Inventory
Inventory Estimation Methods
• In many cases, it is necessary to know the approximate value of inventory when it is
not possible to take a physical count.
• Even if the physical count is possible. The same may prove costly, difficult or
inconvenient at the moment.
• The most common reasons for making an estimate of the cost of the goods in hand
are:
a) The inventory is destroyed by fire and other catastrophe, or theft of the
merchandise has occurred and the amount of inventory is required for insurance
purposes.
b) A physical count of the goods on hand is made and it is necessary to prove the
correctness or reasonableness of such count by making an estimate.
- This is known as the “gross profit test” in the accounting parlance.
c) Interim financial statements are prepared and a physical count of the goods on hand
is not necessary because it may take time to do the same.
- Moreover, only an estimate is required to fairly present the financial position and
financial performance of the entity for interim reporting purposes.
Two common methods of estimating cost of inventory:
a. Gross Profit Method
b. Retail Inventory Method
Gross Profit Method
• The gross profit method of estimating inventory costs is based on an assumed
relationship between gross profit and sales or between gross profit and cost of
sales.
• The gross profit method depends on the accuracy of the gross profit percentage.
• The amount obtained is reported as ending inventory for interim financial reporting
purposes or is considered the amount of loss in cases of fire, flood, theft, and similar
events unless there are undamaged or partially damaged merchandise.
• In computing net sales only Sales return is deducted.
Illustrative Example: Gross Profit Method
Assume the following figures for Jisoo Company for the six months ended June
30,2019:
What if there is undamaged or partially damaged merchandise?
Assume On October 30, 2019, a big fire caused severe damage to the warehouse of
Jisoo Company. Thus, the company suffered a loss on its inventory. The following
information was available from the company’s books.
Retail Inventory Method
• PAS 2, paragraph 22, provides that this method is often used in the retail industry for
measuring inventory of large number of rapidly changing items with similar margin
for which it is impracticable to use other costing method.
• The cost of the inventory is determined by reducing the sales value of the inventory
by the appropriate percentage gross margin.
• The retail inventory method requires the maintenance of records of purchases at
both cost and selling price. A ratio of cost of retail is calculated and applied to the
ending inventory at retail to compute the approximate cost.
The original selling prices of goods may be modified as a result of some market and
economic forces, thus the following terms:
1. Original terms – the first selling price at which goods are offered for sale.
2. Markup or additional markup – an increase in the selling price over the original retail
price.
3. Markdown – decrease in the selling price below the original retail price.
4. Markup cancellation – a decrease in the selling price which does not bring the new selling
price below the original retail.
5. Markdown cancellation – an increase in the selling price which does not bring the new
selling price above the original retail price.
6. Net Markup – markup less markup cancellation.
7. Net Markdown – markdown less markdown cancellation.
8. Normal losses, shortage, shrinkage are deducted from the goods available for sale at retail,
after computing the cost ratio.
9. Abnormal losses are deducted from both cost and retail amounts of purchases, before
computing the cost ratio.
10. Discounts to employees and favored customers are deducted from the goods available
for sale at retail, after computing the cost ratio (in effect, this is an addition to sales).
The original selling prices of goods may be modified as a result of some
market and economic forces, thus the following terms:
1. Original terms – the first selling price at which goods are offered for sale.
2. Markup or additional markup – an increase in the selling price over the
original retail price.
3. Markdown – decrease in the selling price below the original retail price.
4. Markup cancellation – a decrease in the selling price which does not
bring the new selling price below the original retail.
5. Markdown cancellation – an increase in the selling price which does not
bring the new selling price above the original retail price.
6. Net Markup – markup less markup cancellation.
7. Net Markdown – markdown less markdown cancellation.
Illustrative Problem: Retail Inventory Method
(Approximating Average Cost)
• The net markups and net markdowns, as well as the beginning
inventory are included in the computation of the cost percentage that
is applied to the ending inventory at retail.
• The approximated average cost of the inventory is then compared
with the net realizable value.
• The lower between the cost (approximating the result of the average
cost method) and the net realizable value is the inventory amount
that will be reported on the statement of financial position.
Illustrative Problem: Retail Inventory Method
(Approximating Average Cost)
Illustrative Problem: Retail Inventory Method (FIFO Retail)
• When the retail method assumes a FIFO Cost flow, the cost and the
retail value of beginning inventory are excluded from the cost ratio
computation.
• The cost percentage that is developed is the ratio of the current cost
of purchases to the current retail prices of these purchases (adjusted
for net markups and net markdowns). The approximated cost of the
ending inventory is, therefore, based on the ratio of cost to retail on
current period purchases only.
• The amount of the ending inventory at retail would be the same in
both computations; however, the estimated cost of the ending
inventory would vary, depending on the cost ratio applied.
Illustrative Problem: Retail Inventory Method (FIFO Retail)