Chapter I

Inventories
What is inventory? Inventories are asset items held for sale in the ordinary course of
business or goods that will be used or consumed in the production of goods to be sold.
Different firms may have different types of inventories based on the nature and scope of their
activities. They are mainly divided into two major parts:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses
i. Inventories of merchandising businesses: are merchandise purchased for resale in
the normal course of business. These types of inventories are called merchandise
inventories.
inventories.
ii. Inventories of manufacturing businesses: manufacturing businesses are businesses
that produce physical output. They normally have three types of inventories. These
are:
 Raw material inventory
 Work in process inventory
 Finished goods inventory
1. Raw material inventory – is the cost assigned to goods and materials on hand but not yet
placed into production. Raw materials include the wood to make a chair or other office
furniture, the steel to make a car etc.
2. Work in process inventory – is the cost of raw material on which production has been
started but not completed, plus the direct labor cost applied specifically to this material
and allocated manufacturing overhead costs.
3. Finished goods inventory – is the cost identified with the completed but unsold units 
units on
hand at the end of each period.
Importance of Inventories
Merchandise, being continually purchased and sold is one of the most active elements in
merchandising business, i.e. in wholesale and retail type of businesses. This is due to the
following reasons:
1. The sale of merchandise provides for the principal source of revenue for them.
2. The cost of merchandise sold is the largest deductions from sales.
3. Inventories (ending inventories) are the largest of the current assets of such firms.
Inventory determination plays an important role in matching expired costs with revenues of the
period. An error in the determination of the inventory figure at the end of the period will cause
an equal misstatement of gross profit and net income, and the amount reported for both assets

1
and owner’s equity in the balance sheet will be incorrect by the same amount. Because of the
above reasons inventories have effects on the current and the following period’s financial
statements. If inventories are misstated (understated of overstated), the financial statements will
be distorted.
Effects of Inventories on Financial Statements
A.  Effect 
Effect of 
of Ending 
Ending Inventory 
Inventory on 
on Current 
Current Period’s 
Period’s Financial Statements
Ending inventory is the cost of merchandise on hand at the end of the accounting period. Let us
see its effect on current period’s financial statements.
Income Statement
a. Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending
inventory
As you see, ending inventory is a deduction in the computation of cost of merchandise sold. So,
it has an indirect (negative) relationship to cost of merchandise sold, i.e. if ending inventory is
understated, the cost of merchandise sold will be overstated, and if ending inventory is
overstated, the cost of merchandise sold will be understated.
b. Gross Profit = Net sales – Cost of merchandise sold
Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of
ending inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is,
if ending inventory is understated, the gross profit will be understated and if ending inventory is
overstated, the gross profit will be overstated. This is a direct (positive) relationship.
c. Operating income = Gross Profit – Operating Expenses
Gross profit and operating income have direct relationships. Thus, the effect of ending inventory
on net income is the same as its effect on gross profit, i.e. direct (positive) effect (relationship).
Balance Sheet
a. Current assets – Ending inventory is part of current assets, even the largest. So, it has a
direct (positive) relationship to current assets. If ending inventory balance is understated
(overstated), the total current assets will be understated (overstated). Since current assets
are part of total assets, ending inventory has direct relationship to total assets.
b. Liabilities – No effect on liabilities. Inventory misstatement has no effect on liabilities.
c. Owners’ equity – The net income will be transferred to the owners’ equity at the end of
accounting period. Closing income summary account does this. So, net income has direct
relationship with owners’ equity at the end of accounting period. The effect of ending
inventory on owners’ equity is the same as its effect on net income, i.e. if ending
inventory is understated (overstated), the owners’ equity will be understated (overstated).
B. Effects of Beginning Inventory on Current Period’s Financial Statements:

