CHAPTER FOUR

INVENTORIES
4.1. Nature and classification of inventory
Inventories are an 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. They are mainly divided into two
major categories:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses
Inventories of merchandising businesses are merchandise purchased for resale in the normal
course of business. These types of inventories are called merchandise inventories. Inventories of
manufacturing businesses manufacturing businesses are businesses that produce physical output.
They normally have three types of inventories. These are:
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’s, 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 on hand
at the end of each period.
In this unit only the determination of the inventory of merchandise purchased for resale
commonly called merchandise inventory will be discussed.

4.2. Inventory Control

For various reasons, management is vitally interested in inventory planning and control. Whether
a company manufactures or merchandises goods, it needs an accurate accounting system with
up-to-date records. It may lose sales and customers if it does not stock products in the desired
style, quality, and quantity. Further, companies must monitor inventory levels carefully to limit
the financing costs of carrying large amounts of inventory.
4.2.1. Effect of Inventory Errors on Financial Statements
Any error in inventory count will affect both the balance sheet and the income statement.
 If CMS = BI + Net Purchase – EI, then CMS = CMAS – EI or CMS + EI = CMAS. This
implies that at the end of the period the CMAS is divided in to EI and CMS. Therefore, an
error in determining EI will cause misstatement on CMS. This in turn will affect Gross Profit
(GP) and Net Income (NI) on the income statement of the period; and asset and capital
reported on the balance sheet at the end of the period.
 EI of the current period becomes BI of the next period. Thus, if EI is incorrectly stated at
the end of the current period, the CMS, GP & NI of the current period will be misstated and
so will the CMS, GP & NI for the next period. The amount of the two misstatements will be
equal and in opposite directions. Therefore, the effect on CMS, GP & NI of an incorrectly
stated inventory, if not corrected, is limited to the period of the error (current period) and the

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 next period. At the end of the next period, assuming no additional errors, both assets and
owners’ equity (capital) will be correctly stated.
The Relationship of Inventory with Net Income:
1. If EI is Understated, CMS is Overstated, Net Income is Understated
2. If EI is Overstated, CMS is Understated, Net Income is Overstated
3. If BI is Understated, CMS is Understated, Net Income is Overstated
4. If BI is Overstated, CMS is Overstated, Net Income is Understated
Please Note: BI is part of CMS whereas EI is not part of CMS; Remember the Formula
(CMS = BI + Net Purchase – EI)
Illustrative Example: Suppose Beginning inventory, January 1, 2004: Birr 10,000, Net
purchase for the year 2004: Birr 130,000; Then, CMAS = 10,000 + 130,000 = 140,000
Assumption 1: EI as of December 31, 2004 is Birr 20,000; Correctly Stated
Assumption 2: EI as of December 31, 2004 is Birr 12,000; Understated by Birr 8,000
Assumption 3: EI as of December 31, 2004 is Birr 27,000; Overstated by Birr 7,000
Assumption 1 Assumption 2 Assumption 3
EI as of Dec. 31,2004 EI as of Dec. 31,2004 EI as of Dec.31,2004
Correctly stated Understated by Birr 8,000 Overstated by Birr 7,000
CMAS… Birr 140,000 Birr 140,000 Birr 140,000
Less: EI (20,000) (12,000) (27,000)
CMS Birr 120,000 Birr 128,000* Birr 113,000*
Effect of Inventory Error on Current and Next periods Financial Statements
1. If EI of the current period (2004) is understated by Birr 8,000 and no additional error in the
next period (2005).
On Current Period’s On Next Period’s Income Net effect of the error over
Income Statement Statement a two years period
- CMS will be overstated - CMS will be understated - Overstatement of CMS is
by Birr 8,000 by Birr 8,000 offset by the
- GP & NI will be - GP & NI will be Understatement.
understated by Birr overstated by Birr 8,000 - Understatement of GP &
8,000 NI is offset by the
Overstatement.
On Current Period’s Balance On Next Period’s Balance Sheet
Sheet Asset & Capital will be stated
- Asset & Capital will be understated by Birr 8,000 correctly since the error offsets
due to the understatement of EI and NI. each other.
2. If EI of the current period (2004) is overstated by Birr 7,000 and no additional error in the
next period (2005).
On Current Period’s Income On Next Period’s Income Net effect of the error
Statement Statement over a two years period
- CMS will be understated by - CMS will be overstated by - Understatement of
Birr 7,000 Birr 7,000 CMS is offset by the
- GP & NI will be overstated - GP & NI will be Overstatement.
by Birr 7,000 understated by Birr 7,000 - Overstatement of GP &
NI is offset by the
Understatement.

