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Gross Profit Method – Impact of overstating the gross profit %

A company will often use the gross profit method to estimate cost of goods sold and ending inventory during an interim period. A company would use this method if they do not have a perpetual inventory system and they only perform a physical inventory count at the end of a period.

The formula for calculating cost of goods sold would just be sales x (1 – gross profit %). So what happens if the company overstates the gross profit % used in the calculation? The result would be an overstatement of ending inventory and an understatement of cost of goods sold. The example below assumes that the gross profit % used is 40%, but the correct gross profit % is actually 30%.

As you can see, if we use a gross profit % of 40% on sales of $1,000, that results in cost of goods sold of $600. If the gross profit % should have been 30%, then cost of goods sold would have been $700. When we plug those figures into an inventory rollforward, we can see that ending inventory ends up being overstated when we overstate the gross profit % used.

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