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Beginning inventory is inventory balance that was left on hand in the previous period and
transferred to the current period. Its effect is summarized below:
Income Statement
a. Cost of merchandise sold = Beginning inventory + Net Purchases – Ending inventory
As you see, beginning inventory is an addition in determining cost of goods sold. It has
direct effect on cost of merchandise sold. That is, if the beginning inventory is
understated (Overstated), the cost of merchandise sold will be understated (Overstated)
b. Gross Profit = Net Sales – Cost of merchandise sold
The effect of beginning inventory on gross profit is the opposite of the effect on cost of
merchandise sold, i.e. indirect (negative) relationship. If the beginning inventory is
understated, the gross profit will be overstated and if it is overstated, the gross profit will
be understated.
c. Net income = Gross Profit – Operating expenses
The effect of beginning inventory on net income is the same as its effect on gross profit.
Balance Sheet
a. Current assets – The inventory included in current assets is the ending inventory. So,
beginning inventory has no effect on current assets.
b. Owners’ equity – If the effect comes from the previous year, the beginning inventory will
not have an effect on ending owners’ equity since the positive or negative effect of the
previous year will be netted off by the negative or positive effect of the current year. But
if the error is made in the current period, it will have indirect effect on ending owners’
equity.
C. Effect of Ending Inventory on the Following Period’s Financial Statements
The ending inventory of the current period will become the beginning inventory for the
following period. So, it will have the same effect as beginning inventory of the current period.
Let us summarize it.
Income statement of the following period
Cost of merchandise sold direct relationship
Gross profit indirect relationship
Net income indirect relationship
Balance sheet of the following period
The ending inventory of the current period will not have an effect on the following period’s
balance sheet items.
Example: The following amounts were reported in Ginjo Company’s financial statements for
three consecutive fiscal year ended December 31.

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 2008 2007 2006
a) Cost of merchandise sold Br. 360,000 Br. 288,000 Br. 150,000
b) Net income 140,000 105,000 51,000
c) Total Current assets 320,000 285,000 195,000
d) Owner’s equity 425,000 365,000 220,000
In making the physical counts of inventory, the following errors were made:
© Inventory on December 31, 2006, understated by Br. 10,000
© Inventory on December 31, 2007, overstated by Br. 15,000
Required:
Determine the correct amount of the items listed above.
Solution
2008 2007 2006
a) Cost of Goods Sold:
Sold:
Reported Br. 360,000 Br. 288,000      Br. 150,000
Adjustment of
2006 error _ 10,000 (10,000)
2007 error (15,000) 15,000 -__
Corrected Bal. Br. 345,000 Br. 313,000 Br. 140,000
b) Net Income:
Reported Br. 140,000 Br. 105,000 Br. 51,000
Adjustment of
2006 error _ (10,000) 10,000
2007 error 15,000 (15,000) -_
Corrected Bal. Br. 155,000 Br. 80,000 Br. 61,000
c) Total Current Assets:
Reported Br. 320,000 Br. 285,000 Br. 195,000
Adjustment of
2006 error - - 10,000
2007 error -___ (15,000)
(15,000) -__
Corrected Bal. Br. 320,000 Br. 270,000 Br. 205,000
d) Owner’s Equity:
Reported Br. 425,000 Br. 365,000 Br. 220,000
Adjustment of
2006 error - - 10,000
2007 error - (15,000) -__
Corrected Bal. Br. 425,000 Br. 350,000 Br. 230,000

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 Inventory Systems:
There are two principal systems of inventory Accounting: periodic and perpetual.
1) Periodic Inventory System
Under this system there is no continuous record of merchandise inventory account. The
inventory balance remains the same throughout the accounting period, i.e. the beginning
inventory balance. This is because when goods are purchased, they are debited to the purchases
account rather than to the merchandise inventory account.
The revenue from sales is recorded each time a sale is made. At the time of sale no entry is made
to record the cost of goods sold. Consequently, a physical inventory must be taken periodically
(usually at the end of each fiscal period) to determine the cost of inventory on hand and goods
sold. In the periodic inventory system merchandise purchased is recorded or accumulated in the
‘Purchases’ account.
The periodic inventory system is less costly to maintain than the perpetual inventory system, but
it gives management less information about the current status of merchandise.
This system is often used by retail enterprises that sell many kinds of low unit cost merchandises
such as groceries, drugstores, hardware etc.
The journal entries to be made are:
1. At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
2. At the time of sale of merchandise:
Accounts receivable or cash XX at 
at retail 
retail price 
price 
Sales XX
3. To record purchase returns and allowances:
Accounts payable or cash XX
Purchase returns and allowances XX
4. To record adjusting entry or closing entry for merchandise inventory:
Income Summary XX
Merchandise inventory (beginning) XX
To close beginning Merchandise inventory
Merchandise inventory (ending) XX
Income Summary XX
To record ending Merchandise inventory
2)       Perpetual Inventory System
In contrast to the periodic inventory system, the perpetual inventory system uses accounting
records that continuously disclose the amount of inventory. A separate account for each type of

