The gross profit method may be used to estimate the cost of inventory.
Required:
a.List four situations when it might be appropriate to use the gross profit method to estimate the cost of inventory.b.Discuss the potential disadvantages of the gross profit method.
What will be an ideal response?
| a. | (1) | To determine the cost of the inventory for interim financial statements without taking a physical count. |
| (2) | To verify the accuracy and reasonableness of a physical inventory count or of the perpetual inventory records. | |
| (3) | To estimate the cost of inventory destroyed by a casualty. | |
| (4) | To determine an ending inventory figure and a cost of goods sold amount for budgeting purposes. | |
| b. | Potential disadvantages of the gross profit method are as follows: | |
| (1) | It is normally not an acceptable approach for determining the cost of inventory for the annual financial statements. | |
| (2) | The accuracy of the inventory's cost is a function of the accuracy of the gross profit percentage developed. If a company uses one overall gross profit percentage in applying the method, but uses different markup percentages in different departments, the results may not be accurate. | |
| (3) | The gross profit rate used with this method is determined by using the gross profit rates from previous periods. If the current period's markups are different from those of previous periods, the results obtained with the gross profit method will not be accurate. | |
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