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 On Current Period’s Balance Sheet On Next Period’s Balance Sheet
- Asset & Capital will be overstated by Birr 7,000 Asset & Capital will be stated
due to the overstatement of EI and NI. correctly since the error offsets each
other.
Example: As a result of an error in the physical count of Merchandise on December 31, 1999,
XYZ Company overstated the merchandise on hand (EI) by Birr 25,000. Assume no additional
error was committed in the year 2000. Illustrate the effect of the error on the financial statements
prepared by XYZ Company during the year 1999 & 2000.
Solution:
Financial statement items 1999 2000
CMS Understated by Birr 25,000 Overstated by Birr 25,000
GP & NI Overstated by Birr 25,000 Understated by Birr 25,000
Total Assets as of December 31 Overstated by Birr 25,000 Not affected
Capital as of December 31 Overstated by Birr 25,000 Not affected

4.2.2. Inventory Systems

There are two principal systems of inventory accounting, Periodic and Perpetual.
Periodic Inventory System: Under this system, increases in merchandise inventory (purchase of
merchandise) are accumulated in an account titled “Purchase”.
Dr. Purchase………………xxx
Cr. A/P/Cash………………xxx
 Decrease in merchandise inventory is not recorded after each sale; thus, there is no
determination of the CMS and the EI after each sale. The only entry recorded at time of sale
is:
Dr. A/R/Cash…………..xxx
Cr. Sales……………………..xxx
 Periodically, usually at the end of the accounting period, for the purpose of preparing balance
sheet and income statement, the merchandise inventory on hand is determined by physical
count. Then, the CMS is determined by deducting the EI from CMAS. i.e.
CMS = CMAS* - EI
*CMAS = BI + Net Purchase
- This system is often used by firms having variety of merchandise with low unit price.
Examples: Retail Stores, Drug Stores, Groceries etc.

Perpetual Inventory System: Under this system, increases in merchandise inventory (purchase
of merchandise) are accumulated in a control account titled “Merchandise Inventory” and
subsidiary ledgers are maintained for each item.
Dr. Merchandise Inventory………………xxx
Cr. A/P/Cash………………xxx
 The Cost of Merchandise Sold is recorded after each sale and the inventory account is
updated for the decrease in inventory balance as a result of the sales. Two entries are
recorded at time of sale:
Dr. A/R/Cash…………………………….xxx
Cr. Sales…………………………………………..xxx
Dr. Cost of Merchandise Sold…………...xxx
Cr. Merchandise Inventory……………………xxx

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 Thus, accounting records perpetually (continuously) show the EI & the CMS.
 Under this method, physical inventory is conducted for controlling purpose; just to compare
book inventory (Merchandise inventory balance per record) with the actual count. This
system is frequently used by companies that sell items of high unit price like office
equipment, automobiles etc
4.2.3. Physical goods and costs included in inventory
Basic Issues in Inventory Valuation: Valuing inventories can be complex. It requires
determining the following.
1. The physical goods to include in inventory (who owns the goods? goods in transit,
consigned goods, special sales agreements).
2. The costs to include in inventory (product vs. period costs)
3. The cost flow assumption to adopt (specific identification, average-cost, FIFO, retail, etc.
1. Physical goods included in inventory
Conceptually, a company should record purchases of inventory in the Inventory account when it
has control of the asset. That is, the company has the ability to direct the use of and obtain
substantially all the remaining benefits from the inventory purchased. Control also includes the
company’s ability to prevent other companies from directing the use of, or receiving the benefits
from, the inventory purchased. A general rule is that a company should record inventory when it
obtains legal title to the goods.
General Rule: Inventory is buyer’s when received, except:
FOB shipping point Buyers at time of delivery to common carrier
Consignment goods Seller’s, not buyer’s
Sales with repurchase Seller’s, not buyer’s
Sales with rights of return Buyer’s, if you can estimate returns
A. Goods in Transit
A complication in determining ownership is goods in transit (on board a truck, train, ship, or
plane) at the end of the period. The company may have purchased goods that have not yet been
received, or it may have sold goods that have not yet been delivered. To arrive at an accurate
count, the company must determine ownership of these goods.
 Goods in transit should be included in the inventory of the company that has legal title to the
goods. Legal title is determined by the terms of the sale, as shown below.
 When the terms are FOB (free on board) shipping point, ownership of the goods passes to the
buyer when the public carrier accepts the goods from the seller.
 When the terms are FOB destination, ownership of the goods remains with the seller until the
goods reach the buyer. If goods in transit at the statement date are ignored, inventory
quantities may be seriously miscounted.
B. Consigned Goods
In some lines of business, it is common to hold the goods of other parties and try to sell the
goods for them for a fee, but without taking ownership of the goods. These are called consigned