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merchandise is maintained in a subsidiary ledger. So, the inventory balance will not remain the
same in the accounting period. All increases are debited to merchandise inventory account and
all decreases are credited to the same account. The balances of accounts are called book
inventories of the items on hand. Irrespective of the case with which the perpetual inventory
records are maintained, their accuracy must be tested by taking physical inventory of each type
of merchandise at least once in a year. The records are then compared with the actual quantities
on hand and any differences are corrected.
There are no purchases and purchase returns and allowances accounts in this system. At the time
of sale, the cost of goods sold is recorded in addition to journal entry for the sale. So, we can
determine the cost of inventory as well as goods sold from the accounting records. No need of
physical counting to determine their costs.
Companies that sell items of high unit value, such as appliances, fur garments or automobiles,
tended to use the perpetual inventory system.
Given the number and diversity of items contained in the merchandise inventory of most
businesses, the perpetual inventory system is usually more effective for keeping track of
quantities and ensuring optimal customer service. Management must choose the system or
combination of systems that is best for achieving the company's goal.
Journal entries to be made are:
1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of Merchandise purchased
2. At the time of sale of merchandise
Accounts receivable or cash XX   at 
at retail 
retail price
Sales XX
To record the sale
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold or cost of sale
3. To record purchase returns and allowances
Accounts payable or cash XX
Merchandise inventory XX
4. No adjusting entry or closing entry for merchandise inventory is needed at the end of
each accounting period.
Example: In its beginning inventory on Jan 1, 2008, Ziquala Trading Company had 280 units of
merchandise that cost Br. 10 per unit. The following transactions were completed during 2008.

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January 17 Purchased 200 units of merchandise on account at Br. 12 per unit.
24 Returned 50 defective units from the January 17 purchases to the     supplier
(payment for the entire invoice was not made).
April 19 Purchased 300 units of merchandise for cash at Br 15 per unit.
August 26 Sold 480 units of merchandise for cash at a price of Br. 17 per unit.
These goods are: 230 units from the beginning inventory and 100 units                             from
January 17 purchase and the rest from the April 19 purchases.
December 31  248 units are left on hand, 50 units from January 1 inventory, another
50 units from the January 17 purchase, and the rest from the last                             purchase.
Required: Prepare general journal entries for Ziquala Trading Company to record the above
transactions and adjusting or closing entry for merchandise inventory on December 31, 2008 (the
end of the current fiscal period) under:
a) Periodic inventory system
b) Perpetual inventory system
Solution
a) Under Periodic Inventory System:
January 17 Purchases (200 x Br.12) 2,400
Accounts payable 2,400
24 Accounts payable (50 x Br. 12) 600
Purchase returns and allowances 600
April 19 Purchases (300 x Br. 15) 4,500
Cash 4,500
August 26 Cash (480 x Br. 17) 8,160
Sales 8,160
December 31 To record or close the merchandise inventory account
Income summary (280 x Br. 10) 2,800
Merchandise inventory (beginning) 2,860
To close the beginning inventory
31. Merchandise inventory (ending) 3,320
Income summary [(50 x Br. 10) + (50 x Br. 12) + (148 x Br. 15)] 3,320
To record the ending merchandise inventory
b) Under Perpetual Inventory System:
January 17 Merchandise inventory (200 x Br. 12) 2,400
Accounts payable 2,400
24 Accounts payable (50 x Br. 12) 600
Merchandise inventory 600
April 19 Merchandise inventory (300 x Br. 15) 4,500
Cash 4,500
August 26 i) To record the sale:
Cash (480 x Br. 17) 8,160
Sales 8,160
ii) To record cost of goods sold:
= [(230 x Br. 10) + (100 x Br. 12) + (150 x Br. 15)]
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 = Br. 2,300 + Br. 1,200 + Br. 2,250 = Br. 5,750
Cost of Goods Sold 5,750
Merchandise inventory 5,750
December 31. No entry is needed to record or close merchandise inventory account. This is
because the Merchandise Inventory ledger account reflects its correct balance at the end of the
period. The merchandise Inventory ledger account after posting the above transactions is shown
below:
Merchandise Inventory

