GROSS PROFIT METHOD

    ON THIS POST, I WILL DISCUSS, GROSS PROFIT METHOD AND RETAIL INVENTORYMETHOD OF DETERMINING THE  INVENTORY AMOUNT.

THE GROSS PROFIT METHOD OF ESTIMATING INVENTORY COST IS BASED ON AN ASSUMED RELATIONSHIP OF GROSS PROFIT AND SALES. A GROSS PROFIT RATIO IS APPLIED TO SALES AMOUNT TO DETERMINE THE GROSS PROFIT AND FINALLY THE COST OF SALES .

ON THE OTHER HAND GIVEN THE AMOUNT OF COST OF SALES , YOU CAN DETERMINE THE VALUE OF INVENTORY BY  COMPUTING FOR THE GOODS AVAILABLE FOR SALE( BEG INV. + PURCHASE) LESS THIS COST OF SALES , THEN YOU GET THE ESTIMATED INVENTORY.

                         BEG INV.                           3,000
                         PURCHASE                       4,000
                      AVAILABLE FOR SALE       7,000
                      LESS: COST OF SALES       3,000
                     estimated inventory end             4,000

take note that you can compute this cost of sales by way of knowing the gross profit percentage and finally the cost of sales percentage.

Example:1    GROSS PROFIT AS PERCENTAGE OF SALES ( MARK UP ON SALES).
When we say mark up on sales, that means the gross profit is a certain percent of  SALES AMOUNT.
  assume a sales of 100,000, the company applies 40% gross profit on sales , therefore:

                       sales                        100,000             100%
                    cost of  sales                 60,000                60%
                          gross profit              40,000                40%
so assuming the  available goods for sale is 85,000, the estimated inventory would be:

             available for sales                                     85,000
             less cost of sales                                      60,000
           estimated inventory                                    25,000


example 2   GROSS PROFIT AS PERCENTAGE OF COST ( MARK UP ON COST) When we say mark up on cost , that means the gross profit  is a certain percent of  COST OF THE PRODUCT.
EXAMPLE:  A PRODUCT COSTING 100.00 AND SAID TO HAVE PRICED 20% MARK UP ON COST , IT  DOES NOT MEAN THAT  20% IS THE GROSS PROFIT PERCENTAGE AGAINST SALES AMOUNT  BECAUSE THE 20% IS BASED ON THE COST AND NOT ON THE SALES PRICE.  SO, THE SELLING PRICE OF 100.00 IS 120.00 ( 100.00 X 20% =20  MARK UP + 100.00). IF GET THE PERCENTAGE OF GROSS PROFIT OF 20.00  VS.  120.00 IS NOT 20% BUT 16.67%.

When  a product  is said to have a gross profit ratio of say 40% based on cost. That means the base is the cost of the product , and this cost is of course the 100% because this is where the 40% was based , NOW CONSIDERING THAT IN THE ORDINARY COMPUTATION OF GROSS PROFIT IT IS THE SALES AMOUNT THAT IS BEING USED AS THE BASE OF GROSS PROFIT PERCENTAGE , RATIO.  NOW IF THE COST IS 100% AND THE GROSS PROFIT IS 40%, THEREFORE MATHEMATICALLY THE SALES  PERCENTAGE RATIO IS 140%
   Assume sales is 100,000 and gross profit ratio is 60% of cost .If sales are made at a gross profit based on cost  then to get the gross profit ratio is.

              sales                       ?    %
              cost of sales    (  100%)
           gross profit             40%

since , mathematically, cost is deducted from sales to arrive at gross profit, in the above example , using a work back approach, the sales percentage ratio is  140% , arrived by  40% + 100% is 140%,   therefore in making the normal reading of gross profit percentage ratio , you have to divide 40% with 140% to get the gross profit percentage based on SALES PRICES   which is 28.57%.

                  sales               140%
                 cost               ( 100%)
                  gross profit      40%                      40% divide 140% = 28.57%

    since the sales amount is given, and the cost amount is not given, and it says  the gross profit is 40% of cost, then  to get the gross profit amount and its percentage to sales ,  and also the cost amount and percent to sales  , you have to divide the 100,000 by 140%  to get the cost amount of   71,430.00

              sales                        100,000    100%
              cost of sales               71,430   71.43%
             gross profit                 28,570   28.57%

 so if the product  cost is 71,430.00 , adding 40% to it is 28,570 ( round off diff.) but basing the 28,570 on sales amount , it is 28.57%.

so, when the problem says the gross profit is said to be a certain percent of cost, to be able to get the gross profit percentage against sales , all you have to do is  divide the gross profit percent against the sum total percentage of gross profit and cost of sales percentage.

TO BE ABLE TO ESTIMATE THE ENDING INVENTORY  USING THAT COST OF SALES, ALL YOU HAVE TO DO IS ,  OBTAIN THE GOODS AVAILABLE FOR SALES LESS THIS COST OF SALES =   ESTIMATED INVENTORY COST.