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goods. For example, you might have a used car that you would like to sell. If you take the item to
a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is
sold. Under this agreement, the dealer would not take ownership of the car, which would still
belong to you. Therefore, if an inventory count were taken, the car would not be included in the
dealer’s inventory.
C. Special Sales Agreements
Transfer of legal title is often used to determine whether a company should include an item in
inventory. Unfortunately, transfer of legal title and the underlying substance of the transaction
often do not match. For example, legal title may have passed to the purchaser, but the seller of
the goods retains the control of the goods. Conversely, transfer of legal title may not occur, but
the economic substance of the transaction is such that the seller no longer retains the control of
the goods. Two special sales situations are illustrated here to indicate the types of problems
companies encounter in practice. These are:
1. Sales with Repurchase Agreements
Example: Hill Enterprises transfers (“sells”) inventory to Chase, Inc. and simultaneously agrees
to repurchase this merchandise at a specified price over a specified period of time. Chase then
uses the inventory as collateral and borrows against it.
 Essence of transaction is that Hill Enterprises is financing its inventory—and retains control
of the inventory—even though it transferred to Chase technical legal title to the merchandise.
 Often described in practice as a “parking transaction.”
 Hill should report the inventory and related liability on its books
Sales with Rights of Return: Example: Quality Publishing Company sells textbooks to
Campus Bookstores with an agreement that Campus may return for full credit any books not sold.
Quality Publishing should recognize
a) Revenue from the textbooks sold that it expects will not be returned.
b) A refund liability for the estimated books to be returned.
c) An asset for the books estimated to be returned which reduces the cost of goods sold.
If Quality Publishing is unable to estimate the level of returns, it should not report any revenue
until the returns become predictive.
Costs included in inventory: One of the most important problems in dealing with inventories
concerns the dollar amount at which to carry the inventory in the accounts. Companies
generally account for the acquisition of inventories, like other assets, on a cost basis.
Product Costs: are those costs that “attach” to the inventory. As a result, a company records
product costs in the Inventory account. These costs are directly connected with bringing the
goods to the buyer’s place of business and converting such goods to a salable condition. Such
charges generally include (1) costs of purchase, (2) costs of conversion, and (3) “other costs”
incurred in bringing the inventories to the point of sale and in salable condition.

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 Cost of purchase includes all of:
1. The purchase price.
2. Import duties and other taxes.
3. Transportation costs.
4. Handling costs directly related to the acquisition of the goods.
Conversion costs for a manufacturing company include direct materials, direct labor, and
manufacturing overhead costs. Manufacturing overhead costs include indirect materials, indirect
labor, and various costs, such as depreciation, taxes, insurance, and heat and electricity. “Other
costs” include costs incurred to bring the inventory to its present location and condition ready to sell.
Period Costs: are those costs that are indirectly related to the acquisition or production of goods.
Period costs such as selling expenses and, under ordinary circumstances, general and
administrative expenses are therefore not included as part of inventory cost.
4.3. Valuation of inventories: A cost-basics approach
During any given fiscal period, companies typically purchase merchandise at several different
prices. If a company prices inventories at cost and it made numerous purchases at different unit
costs, which cost price should it use? Conceptually, a specific identification of the given items
sold and unsold seems optimal. Therefore, the IASB requires use of the specific identification
method in cases where inventories are not ordinarily interchangeable or for goods and
services produced or segregated for specific projects. Unfortunately, for most companies, the
specific identification method is not practicable. Only in situations where inventory turnover is
low, unit price is high, or inventory quantities are small are the specific identification criteria met.
In other cases, the cost of inventory should be measured using one of two cost flow assumptions:
(1) first-in, first-out (FIFO) or (2) average-cost. To illustrate these cost flow methods, assume
that ABC co had the following transactions in its first month of operations.