Jan. 1. Bal. 2,800 Jan. 24. 600

Jan. 17. 2,400 Aug. 26 5,750
April 19. 4,500 6,350
9,700
Dec.31. 3,350 Dec. 31. 30
Dec. 31. Bal. 3,320

Under the perpetual inventory system the Merchandise Inventory ledger account shows a debit
balance of Birr 3,350, which is the correct amount. However, the actual count of the merchandise
inventory on hand shows a balance of Birr 3,320. The difference of Birr 30 (Br. 3,350 – Br.
3,320), therefore, is considered as inventory shortage,
shortage, and it should be recorded as a credit to the
Merchandise Inventory account as shown below:
Dec. 31. Inventory Shortage 30.00
Merchandise Inventory 30.00
To adjust the Merchandise Inventory account
After posting the above entry to the merchandise inventory account, the Merchandise Inventory
account in the general ledger reflects the correct amount of the inventory on hand as of Dec. 31,
2008, as shown above in the T account.
1.4. Determining Actual Quantities in the Inventory
The first stage in the process of taking inventory is to determine the quantity of each kind of
merchandise owned by an enterprise. The physical count of inventory is needed under both
inventory systems.
Under periodic inventory system, it is needed to determine the cost of inventory and goods sold.
When the periodic system is used, the counting, weighting, and measuring should be done at the
end of the accounting period. To accomplish this, the inventory crew may work during the night
or business operations may be stopped until the count is finished.
The inventory account under a perpetual inventory system is always up to date. Yet events can
occur where the inventory account balance is different from inventory on hand. Such events

8
include theft, loss, damage, and errors. The physical count (sometimes called “taking an
inventory”) is used to adjust the inventory account balance to the actual inventory on hand.
We determine a Birr (dollar) amount for physical count of inventory on hand at the end of a
period by:
(1) Counting the units of each product on hand
(2) Multiplying the count for each product by its cost per unit
(3) Adding the cost for all products
At the time of taking an inventory, all the merchandise owned by the business on the inventory
date, and only such merchandise, should be included in the inventory. The merchandise owned
by the business may not necessarily be in the warehouse. They may be in transit.
The legal title to the merchandise in transit on the inventory date is known by examining
purchase and sales invoices of the last few days of the current accounting period and the first few
days of the following accounting period. This legal title depends on shipping terms (agreements).
There are two main types of shipping terms: FOB shipping point and FOB destination
(1) FOB Shipping Point
Point – the ownership title passes to the buyer when the goods are
shipped (when the goods are loaded on the means of transportation, i.e. at the seller’s
point). The purchaser is responsible for freight charges.
(2) FOB Destination – the title passes to the buyer when the goods arrive at their destination,
i.e. at the buyer’s point.
So, in general, goods in transit purchased on FOB shipping point terms are included in the
inventories of the buyer and excluded from the inventories of the seller. And goods in transit
purchased on FOB destination terms are included in the inventories of the seller and excluded
from the inventories of the buyer.
There is also a problem with goods on consignment at the time of taking an inventory. Goods on
consignment to another party (agent) called the consignee.
consignee. A Consignee is to sell the goods for
the owner usually on commission are included in the consignor’s inventories and excluded from
the consignee’s inventories.

Methods of inventory costing (cost flow assumptions)

After taking physical inventory or determining items available in terms of quantity, the next task
determining a birr (dollar) amount for physical count of inventory.
Thus, inventory costing are all about converting determined quantity to costs. However, when
identical units of items purchased throughout the period at different unit cost price, a question
arises as to which items, at which cost purchased have been sold and which are still remain
unsold
i. Inventory Costing Methods under Periodic Inventory System

