ACCT201 - Chapter 8
Methods of Estimating Ending Inventory
Inventory values must often be determined by using an estimate because a valuation by physical
count may be costly or impossible to obtain. Estimated inventory may be required for:
- Interim reporting
- Estimation of inventory loss due to fire, theft, etc.
- Comparison to actual inventory counts for purposes of determining shortages
Gross Margin (Profit) Method
The gross margin method is based on the assumption that a constant gross margin rate (%)
estimated on recent sales, can be used to estimate inventory values from current sales.
GROSS MARGIN RATE = (GROSS MARGIN
NET SALES x 100%)
STEPS:
(1) Estimate the gross margin rate, as a percentage of net sales, based on historic data
(2) Calculate the total cost of goods available for sale, based on actual data.
(Opening inventory plus purchases, net of discounts, returns and allowances plus
freight-in)
(3) Calculate the estimated gross margin (gross profit)
= NET SALES x Gross margin rate {Step (1)}
(4) Calculate the Cost of Goods Sold
= NET SALES – GROSS MARGIN {(Step (3)}
(5) Calculate Ending Inventory
= COST OF GOODS AVAILABLE FOR SALE – COST OF GOODS SOLD
(Step 2)
(Step 4)
ACCT201- Chapter 8
Methods of Estimating Ending Inventory
Gross Margin Method (continued):
Example:
Sales
Sales returns
Purchases
Purchases returns
Opening inventory
Freight-in
= $315,000
=
5,000
= 155,000
=
2,000
= 50,000
=
5,000
Estimated gross margin rate = 40% of net sales
Step (1) 40% (Given)
Step (2) Cost of Goods Available for Sale:
Opening inventory
$ 50,000
Purchases
155,000
Purchases returns
(2,000)
Freight-in
5,000
$208,000
Step (3) Gross Margin = ($315,000 – $5,000) x 40%
= $124,000
Step (4) Cost of Goods Sold
= $310,000 – $124,000
= $186,000
Step (5) Ending Inventory
= $208,000 – $186,000
= $22,000
Sales, net
Goods Available for sale
Ending inventory (estimated)
Gross Margin
$ 310,000
208,000
(22,000)
(186,000)
$ 124,000
ACCT201- Chapter 8
Methods of Estimating Ending Inventory
When the gross margin method is applied in a situation that involves broad aggregations of
inventory items with significantly different markup rates, the computations should be developed
for each separate class. The estimate of total inventory is then determined by summing up the
estimates for the separate classes
In the application of the gross margin method, it is necessary to have the gross margin (markup)
expressed as a percentage of sales. However, this rate maybe expressed as a percentage of cost,
and therefore must be converted to a percentage of sales.
Example:
Assume that the markup on cost is 60%. To convert this to a percentage of sales, this translates
to the following formula:
Sales – Cost = 60% of Cost
Sales is always the "100 % " number, so let sales = 1 and let cost = C
1 - C = .6C and solve for "C"
1 = .6C + (1)C
1 = 1.6C
1/1.6 = C
.625 = C
Therefore 1 - .625 = .375 and therefore, the gross margin rate = 37.5% of sales
Homework: BE8-15 and BE 8-16, page 502
E8-21 and E8-22, page 510
P8-10, page 518
ACCT201- Chapter 8
Methods of Estimating Ending Inventory
Retail Method
The retail method is often used by retail stores, especially department stores carrying a wide
variety of items. The retail inventory method is appropriate when items sold within a department
have essentially the same markup rate and items purchased for resale are priced immediately.
The retail method uses both retail value and actual cost data to compute a cost ratio (cost/retail),
calculate the ending inventory at cost and convert that retail value to a cost value by applying the
computed cost ratio to the ending value.
Records and information required:
(1) Sales revenue, net of returns and allowances (sales discounts are ignored!)
(2) Beginning inventory valued @ cost AND @ retail
(3) Purchases, net of discounts, returns and allowances, valued @ cost AND @ retail
(4) Adjustments to the original retail price, such as additional markups, markup cancellations,
markdowns, markdown cancellations, normal shrinkage, employee discounts and abnormal
shrinkage
FOR DEFINITIONS OF THESE TERMS SEE PAGES 493, 494 AND 497 OF THE
TEXT.