From this information, ABC computes the ending inventory of 6,000 units and the cost of
goods available for sale (beginning inventory + purchases) of €43,900 [(2,000* @ €4.00) +
(6,000* @ €4.40) + (2,000 @ €4.75)]. The question is, which price or prices should it assign to
the 6,000 units of ending inventory? The answer depends on which cost flow assumption it uses.
1. Specific identification:
Calls for identifying each item sold and each item in inventory. A company includes in cost of
goods sold the costs of the specific items sold. It includes in inventory the costs of the specific
items on hand. This method may be used only in instances where it is practical to separate
physically the different purchases made. As a result, most companies only use this method when
handling a relatively small number of costly, easily distinguishable items. In the retail trade, this
includes some types of jewelry, fur coats, automobiles, and some furniture. In manufacturing, it
includes special orders and many products manufactured under a job cost system.

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To illustrate, assume that ABC.’s 6,000 units of inventory consists of 1,000 units from the March
2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase.
Illustration 4.3 shows how Call-Mart computes the ending inventory and cost of goods sold.

This method appears ideal. Specific identification matches actual costs against actual revenue.
Thus, a company reports ending inventory at actual cost. In other words, under specific
identification the cost flow matches the physical flow of the goods. On closer observation,
however, this method has certain deficiencies in addition to its lack of practicability in many
situations. Some argue that specific identification allows a company to manipulate net income.
For example, assume that a wholesaler purchases identical plywood early in the year at three
different prices. When it sells the plywood, the wholesaler can select either the lowest or the
highest price to charge to expense. It simply selects the plywood from a specific lot for delivery
to the customer. A business manager, therefore, can manipulate net income by delivering to the
customer the higher- or lower-priced item, depending on whether the company seeks lower or
higher reported earnings for the period. Another problem relates to the arbitrary allocation of
costs that sometimes occurs with specific inventory items. For example, a company often faces
difficulty in relating freight charges, storage costs, and discounts directly to a given inventory
item. This results in allocating these costs somewhat arbitrarily, leading to a “breakdown” in the
precision of the specific identification method.
2. Average-Cost
As the name implies, the average-cost method prices items in the inventory on the basis of the
average cost of all similar goods available during the period. To illustrate use of the periodic
inventory method (amount of inventory computed at the end of the period), ABC computes the
ending inventory and cost of goods sold using a weighted-average method as follows.
Illustration 4.4

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In computing the average cost per unit, ABC includes the beginning inventory, if any, both in the
total units available and in the total cost of goods available. Companies use the moving-average
method with perpetual inventory records. Illustration 4.4 shows the application of the average-
cost method for perpetual records

In this method, ABC computes a new average unit cost each time it makes a purchase. For
example, on March 15, after purchasing 6,000 units for €26,400, ABC has 8,000 units costing
€34,400 (€8,000 plus €26,400) on hand. The average unit cost is €34,400 divided by 8,000, or
€4.30. ABC uses this unit cost in costing withdrawals until it makes another purchase. At that
point, ABC computes a new average unit cost. Accordingly, the company shows the cost of the
4,000 units withdrawn on March 19 at €4.30, for a total cost of goods sold of €17,200. On March
30, following the purchase of 2,000 units for €9,500, ABC determines a new unit cost of €4.45,
for an ending inventory of €26,700. Companies often use average-cost methods for practical
rather than conceptual reasons. These methods are simple to apply and objective. They are not as
subject to income manipulation as some of the other inventory pricing methods. In addition,
proponents of the average-cost methods reason that measuring a specific physical flow of
inventory is often impossible. Therefore, it is better to cost items on an average-price basis. This
argument is particularly persuasive when dealing with similar inventory items.
3. First-In, First-Out (FIFO)
The first-in, first-out (FIFO) method assumes that a company uses goods in the order in which
it purchases them. In other words, the FIFO method assumes that the first goods purchased are

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the first used (in a manufacturing concern) or the first sold (in a merchandising concern). The
inventory remaining must therefore represent the most recent purchases. To illustrate, assume
that ABC uses the periodic inventory system. It determines its cost of the ending inventory by
taking the cost of the most recent purchase and working back until it accounts for all units in the
inventory. ABC determines its ending inventory and cost of goods sold as shown in Illustration 4.5

If ABC instead uses a perpetual inventory system in quantities and euros, it attaches a cost figure
to each withdrawal. Then, the cost of the 4,000 units removed on March 19 consists of the cost
of the items purchased on March 2 and March 15. Illustration 4.6 shows the inventory on a FIFO
basis perpetual system for ABC.

