Financial Accounting and Reporting Shellah Mae Carpio, CPA

FAR.1605-Estimating Inventories

LECTURE NOTES
Gross profit method
The gross profit method is an
 This inventory estimation technique based on a
relationship between gross profit and sales that is
assumed to be fairly stable.
 Its use is not appropriate for financial reporting
purposes;
 However, it can serve a useful purpose when an
approximation of ending inventory is needed. Such
approximations are sometimes required by auditors
or when inventory and inventory records are
destroyed by fire or some other catastrophe.
 The gross profit method should never be used as a
substitute for a yearly physical inventory unless
the inventory has been destroyed.
The gross profit method is based on the assumptions that
(a) the beginning inventory plus purchases equal
total goods to be accounted for;
(b) goods not sold must be on hand; and
To obtain the appropriate inventory figures under the retail
inventory method, proper treatment must be given to
markups, markup cancellations, markdowns, and
markdown cancellations.
When the cost to retail ratio is computed after net markups
(markups less markup cancellations) have been added, the
retail inventory method approximates lower of cost or
market. This is known as the conventional retail inventory
method. If both net markups and net markdowns are
included before the cost to retail ratio is computed, the
retail inventory method approximates cost.
The retail inventory method becomes more complicated
when such items as freight-in, purchase returns and
allowances, and purchase discounts are involved. In
essence, the treatment of the items affecting the cost
column of the retail inventory approach follows the
computation of cost of goods available for sale. Freight
costs are treated as a part of the purchase cost; purchase
returns and allowances are ordinarily considered both a
reduction of the price at both cost and retail; and purchase

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(c) if sales, reduced to cost, are deducted from the discounts usually are considered as a reduction of the cost

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sum of the opening inventory plus purchases, of purchases.

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the result is the ending inventory.
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In developing a reliable gross profit percentage, reference
Other items that require careful consideration include
transfers-in, normal shortages, abnormal shortages, and

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is made to past years and adjustments are made for employee discounts. Transfers-in from another
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current circumstances. departments should be reported in the same way as
purchases from an outside enterprise. Normal shortages
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should reduce the retail column because these goods are

Techniques for the Measurement of Cost under PAS 2 no longer available for sale. Abnormal shortages should be
deducted from both the cost and retail columns and
Techniques for the measurement of the cost of inventories, reported as a special inventory amount or as a loss.
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such as the standard cost method or the retail method, Employee discounts should be deducted from the retail
may be used for convenience if the results approximate
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column in the same way as sales.

cost.
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The retail inventory method is widely used (a) to permit the

Standard cost method computation of net income without a physical count of
Standard costs take into account normal levels of materials inventory, (b) as a control measure in determining
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and supplies, labor, efficiency and capacity utilization. inventory shortages, (c) in regulating quantities of
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They are regularly reviewed and, if necessary, revised in inventory on hand, and (d) for insurance information.
the light of current conditions.
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The retail method is often used in the retail industry for

Retail method measuring inventories of large numbers of rapidly
changing items with similar margins for which it is
The retail inventory method is an inventory estimation impracticable to use other costing methods.
technique based upon an observable pattern between cost 
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The percentage used takes into consideration

and sales price that exists in most retail concerns. inventory that has been marked down to below its
This method requires that a record be kept of original selling price.
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(a) the total cost and retail of goods purchased,

 An average percentage for each retail department is
(b) the total cost and retail value of the goods
often used.
available for sale, and
(c) the sales for the period.
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Basically, the retail method requires the computation of the

cost-to-retail ratio of inventory available for sale. This ratio
is computed by dividing the cost of the goods available for
sale by the retail value (selling price) of goods available for
sale. Once the ratio is determined, total sales for the
period are deducted from the retail value of inventory
available for sale. The resulting amount represents ending
inventory priced at retail. When this amount is multiplied
by the cost to retail ratio, an approximation of the cost of
ending inventory results. Use of this method eliminates
the need for a physical count of inventory each time an
income statement is prepared. However, physical counts
are made at least yearly to determine the accuracy of the
records and to avoid overstatements due to theft, loss, and
breakage.

