Inventory Estimation: Gross Profit Method and Retail Inventory Method

Learning Objectives:

1. Calculate ending inventory under Gross Profit Method

2. Calculate ending inventory under Retail Inventory Method

Generally, a physical count is done to determine the ending inventory, but sometimes this may not be
possible or not cost effective, hence estimates are employed.

Uses of Inventory value estimation:

1. Preparation of interim FS (shorter than one year)

2. Reasonable test of ending inventory balance (compare with physical count and in the accounting
record)
3. If catastrophe destroyed the inventory

2 Inventory estimation techniques:

1. Gross Profit Method – company’s normal gross profit (i.e. gross profit as a percentage of sales or
based on cost) would be used to estimate the amount of gross profit, ending inventory value and cost of
sales. Gross profit rates can be determined by the average of previous GPR (based on records).

Illustration 1. An entity during the prior period, reported net sales of P6,000,000 and COGS of
P4,800,000. At what percentage will the gross profit be represented if the gross profit rate is based on:

a. Net sales b. COGS

GPR based on Sales GPR based on Cost

Net sales P6,000,000 100% 125%

COGS 4,800,000 80% 100%
Gross Profit 1,200,000 20% 25%

Illustration 2: GPM
How much is the entity’s estimated COGS for the period if net sales is P10,000,000 and GPR is:
Case 1: 60% based on sales Case 2: 60% based on Cost
Net sales P10,000,000 100% Net Sales P10,000,000 160%
COGS 4,000,000 40% COGS 6,250,000 100%
GP 6,000,000 GP 3,750,000 60%

Illustration 3: Calculation of Ending Inventory presumed destroyed by fire (Fire Loss)

Assume that XYZ Company’s inventory was destroyed by fire. Sales for the year, prior to the date of fire
were P1,000,000 and XYZ usually sells goods at a 40% gross profit rate. Therefore, XYZ can readily
estimate that COGS was P600,000. XYX’s beginning inventory was P500,000 and P800,000 purchases
had occurred prior to the date of fire. The inventory destroyed by fire can be estimated via gross profit:

Step 1: Determine the relative percentages Step 2: Solve for COGS Step 3: Solve for fire loss

Sales P1,000,000 Beginning Inventory P500,000

COGS (60%) 600,000 Purchases 800,000
GP 400,000 TGAS 1,300,000
Less: COGS 600,000
Ending Inventory- Fire Loss 700,000

Illustration 4: Seolyun merchandising would like to estimate their inventory balance during the period
without the need for actual inventory count. Gross profit has always been 40% based on sales. Records
show the following: Net Sales, P12,000,000; Net purchases, P6,000,000; Beginning inventory is
P2,500,000. How much is the estimated ending inventory?

Net Sales P12,000,000 100% Beginning Inventory P2,500,000

COGS 7,200,000 60% Net purchases 6,000,000
Gross Profit P 4,800,000 40% TGAS P8,500,000
Less: COGS 7,200,000
Estimated ending Inventory 1,300,000
Illustration 5: A fire razed the warehouse of Jimin merchandising during the period. Records available
before the incident were as follows: Beginning inventory, P7,000,000; Purchases, P9,540,000; Freight-
in, P400,000; Purchase returns, P56,000; Purchase allowances, P90,000; Purchase discounts, P60,000;
Gross Sales, P15,650,000; Sales returns, P650,000; Sales discount, P50,000. Gross profit is 25%
based on cost. Some inventories were saved costing P1,230,000. How much is the inventory loss from
fire? Gross Sales P15,650,000 Note: Sales allowances/discount – not considered
Less: Sales returns 650,000 when estimating inventory – no physical
GOGS P15,000,000 125% flow of inventory
COGS 12,000,000 100%
Gross Profit P 3,000,000 25%

Beginning inventory P7,000,000

Add: Purchases 9,540,000
Freight-in 400,000
Less: Purchase Returns 50,000
Purchase allowance 90,000
Purchase discount 60,000
TGAS P16,740,000
Less: COGS 12,000,000
Est. inventory affected
By fire P 4,740,000
Less: saved inventory 1,230,000
Inv. Loss due to fire P 3,510,000

2. Retail Inventory Method – used by merchandising firms to estimate ending inventory. This would work
where a category of inventory has a consistent mark-up. The cost-to-retail percentage is multiplied times
the ending inventory at retail. Ending inventory at retail can be determined by a physical count of goods
on hand, at their retail value. Or, sales might be subtracted from TGAS at retail.

RIM is an inventory estimation method that applies retail (sales price) information to determine its
relationship with costs (cost ratio) and ultimately, the estimated ending inventory. This is applicable for
industries that has numerous product offers and variety of goods that monitoring of costs would be
burdensome like groceries and department stores.

Formula: Beg. Inventory at retail price (Selling price)

+ Net purchases at retail price
TGAS at retail price
Ending Inventory at retails price
X Cost to retail ratio (GAS at cost/GAS at retail price)
Estimated ending inventory at cost

Methods of Retail Inventory Estimation: Computing the Cost Ratio

1. Conservative Method – considers all effects of price markups but does not consider price markdowns.

2. Average Method – considers both price markups and price markdowns based on the claim that
markups and markdowns are applied only to purchases during the period and not on beginning inventory.

3. FIFO method- cost to retail ratio is only based on current period purchases which excludes beginning
inventory

Beg. Inventory Markups Markdowns

1. FIFO x / /

2. Average / / /

3. Conservative / / /

Cost ratio = TGAS at cost/TGAS at retail

GPM Retail Inv. Method

TGAS at cost xxx TGAS at retail xxx

COGS ( xxx ) Net Sales ( xxx)*
Inventory end at retail xxx
x Cost ratio %
Inventory end at cost xxx

*Net Sales:

Sales xxx
Sales returns only (xxx)
xxx
Employee discount xxx
Normal losses xxx

Net Sales xxx

RIM: Treatment of Items

Cost Retail

Beginning Inventory xxx xxx

Net Purchases xxx xxx (Purchase Ret only)
Departmental transfer in (debit) xxx xxx
Departmental transfer out (xxx) (xxx)
Abnormal losses (xxx) (xxx)
Markup xxx
Markup cancellation (xxx)
Markdown (xxx)
Markdown cancellation xxx
TGAS xxx xxx

Illustration 6: Retail Inventory Method

AB Company sells pots that cost P7.50 for P10. This yields a cost-to-retail percentage of 7.5%. The
beginning inventory totaled P200,000 (at cost): purchases – P300,000 (at cost); Sales totaled P460,000
(at retail). Compute the ending inventory at cost and at retail.

At Cost At Retail

Beginning Inventory P200,000 /.75 P266,667

Purchases 300,000 /.75 400,000
TGAS P500,000 P666,667
Sales 345,000 460,000
Ending P155,000 P206,667