Here, the ending inventory is €27,100, and the cost of goods sold is €16,800 [(2,000 @ €4.00) 1
(2,000 @ €4.40)]. Notice that in these two FIFO examples, the cost of goods sold (€16,800) and
ending inventory (€27,100) are the same.
In all cases where FIFO is used, the inventory and cost of goods sold would be the same at
the end of the month whether a perpetual or periodic system is used. Why? Because the
same costs will always be first in and, therefore, first out. This is true whether a company
compute cost of goods sold as it sells goods throughout the accounting period (the perpetual
system) or as a residual at the end of the accounting period (the periodic system). One objective
of FIFO is to approximate the physical flow of goods. When the physical flow of goods is
actually first-in, first-out, the FIFO method closely approximates specific identification. At the
same time, it prevents manipulation of income. With FIFO, a company cannot pick a certain cost
item to charge to expense.

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Another advantage of the FIFO method is that the ending inventory is close to current cost.
Because the first goods in are the first goods out, the ending inventory amount consists of the
most recent purchases. This is particularly true with rapid inventory turnover. This approach
generally approximates replacement cost on the statement of financial position when price
changes have not occurred since the most recent purchases. However, the FIFO method fails to
match current costs against current revenues on the income statement. A company charges the
oldest costs against the more current revenue, possibly distorting gross profit and net income.
Companies often combine inventory methods.
4.4 Special inventory valuation methods (valuation other than cost)
Inventories are recorded at their cost. However, if inventory declines in value below its original
cost, a major departure from the historical cost principle occurs. Whatever the reason for a
decline obsolescence, price-level changes, or damaged goods—a company should write down
the inventory to net realizable value to report this loss. A company abandons the historical cost
principle when the future utility (revenue-producing ability) of the asset drops below its original
cost. Lower-of-cost-or-net realizable value (LCNRV) method Cost is the primary base for
recording and reporting inventories. In some cases, however, inventory is recorded and reported
at other than cost. This is when:
The replacement cost of inventory is below the recorded cost, and
The inventory is not salable at normal selling price which may be due to imperfections,
shop wear, style changes, and other causes.
In such cases, inventories are valued using:
1. The Lower of Cost or Market (LCM) Method
2. The Net Realizable Value (NRV) Method
1. Valuation at Lower of Cost or Market (LCM): If the replacement cost of inventory is
lower than the original purchase cost, the lower of cost or market (LCM) method is used to
value the inventory. Market, as used in lower of cost or market, is the cost to replace the
merchandise on the inventory date. The use of LCM methods helps to record loss from
decline of the market value of inventories in the period in which the decline occurred. The
method avoids overstatement of assets (inventories) and net income.
Steps in applying the LCM Method:
1. Determining the cost of inventory using FIFO, or Average Cost Method
2. Checking the current market price of merchandise/replacement cost from suppliers
3. If Market > Cost; report inventory at cost, the lower and ignore the unrealized gain
4. If Market < Cost; report inventory at market, the lower and record the loss for the
deference. The loss may be added to the cost of merchandise sold or reported as general expense.
LCM may be applied:
- To each item of inventory (On item-by-item basis)
- To major categories of inventory
- To inventory as a whole

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Illustration: Valuation of inventory at Lower of Cost or Market (LCM) Method.

LCM application

To major To inventory
Inventory Category Cost Market To each item category as a whole
Category 1
Item A * 3,000 5,500 * 3,000
Item B 5,000 * 4,000 * 4,000
Sub total * 8,000 9,500 * 8,000
Category 2
Item C * 7,500 9,000 * 7,500
Item D 9,300 * 7,000 * 7,000
Sub total 16,800 * 16,000 * 16,000
Total * 24,800 25,500 * 24,800
Valuation of inventory at LCM 21,500 24,000 24,800