Steps to Calculate Ending Inventory at Cost:
STEP (1) Calculate Ending Inventory @ Retail
= Beginning Inventory @ retail + Purchases, net (of R & A and discounts) @ retail +
(Additional Markups – Additional Markup Cancellations) – (Markdowns – Markdown
cancellations) – Abnormal Shrinkage – Sales, net (of R & A) – Employee Discounts –
Normal Shrinkage
Note that what we are essentially calculating with this formula is:
Goods Available for Sale @ Retail – (Net Sales + Employee Discounts + Normal Shrinkage)
= Ending Inventory @ Retail
ACCT201- Chapter 8
Methods of Estimating Ending Inventory
Steps to Calculate Ending Inventory at Cost (continued):
STEP (2)
Calculate the appropriate cost-to-retail ratio. There are four different possibilities for this
calculation: (1) FIFO, (2) FIFO with LCM, (3) Average Cost and (4) Average Cost with LCM
For purposes of these formulas:
Net Purchases = Purchases – Purchases R & A – Purchase discounts
Net Markups = Additional Markups – Markup Cancellations
Net Markdowns = Markdowns – Markdown Cancellations
1. Cost Ratio, FIFO =
(Net Purchases – Abnormal Shrinkage + Freight) @ Cost
(Purchases, net + Net Markups – Abnormal Shrinkage – Net Markdowns) @ Retail
2. Cost Ratio, FIFO with LCM (net markdowns are excluded) =
(Net Purchases – Abnormal Shrinkage + Freight) @ Cost
(Net Purchases + Net Markups – Abnormal Shrinkage) @ Retail
3. Cost Ratio, Average Cost =
(Opening Inventory + Net Purchases – Abnormal Shrinkage + Freight) @ Cost
(Opening Inventory + Purchases, net + Net Markups – Abnormal Shrinkage – Net Markdowns)
@ Retail
4. Cost Ratio, Average Cost with LCM – “the conventional retail inventory method”
(net markdowns are excluded) =
(Opening Inventory + Net Purchases – Abnormal Shrinkage + Freight) @ Cost
(Opening Inventory + Net Purchases + Net Markups – Abnormal Shrinkage) @ Retail
STEP (3)
Calculate Ending Inventory @ Cost = Ending Inventory @ Retail x Appropriate Cost Ratio
[from STEP (1)]
[from STEP (2)]
Note: Net markdowns are excluded from LCM calculations in order to reduce the ratio
and produce a (lower) conservative value for ending inventory.
ACCT201- Chapter 8
Methods of Estimating Ending Inventory
Sample Problem
The data:
Beginning inventory.......................................
Purchases........................................................
Purchase returns .............................................
Freight on purchases ......................................
Additional markups ........................................
Additional markup cancellations ...................
Markdowns ....................................................
Markdown cancellations ................................
At Cost
At Retail
$ 45,000
459,500
2,200
7,000
$ 80,000
850,000
4,000
Sales ...............................................................
Less: Sales returns.........................................
9,000
5,000
7,000
3,000
$800,000
2,000
Required:
(1) Calculate the estimated cost of the ending inventory, using the Gross Margin method, under
the assumption that the gross margin rate is 51% of net sales.
(2) Calculate the estimated cost of the ending inventory using
(a)
(b)
(c)
(d)
the Retail method and Average cost, with LCM
the Retail method and Average, without LCM
the Retail method and FIFO, with LCM
the Retail method and FIFO, without LCM
Round the cost ratios to 3 decimal places!
(3) Based on your answers to part (2), calculate the gross margin rates for parts (a), (b), (c) and
(d).
Refer to illustration 8A-3 on page 494 – excellent!
Homework: BE8-17, page 502
E8-25, page 511
P8-13, page 519
ACCT201 – Chapter 8
Methods of Estimating Ending Inventory
Solution to Sample Problem
Requirement 1
Net Sales .................................................................
Opening Inventory .................................................. $ 45,000
Net purchases1 ........................................................ 464,300
509,300
Gross Margin ($798,000 x .51) ...............................
Cost of Goods Sold ($798,000 - $406,980) ............
Ending Inventory ($509,300 - $391,020) ...............
$798,000
406,980
$391,020
$118,280
1$459,500 + $7,000 - $2,200 = $464,300
Requirements 2 and 3 (a)
Goods available for sale:
Beginning inventory.......................................
Purchases........................................................
Purchase returns .............................................