                BEG INV.                             80,000
                PURCHASE                         40,000
             AVAILABLE FOR SALE        120,000               available                         120,000
             LESS: COST OF SALES         71,430                   INV. END                (   48,570)
             ENDING INVENTORY          48,570                    COST OF SALES       71,430

THIS METHOD OF INVENTORY VALUATION IS VALUABLE ESPECIALLY WHEN IT IS IMPOSSIBLE OR DIFFICULT TO UNDERTAKE PHYSICAL INVENTORY COUNTING  BECAUSE OF LOSS OR DESTRUCTION OF GOODS.

EXAMPLE   assume in oct 31, 2001a fire destroyed the inventory .  :

 inventory dec 31, 2000    329,500.
payments of purchases  based on check issued  in 2001   1,015,000.00
unpaid suppliers invoices  beginning jan 2001         260,000.00
balance of accts.payable according to suppliers at the time of fire    315,000.00
bank deposits from jan to oct 31,                           1,505,000.00
accts. receivable  dec 31, 2000               328,000.00
accts receivable oct 31, 2001                  275,000.00

gross profit percentage  2000        24%     1999,  23%,  1998  25%,    1997     28%

based on the above the inventory at thetime  of fire could be as ff:

what is still unknown here is the amount sales made jan to oct .  Now since there is a beginning accounts receivable dec 31,2000  and there is also a collections made during the year up to oct,  and the ending receivable , by reconstructing  IN  T  ACCOUNTS , you can compute for the sales amount.
Having sales amount you can compute the cost of sales percentage because you simply compute the average gross profit for the 4 year period .


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RETAIL INVENTORY METHOD

when this method is maintained , the purchases is valued at cost and at retail price.    a cost percentage is computed by dividing the goods available for sale  at cost against  the goods available for sale at retail price . this cost percentage can be applied to the ending inventory at RETAIL  to get the inventory at cost.

As you maybe aware, the immediately available figure for a product is its RETAIL OR SELLING PRICE because this is the figure that must be shown to the buyer of your products.  The purchase cost of those products is not always given or identified  at a click of the finger unlike the retail price, especially when a company is handling multiple or varied line of products.   HENCE , to easily compute for the ending inventory cost, without resorting to a perpetual or counting of inventories ,  a cost ratio of the product against its selling price is established and use this ratio to compute for inventory cost.

                                          at cost          retail
        beg                                100          200  
       purchases                       200          400
 available for sale                   300          600        300 divide 600  is  50% this the ratio of cost vs. retail

to be able to determine the inventory at retail , the following procedure:

                        available for sale at retail                               600
               sales made out of this available at retail                  (400)
             REMAINING INVENTORY  at retail                     200        
                             

                            sales                                 400
                         beg. inventory retail 200
                        purchases   retail      400
                  available for sale retail     600
                  Less: inventory retail     (  200)   ( 400  )   cost of sales at retail

inventory at cost therefore is 200 x 50% =   100

Use of this  retail inventory method offers the ff  advantages .

1. no need physical count of inventory at interim period
2.  when physical inventory is taken for financial statement preparation, of course since each item has a retail pricing easily available  therefore inventory at retail can easily computed  without having to dig up records of its cost  and it will just be multiplied by the cost ratio vs retail price to get the INVENTORY AT COST.

THE ACCOUNTING ENTRIES IS SIMILAR TO A PERIODIC METHOD OF INVENTORY.

              Purchases                   200
                  accts. payable                 200

    accts receivable                   400
              sales                                   400

      cost of sales              100
          beg inv                          100

     cost of sales                200
             purchases                  200
 
       end inve.                  100
              cost of sales                100

the net cost of sales of the above is  200.  so the following computation

          beg inve.                    100
          purchases                   200
          available                     300
         less: ending inv.            100
       = COST OF SALES     200
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EXERCISES  1.  on august 15,1996 ,  a hurricane damage the entire inventory .

 inventory jan 1                                                            375,000
purchases   jan 1 aug 15                                            1,385,000
cash sales  jan 1 aug 15                                                225,000
collection jan 1 augs 15                                             2,115,000
accounts receivable   jan 1                                            175,000
accts receivable     aug 15                                             265,000
salvage value of inventory                                                  5,000
gross profit percent on sales                                                  32%

 COMPUTE THE INVENTORY LOSS.

1.    DETERMINE SALE AMOUNT:

      Accts receivable beg                                    175,000
      less collection                                             (2,115,000)
     accts. rec. end                                                 265,000
      SALES AMOUNT                                    2,205,000
   
2.    DETERMINE  COST OF SALES:
      SALES      2,205,000 X  (100% -32 % )  = 1,499,400
3   DETERMINE GOODS AVAILABLE FOR SALE

BEG INV                            375,000
PURCHASES                  1,385,000
TOTAL                            1,760,000

4     DETERMINE INVENTORY:

TOTAL AVAILABLE FOR SALE      1,760,000
LESS:  COST OF SALES                   1,499,400
ENDING INVENTORY                        260,600  L
LESS SALVAGE VALUE                          5,000

ACTUAL INVENTORY LOSS              255,600

4.   TO PROVE:

 SALES                                                           2,205,000
 COST OF SALES:
  AVAILABLE FOR SALES      1,760,000
 LESS ENDING INV.                   260,600      1,499,400     68%
GROSS PROFIT                                                705,600      32%

