How does the gross profit method estimate inventory, and when is it used in practice?

The gross profit method estimates ending inventory by working backwards from sales using the company's historical gross profit percentage. It is NOT an acceptable method for annual financial reporting under GAAP or IFRS, but it is widely used for:

1. Insurance claims — estimating inventory destroyed by fire, flood, or theft
2. Interim estimates — quick approximation between physical counts
3. Reasonableness checks — verifying that a physical count or perpetual balance seems reasonable

The Formula:

Estimated COGS = Net Sales × (1 − Gross Profit %)

Estimated Ending Inventory = Goods Available for Sale − Estimated COGS

Worked Example — Cascade Warehouse Fire:

Cascade Logistics experiences a warehouse fire on March 15, 2026. The company needs to estimate destroyed inventory for its insurance claim.

Step 1: Goods available for sale

$1,850,000 + $2,430,000 = $4,280,000

Step 2: Estimated COGS

$3,600,000 × (1 − 0.35) = $3,600,000 × 0.65 = $2,340,000

Step 3: Estimated ending inventory (pre-fire)

$4,280,000 − $2,340,000 = $1,940,000

Step 4: Inventory loss

If salvageable inventory after the fire = $210,000:

Insurance claim = $1,940,000 − $210,000 = $1,730,000

Limitations:

• Relies on historical margins being stable — if the product mix has shifted or pricing has changed, the estimate will be inaccurate
• Cannot distinguish between different product categories with different margins
• Is an estimate, not a precise measurement — auditors accept it for special purposes only

Exam Tip: Know the difference between the gross profit method (uses historical gross profit %) and the retail inventory method (uses cost-to-retail ratio). Both estimate ending inventory, but they use different inputs and are accepted for different purposes.

Explore more FRA estimation topics in our CFA Level I course.