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 PROBLEMS
1. On May 6, 2012 a flash flood caused damage to the GPR 30% 26% 34%
merchandise stored in the warehouse of Cabanatuan
Determine the inventory loss suffered as a result of the
Co. You were asked to submit an estimate of the
fire.
merchandise destroyed in the warehouse. The
a. P139,590 c. P86,690
following data were established:
b. P102,560 d. P86,310
a. Net sales for 2011 were P800,000, matched
against cost of P560,000.
4. The work-in-process inventory of Burp Company were
b. Merchandise inventory, Jan. 1, 2012 was P200,000,
completely destroyed by fire on June 1, 2012. You were
90% of which was in the warehouse and 10% in
able to establish physical inventory figures as follows:
downtown showrooms.
c. For Jan. 1, 2012 to date of flood, you ascertained January 1, 2012 June 1, 2012
invoice value of purchases (all stored in the Raw materials P 60,000 P120,000
warehouse), P100,000; freight inward, P4,000; Work-in-process 200,000 -
purchases returned, P6,000. Finished goods 280,000 240,000
d. Cost of merchandise transferred from the
Sales from January 1 to May 31, were P546,750.
warehouse to show-rooms was P8,000, and net
Purchases of raw materials were P200,000 and freight
sales from January 1 to May 6, 2012 (all warehouse
on purchases, P30,000. Direct labor during the period
stock) were P320,000.
was P160,000. It was agreed with insurance adjusters
Assuming gross profit rate in 2012 to be the same as in that an average gross profit rate of 35% based on cost
the previous year, the estimated merchandise be used and that direct labor cost was 160% of factory
destroyed by the flood was overhead.
a. P80,000 c. P50,000
The work in process inventory destroyed by fire is
b. P66,000 d. P46,000
a. P366,000 c. P265,000
b. P314,612 d. P185,000

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2. The Bayambang Corporation was organized on January

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1, 2011. On December 31, 2012, the corporation lost
most of its inventory in a warehouse fire just before the

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Use the following information for the next two questions.
year-end count of inventory was to take place. Data
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from the records disclosed the following: Pugo uses the retail inventory method. The following
information is available for the current year:

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2011 2012
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Beginning inventory, Cost Retail
January 1 P 0 P1,020,000 Beginning inventory P 1,300,000 P 2,600,000
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Purchases 4,300,000 3,460,000 Purchases 18,000,000 29,200,000

Purchases returns and Freight in 400,000
allowances 230,600 323,000 Purchase returns 600,000 1,000,000
Sales 3,940,000 4,180,000 Purchase allowances 300,000
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Sales returns and Departmental transfer in 400,000 600,000

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allowances 80,000 100,000 Net markups 600,000

Net markdowns 2,000,000
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On January 1, 2012, the Corporation’s pricing policy

was changed so that the gross profit rate would be Sales 24,700,000
three percentage points higher than the one earned in Sales returns 350,000
Sales discounts 200,000
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2011.
Employee discounts 600,000
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Salvaged undamaged merchandise was marked to sell Loss from breakage 50,000
at P120,000 while damaged merchandise was marked
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to sell at P80,000 had an estimated realizable value of 5. The estimated cost of inventory at the end of the
P18,000. current year using the conventional (lower of cost or
market) retail inventory method is
How much is the inventory loss due to fire?
a. P3,200,000 c. P3,250,000
a. P918,200 c. P856,200
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b. P3,000,000 d. P3,360,000
b. P947,000 d. P824,600
6. The estimated cost of inventory at the end of the
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3. Luna Manufacturing began operations 5 years ago. On

current year using the average retail inventory method
August 13, 2012, a fire broke out in the warehouse
is
destroying all inventory and many accounting records
a. P3,200,000 c. P3,250,000
relating to the inventory. The information available is
b. P3,000,000 d. P3,584,000
presented below. All sales and purchases are on
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account.
7. The estimated cost of inventory at the end of the
January 1, August 13,
current year using the FIFO retail inventory method is
2012 2012
a. P3,200,000 c. P3,250,000
Inventory P143,850
b. P3,000,000 d. P3,658,480
Accounts Receivable 130,590 P128,890
Accounts Payable 88,140 122,850
Collections on accounts rec.,
Jan. 1- Aug. 13 753,800
Payments to suppliers,
Jan. 1- Aug. 13 487,500
8. The records of Binmaley’s Department Store report the
Goods out on consignment
following data for the month of January:
at Aug. 13, at cost 52,900
Beginning inventory at cost 440,000
Summary on previous years’ sales: Beginning inventory at sales price 800,000
2009 2010 2011 Purchases at cost 4,500,000
Sales P626,000 P705,000 P680,000 Initial markup on purchases 2,900,000
Gross Profit 187,800 183,300 231,200 Purchase returns at cost 240,000

