Masters Technological Institute of Mindanao

College of Accountancy
Intermediate Accounting 1 - Millan
MODULE 11-INVENTORY ESTIMATION

LEARNING OBJECTIVE:
1. Apply the methods of inventory estimation

TOPIC OUTLINE:
Inventory estimation
Gross profit method
Retail method

Inventory estimation
- Estimates are allowed under PAS 2 only if they approximate the cost.
- Generally, inventory estimation is made only for interim reports.
o For annual reporting, physical count of inventories is more appropriate.
- Cost of inventories may be estimated using:
1. Gross Profit Method
2. Retail Method

Gross Profit Method

- Gross profit is assumed to be relatively constant from period to period.
o Thus, gross profit rate (GPR) is used to determine the cost ratio which in
turn is used to estimate the inventory and the cost of goods sold.
o Gross profit rate can be expressed as a percentage (a) based on sales or (b)
based on cost of goods sold.

Illustration: The gross profit rates of an entity with sales of P1,000 and cost of
goods sold of P800 are computed as follows:
GPR based on Sales GPR based on Cost
Net Sales 1,000 Gross Profit Gross Profit 200
GPR = = GPR = =
COGS ( 800) Net Sales COGS 800
200 = 25%
Gross Profit 200 = 20%
1,000 Here the 100% is the COGS
Here the 100% is the
sales

Illustration: Translation of Gross Profit Rates

❖ If GPR based on cost is 25%, what is the GPR based on sales?
25 %
Net Sales 125% GPR based on sales = = 20%
125 %
COGS (100%)
Gross Profit Rate 25%

❖ If GPR is based on sales is 20%, what is the GPR based on cost?

20 %
Net Sales 100% GPR based on cost = = 25%
80 %
COGS (80%)
GPR 20%

- Cost Ratio
 o It is derived from the gross profit rate as follows:
Net Sales 100%
Less: GPR based on sales ( x%)
Cost Ratio x%

COGS(100 %)
Cost Ratio =
1+ GPR based on cost

Illustration:
o If the GPR based on sales is 20%, what is the cost ratio?
Net Sales 100%
GPR based on sales (20%)
Cost Ratio 80%
o If the GPR based on cost is 25%, what is the cost ratio?
100 %
Cost Ratio = = 80%
125 %

- Net Sales
o For purposes of inventory estimation, only SALES RETURNS are deducted
from gross sales when computing for net sales.
▪ Sales discounts and allowances are NOT deducted because these
do not affect the physical inventory of goods.

- Steps for computation:

o Step 1: Compute for the cost ratio
o Step 2: Compute for the net Sales
● Deduct only Sales returns, and ignore any sales discounts and
allowances.
Gross Sales P xx
Less: Sales returns ( xx )
Net Sales P xx
o Step 3: Compute for the cost of goods sold or cost of sales
COGS = Net Sales * Cost Ratio
o Step 4: Compute for the ending inventory
Inventory Beginning P xx
Net Purchases xx
Freight-in xx
Ending Inventory ?
Cost of Goods Sold P xx
o Step 5: Compute for Estimated Loss
Inventory after casualties (on hand) P xx
Less: Ending inventory per computation ( xx )
Estimated Loss P xx

- 3 types of inventories you look after casualties (they are included as part of
inventory on hand)
1. Retained by company: if damage – use the NRV , if undamaged – used cost
2. Inventory in transit
3. Inventory out on consignment

Accounts Payable Inventory

Beginning Bal. Beginning Bal.

Payments Net purchases Net Purchases

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 Freight-in COGS

End Balance End Balance

Illustration:
On October 1, 20x1, a flood destroyed the warehouse of ABC Co. and all the
inventories contained therein. Off-site back up to data based shows the following
information:
Inventory, Jan. 1 14,500
Accounts Payable, Jan. 1 6,000
Accounts Payable, Sept. 30 3,000
Payments to supplies 50,000
Freight-in 5,000
Purchase returns and discounts 2,500
Sales from Jan. to Sept. 75,000
Sales returns 5,000
Sales discounts 2,000
Gross profit rate based on sales 20%

Additional information
The inventory on September 30, 20x1 includes goods in transit of P2,000 and goods
out on consignment of P1,200. Partially damaged goods salvaged from the flood can
be sold as scrap for P500.

Requirement: Compute for the inventory loss due to the flood.

SOLUTION;
Step 1: determine the cost ratio: Cost Ratio = 100% - 20% = 80%
Step 2: Compute for the net sales: Sales 75,000
Sales Returns (5,000)
Net Sales 70,000
Step 3: Compute for the COGS
COGS = 70,000 * 80% = 56,000
Step 4: Compute for the ending inventory
Accounts Payable
6,000 Beginning
Payment 50,000 47,000 Net Purch.
3,000 Ending

Beginning balance, inventory 14,500

Net purchases 47,000
Freight-in 5,000
Ending Inventory (squeezed) (10,500)
COGS 56,000

Step 5: Compute for the estimated loss

Inventories on hand (2,000+1,200+500) 3,700
Less: Inventory per computation (10,500)
Inventory Loss ( 6,800)

Illustration:
On October 1, 20x1, a fire razed the warehouse of ABC Co. and all the inventories
contained therein. Off-site back up of data base shows the following information:
Inventory, January 1 14,500
Net purchases 75,000
Net Sales from Jan. to Sept. 96,000
Gross profit rate based on cost 20%
Requirement: Compute for the inventory loss due to the fire.

