Inventory Estimation

By: Dr. Angeles A. De Guzman

Dean, College of Business Education
 Reasons for Inventory Estimation
• The inventory is destroyed by fire and other catastrophe,
or theft of the merchandise has occurred and the amount
of inventory.
• A physical count of the goods on hand is made and it is
necessary to prove the correctness or reasonableness of
such count by making an estimate
• Interim financial statements are prepared and a physical
count of the goods on hand is not necessary either
because it may take time to do the same or because only
an estimated is required to fairly present the financial
position and performance of the entity
 Gross Profit Method
• Based on the assumption that the rate of gross
profit remains approximately the same from
period to period and therefore the ratio of cost
of goods sol to net sales is relatively constant
from period to period
• Basic formula
Goods Available for Salexx
Less: Cost of Sales xx
Ending Inventory xx
 Gross Profit Method
• Goods Available for Sale
Beginning Inventory xx
Purchases xx
Add: Freight In xx
Total xx
Less: Purch. Ret, Allow & Disct. xx xx
Goods Available for Sale xx
 Gross Profit Method
• Cost of Sales
Net Sales multiplied by cost ratio – This is used when the gross profit rate
is based on sales
Net Sales divided by sales ration – This is used when the gross profit rate
is based on cost
• Computation of gross profit rate
Net Sales xx
Cost of Goods Sold xx
Gross profit xx
• The gross profit rate is expressed as a percent of sales or as a percent of cost of
goods sold
– The gross rate on sales is computed by dividing the amount of gross profit by the net sales
– The gross profit rate on cost is computed by dividing the gross profit by the cost of sales
 Retail Inventory Method
• The retail inventory method is generally employed by
department stores, supermarkets and other retail concerns
where there is a wide variety of goods
• The use of the retail method requires that records be kept
which show the following data:
– Beginning inventory valued at cost and at retail price
– Purchases during the period at cost and at retail price
– Adjustments to the original retail price such as additional markup,
markup cancellation, markdown and markdown cancelation
– Other adjustments such as departmental transfer, breakage,
shrinkage, theft, damaged goods and employee discount
 Retail Inventory Method
• Basic Formula
Goods available for sale at retail or
selling price xx
Less: Net sales (Gross sales less S/R) xx
Ending Inventory at selling price xx
Multiply by cost ratio xx
Ending inventory at costxx
Goods Available for sale at cost______
Cost ratio Goods Available for sale at selling price
 Items Related to Retail Method
• Initial markup – original markup on the cost of goods
• Original retail – the sales price at which the goods are first offered for sale
• Additional markup – increase in sale price above the original sales price
• Markup cancelation – decrease in sales price that does not decrease the
sales price below the original sales price
• Net additional markup or net markup – markup minus markup
cancelation
• Markdown – decrease in sales price below the original sales price
• Markdown cancelation – increase in sales price that does not increase the
sales price above the original sales price
• Net markdown – markdown minus markdown cancelation
• Maintained markup – difference between cost and sales price after
adjustment for all the above items. Sometimes this is referred to as
“markon”
 Treatment of other items
• Purchase discount – deducted from purchases at cost only
• Purchase return – deducted from purchases at cost and at retail
• Purchase allowance – deducted from purchases at cost only
• Freight in – addition to purchases at cost only
• Department transfer in or debit – addition to purchases at cost and at retail
• Departmental transfer out or credit – deduction from purchases at cost and retail
• Sales discount and sales allowance – disregarded, meaning not deducted from
sales
• Sales return – deducted from sales
• Employee discounts – added to sales
• Normal shortage, shrinkage, spoilage, breakage – this is deducted from goods
available for sale at retail
• Abnormal shortage, shrinkage, spoilage, breakage – this is deducted from goods
available for sale at both cost and retail so as not to distort the cost ratio.
Approaches in the use of Retail Method

• Conservative or conventional or lower of cost

or market approach
• Average cost approach
• FIFO approach
 Conservative and Average Cost
• Conservative approach includes net markup
and excludes net markdown in determining
the cost ratio in order to arrive a conservative
cost
• Average cost approach includes both net
markup and net markdown in determining
cost ratio
 FIFO Retail Approach
• Similar to the average cost approach in that it
considers both net markup and net markdown
in arriving at the goods available for sale at
retail to serve as basis in computing the cost
ratio
• If there is no beginning inventory, the
inventory value is the same under both
average cost and FIFO method.