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 Purchase returns at sales price 350,000 Employee discounts 200,000
Freight on purchases 100,000 Theft and other losses 100,000
Additional mark up 250,000
Using the average retail inventory method, Binmaley’s
Mark up cancellations 100,000
ending inventory is
Mark down 600,000
a. P360,000 c. P420,000
Mark down cancellations 100,000
b. P384,000 d. P448,000
Net sales P6,500,000
Sales allowance 100,000
- now do the DIY drill -
Sales returns 500,000

DO-IT-YOURSELF (DIY) DRILL

1. Ring Company’s accounting records indicated the
The cost of the raw materials destroyed by the fire was
following for 2012:
a. P140,000 c. P 80,000
Inventory, January 1 P6,000,000 b. P 75,000 d. P176,000
Purchases 20,000,000
Sales 30,000,000 4. A fire destroyed the New Jersey Company’s warehouse
causing damage to its inventories stored in the
A physical inventory taken on December 31, 2012
warehouse. The company uses average retail
resulted in an ending inventory of P4,500,000. The
inventory method in inventory estimation. In
gross profit on sales remained constant at 30% in
connection with this, the company’s accountant
recent years. Ring suspects some inventory may have
gathered the following information relating its
been taken by a new employee. At December 31,
inventories:
2012 what is the estimated cost of missing inventory?
a. P5,000,000 c. P500,000 Cost Retail Price

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b. P4,500,000 d. P 0 Inventory, Beginning 190,000 300,000

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Purchase Price 2,900,000 4,000,000

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2. Compute for the cost of inventory lost in fire using Purchase Discount 50,000 100,000
the data below:
Inventory, July 1, 2011
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Purchase Allowance 90,000 150,000

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Purchases, July 1, 2011 to Jan. 19, 2012 368,000 Purchase returns 60,000 120,000
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Sales, July 1, 2011 to Jan. 19, 2012 583,000 Freight In 20,000 30,000
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Purchase returns 11,200 Net Mark-up 60,000

Purchase discounts taken 5,800
Net Mark Down 80,000
Freight in 3,800
Departmental Transfer –
Sales returns 8,600
in (Debit) 386,800 430,000
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A fire destroyed the entire inventory except for Departmental Transfer –

Out (Credit) 400,000 550,000
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purchases in transit, FOB shipping point, of P2,000 and

goods having selling price of P4,900 that were
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Abnormal Wastages 80,000 120,000

salvaged from the fire. The average gross profit rate
Normal Wastages 100,000 120,000
on net sales is 40%.
a. P59,760 c. P62,660 Employee Discounts 6,000 9,500
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b. P56,940 d. P56,820 Sales Discount 5,000 8,200

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Sales Allowances 21,000 32,150

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3. On December 24, 2012, a fire destroyed totally the Sales Returns 5,000 6,780
raw materials bodega of Bautista Manufacturing Co. The company’s policy is to record sales adjustments
There was no purchase of raw materials from the time directly to sales account. The sales account showed
of the fire until December 31, 2012. ending balance of P2,908,000 on the date of fire.
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Inventories 01/01/12 12/31/12 Physical inventory conducted after the fire disclosed
Raw materials P 90,000 ? usable damaged goods which the company estimates
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Factory supplies 6,000 P 5,000 can be sold at P100,000. Also, it is estimated that the
Goods in process 185,000 210,000 company will incur P4,000 to sell the goods. The
Finished goods 220,000 225,000 original cost of this goods amounted to P50,000.
How much should the company recognize as loss on
inventory fire?
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The accounting records show the following data:

a. P556,348 c. P585,400
Sales P1,200,000
b. P581,613 d. P611,875
Purchases of raw materials 400,000
Purchases of factory supplies 30,000
Freight-in, raw materials 15,000
Direct labor 220,000
Manufacturing overhead 75% of direct labor
 - end - 
Gross profit rate 35% of sales

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