLD

The gross profit method is so called because the cost of goods sold is
computed through the use of the gross profit rate.

The cost of goods sold is computed depending on the basis of gross profit
rate whether on sales or on cost.

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.
COMPUTATION OF GROSS PROFIT RATE
The following details are available in the computation of the gross
profit rate:

Net sales 1,000,000

Cost of goods sold 750,000
Gross profit 250,000

The gross profit rate is expressed as a percent of sales or as a percent

of cost of goods sold.

The gross profit rate on sales is the common way of quoting gross
margin because goods are stated on a sale price basis, rather than on
cost basis.
 GROSS PROFIT RATE ON COST TO GROSS
PROFIT RATE ON SALES
Sometimes,
Sometimes,
it becomes
it becomes
necessary
necessary
to convert
to convert
the gross
the profit rate from one basis
to gross
another.
profit rate from one basis to another.
If the gross profit rate on cost is 25%, the gross profit rate on sales is computed
in the following manner:

Net sales 125%

Cost of goods sold 100%
Gross profit on cost 25%
Gross profit on sales (25/125) 20%

Note that cost of goods sold is 100% because it is the basis of the gross profit.
GROSS PROFIT RATE ON SALES TO GROSS
PROFIT RATE ON COST
If the gross profit on sales is 20%, the gross profit on cost is computed
in the following manner.
Net sales 100%
Cost of goods sold 80%
Gross profit on sales 20%
Gross profit on cost (20/80) 25%

Arithmetically, any number or figure that is used as basis is

considered to be 100%.
Thus, if the basis of the gross profit is cost of goods sold, then cost is
100% and if the basis is sales, then net sales is 100%.
GROSS PROFIT RATE BASED ON SALES
The cost ratio is
determined by
deducting the gross
profit of 25% from the
sales of 100% or 75%.

In computing "net
sales", the sales
allowance and sales
discount are
disregarded.
Observe the computation of gross profit rate based on
sales:
GROSS PROFIT RATE BASED ON COST

The sales ratio is determined by adding the cost of goods sold of 100% and
the gross profit of 25% or 125%.
Observe the computation of gross profit rate based
on cost:
SALES ALLOWANCE AND SALES
DISCOUNT
Sales allowance and sales discount are ignored or not deducted
from sales in computing net sales under the gross profit method.

The reason is that while these items decrease the amount of sales,
the sales allowance and sales discount do not affect the physical
volume of goods sold.

Sales allowance and sales discount do not increase the physical

inventory of goods, unlike in sales return where there is an actual
addition to goods on hand.
SALES ALLOWANCE AND SALES
DISCOUNT

To deduct sales allowance and sales discount from sales would

result in an overstatement of inventory with a consequent
understatement of cost of goods sold and an overstatement of
gross income.
THANK YOU!