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 One of the most important decisions in accounting for inventory is determining per unit costs
assigned to inventory items. When all units are purchased at the same unit cost, this process is
simple since the same unit cost is applied to determine the cost of goods sold and ending
inventory. However, when identical items are acquired at different unit costs, a question arises as
to what amounts are included in the cost of merchandise sold and what amounts remain in
inventory. When such is the case, it is necessary to determine the unit cost of the items still on
hand. A periodic inventory system determines cost of merchandise sold and inventory at the end
of the period. How we assign these costs to inventory and cost of merchandise sold affects the
reported amounts for both systems.
The assumed flow of costs to be used in the assignment of costs to inventories and to goods sold
need not conform to the physical flow of goods. Cost flow assumption relate to the flow of costs,
rather than to the physical flow of goods. The question of which physical units of identical goods
were sold and which remain in inventories is not relevant to income measurement and inventory
valuation.
All methods of inventory valuation are based on the cost principle; no matter which method is
selected, the inventory is stated at cost. In general, a major objective of accounting for
inventories is the proper determination of income through the process of matching appropriate
costs against revenue.
There are three methods commonly used in assigning costs to inventory and cost of merchandise
sold. These are:
I) Specific identification
II) First-in first-out(FIFO)
III) Weighted average
Example
Ghibe Trading began the year and purchased merchandise as follows:
Jan. 1 Beginning inventory 150 units @ Br. 40 = Br. 6,000
Mar. 17 Purchase 900 units @ 45 = 40,500
June. 21 Purchase 1200 units @ 48 = 57,600
Sept 1 Purchase 860 units @ 52 = 44,720
Nov. 13 Purchase 750 units @ 55 = 41,250
Total 3860 units Br.190,
Br.190, 070
 The ending inventory consists of 800 units; 50 units from the opening stock, 150 units
from the first purchase and 200 from each of the last three purchases.
a. Specific Identification Method

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When each item in inventory can be directly identified with a specific purchase and its invoice,
we can use specific identification (also called specific invoice pricing) to assign costs. This
method is considered appropriate for a business enterprise handling a small number of items and
when the variety of goods carried in stock is small and the volume of sales is relatively small, for
example, an automobile dealer, it becomes completely inoperable in a complex manufacturing
business when the identity of the individual item is lost.
For example, from the above illustration, it is given that the ending inventory consists of 800 units;
50 from the opening stock, 150 from the purchase of March 17, and 200 units from each of the last
three purchases. So, the items on hand are specifically known from which purchases they are:
Cost of ending inventories under specific identification method, therefore, is:
From Jan 1. Inventory 50 units @ Br. 40 = Br. 2000
Mar 17. Purchase 150 units @ 45 = 6750
June 21. Purchase 200 units @ 48 = 9600
Sept 1. Purchase 200 units @ 52 = 10,400
Nov 13. Purchase 200 units @ 55 = 11,000
800 units Br. 39,750
® Cost of Ending inventory = Br. 39,750
® The Cost of Goods Sold = Cost of Goods Available for Sale – Ending
inventory
= Br. 190,070 – Br. 39,750 = Br. 160,320
b. First-in, First-out (FIFO)
This method of assigning cost to inventory and the goods sold assumes inventory items are sold in the
order acquired. This means the cost flow is in the order in which the expenditures were made. So, to
determine the cost of ending inventory, we have to start from the most recent purchase and continue to the
next recent. Because the first purchased items (old purchases) are the first to be sold they are used
(included) in the computation of cost of goods sold.
For example, easily spoiled goods such as fruits, vegetables etc., must be sold near the time of their
acquisition. So, the inventory on hand will be from the recent purchases. As an example, consider the
above illustration.
The cost of ending inventory under FIFO method would be:
From Nov. 13 purchase 750 units @ Br. 55 = Br. 41,250
From Sept. 1 purchase 50 units @ 52 = 2,600
Total 800 units Br. 43,850
® Cost of Ending inventory Br. 43,850
® Cost of Goods sold = Br. 190,070 – Br. 43,850 = Br. 146,220
c. Weighted Average Method

