11. Estimating with Gross Profit

Let's talk about gross profit. Now, you may think you're in the wrong chapter because we talked about gross profit a long time ago in one of the first four chapters, but this time we're gonna actually use the gross profit ratio to do something. So if you'll recall, we had sales less cost of goods sold gave us gross profit, and we said something stupid like 100, 60, 40 makes it super easy. So then we could say the gross profit ratio equals gross profit, 40, over sales, 100, 40%. So this is all meant to be a recap. If you don't remember this, go back and watch the gross profit ratio video, and I go into more depth on it there.

But once we have this, what is that number actually saying to us? That number is saying that from our sales, 40% of it makes it down to gross profit. So if we sold $1, we would expect 40 cents to show up in gross profit and 60 cents to get eaten up in cost of goods sold. So why are we talking about this now? Why are we talking about this in the inventory chapter? Why does this make sense? Let's see if we can figure that out. So here we have COGS in one formula. Sales minus cost of goods sold is gross profit.

We also have another formula, goods available for sale equals cost of goods sold plus ending inventory. Or put another way, goods available for sale minus the cost of goods that we actually sold gives us the goods that we didn't sell. So you could look at it either way. Goods available for sale equals COGS plus ending inventory, or goods available for sale minus cost of goods sold equals ending inventory. So we've now got a couple equations here that include cost of goods sold. So why do we need gross profit ratio? Well, under the periodic system, we only know cost of goods sold and ending inventory periodically.

What if we wanna know before the period is over what our cost of goods sold is? Or what if we wanna know in the middle of the period how much inventory we had because we just had a fire and lost it all, and we need to know how much inventory did we actually lose? That is where the gross profit ratio becomes super helpful as an estimating tool.

And you're definitely gonna see one of these problems where the warehouse burns down, and you gotta figure out how much inventory was in there. You'll be given something like sales, 180. You'll probably also have returns and allowances and discounts, and just remember to take those out so you get to net sales. You'll have sales, uh, beginning inventory, let's say 40, and then some purchases, 130. Now, for sales and for purchases, make sure that you're doing net. So remove any returns and allowances and discounts from sales and do the same for purchases. The question will say something like, "These are the balances as of 6/30 when a fire destroyed all inventory."

And now you're supposed to figure out, well, how much inventory was in the warehouse. So we know that inventory in the warehouse is going to be beginning inventory plus any purchases minus any goods sold will be the leftover inventory. But here's the problem. This is what we're trying to figure out. Here's the other problem. We don't know this because we're under the periodic system. We know these two. We don't know these two. But with the gross profit ratio, we can kind of estimate that. So if we say that beginning inventory was 40, purchases were 130, cost of goods sold we're gonna estimate to be 60% of sales because our gross profit is 40%, so we're saying that 60% went to cost of goods sold.

So we can say cost of goods sold is estimated to be 180 times 0.6, and that will give us our estimate ending inventory. 180 times 0.6 is 108,000. So 40 plus 130 minus 108 gives us $62,000 estimated ending inventory. So now we can go to the insurance company and say, "Here's our formula. Here's how we did it. We estimate that we had 62 grand in inventory in the warehouse at the time of the fire based on our historical gross profit percentage, our sales up to date, the amount of inventory we started the year with, and the amount of inventory we purchased during the year."

And this is a pretty good estimate of how much we lost when there was the fire, and I guarantee you that one of these questions is gonna be on the test, so you need to know how to use the gross profit ratio as an estimating tool. And if you wanna think about it like this, 1 minus gross profit percentage equals cost of goods sold percentage. That's fine 'cause what we did is we said, "Well, the gross profit percentage is 40%, so the other half must be cost of goods sold. The other 60% must be cost of goods sold." So then we said, "Well, we had 180 in sales.

I bet about 60% of that went to cost of goods sold, which means I bet we had about 62 left in ending inventory." Now, this is no substitute for an end-of-year physical count. You can't just say, "Well, we made 180 in sales and 60%, so ending inventory is 108." That's not a substitute for a physical count. But when you can't make a physical count because it's, you know, the middle of the year and you just kinda wanna know, or the inventory is gone because it burned to the ground, this is a great method to estimate how much inventory you should have.