The gross profit method in inventory accounting and valuation is a common technique of assuming that margin ratio is available, thus, the subsequent calculations target identifying the ending inventory amount. The primary advantage of the given approach is the fact that it does not require physical presence of the inventory, which allows to complete financial statements based on accurate estimates.
The costs on which the gross profit method of inventory valuation is calculated can be variable production costs per unit, total production costs per unit, and total costs per unit. Often, the total production costs per unit of output are easy to determine, which makes the method of pricing based on gross profit a good pricing tool. Pricing based on the return on assets is also a good method if the value of the assets used in the production of a given type of product can be accurately determined.
Otherwise, this method may give the wrong result. According to the method, the gross profit is used as the calculation base – the difference between the volume of sales of products or revenue from sales and the cost of sales. The valuation set by this method should ensure the desired profit and cover all costs that are not considered in the calculation of gross profit.
This method is easily applicable, since information on production costs, operating costs per unit of output is simply obtained from the credentials, there is no need to subdivide the costs into fixed and variable. The valuation calculated on the basis of variable costs coincides with the price calculated on the basis of gross profit. The difference in these methods is that in the first case only variable costs are used, in the second – all production costs and the difference is offset by a percentage markup.
Often, the total production costs per unit of output are very easy to determine, which makes the method of pricing based on gross profit a convenient pricing tool. A key element of method of gross profit is the estimation of sales needed to calculate average fixed costs and the required gross margin, although on the other hand, the set valuation will inevitably affect sales. Alternatively, another used name for this method is average cost pricing. Despite the name of the gross profit method of inventory valuation, in practice, managers take into account demand and competition, they make changes in the target margin in time and for various types of products. The general rule of establishing transfer valuation can be formulated as the transfer valuation. Gross profit method formula is equal to direct variable costs plus lost profits per unit of output if it was supplied to an external buyer. This method allows people to provide a certain level of gross profit for the selling unit.
It is equally useful when the selling unit is operating at full capacity or underloaded. To set the valuation using the given method, the gross profit, which is defined as the difference between the sales proceeds and the cost of goods sold, is used as the calculation base. The assigned valuation should provide the desired profit and cover all costs that are not considered in the calculation of gross profit. The price calculated on the basis of variable costs coincides with the price calculated on the basis of gross profit.