Inventory management requires several different tasks tht accountants must complete. The gross profit method is one such process when accounting for inventory. Accountants will determine a company's gross profit percentage and apply it to future inventory dollar amounts. This allows accountants to compute inventory figures without a physical count. The gross profit method has both advantages and disadvantages.
The gross profit method does not require major computations. Accountants need to subtract an item's cost from its sales price, and then divide by the sales price. This results in the gross profit percentage. Multiplying this percentage by total sales will provide the cost of goods sold for the current period. Accountants can subtract the current period's cost of goods sold from the company's beginning inventory amount. This provides an estimate for the company's ending inventory.
Works Well for Large Inventories
Large inventories with several small items can be difficult to count repeatedly. Grocery stores and fast food restaurants are common users of the gross profit method. Computing inventory amounts using this method provides a workable number a company can report on its balance sheet. Government tax authorities and accounting regulators will usually accept the gross profit method for large inventories with small items as it works well for companies.
Using an accounting calculation to provide inventory figures can result in potentially inaccurate figures. Under this method, accountants may not adjust inventory for lost, stolen, damaged or obsolete inventory items. The company's ending inventory will have a higher value reported than is actually on hand. A physical inventory is necessary to reconcile the actual inventory with the company's accounting inventory figure.
Large Inventory Write-Offs
Companies may experience larger inventory write-offs with the gross profit method. Inaccurate figures lead to physical inventories, as mentioned previously. The differences between the two resulting figures may indicate a loss on inventory. Companies will have to write off losses on inventory against current net income. This lowers a company's profit and also requires it to replace the inventory with new purchases.