Inventory estimation: Gross profit method definition-formula-example
Inventory estimation method
The inventory estimation is used by the business concern in the case when some events occur or if a business is a retail business. This method forecast the price and it gets near the price of the actual price. The inventory estimation includes two methods first Retail inventory method and second Gross profit method.
Gross Profit Method
This method is applicable only when an accident occurred in-store and goods are destroyed. This method estimates the value of goods destroyed by accident or fire. In this method, the gross profit is to be fixed based on past experience or transactions. The business can fix the gross profit this method involves the following steps:
First, Step-1 – Set of the gross profit ration
Gross Profit Ratio = Amount of gross profit / Net amount of sale
The gross profit ratio signifies the cost incurred by the business to attain that the profit amount. For e.g., if the gross profit ratio is 60% determined that the cost of goods sold is 40%.
Step-2 – Calculate the cost f goods sold just before the accident occurred
Cost of goods sold (COGS) = Cost of goods available for sale - Cost of ending inventory
OR,
Cost og goods sold (COGS) = Sales - Gross Profit
Step-3 – Calculate the amount of goods destroyed by accident
Estimated amount of destroyed goods = Estimated cost of ending inventory before accident - Inventory set after accident (or not destroyed inventory)
Where,
Estimated cost of ending inventory before accident = Cost of goods available for sale - Cost of goods sold
Journal Entries
According to this method inventory destroyed by accident or fire and insurance claim or compensation from insurance are recorded. Suppose, there loss by fire
When no insurance claim is admitted
Loss by fire a/c Dr. xxx
Inventory a/c xxx
(To record the loss of inventory by fire)
When full insurance claim is admitted
Insurance receivable or cash a/c Dr. xxx
Inventory a/c xxx
(To record the loss of inventory and full insurance claim admitted)
When partial insurance claim is admitted
Insurance receivable or cash a/c Dr. xxx
Loss of inventory a/c Dr. xxx
Inventory a/c xxx
(To record the loss of inventory and partially settled by the insurance company)
When more insurance claim is admitted
Insurance receivable a/c Dr. xxx
Inventory a/c xxx
Gain on settlement a/c xxx
(To record the loss of inventory by fire and fully settled by the insurance company with profit)
Example:
On February 10, 2019, an explosion destroyed a store of raw material. The insurance company has agreed to pay store Rs. 10,000 as a settlement for the inventory destroyed. But an estimate of the amount of inventory loss is needed for insurance purpose. The following information is available:
| Beginning inventory Purchases, January – February 10 Sales, January – February 10 Inventory no destroyed Gross profit margin | Rs. 24,000 23,000 40,000 2,000 20% |
Determine the inventory lost and prepare the journal entry on this store books to recognize the inventory lost as well as the insurance reimbursement.
Solution:
Using the Gross Profit Method
Cost of goods available for sale = Beginning inventory + Purchases = 24,000 + 23,000 = Rs. 47,000
Sales = Rs. 40,000
Gross profit margin = 20%
Gross profit amount = 20% of Sales = 20 % of 40,000 = Rs. 8,000
Cost of goods sold (COGS) = Sales – Gross profit amount = 40,000 – 8,000 = Rs. 32,000
Cost of ending inventory before explosion = Cost of goods available for sale – Cost of goods sold = 47,000 – 32,000 = Rs. 15,000
Inventory destroyed by fire = Ending inventory before explosion – Inventory no destroyed = 15,000 – 2,000 = Rs. 13,000
Loss of Inventory = Insurance receivable – Inventory destroyed = Rs. 10,000 – 13,000 = Rs. 3,000
Journal Entry
February 10, 2019
Insurance receivable a/c Dr. Rs. 10,000
Loss of inventory a/c Dr. Rs. 3,000
Inventory a/c 13,000
(To record the loss of inventory and partially settled by the insurance company)
Suppose, the insurance company has agreed to pay store full settlement of destroyed inventory. Prepare the necessary journal entry.
Journal entry
February 10, 2019
Insurance receivable a/c Dr. Rs. 13,000
Inventory a/c Rs. 13,000
(To record the loss of inventory and fully settled by the insurance company)
Again, suppose the insurance company has not agreed to pay store any amount to settle for the inventory destroyed. Prepare journal entry,
Journal Entry
February 10, 2019
Loss of inventory a/c Dr. Rs. 13,000
Inventory a/c Rs. 13,000
(To record the loss of inventory by explosion)
Again, suppose the insurance company has agreed to store Rs. 15,000 as a settlement for the inventory destroyed. Prepare a journal entry.
Journal entry
February 10, 2019
Insurance receivable a/c Dr. Rs. 15,000
Inventory a/c Rs. 13,000
Gain on settlement a/c Rs. 2,000
(To record the loss of inventory and fully settled by the insurance company with profit)