They help us estimate our inventory. Reasons we might need to estimate our ending inventory:
1) Need balances for interim financial statements. A physical inventory might be too costly (explain to them and give examples of how many people and lost production).
2) Inventory is lost in a disaster, such as a fire, flood, tornado, hurricane, or earthquake.
3) Inventory is stolen. Physical count is compared to the amount that should be on hand based on our estimation.
Gross Profit Method:
*Sales – Gross Profit on Sales = Cost of merchandise Sold
*Uses the estimated gross profit for the period to estimate the inventory at the end of the period.
*Usually estimated from the preceding years actual rate.
*Useful for estimating inventories for monthly or quarterly financial statements in a periodic inventory system.
*Works best with companies that have stable/consistent gross profit percentages.
Retail Inventory Method:
*Useful for estimating inventories for monthly or quarterly financial statements in a periodic inventory system.
*Helps identify shortages by comparing the estimated ending inventory with the physical ending inventory.
*Can aid in taking a physical inventory in a retail operation: the items counted are recorded on the inventory sheets at their retail prices instead of costs. Then it is converted to its cost.
*Can be used by companies that NOT use a stable gross profit percentage.
We compare the cost of inventory to their retail value.
*Retailer must track inventory purchases, and beginning inventory at it’s cost and it’s retail value.
*Some retailers take inventory at their retail prices, because that is marked on all the tags, and then convert it to their cost.
Inventory is carried on our books/financial statements at the price/”cost” we pay for it unless:
1) The current cost to purchase it is lower than our costs. – We need to lower our inventory to this replacement cost.
2) The inventory has been damage or become obsolete such that they cannot be sold at their current prices – We need to lover them to their “net realizable value” (estimated sales price – cost to sell or dispose of the items).