COLLEGE OF BUSINESS AND ACCOUNTANCY

Topic: Inventory Estimation

Learning Outcomes:

At the end of this module, the student should be able to:

a. Apply the methods of Inventory Estimation

Biblical Values Integration

Let Go. Let God. “For we fix our attention, not on things that are seen, but on things that are unseen. What can
be seen lasts only for a time, but what cannot be seen lasts forever. (2 Corinthians 4:16-18)

Introduction:

Inventory Estimation

There may be instances where the value of inventories must be estimated, such as when it is not practicable
to take a physical count. For example, in the interest of timeliness and cost consideration an entity may elect
to rely on estimates of inventory at interim dates. Another instance is when records of inventories are
incomplete and inventories must be approximated.

Estimates are allowed under PAS 2 only if they approximate the cost. Generally, inventory estimation is made
only for interim reporting. For annual reporting, physical count of inventories is more appropriate.

The cost of inventories may be estimated using either the (a) gross profit method or the (b) retail method.

Body:

GROSS PROFIT METHOD

Under the gross profit method, gross profit is assumed to be relatively constant from period to period. Thus,
the gross profit rate (GPR) is used to determine the cost ratio which in turn is used to estimate the inventory
and the cost of goods sold.

Gross profit rate can be expressed as a percentage (a) based on sales, or (b) based on cost of goods sold.

The gross profit rates of an entity with sales of P1,000 and cost of goods sold of P800 are computed as
follows:

Net Sales 1,000 GPR based on sales GPR based on cost

Cost of Goods Sold (800) 200/1,000 = 20% 200/800 = 25%
Gross Profit 200

*Note that GPR based on cost can be translated to GPR based on sales. See below illustrations.

1. If GPR based on cost is 25%, what is the GPR based on sales?

Net Sales (squeeze) 125%

Cost of Sales (constant) (100%)
Gross Profit rate based on cost 25%

✔ GPR based on sales (25%/125%) = 20%

*Note that Cost of sales is 100%, when the given GPR is based on cost.

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

Net Sales (constant) 100%

Cost of Sales (squeeze) (80%)
Gross Profit rate based on sales given 20%

✔ GPR based on cost (20%/80%) = 25%

*Note that Sales is 100% when the given GPR is based on sales.

COST RATIO

Cost ratio is derived from the gross profit rate as follows:

❖ Cost ratio from GPR based on sales = 100% Net Sales – GPR based on sales

❖ Cost ratio from GPR based on cost = 100% Cost of Goods Sold/Net sales (100% + GPR based on
cost)

Illustration:

1. If the GPR based on sales is 20%, what is the cost ratio?

Net Sales 100%

Cost of Sales (80%)
GPR based on sales 20%

2. If GPR based on cost is 25%, what is the cost ratio?

Net Sales 125%

Cost of Sales (100%)
GPR based on cost 25%

Cost Ratio (100%/125%) = 80%

NET SALES

For the purposes of inventory estimation, only sales returns are deducted from gross sales when computing
for net sales. Sales discounts and allowances are not deducted because these do not affect the physical
inventory of goods. Sales returns, on the other hand, affect the physical inventory of goods because goods are
physically returned to the seller.

ESTIMATING INVENTORIES UNDER THE GROSS PROFIT METHOD

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 The formula below is derived from the inventory T-account above.

Inventory, beg. xx
Net Purchases xx
Freight-In xx
Total Goods available for sale xx
Inventory, end. (xx)
Cost of Goods sold (COGS) xx

Illustrations

a. An entity had net sales of P600,000 and cost of sales of P400,000. What are the (a) gross profit rate
based on sales and (b) gross profit based on cost?

Solution:

GPR based on sales GPR based on cost

Net sales 600,000
Less: COGS 400,000 (200K ÷ 600K) (200K ÷ 400K)
Gross profit 200,000 33.33% 50%

b. If the gross profit based on sales is 40%, what is the gross profit rate based on cost?
Solution:

(40% ÷ 60%) = 66.67%

c. If the mark-up based on cost is 50%, what is the mark-up based on sales?

Solution:

(50% mark-up based on cost ÷ (100% cost + 50% mark-up) = 33 1/3%

d. If the gross profit rate based on cost is 42.86%, what is the cost ratio?