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IF IN CASE THE SALES,  THE RECEIVABLE , INVENTORY , THE COST OF SALES IS UNKNOWN,  TRY TO MAKE A  T  ACCOUNTS FOR THEM AND PUT THE AVAILABLE FIGURES OR THE GIVEN FIGURES THEN COMPUTE THE UNKNOWN FIGURE by simple mathematical computation :

EXAMPLE :
                     accts. receivable                                                      accts receivable
         ____dr___________________cr_______                  dr                                         cr
beg bal          1,000      :                                             beg        100                           
sales              3,000     :     collection     ?                                                     coll                50
end balance      200     :                                               sales       ?
                                                                                   end bal    80
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MARKUPS AND MARKDOWN - CONVENTIONAL RETAIL

In the previous discussion , it was assumed there were no changes in retail prices. Frequently , retail prices do change .

the following terms are used in retail method.

1.  original  retail price -   the initial sales price, arrived at adding markup  called INITIAL MARKUP
2.  additional markups-  increases that raise sales price above the original price
3. mark up cancellation   -  decrease in additional mark up that do not reduce sales price below original
4. net markups               -  additional markups less markup cancellation
5. markdowns    -  decrease that reduce sales price from the original
6. markdown cancellation  - decrease in markdown that do not raise the sales price above original
7. net markdowns       -markdowns less markdown cancellation

EXAMPLE:  

                                           cost                         retail
   original                               4                              6           the 2 is 50%markup on cost
   add'l markup                                                      1.50     increase the original price
         NEW PRICE                                               7.50
   markup cancellation                                              .50  reduce the orig. markup of 1.50
NEW PRICE                                                         7.00

NET MARKUP   IS     1.50 LESS .50  =1.00  
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ORIGINAL                                                            6.00
  markdowns                                                           1.00  reduce below original of 6
NEW PRICE                                                         5.00   below original
mark down cancellation                                            .25   the 1.00 decrease it to.75 instead
NEW PRICE                                                         5.25

NET MARKDOWN  IS   1.00 LESS .25  = .75

Retail inventory results will vary depending on whether net markdowsn are used in computing the cost percentage.  When applying retail method , NET MARKUP  are added to GOODS AVAILABLE FOR SALES AT RETAIL  ,before calculating the cost percentage, net markdowsn , however are not deducted in arriving at the percentage.  this method is CONVENTIONAL RETAIL INVENTORY METHOD.

EXAMPLE
                                                              COST                     RETAIL
BEGINNING INVENTORY               8,600                      14,000
PURCHASES                                    72,100                     110,000
ADDITIONAL MARK UP                                                  13,000
MARKUP CANCELLATION                                           (    2,500)
GOODS AVAILABLE FOR SALE     80,700                    134,500

LESS:   SALES                                    108,000
             MARKDOWN                           4,800
             MARKDOWN CANCEL       (    800)                 112,000
ending inventory at retail                                                       22,500

cost percentage ( 80,700 divide 134,500)  = 60%
inventory end at cost    60% x 22,500  =  13,500

YOU MAY ASK WHY THE ADDITIONAL MARK UP IS ADDED TO AVAILABLE FOR SALE, IT IT IS BECAUSE , THE SALES AMOUNT THAT WILL BE DEDUCTED INCLUDES THAT MARK UP . SO IF YOU WILL NOT ADD THE ADDITIONAL MARK UP TO THE AVAILABLE FOR SALE  THE RESULTING INVENTORY AT RETAIL WILL BE UNDERSTATED
USING THE ABOVE EXAMPLE.

THE AVAILABLE FOR SALE WOULD BE                                              124,000
LESS  :   SALES                                                                                         112,000
ENDING INVENTORY                                                                               12,000

ON THE OTHER HAND IF INSTEAD OF THE NET MARK UP IS ADDED TO THE AVAILABLE FOR SALE , THE NET MARKDOWNS WERE ADDED TO THE AVAILABLE FOR SALE, THE COST PERCENTAGE WILL BE HIGHER BECAUSE THE AVAILABLE FOR SALE WILL BECOME LOWER.

BUT  THE SALES AMOUNT TO BE DEDUCTED FROM THAT AVAILABLE FOR SALE TO ARRIVE AT INVENTORY AT RETAIL  WOULD NOT INCLUDE THE NET MARKDOWN ,BECAUSE IT WAS ALREADY ADDED TO THE AVAILABLE FOR SALE, THUS BRINGING THE SAME INVENTORY AT RETAIL  .


       GOODS AVAILABLE FOR SALES                                               134,500
DEDUCT NET MARKDOWN                                                                  4,000
GOODS AVAILABLE  FOR SALE                                                        130,500
LESS: SALES WITHOUT MARK DOWN                                             108,000
ENDING INV                                                                                            22,500

COST PERCENTAGE WILL BECOME HIGHER BECAUSE THE NET MARKDOWN WILL BE DEDUCTED TO THE AVAILABLE FOR SALE . 
80,700 DIVIDE 130,500 = 61.48%  X 22,500 = 13,914.00