Inventories: Additional Issues
INVENTORY ESTIMATION TECHNIQUES
Gross Profit Method
In preparing interim financial statement many organizations use a technique for estimating
ending inventory rather than taking a physical count. One such method is the gross profit
method, which is based on three assumptions:
(1) Beginning inventory plus purchases is equal to goods available for sale
(2) Inventory not sold must be on hand at the end of the accounting period
(3) The calculated cost of goods sold subtracted from goods available for sale equals the
value of ending inventory
Example: On October 31, 2000 Spencer Company incurred a loss as a result of flood damage.
The following information is available regarding sales and inventory for the period January 1
though October 31.
Spencer Company
Financial Information
January 1 through October 31, 2000
Sales
Normal gross profit percent
Beginning inventory
Purchases
Purchase returns and allowances
Purchase discounts
Ending inventory (not destroyed)
$
$
$
$
$
$
900,000
45%
200,000
600,000
30,000
12,000
100,000
The insurance company needs to know how much inventory was lost in order to pay the claim.
Using the gross profit method, the following provides the calculation of the estimated ending
inventory less the amount that was salvaged from the flood.
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Inventories: Additional Issues
Spencer Company
Estimated Ending Inventory Using the Gross Profit Method
January 1, through October 31, 2000
Retail
Beginning inventory
Purchases
Purchase returns and allowances
Purchase discounts
Goods available for sale
Sales
Less: gross profit (45% of sales)
Cost of goods sold
Estimated ending inventory, October 31
Less: inventory salvaged
Insurance loss
$
Cost
$ 200,000
600,000
(30,000)
(12,000)
758,000
900,000
405,000
$
495,000
263,000
100,000
163,000
Estimating ending inventory is normally acceptable on an interim basis. At least once per year a
company should conduct a physical count of inventory to determine the actual physical amount
and make the appropriate adjustment in the accounting records.
Retail Inventory Method
In retailing most inventory records are kept at retail prices. Using the format provided in your
homework you can apply a formula to the retail amounts to determine the estimated ending
inventory. The retail inventory method requires the following:
(1) Records must be kept of the total cost and retail value of merchandise purchased
(2) Records must be kept of the total cost and retail value of goods available for sale
(3) Records must be kept of the sale for the accounting period
Retail Terminology
Retailers use a number of terms to indicate how merchandise has been priced. The following
terms will be used in calculating the retail method.
 Markup - an amount in excess of the normal gross profit
 Markup cancellation - the subsequent reduction of the profit margin to normal the gross
profit level
 Markdowns - the amount by which the normal retail price has been reduced in order to
move the merchandise
 Markdown cancellations - repricing the merchandise to normal margin
Conventional Retail Inventory Method
The following format is used to calculate the estimated ending inventory using the conventional
retail inventory method.
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Inventories: Additional Issues
Conventional Retail Inventory Method
COST
Beginning inventory
Purchases (net)
Totals
Add: Markups (net)
Totals
Less: Markdowns (net)
Goods available for sale at retail
Less: Sales (net)
Ending inventory at retail
$
$
$
Cost-to-retail ratio:
Computation of ending inventory at cost:
Ending inventory at retail
Cost-to-retail ratio
Ending inventory at cost
$
RETAIL
$
$
$
$
$
$
$
$
$
$
COST
SALES
RATIO
$
%
$
%
$
Exercise: Spencer Company had beginning inventory of $12,000 at cost and $20,000 at retail.
Net purchases were $120,000 at cost and $170,000 at retail. Net markups were $10,000; net
markdowns were $7,000; and sales were $157,000. Using the format provided compute the
estimated ending inventory at cost using the conventional retail method.
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Inventories: Additional Issues
Spencer Company
Estimated Ending Inventory at Cost Using the Conventional Retail Inventory Method
Conventional Retail Inventory Method
COST
RETAIL
Beginning inventory
Purchases (net)
Totals
Add: Markups (net)
Totals
Less: Markdowns (net)
Goods available for sale at retail
Less: Sales (net)
Ending inventory at retail
COST
SALES
RATIO
Cost-to-retail ratio:
Computation of ending inventory at cost:
Ending inventory at retail
Cost-to-retail ratio
Ending inventory at cost
Solution:
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Inventories: Additional Issues
Spencer Company
Estimated Ending Inventory at Cost Using the Conventional Retail Inventory Method
Conventional Retail Inventory Method
Beginning inventory
Purchases (net)
Totals
Add: Markups (net)
Totals
Less: Markdowns (net)
Goods available for sale at retail
Less: Sales (net)
Ending inventory at retail
Cost-to-retail ratio:
Computation of ending inventory at cost:
Ending inventory at retail
Cost-to-retail ratio
Ending inventory at cost
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COST
12,000
120,000
132,000
RETAIL
20,000
170,000
190,000
10,000
200,000
7,000
193,000
157,000
36,000
132,000
COST
132,000
SALES
200,000
RATIO
66%
36,000
66%
23,760
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