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This method of assigning cost requires computing the average cost per unit of merchandise
available for sale. That means the cost flow is an average of the expenditures.
The weighted average unit cost is determined by dividing the total cost of the identical units of
each commodity available for sale during the period by the total number of units of merchandise.
Average cost per unit = Cost of goods available for sale
Total units available for sale
Once the average unit cost is determined, and then it is multiplied by units on hand (unsold) at
the end of the period to calculate the cost of ending inventory. Also, the same average unit cost is
applied in the computation of cost of goods sold.
Once again, using the previous illustration the costs of ending inventory and goods sold for Gibe
Trading would be computed as follows:
Weighted average unit cost = Br. 190,070 = Br. 49.24
3860 units
® Ending inventory cost = Br. 49.24 x 800 = Br. 39,392
® Cost of Goods Sold = Br. 190,070 - Br. 39,392 = Br. Br. 150,678
ii. Inventory Costing Methods under Perpetual Inventory System
The use of perpetual inventory system provides the most effective means of control over this
important asset. Although it is possible to maintain a perpetual inventory memorandum records
only or to limit the data to quantities, a complete set of records integrated with the general ledger
is preferable. As you learned in Part I, the basic feature of this system is recording all
merchandise increases and decreases in a manner similar to the recording of increases and
decreases in cash. That means, all purchases of merchandise are debited to the Merchandise
Inventory account and sales and other reductions of merchandise are credited to the Merchandise
Inventory account. Thus, the balance of merchandise inventory reflects the amount of
merchandise inventory assumed to be on hand.
Under perpetual inventory system we will apply the inventory costing methods each time sale of
merchandise is made. We calculate the cost of goods (merchandise) sold and inventory on hand
at the time of each sale. This means the merchandise inventory account is continually updated to
reflect purchase and sales.
Example: The beginning inventory, purchases and sales of Shebe Business Group Ltd for the
month of December are as follows:

Units Cost
Dec. 1 Inventory 21 Br. 60.00
5 Sale 8

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 13 purchase 12 Br. 64.00
17 Sale 15
24 purchase 25 Br. 69.00
26 Sale 19
28 purchase 20 Br. 72.00
30 Sale 6
31 Sale 15
a. First-in First-out Method
The assignment of costs to goods sold and ending inventory using FIFO is the same for both the
perpetual and periodic inventory systems. Because each withdrawal of goods is from the oldest
stock on hand, the oldest is the same whether we use periodic inventory system or perpetual
inventory system.
Using the data above, let us calculate the cost of goods sold and ending inventory in each of the
inventory costing methods under perpetual inventory system.
Perpetual - FIFO
Purchase Cost of merchandise sold Inventory
Date Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Dec. 1 21 Br. 60.00 Br. 1260
5 8 Br. 60.00 Br.480.00 13 60.00 780
13 60.00 780
13 12 Br. 64.00 Br.768.00 12 64.00 768

17 13 60.00 780.00 10 64.00 640

2 64.00 128.00
10 64.00 640
24 25 69.00 1725.00 25 69.00 1725

26 10 64.00 640.00 16 69.00 1104

9 69.00 621.00
16 69.00 690
28 20 72.00 1440.00 20 72.00 1440

30 6 69.00 414.00 10 69.00 690

20 72.00 1440
31 10 69.00 690.00 15 72.00 1080
5 72.00 360.00
63 4113.00 15 72.00 1080

So, the cost of merchandise sold and ending inventory under perpetual- FIFO method are Br.
4,113 and Br. 1,080, respectively.
Let us see them under periodic - FIFO method:

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 Units on hand = Units available for sale – Units sold
= (21 + 12 + 25 + 20) – (8+ 15 + 19 + 6 + 15)
= 78 - 63 = 15 units
 Cost of Ending inventory = 15 units @ Br. 72.00 = Br. 1,080
Cost of goods available for sale = Br. 1,260 + Br. 768 + Br. 1,725 + Br. 1,440 = Br. 5,193
Cost of goods sold = Cost of goods available for sale – Cost of ending inventory
= Br. 5,193 – Br. 1,080 = Br. 4,113
So, we can see that FIFO method of inventory costing results the same amounts of cost of goods
sold and ending inventory under both periodic and perpetual inventory systems.
b. Weighted Average Cost Method.
Under this method, the average unit cost is calculated each time purchase is made to be applied
on the sales made after the purchases. The results may be different under periodic and perpetual
inventory systems.
Let us calculate the cost of merchandise sold and ending inventory using the average cost
method from the previous illustration under perpetual inventory system.
Average Cost Method (Moving Average)
Purchase Cost of merchandise sold Inventory
Date Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost

Dec. 1 21 Br. 60.00 Br. 1260.00

5 8 Br. 60.00 Br. 480.00 13 60.00 780.00
25 61.92 1548.00
13 12 64.00 Br. 768.00 = 780+768
13+12
17 15 61.92 928.80 10 61.92 619.20
35 66.98 2344.20
24 25 69.00 1725.00 619.20+1725
10+25

26 19 66.98 1272.51 16 66.98 1071.63

28 20 72.00 1440.00 36 69.77 2511.63
1071.63+144
0
16+20
30 6 69.77 418.61 30 69.77 2093.00
31 15 69.77 1046.51 15 69.77 1046.51
63 Br. 4146.43 15 Br. 69.77 Br 1046.51
So, the cost of goods sold and ending inventory under perpetual inventory system are Br.
4146.43 and Br. 1046.51, respectively.
The results under periodic inventory system are:
Weighted average unit cost = Br. 5193 = Br. 66.58

14
 78
Ending inventory cost = Br. 15 @ Br. 66.58 = Br. 998.65
Cost of goods sold = Merchandise available for sale – cost of ending inventory
= Br. 5193.00 – Br. 998.65 = Br. 4194.35
So, the result is different under periodic and perpetual inventory systems.
Estimating Inventory Cost
In practice, an inventory amount is estimated for some purposes, when it is impossible to take a
physical inventory or to maintain perpetual inventory records. The following are some of the
circumstances in which the cost of inventories is estimated.
1) Monthly income statements are needed. It may be too costly, to take physical inventory. This
is especially the case when periodic inventory system is used.
2) When a catastrophe such as a fire has destroyed the inventory. In such case, to ask claims
from insurance companies, there is a need of estimating inventory.
3) When we want to test the validity of cost data.
To estimate the cost of inventory, two methods are commonly used. These are retail method and
gross profit method.
1. Retail Method of Inventory Costing
This method is mostly used by retail businesses. The estimate is made based on the relationship
between the cost and the retail price of merchandise available for sale.
The steps to be followed are:
(1) Calculate the cost- to-retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale
(2) Calculate the ending inventory at retail price
Ending inventory at retail price = retail price of merchandise available for sale –
Sales
(3) Calculate the estimated cost of ending inventory
Estimated cost of ending inventory = Cost to retail ratio X Ending inventory at 
at retail
Example:
Cost Retail
Dec. 1, beginning inventory Br. 160,000 Br. 200,000
Purchases in December (Gross) 620,000 780,000
Purchase Returns and Allowances 15,000
Purchase Discounts 5,000
Sales in December (net) 740,000
(1) Cost-to-retail ratio = Br. 160,000 + Br. 620,000 – [15,000 + 5000] = 0.7755 
0.7755 or        77.55%
Br. 200,000 + Br. 780,000

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(2) Ending inventory at retail = (Br. 200,000 + Br. 780,000) – Br. 740,000 = Br.
Br. 240,000
(3) Estimated ending inventory at cost = 0.7755 x Br. 240,000 = Br. 186,120

2. Gross Profit Method of Inventory Costing

This method uses an estimate of the gross profit realized during the period to estimate the cost of
inventory. The gross profit rate may be estimated based on the average of previous periods’ gross
profit rates.
The steps are as follows:
(1) The gross profit rate is estimated and then estimated gross profit is calculated:
Estimated gross profit = Gross profit rate x Current period Sales
(2) Cost of goods sold is estimated:
Estimated cost of goods sold = Current period Sales – Estimated gross profit
(3) Calculate the estimated cost of ending inventory:
Estimated cost of ending inventory = Cost of goods available for sale – Estimated cost of goods
sold.
Example
Jan. 1, beginning inventory (cost) Br. 120,000
Purchases during January (cost) 490,000
Purchase Returns and Allowances 10,000
Net sales during January 580,000
Estimated gross profit rate is 30%
The ending inventory is estimated as follows:
(1) Estimated gross profit = 0.30 x 580,000
= Br. 174,000
(2) Estimated cost of goods sold
= Br. 580,000 – Br. 174,000
= Br. 406,000
(3) Estimated cost of ending inventory
= [Br. 120,000 + (490,000 – 10,000) – Br. 406,000]
= Br. 600,000 – Br. 406,000
= Br. 194,000

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