Solution:

(100% ÷ 142.86%) = 70%

e. On Nov. 29, 20x1, a meteorite struck the warehouse of Unlucky Co. and destroyed the inventories
contained therein. The following information was determined:

Beginning Inventory 80,000

Accounts Payable, Jan. 1 30,000
Accounts Payable, Nov. 29 60,000
Payments to Suppliers 480,000
Purchase returns 3,000
Purchase discounts 4,000
Freight-in 5,000
Sales fr. Jan-Nov 585,000
Sales returns 15,000
Sales discounts 117,000
Gross Profit rate based on sales 25%

Goods in transit, purchased FOB shipping point, from a vendor on Nov. 29, 20x1 were P28,000, while
goods held by consignees were P32,000. The goods salvaged from the fire can be sold at a scrap value
of P2,500. How much is the inventory loss?

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 Solutions:

Accounts payable

30,000 beg.
Payments 480,000 510,000 Net purchases (squeeze)
end. 60,000

Inventory
beg. 80,000
Net purchases 510,000 427,500 COGS (585K - 15K) x 75%
Freight-in 5,000
167,500 end.
(28,000) goods in-transit
(32,000) consigned goods
(2,500) salvage value
105,000 Inventory loss

f. On Dec. 1, 20x1, aliens invaded the Earth and destroyed the warehouse of Unlucky Too Co. The following
information was determined:

Beginning Inventory 80,000

Gross Purchases 517,000
Freight-In 5,000
Purchase returns 3,000
Purchase discounts 4,000
Sales fr. Jan to Nov 585,000
Sales returns 15,000
Sales discounts 117,000
Gross profit rate based on cost 33 1/3%

20% of the inventory contained in the warehouse has been salvaged from the destruction, while half is partially
damaged. The aliens agreed to buy the partially damaged goods at 30% of the cost as peace offering. How much
is the inventory loss?

Solution:

Inventory
80,000
517,000 3,000 Purchase returns
5,000 4,000 Purchase discounts
COGS
427,500
(585K - 15K) x 100%/133 1/3%
167,500 end.
(33,500) Undamaged (20% x 167.5K)
Salvage value
(25,125)
(50% x 167.5K x 30%)
108,875 Inventory loss

g. You were engaged to assist in reconstructuring ABC Co.’s records after an operating crashed on
August 1. ABC Co. does not have an established business continuity plan or a disaster recovery
program and only the following information has been determined:

Increase in Inventory 16,000

Decrease in AP 8,000
Payments to suppliers 70,000

Compute for the cost of goods sold.

Solution:

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 ACCOUNTS OF A MANUFACTURING COMPANY

The inventory accounts of a manufacturing company entity include the raw materials, work in process and
finished goods. The relationships between these accounts and accounts payable are depicted below:

The formula below is derived from the T-accounts above.

Raw materials, beg. xx

Purchases xx
Freight-in xx
Purchase returns and allowances (xx)
Total Raw Materials available for use xx
Raw materials, end. (xx)
Raw materials issued to production xx
Work in process, beg. xx
Direct Labor xx
Production overhead xx
Total goods put into process xx
Work in process, end. (xx)
Cost of goods manufactured xx
Finished Goods, beg. xx
Total goods available for sale xx
Finished goods, end (xx)
Cost of goods sold xx

Illustration:

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 On June 1, 20x1, a fire completely destroyed the work in process inventories of ABC Manufacturing, Inc. The
following amounts were determined:

January 1, 20x1 June 1, 20x1

Accounts Payable 78,000 90,000

Raw Materials 10,000 7,000
Work in process 40,000 ?
Finished goods 46,000 58,000

Additional information:
● Payments to suppliers for purchases on account, 40,000

● Freight on purchases, 5,000

● Purchase returns, 5,000

● Direct labor, 32,000

● Production overhead, 12,000

● Sales from Jan 1 to May 31, 150,000

● Sales returns, 30,000

● Sales discounts, 10,000

● Gross Profit rate based on sales, 25%

Answer: Php42,000

1.

2.

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 3. Gross Sales 150,000
Sales returns (30,000)
Net sales 120,000
Multiply by: Cost ratio (100%-25% GPR based on sales) 75%
Cost of Goods Sold 90,000

4.

RETAIL METHOD

The retail method is often used in the retail industry (e.g., supermarkets and department stores) for
measuring large quantities of inventories with rapidly changing items and with similar margins and for which
it is impracticable to use other costing methods.

The retail method is similar to the gross profit method. Actually, the gross profit method is a variation of the
retail method. The following are peculiar to the retail method:

a. The cost ratio is computed directly without regard to the gross profit rate.
b. Net mark-ups and net mark-downs are considered.

✔ Net markups (markups less markup cancellations) are net increases above the original retail
price, which are generally caused by changes in supply and demand.

- Markup refers to increase above the original retail price.

- Original retail price refers to the selling price at which the goods are first offered for
sale.
- Markup cancellation refers to decrease in selling price that does not reduce the
selling price below the original retail price.

