A physical inventory count reveals the exact inventory your small business has at the end of an accounting period, but doing one can be costly and time-consuming. For those periods in which a physical count is unpractical, you can use your gross profit ratio, or margin, to estimate ending inventory. Gross profit is the income you earn from sales after paying cost of goods sold. Gross profit margin is your gross profit as a percentage of sales. Because this method relies on past information, it works best for businesses that buy and sell merchandise and that have relatively stable costs.
Subtract your cost of goods sold in the most recent year from your net sales in the same year to figure your gross profit. Cost of goods sold are the direct costs required to make or buy your merchandise. Net sales equals total sales minus refunds and sales discounts. For example, assume your small business had $200,000 in net sales and $120,000 in cost of goods sold last year. Subtract $120,000 from $200,000 to get $80,000 in gross profit.
Divide gross profit by net sales to figure your gross profit margin. In this example, divide $80,000 by $200,000 to get 0.4, or 40 percent.
Adjust last year’s gross profit margin to account for any changes that could affect
your gross profit and cost of goods sold in the current period. If you believe your cost of goods sold might rise in the current period, reduce your gross profit margin. Decreasing costs might warrant an increase in your margin. In this example, assume your costs are improving in the current period, which you believe justifies an increase to a 42 percent gross profit margin.
Add the cost of the inventory you had at the beginning of the current period to the cost of inventory you purchased during the period to calculate your cost of goods available for sale. In this example, assume you had $75,000 in beginning inventory and bought $100,000 in inventory during the period. Add these together to get $175,000 in cost of goods available for sale.
Subtract your adjusted gross profit margin from 1. Multiply your result by the current period’s net sales to estimate the current period’s cost of goods sold. In this example, assume you had $250,000 in net sales in the current period. Subtract 42 percent, or 0.42, from 1 to get 0.58. Multiply 0.58 by $250,000 to get $145,000 in estimated cost of goods sold.
Subtract your result from your cost of goods available for sale to estimate your ending inventory for the current period. Concluding the example, subtract $145,000 from $175,000 to get $30,000 in ending inventory.