Inventory

Inventory Estimation Methods

Inventory Estimation Methods
• In many cases, it is necessary to know the approximate value of inventory when it is not possible to take a physical count.
• Even if the physical count is possible. The same may prove costly, difficult or inconvenient at the moment.
• The most common reasons for making an estimate of the cost of the goods in hand are:
a) The inventory is destroyed by fire and other catastrophe, or theft of the merchandise has occurred and the amount of
inventory is required for insurance purposes.
b) 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.
- This is known as the “gross profit test” in the accounting parlance.
c) Interim financial statements are prepared and a physical count of the goods on hand is not necessary because it may
take time to do the same.
- Moreover, only an estimate is required to fairly present the financial position and financial performance of the entity
for interim reporting purposes.

Two common methods of estimating cost of inventory:

a. Gross Profit Method
b. Retail Inventory Method
GROSS PROFIT METHOD:
• The gross profit method of estimating inventory costs is based on an assumed relationship between gross profit and sales
or between gross profit and cost of sales.
• The gross profit method depends on the accuracy of the gross profit percentage.

• The amount obtained is reported as ending inventory for interim financial reporting purposes or is considered the amount
of loss in cases of fire, flood, theft, and similar events unless there are undamaged or partially damaged merchandise.
• In computing net sales only Sales return is deducted.
• Sales allowance and sales discount are ignored, that is, not deducted from sales.
• The reason is that while these items decrease the amount of sales, they do not affect the physical volume of goods sold.
• Sales allowance and sales discount do not increase the physical inventory of goods, unlike in sales return where there is
an actual addition to goods on hand.
• However, in some exceptional cases, when sales discounts are significant and the company anticipates these discounts in
setting sales prices, sales discounts may be considered.

• The cost of undamaged merchandise to be deducted must be lower of cost and Net Realizable value
• The gross profit method of inventory estimating inventory is not allowed for annual external financial reporting purposes.
Illustrative Example 1: Gross Profit Method

Assume the following figures for Jisoo Company for the six months ended June 30,2019:
Illustrative Example 1: Gross Profit Method
Illustrative Example 2: Gross Profit Method (When there is undamaged or partially
damaged merchandise)

Assume On October 30, 2019, a big fire caused severe damage to the warehouse of Jisoo Company. Thus, the company
suffered a loss on its inventory. The following information was available from the company’s books.
Illustrative Example 2: Gross Profit Method (When there is undamaged or partially
damaged merchandise)

Cost ratio)
Illustrative Example 3: Gross Profit Method (With sales allowance and sales
discount)
The following data are gathered for the current year:

Inventory, beginning 600,000

Purchases 2,530,000
Purchase return 15,000
Purchase allowance 5,000
Purchase discount 10,000
Freight in 50,000
Sales 3,100,000
Sales return 100,000
Sales allowance 50,000
Sales discount 150,000

Compute for the ending inventory under the following assumptions:

1. Gross profit of 25% on sales
2. Gross profit of 25% on cost
Retail Inventory Method
• PAS 2, paragraph 22, provides that this method is often used in the retail industry for measuring inventory of
large number of rapidly changing items with similar margin for which it is impracticable to use other costing
method.
• The cost of the inventory is determined by reducing the sales value of the inventory by the appropriate
percentage gross margin.
• The retail inventory method requires the maintenance of records of purchases at both cost and selling price. A
ratio of cost of retail is calculated and applied to the ending inventory at retail to compute the approximate
cost.
Information required:
a. Beginning inventory at cost and retail price
b. Purchases during the period at cost and at a retail price
c. Adjustments to the original retail price such as additional markup, markup cancelation, markdown, and
markdown cancelation
d. Other adjustments such as departmental transfer, breakage, shrinkage, theft, damaged goods, and
employee discount
Appropriate treatment for freight, discounts, returns and allowances, and other relevant items are:
a. Freight-in is an addition to purchases at cost.
b. Purchase discounts and purchase allowances are deductions from purchases at cost only.
c. Purchase returns are deducted from the cost and retail amounts of purchases.
d. Sales returns are deducted from retail sales.
e. Sales discounts and sales allowances are not deducted from retail sales.
f. Departmental transfer-in (debit) is an addition to both cost and retail amount of purchases.
g. Departmental transfer-out (credit) is a deduction from both cost and retail amounts of purchases.
h. Normal losses, shortage, shrinkage are deducted from the goods available for sale at retail, after computing
the cost ratio.
i. Abnormal losses are deducted from both cost and retail amounts of purchases, before computing the cost
ratio.
j. Discounts to employees and favored customers are deducted from the goods available for sale at retail, after
computing the cost ratio (in effect, this is an addition to sales).
The original selling prices of goods may be modified as a result of some market and economic forces,
thus the following terms:
1. Original terms – the first selling price at which goods are offered for sale.
2. Markup or additional markup – an increase in the selling price over the original retail price.
3. Markdown – decrease in the selling price below the original retail price.
4. Markup cancellation – a decrease in the selling price which does not bring the new selling price
below the original retail.
5. Markdown cancellation – an increase in the selling price which does not bring the new selling
price above the original retail price.
6. Net Markup – markup less markup cancellation.
7. Net Markdown – markdown less markdown cancellation.
8. Maintained markup – difference between cost and sales after adjustment for all of the above
items
Approaches in the use of retail method
1. Conservative or conventional or lower of cost and NRV
2. Average Cost Approach
3. FIFO approach
Illustrative Example 3:
Assume the following information in relation to a company’s retail
inventory accounting system:

Compute for the ending inventory and COGS

assuming:

1. Average cost approach

2. Conservative approach
3. FIFO retail approach
Illustrative Example 3: Retail Inventory Method (Average Cost)
Illustrative Example 3: Retail Inventory Method (Conservative Method)
Illustrative Example 3: Retail Inventory Method (FIFO Retail)