✔ Net markdowns (markdowns less markdown cancellations) are net decreases below the
original retail price.
- Mark-down refers to the decrease below the original retail price.
- Markdown cancellation refers to increase in selling price that does not raise the
selling price above the original retail price.

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 APPLICATION OF THE RETAIL METHOD

The retail method is applied using either the

a. Average cost method – under this method, the total goods available for sale at cost (beginning inv +
net purchases) is determined and divided by the total goods available for sale at sales price to come
up with the cost ratio.
Cost Ratio = Total goods avail. For sale at cost___________
Total goods avail. For sale at sales price or at retail

*COGS = Net Sales x Cost Ratio

*Ending inventory at cost = Ending inventory at retail x cost ratio

b. FIFO Cost Method – this method is very similar to average method, the only difference lies on the
computation of cost ratio. Under FIFO, the beginning inventories at cost and at retail are simply
excluded from TGAS when computing the cost ratio.

Cost Ratio = Total goods avail. For sale (TGAS) at cost less beg. Inventory at cost
TGAS at sales price or at retail less beg. Inventory at retail

Illustration:

The invading aliens in illustration about GPR based on cost put up a department store to sell alien stuff to the
alien stuff to the alien settlers. The alien accountant determined the following information:

Compute for the ending inventory and COGS under Average and FIFO Method.

Solutions:
Cost Retail
Inventory, beg. 300,000 375,000
Net purchases (a) 1,056,000 1,495,000
Departmental Transfers-In 2,000 3,000
Net mark-ups (20,000 – 2,000) 18,000
Net mark-downs (6,000 – 1,000) (5,000)
Abnormal spoilage (8,000) (11,000)
TGAS 1,350,000 1,875,000
Net sales (b) (1,375,000)
EI @ retail 500,000

@ cost: 1,180,000 + 30,000 - 150,000 - 4,000 = 1,056,000;

(a)

@ retail: 1,500,000 – 5,000 = 1,495,000

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 (b)

Normal spoilage 400

Sales 1,428,000
Sales returns (56,000)
Employee discounts 2,600
Net sales 1,375,000
Cost ratios:

Cost ratio (Average Total goods avail. for sale at cost

=
cost) Total goods avail. for sale at sales price

Average cost ratio = (1,350,000 ÷ 1,875,000) = 72.00%

Cost ratio TGAS at cost less beg. inventory at cost

=
(FIFO) TGAS at retail less beg. inventory at retail

FIFO cost ratio = [(1,350,000 – 300,000) ÷ (1,875,000 – 375,000)] = 70.00%

Average FIFO
Cost ratios 72.00% 70.00%
Multiply by: EI @ retail 500,000 500,000
Ending inventory @ cost 360,000 350,000

Average FIFO
TGAS @ cost 1,350,000 1,350,000
Ending inventory @ cost (360,000) (350,000)
Cost of goods sold 990,000 1,000,000

SEPARATE COST RATIO FOR EACH DEPARTMENT

When applying the retail method, separate computations should be made for departments that experience
significantly higher or lower profit margins. These separate computations for each department necessitate
the consideration for departmental transfers-in and out.

Distortions arise in the retail method when a department sells goods with varying margins in a proportion
different from that purchased. In which case, the cost-to-retail percentage would not be representative of the
mix of goods in ending inventory. Also, manipulations of income are possible by planning the timing of
markups and markdowns.

Summary/Conclusion:

Whether a company uses a periodic or perpetual inventory system, a physical inventory (i.e., physical count)
of goods on hand should occur from time to time. The quantities determined via the physical count are
presumed to be correct, and any differences should result in an adjustment of the accounting records.
Sometimes, however, a physical count may not be possible or is not cost effective, and estimates are
employed.

One such estimation technique is the gross profit method. This method might be used to estimate inventory
on hand for purposes of preparing monthly or quarterly financial statements, and certainly would come into
play if a fire or other catastrophe destroyed the inventory. Very simply, a company’s normal gross profit rate
(i.e., gross profit as a percentage of sales) would be used to estimate the amount of gross profit and cost of
sales.

On another note, a method that is widely used by merchandising firms to value or estimate ending inventory
is the retail method. This method would only work where a category of inventory has a consistent mark-up.

The cost-to-retail percentage is multiplied times 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
goods available for sale at retail.

References:

Intermediate Accounting Part IA and Part IB (2021 Edition) by Zeus Vernon B. Millan
Financial Accounting Volume 1 (2021 Edition) by Conrado T. Valix, Jose F. Peralta, and Christian Aris M. Valix

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 https://www.principlesofaccounting.com/chapter-8/inventory-estimation/

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