Business Lesson 1 - Estimating Inventory Value Using Gross Profit

I love incorporating business principles almost as much as I love using technology. They both have played a big role in my business success. As a small business consultant, I’m often asked the best way to estimate the value of inventory. One method is based on gross profit. Warning – this post does come with a quiz at the end.

The gross profit method of valuing inventory is a technique using a company’s historical or projected gross profit margin to estimate cost of goods sold during a period. The gross profit method assumes the gross profit ratio remains stable during the period.

It’s usually used to estimate the value of inventory when the retail values of beginning inventory and purchases are not available.  Basically, this is how to estimate the value of inventory when a value doesn’t exist.

Summary of steps in the gross profit method:

  1. Calculate the cost of goods available for sale as the sum of the cost of beginning inventory and cost of net purchases.
  2. Determine the gross profit ratio. Gross profit ratio equals gross profit divided by sales. Use projected gross profit ratio or historical gross profit ratio – whichever is more accurate and reliable.
  3. Multiply sales made during the period by gross profit ratio to obtain estimated cost of goods sold.
  4. Calculate the cost of ending inventory as the difference of cost of goods available for sale and estimated cost of goods sold.

Example:

Make sense?

In the spirit of the best way to know if you truly understand something is to put it into practice…

Gross Profit Method of Valuing Inventory Quiz – With answers at the end

You’re working with a retail furniture company called Furniture Heaven. Currently Furniture Heaven has items on their showroom floor with a cost of goods available for sale of $3000. They have made purchases this month of more inventory in the warehouse of $2000.  Sales during the current month were $1000. 

When looking over the last three years of financial statements you calculate that the company has historically operated with a gross profit ratio of 25%

1. What estimate for Cost of Goods Sold will be listed on the Income Statement for this month?

 2. On the Balance Sheet, what is the ending value of the inventory Furniture Heaven has on hand?

 ANSWER:

  1.  The estimated cost of goods sold on the Income Statement for the period is $250

 Sales of $1000 is divided by the Gross Profit Margin of 25%

 1000/.25 = $250

     2. The ending inventory on the Balance Sheet is $4750

The value of the furniture on the showroom floor is $3000. Add the value of the purchases made and being stored in the warehouse of $2000. Total beginning inventory is $5000. Subtract the estimated COGS for the month of $250 from the beginning inventory of $5000.

$5000 - $250 = $4750

While it does take a bit of time to gather and organize the financials, it’s a great framework to use when you need to know the value of your inventory.