 Application of LCM on item-by-item bases results in lowest ending inventory cost, Birr
21,500. Application of LCM on total inventory bases results in higher ending inventory cost
Birr 24,800
 If LCM is applied on item-by-item bases, the amount of loss is Birr 3,300, that is Birr 24,800
cost - Birr 21,500 LCM; and if perpetual inventory system is used; CMS or general expense
is debited and merchandise inventory is credited for the amount of the loss to adjust the
inventory account to LCM price. The LCM amount is used as a cost of inventory for the
following periods.
2. Valuation at Net Realizable Value (NRV)
Merchandises that are spoiled, damaged, out of date, or that can be sold only at prices below
cost should be valued at Net Realizable Value.
NRV = Estimated selling price - Any direct cost of disposition
Example: Assume that damaged merchandise costing Birr 1,500 can be sold for only Birr 1250
and direct selling expenses are estimated to be Birr 175.
NRV = Birr 1250 – 175
= Birr 1075
 Ending inventory is reported at Birr 1075 and loss of Birr 425 (1500 – 1075 = 425) is added
to CMS or recorded separately as general expense. Under a perpetual system, the inventory
account is credited by Birr 425 to adjust the net realizable value.
Recording Net Realizable Value Instead of Cost
One of two methods may be used to record the income effect of valuing inventory at net
realizable value. One method, referred to as the cost-of-goods-sold method, debits cost of goods
sold for the write-down of the inventory to net realizable value. As a result, the company does
not report a loss in the income statement because the cost of goods sold already includes the
amount of the loss. The second method, referred to as the loss method, debits a loss account for
the write-down of the inventory to net realizable value. We use the following inventory data for
TOSA Company to illustrate entries under both methods.

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Cost of goods sold (before adjustment to net realizable value) …………………. $108,000
Ending inventory (cost) ……………………………………………………………82,000
Ending inventory (at net realizable value) …………………………………………70,000
For both the cost-of-goods-sold and loss methods, assuming the use of a perpetual inventory
system.

The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The loss
method, by identifying the loss due to the write-down, shows the loss separate from Cost of
Goods Sold in the income statement. Illustration 9-6 contrasts the differing amounts reported in
the income statement under the two approaches, using data from the TOSA example.

IFRS does not specify a particular account to debit for the write-down. We believe the loss
method presentation is preferable because it clearly discloses the loss resulting from a decline in
inventory net realizable values.
Use of an Allowance
Instead of crediting the Inventory account for net realizable value adjustments, companies
generally use an allowance account, often referred to as Allowance to Reduce Inventory to Net
Realizable Value. For example, using an allowance account under the loss method, Ricardo
Company makes the following entry to record the inventory write-down to net realizable value.

Loss Due to Decline of Inventory to Net Realizable Value…………………… 12,000

Allowance to Reduce Inventory to Net Realizable Value………………………………….12,000

Use of the allowance account results in reporting both the cost and the net realizable value of the
inventory. TOSA reports inventory in the statement of financial position as follows

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Inventory (at cost) ……………………………………………………………… $82,000
Allowance to reduce inventory to net realizable value ………………….……. (12,000)
Inventory at net realizable value………………………………………………. $70,000

The use of the allowance under the cost-of-goods-sold or loss method permits both the income
statement and the statement of financial position to reflect inventory measured at $82,000,
although the statement of financial position shows a net amount of $70,000. It also keeps
subsidiary inventory ledgers and records in correspondence with the control account without
changing prices.
4.5. Estimating Cost of Inventory
A business may need to estimate the amount of inventory for the following reasons:
 Perpetual inventory records are not maintained.
 A disaster such as a fire or flood has destroyed the inventory records and the inventory
 Monthly or quarterly financial statements are needed, but physical inventory is taken only
once a year.
There are two widely used methods of estimating inventory cost.
1. The Gross Profit Method
2. The Retail Method
4.5.1. Gross profit method
The Gross profit method uses the estimated gross profit for the period to estimate the inventory
at the end of the period. The gross profit is estimated from the preceding year, adjusted for any
current period changes in the cost and sales prices.
Steps in applying this method:
 Step 1: Determine the merchandise available for sale at cost
 Step 2: Determine the estimated gross profit by multiplying the net sales by the gross profit
percentage/rate
 Step 3: determine the estimated cost of merchandise sold by deducting the estimated gross
profit from the net sales.
 Step 4: estimate the ending inventory cost by deducting the estimated cost of merchandise
sold from the merchandise available for sale.
Example:
Merchandise inventory, January 1………………… Birr 57,000
Net Purchase during January……………………… 180,000
Net Sales during January…………………………... 250,000
Estimated Gross profit rate………………………... 30%
Assume the merchandise inventory of the business was lost by fire.
Required: Determine the estimated cost of ending inventory lost by fire.