Freight on purchases ......................................
Additional markups ........................................
Additional markup cancellations ...................
Markdowns ....................................................
Markdown cancellations ................................
Total goods available for sale ....................
At Cost
At Retail
$ 45,000
459,500
(2,200)
7,000
$ 80,000
850,000
(4,000)
$509,300
9,000
(5,000)
(7,000)
3,000
926,000
Cost ratio = $509,300/$930,000 = .548 (exclude markdowns, net of cancellations)
Deduct:
Sales ............................................................... $800,000
Less: Sales returns......................................... ( 2,000)
Net sales .....................................................
Ending inventory (at retail) ..................................
(798,000)
$128,000
Ending inventory (at cost) $128,000 x .548.........
70,144
Cost of goods sold ($509,300 - $70,144).............
$439,156
Actual gross margin achieved,
($798,000 - $439,156)/$798,000 .......................
44.97%
ACCT201 – Chapter 8
Methods of Estimating Ending Inventory
Solution to Sample Problem
Requirements 2 and 3 (b)
Goods available for sale:
Beginning inventory.......................................
Purchases........................................................
Purchase returns .............................................
Freight on purchases ......................................
Additional markups ........................................
Additional markup cancellations ...................
Markdowns ....................................................
Markdown cancellations ................................
Total goods available for sale ....................
At Cost
At Retail
$ 45,000
459,500
(2,200)
7,000
$ 80,000
850,000
(4,000)
$509,300
9,000
(5,000)
(7,000)
3,000
926,000
Cost ratio = $509,300/$926,000 = .55 (include markdowns, net of cancellations)
Deduct:
Sales ............................................................... $800,000
Less: Sales returns......................................... ( 2,000)
Net sales .....................................................
(798,000)
Ending inventory (at retail) ..................................
$128,000
Ending inventory (at cost) $128,000 x .55...........
70,400
Cost of goods sold ($509,300 - $70,400).............
$438,900
Actual gross margin achieved,
($798,000 - $438,900)/$798,000 .......................
45 %
ACCT201 – Chapter 8
Methods of Estimating Ending Inventory
Solution to Sample Problem
Requirements 2 and 3 (c)
Goods available for sale:
Beginning inventory.......................................
Purchases........................................................
Purchase returns .............................................
Freight on purchases ......................................
Additional markups ........................................
Additional markup cancellations ...................
Markdowns ....................................................
Markdown cancellations ................................
Total goods available for sale ....................
At Cost
At Retail
$ 45,000
459,500
(2,200)
7,000
$ 80,000
850,000
(4,000)
$509,300
9,000
(5,000)
(7,000)
3,000
926,000
Cost ratio = $464,300/$850,000 = .546 (exclude opening inventory and markdowns, net of
cancellations)
Deduct:
Sales ............................................................... $800,000
Less: Sales returns......................................... ( 2,000)
Net sales .....................................................
Ending inventory (at retail) ..................................
(798,000)
$128,000
Ending inventory (at cost) $128,000 x .546.........
$ 69,888
Cost of goods sold ($509,300 - $69,888).............
$439,412
Actual gross margin achieved,
($798,000 - $439,412)/$798,000 .......................
44.9%
ACCT201 – Chapter 8
Methods of Estimating Ending Inventory
Solution to Sample Problem
Requirements 2 and 3 (d)
Goods available for sale:
Beginning inventory.......................................
Purchases........................................................
Purchase returns .............................................
Freight on purchases ......................................
Additional markups ........................................
Additional markup cancellations ...................
Markdowns ....................................................
Markdown cancellations ................................
Total goods available for sale ....................
At Cost
At Retail
$ 45,000
459,500
(2,200)
7,000
$ 80,000
850,000
(4,000)
$509,300
9,000
(5,000)
(7,000)
3,000
926,000
Cost ratio = $464,300/$846,000 = .549 (exclude opening inventory and include markdowns,
net of cancellations)
Deduct:
Sales ............................................................... $800,000
Less: Sales returns......................................... ( 2,000)
Net sales .....................................................
(798,000)
Ending inventory (at retail) ..................................
$128,000
Ending inventory (at cost) $128,000 x .549.........
70,272
Cost of goods sold ($509,300 - $70,272).............
$439,028
Actual gross margin achieved,
($798,000 - $439,028)/$798,000 .......................
45 %