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 100 %
Step 1: determine the cost ratio: Cost Ratio = = 83.3333333%
120 %
Step 2: Compute for the net sales: 96,000
100 %
Step 3: Compute for the COGS: COGS = 96,000 * = 80,000
120 %
Step 4: Compute for the ending inventory
Beginning balance, inventory 14,500
Net purchases 75,000
Freight-in -
Ending Inventory (squeezed) (9,500)
COGS 80,000
Step 5: Inventory loss due to fire is P9,500,

Retail Method
- Often used in the retail industry for measuring large quantities of inventories with
rapidly changing items and with similar margins and for which it is impracticable
to use other costing method.
- The following are peculiar to the retail method
1. The cost ratio is computed direct without regard to the gross profit rate
2. Net markups and net markdowns are considered.
Net Markup = Markup – markup cancellation’
Net markdown = Markdown – markdown cancellation

- COMPUTATION:

Cost Retail

Inventory beginning P xx P xx
Purchases xx xx
Freight in xx
Purchase discounts (xx)
Purchase returns & allowances (xx) (xx)
Departmental transfer-in xx xx
Departmental transfer-out (xx) (xx)
Abnormal spoilage (xx) (xx)

Goods Available for Sale (GAS) P xx P xx

Net Markup xx

Goods available for sale with MU P xx

Net Markdown ( xx )

GAS with MU and MD P xx

Cost ratio computation:

1. Conventional method/ Conservative method / Lower of Average cost
method/ NRV retail method
GAS at Cost
COST RATIO =
GAS at Retail with Mark−Up

2. Average method
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 GAS at Cost
COST RATIO =
GAS at Retail with Mark−Up∧Markdown

3. FIFO Method
COST RATIO =
GAS at Cost−Beginnong Inventory at cost
GAS at Retail with Mark−Up−Beginning Inventory at retail

Net Sales computation: Sales P xx

Sales returns ( xx )
Employee Discounts xx
Normal Spoilage xx
Net Sales P xx

Ending Inventory: GAS at retail with MU & MD P xx

Ending inventory at retail ?
Net Sales P xx

Est. Cost of Ending inventory = End. Inventory at retail * Cost ratio

COGS Computation: GAS at cost P xx

Est. Cost of ending inventory ( xx )
COGS P xx

Illustration:
Presented below is information pertaining to ABC Co.
Cost Retail
Inventory, January 1 8,700 14,000
Purchases 55,300 80,300
Freight-in 2,000
Purchase discounts 500
Purchase returns 5,200 8,600
Departmental transfer-in 1,000 1,500
Departmental transfer-out 800 1,200
Markups 6,000
Markup cancellation 2,000
Markdowns 12,000
Markdown cancellation 3,000
Abnormal spoilage (theft and casualty loss) 5,000 7,000
Sales 43,800
Sales returns 2,500
Sales discounts 1,000
Employee discounts 500
Normal spoilage (shrinkage and breakage) 200

SOLUTION:
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 Cost Retail
Inventory beginning 8,700 14.000
Purchases 55,300 80,300
Freight in 2,000
Purchase discounts ( 500)
Purchase returns & allowances (5,200) (8,600)
Departmental transfer-in 1,000 1,500
Departmental transfer-out (800) (1,200)
Abnormal spoilage (5,000) (7,000)
Goods Available for Sale (GAS) 55,500 79,000
Net Markup 4,000
GAS with MU 83,000
Net Markdown (9,000)
GAS with MU and MD 74,000

1. Conventional method/ Conservative method / Lower of Average cost method/

NRV retail method
GAS at Cost 55,500
COST RATIO = = = 66.87%
GAS at Retail with Mark−Up 83,000

2. Average method
GAS at Cost 55,500
COST RATIO = = = 75%
GAS at Retail with Mark−Up∧Markdown 74,000

3. FIFO Method
GAS at Cost −Beginnong Inventory at cost
COST RATIO =
GAS at Retail with MU ∧MD−Beginning Inventory at retail
55,500−8,700 46,800
= = = 78%
74,000−14,000 60,000
Net Sales computation: Sales 43,800
Sales returns (2,500 )
Employee Discounts 500
Normal Spoilage 200
Net Sales 42,000

Ending Inventory: GAS at retail with MU & MD 74,000

Ending inventory at retail (32,000)
Net Sales 42,000

Conventional method
Est. Cost of Ending inventory = End. Inventory at retail * Cost ratio
= 32,000 * 66.87%
= 21,398

Average method
Est. Cost of Ending inventory = End. Inventory at retail * Cost ratio
= 32,000 * 75%
= 24,000
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FIFO Method
Est. Cost of Ending inventory = End. Inventory at retail * Cost ratio
= 32,000 * 78%
= 24,960

Conventional method
COGS Computation: GAS at cost 55,500
Est. Cost of ending inventory (21,398 )
COGS 34,102

Average method
COGS Computation: GAS at cost 55,500
Est. Cost of ending inventory (24,000 )
COGS 31,500

FIFO method
COGS Computation: GAS at cost 55,500
Est. Cost of ending inventory (24,960 )
COGS 30,540