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Solution:

Cost
Merchandise inventory, January 1 Birr 57,000
Purchase in January (net) 180,000
Merchandise available for sale (Step 1) Birr 237,000
Sales for January (net) Birr 250,000
Less: Estimated gross profit (Birr 250,000*0.3) (Step 2) (75,000)
Estimated cost of merchandise sold (Step 3) (175,000)
Estimated merchandise inventory, January 31(Step 4) Birr 62,000

The current period’s records contain all the information Cetus needs to compute inventory at cost,
except for the gross profit percentage. river determines the gross profit percentage by reviewing
company policies or prior period records. In some cases, companies must adjust this percentage
if they consider prior periods unrepresentative of the current period.

Computation of Gross Profit Percentage

In most situations, the gross profit percentage is stated as a percentage of selling price. The
previous illustration, for example, used a 30 percent gross profit on sales. Gross profit on selling
price is the common method for quoting the profit for several reasons.
1. Most companies state goods on a retail basis, not a cost basis.
2. A profit quoted on selling price is lower than one based on cost. This lower rate gives a
favorable impression to the consumer.
3. The gross profit based on selling price can never exceed 100 percent.

In above Illustration gross profit was a given. But how did river derive that figure? To see
how to compute a gross profit percentage, assume that an article costs $15 and sells for $20,
a gross profit of $5. As shown in the computations in this markup is 1⁄4 or 25 percent of retail,
and 1⁄3 or 331⁄3 percent of cost. Although companies normally compute the gross profit on
the basis of selling price, you should understand the basic relationship between markup on
cost and markup on selling price. For example, assume that a company marks up a given item
by 25 percent on cost. What, then, is the gross profit on selling price? To find the answer,
assume that the item sells for $1. In this case, the following formula applies.
Cost + Gross profit =Selling price
C + .25C = SP
(1 + .25) C = SP
1.25C =$1.00
C = $0.80

The gross profit equals $0.20 ($1.00 - $0.80). The rate of gross profit on selling price is
therefore 20 percent ($0.20/$1.00). Conversely, assume that the gross profit on selling
price is 20 percent. What is the markup on cost? To find the answer, assume that the item
sells for $1. Again, the same formula holds:

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 Cost + Gross profit = Selling price
C + .20SP = SP
C = (1 - .20) SP
C = .80SP
C =.80($1.00)
C = €0.80
As in the previous example, the markup equals $0.20 ($1.00 2 $0.80). The markup on
cost is 25 percent ($0.20$€0.80).
Retailers use the following formulas to express these relationships:

To understand how to use these formulas, consider their application in the following
calculations.

4.5.2. Retail-inventory method

The retail method of estimating inventory cost requires costs and retail prices to be maintained
for the merchandise available for sale. A ratio of cost to retail price is then used to convert
ending inventory at retail to estimated ending inventory cost.
Steps in applying this method:
 Step 1: Determine the total merchandise available for sale at cost and retail
 Step 2: Determine the ratio of the cost to retail of merchandise available for sale
 Step3: Determine the ending inventory at retail by deducting the net sales from the
merchandise available for sale at retail
 Step4: Estimate ending inventory cost by multiplying the ending inventory at retail by
the cost to retail ratio.
When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be
the same as the merchandise available for sale. If ending inventory is made up of different
classes of merchandise, cost to retail ratios may be developed for each class of inventory. An

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advantage of the retail method is that it provides inventory figures for preparing monthly
statements. Department stores and similar retailers often determine gross profit and operating
income each month, but may take physical inventory only once or twice a year. Thus, the retail
method allows management to monitor operations more closely.
Example:
at Cost at Retail
Merchandise inventory, January 1………………… Birr 19,400 Birr 36,000
Net Purchase during January……………………… 42,600 64,000
Net Sales during January…………………………... 70,000

Required: Determine the estimated cost of ending inventory and cost of merchandise sold
(CMS). Solution:

at Cost at Retail
Merchandise inventory, January 1 Birr 19,400 Birr 36,000
Purchase in January (net) 42,600 64,000
Step 1-Merchandise available for sale Birr 62,000 Birr 100,000
Step 2 Ratio of cost to retail price: Birr 62,000 = 62%
100,000
Sales for January(net) (70,000)
Step 3Merchandise inventory, January 31, at retail Birr 30,000
Step 4Merchandise inventory, January 31, at cost (Birr Birr 18,600
30,000 * 0.62)

Estimating EI at cost: Birr 18,600

Estimated CMS = CMAS at cost - Estimating EI at cost
= Birr 62,000 – 18,600
= Birr 43,400

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