The gross profit method is not valid when there is substantial increase in the quantity of inventory

Businesses produce revenues through selling their goods and services to interested customers. To acquire the products intended for sale, businesses must either manufacture or purchase them from their suppliers. In either case, the cost of acquisition is called the cost of sales. In the case of businesses that purchase their products, the cost of sales is more often called the cost of goods sold. Revenue minus cost of goods sold is equal to gross profit. Gross profit can be used to estimate inventory at the end of a time period as long as certain other figures are available.

Inventory

1. Inventory is a catch-all term for the products that a business has on hand and has intended for sale. For example, if a store purchases 10 sacks of flour and intends to sell them, those sacks count as inventory. But if the same store intends to use the flour to bake cookies and then sell the cookies, then those cookies count as inventory, but the flour doesn't. Under the most common accounting basis, the value of inventory isn't counted as the cost of goods sold until said goods are sold.

Purchases and Cost of Goods Sold

1. "Purchases" is a term that refers to additional inventory that's purchased during the time period in question. For example, if a business acquired 20 vehicles at $10,000 per vehicle in a single period and intended them for sale, then that business has made purchases of $200,000. The value of inventory at the beginning of the time period plus purchases minus the cost of goods sold is equal to the value of the inventory at the end of the time period.

Gross Profit Margin

1. Revenue minus the cost of goods sold is equal to gross profit. For example, if a business sold 10 desks acquired at $100 per desk for the price of $150 per desk, that business has made a gross profit of $500, or 10 * ($150 - $100). Gross profit margin is gross profit as a percentage of revenue: Using the same example, gross profit margin for this business is 33.3 percent, or ($150 - $100)/$150.

Gross Profit Method

1. The gross profit method is used to estimate inventory at the end of the time period. It can't be used if the figures for beginning inventory, purchases made since, total sales during the period and the gross profit margin are unavailable. If there's no beginning inventory in the sense that the business has no products intended for sale at the period's start, the gross profit method can still be used, as long as the other conditions are met. For example, if a business sold all of its inventory before the current period and thus had a beginning inventory of zero, it can still use the gross profit method to estimate its ending inventory. On the other hand, if the business has no beginning inventory because it has just started operating, it can't use the gross profit method because it has yet to calculate its gross profit margin. Inventory available for the entire period is calculated as being beginning inventory plus purchases; cost of goods sold is estimated as being total sales multiplied by 1 minus the gross profit margin. Available inventory minus the estimated cost of goods sold is equal to the estimate of the ending inventory.

   For example, a business has $2,000 in beginning inventory, made purchases of $5,000 throughout the period, made sales of $8,000 and has a gross profit margin of 20 percent. It has available inventory of $7,000 and an estimated cost of goods sold of $6,400. As such, its estimated ending inventory is $600.

INSTRUCTIONS: On the accompanying answer sheet, blacken the box which

correspond to the correct letter choice. Blacken only one box per item.

1.The gross profit method of estimating ending inventory may be used for all of the

following, except:

A.internal as well as external interim reporting.

B.internal as well as external year-end reports.

C.estimate of inventory destroyed by fire or other casualty.

D.Rough test of the validity of an inventory cost determined under either periodic or

perpetual inventory system.

2.The gross profit method assumes that:

A.the amount of gross profit is the same as in prior years.

B.sales and cost of goods sold have not changed from previous years.

C.inventory values have not increased from previous years.

D.the relationship between the selling price and cost of goods sold is similar to prior

years.

3.The gross profit method of estimating inventory would not be useful when:

A.a periodic inventory system is in use and inventories are required for interim

reports.

B.inventories have been destroyed or lost by fire, theft or other casualty, and the

specific data required for inventory valuation are not available.

C.there is a significant change in the mix of products being sold.

D.the relationship between the gross profit and sales remains stable over time.

4.The gross profit method of inventory valuation is not valid when:

A.there is substantial increase in the quantity of inventory during the year.

B.there is substantial increase in the cost of inventory during the year.

C.the gross profit percentage changes significantly during the year.

D.all ending inventor is destroyed by fire before it can be counted.

5.Which would not require an estimated of inventory?

A.Inventory destroyed by typhoon.

B.Proof of the reasonable accuracy of the physical count.

C.Interim financial statements are prepared.

D.Determination of the ending inventory to be reported in the statements of

financial position at year-end.

6.If the gross profit rate is based on cost, the cost of goods sold is computed as:

A.Net sales times cost ratio.C. Gross sales times cost ratio.

B.Net sales divided by sales ratio.D. Gross sales divided by sales ratio.

7.An advantage of the retail inventory method is that it:

A.Permits entities to avoid taking an annual physical inventory count.

B.Gives a more accurate measurement of inventory.

C.Hides costs from customers and employees.

D.Provides a method for inventory control and facilities determination of the periodic

inventory.

8.To produce an inventory valuation which approximates the lower of cost and NRV

using the retail inventory method, the computation of the ratio of cost to retail

should:

A.Include markups but not markdowns.

B.Include markups and markdowns.

C.Ignore both markups and markdowns.

D.include markdowns but not markups.

9.When the conventional retail inventory method is used, markdowns are commonly

ignored in the computation of cost to retail ratio because:

A.There may be no markdowns during the year.

B.This rends to give a better approximation of the lower of average cost and net

realizable value.

C.Markups are also ignored.

D.This tend to result in the showing of a normal profit margin in a period when no

markdowns goods have been sold.

10.The conventional retail inventory method produces an ending inventory that

approximates:

A.Lower of average cost and net realizable value.

B.Lower of FIFO cost and net realizable value.

C.Lower of LIFO cost and net realizable value.

D.Lower of cost and net realizable value.

Which is not valid about the gross profit method?

What does it mean when gross profit is increasing?

What is the gross profit method of inventory?

Why is the gross profit method not appropriate for annual reports?