ESTIMATING INVENTORY 2019
LECTURE NOTES
Gross profit method
The gross profit method is an inventory estimation
technique based on a relationship between gross profit
and sales that is assumed to be fairly stable. Its use is
not appropriate for financial reporting purposes;
however, it can serve a useful purpose when an
approximation of ending inventory is needed. Such
approximations are sometimes required by auditors or
when inventory and inventory records are destroyed
by fire or some other catastrophe. The gross profit
method should never be used as a substitute for a
yearly physical inventory unless the inventory has
been destroyed.
The gross profit method is based on the assumptions
that (a) the beginning inventory plus purchases equal
total goods to be accounted for; (b) goods not sold
must be on hand; and (c) if sales, reduced to cost, are
deducted from the sum of the opening inventory plus
purchases, the result is the ending inventory.
In developing a reliable gross profit percentage,
reference is made to past years and adjustments are
made for current circumstances.
Techniques for the Measurement of Cost under PAS 2
Techniques for the measurement of the cost of
inventories, such as the standard cost method or the
retail method, may be used for convenience if the
results approximate cost.
Standard cost method
Standard costs take into account normal levels of
materials and supplies, labor, efficiency and capacity
utilization. They are regularly reviewed and, if
necessary, revised in the light of current conditions.
Retail method
The retail inventory method is an inventory estimation
technique based upon an observable pattern between
cost and sales price that exists in most retail concerns.
This method requires that a record be kept of (a) the
total cost and retail of goods purchased, (b) the total
cost and retail value of the goods available for sale,
and (c) the sales for the period.
Basically, the retail method requires the computation
of the cost-to-retail ratio of inventory available for
sale. This ratio is computed by dividing the cost of the
goods available for sale by the retail value (selling
price) of goods available for sale. Once the ratio is
determined, total sales for the period are deducted
from the retail value of inventory available for sale.
The resulting amount represents ending inventory
priced at retail. When this amount is multiplied by the
cost to retail ratio, an approximation of the cost of
ending inventory results. Use of this method
eliminates the need for a physical count of inventory
each time an income statement is prepared. However,
physical counts are made at least yearly to determine
the accuracy of the records and to avoid
overstatements due to theft, loss, and breakage.
To obtain the appropriate inventory figures under the
retail inventory method, proper treatment must be
given to markups, markup cancellations, markdowns,
and markdown cancellations.
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When the cost to retail ratio is computed after net
markups (markups less markup cancellations) have
been added, the retail inventory method approximates
lower of cost or market. This is known as the
conventional retail inventory method. If both net
markups and net markdowns are included before the
cost to retail ratio is computed, the retail inventory
method approximates cost.
The retail inventory method becomes more
complicated when such items as freight-in, purchase
returns and allowances, and purchase discounts are
involved. In essence, the treatment of the items
affecting the cost column of the retail inventory
approach follows the computation of cost of goods
available for sale. Freight costs are treated as a part
of the purchase cost; purchase returns and allowances
are ordinarily considered both a reduction of the price
at both cost and retail; and purchase discounts usually
are considered as a reduction of the cost of purchases.
Other items that require careful consideration include
transfers-in, normal shortages, abnormal shortages,
and employee discounts. Transfers-in from another
departments should be reported in the same way as
purchases from an outside enterprise. Normal
shortages should reduce the retail column because
these goods are no longer available for sale. Abnormal
shortages should be deducted from both the cost and
retail columns and reported as a special inventory
amount or as a loss. Employee discounts should be
deducted from the retail column in the same way as
sales.
The retail inventory method is widely used (a) to
permit the computation of net income without a
physical count of inventory, (b) as a control measure
in determining inventory shortages, (c) in regulating
quantities of inventory on hand, and (d) for insurance
information.
The retail method is often used in the retail industry
for measuring inventories of large numbers of rapidly
changing items with similar margins for which it is
impracticable to use other costing methods.
 The percentage used takes into consideration
inventory that has been marked down to below its
original selling price.
 An average percentage for each retail department
is often used.
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 ESTIMATING INVENTORY 2019

PROBLEMS Summary on previous years’ sales:

2016 2017 2018
1. On May 6, 2019 a flash flood caused damage to Sales P626,000 P705,000 P680,000
the merchandise stored in the warehouse of Gross Profit 187,800 183,300 231,200
Cabanatuan Co. You were asked to submit an GPR 30% 26% 34%
estimate of the merchandise destroyed in the
warehouse. The following data were established: Determine the inventory loss suffered as a result of
a. Net sales for 2018 were P800,000, matched the fire.
against cost of P560,000.
b. Merchandise inventory, Jan. 1, 2019 was
P200,000, 90% of which was in the warehouse 4. The work-in-process inventory of Burp Company
and 10% in downtown showrooms. were completely destroyed by fire on June 1,
c. For Jan. 1, 2019 to date of flood, you 2019. You were able to establish physical
ascertained invoice value of purchases (all inventory figures as follows:
stored in the warehouse), P100,000; freight January 1, 2019 June 1, 2019
inward, P4,000; purchases returned, P6,000. Raw materials P 60,000 P120,000
d. Cost of merchandise transferred from the Work-in-process 200,000 -
warehouse to show-rooms was P8,000, and Finished goods 280,000 240,000
net sales from January 1 to May 6, 2019 (all
Sales from January 1 to May 31, were P546,750.
warehouse stock) were P320,000.
Purchases of raw materials were P200,000 and
Assuming gross profit rate in 2019 to be the same freight on purchases, P30,000. Direct labor during
as in the previous year, the estimated merchandise the period was P160,000. It was agreed with
destroyed by the flood was insurance adjusters that an average gross profit
rate of 35% based on cost be used and that direct
labor cost was 160% of factory overhead.
2. The Bayambang Corporation was organized on
The work in process inventory destroyed by fire is
January 1, 2018. On December 31, 2019, the
corporation lost most of its inventory in a
warehouse fire just before the year-end count of
Use the following information for the next two
inventory was to take place. Data from the
questions.
records disclosed the following:
2018 2019 Pugo uses the retail inventory method. The following
Beginning inventory, information is available for the current year:
January 1 P 0 P1,020,000 Cost Retail
Purchases 4,300,000 3,460,000 Beginning inventory P 1,300,000 P 2,600,000
Purchases returns and Purchases 18,000,000 29,200,000
allowances 230,600 323,000 Freight in 400,000
Sales 3,940,000 4,180,000 Purchase returns 600,000 1,000,000
Sales returns and Purchase allowances 300,000
allowances 80,000 100,000 Departmental transfer 400,000 600,000
On January 1, 2019, the Corporation’s pricing in
policy was changed so that the gross profit rate Net markups 600,000
would be three percentage points higher than the Net markdowns 2,000,000
one earned in 2018. Sales 24,700,000
Sales returns 350,000
Salvaged undamaged merchandise was marked to Sales discounts 200,000
sell at P120,000 while damaged merchandise was Employee discounts 600,000
marked to sell at P80,000 had an estimated Loss from breakage 50,000
realizable value of P18,000.
How much is the inventory loss due to fire? 5. The estimated cost of inventory at the end of the
current year using the conventional (lower of cost
or market) retail inventory method is
3. Luna Manufacturing began operations 5 years ago.
On August 13, 2019, a fire broke out in the 6. The estimated cost of inventory at the end of the
warehouse destroying all inventory and many current year using the average retail inventory
accounting records relating to the inventory. The method is
information available is presented below. All sales
and purchases are on account. 7. The estimated cost of inventory at the end of the
January August current year using the FIFO retail inventory
1, 2019 13, 2019 method is
Inventory P143,850
Accounts Receivable 130,590 P128,890
Accounts Payable 88,140 122,850
Collections on accounts rec.,
Jan. 1- Aug. 13 753,800
Payments to suppliers,
Jan. 1- Aug. 13 487,500
Goods out on consignment at
Aug. 13, at cost 52,900

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 ESTIMATING INVENTORY 2019

The records of Binmaley’s Department Store report the

following data for the month of January:
Beginning inventory at cost 440,000
Beginning inventory at sales price 800,000
Purchases at cost 4,500,000
Initial markup on purchases 2,900,000
Purchase returns at cost 240,000
Purchase returns at sales price 350,000
Freight on purchases 100,000
Additional mark up 250,000
Mark up cancellations 100,000
Mark down 600,000
Mark down cancellations 100,000
Net sales 6,500,000
Sales allowance 100,000
Sales returns 500,000
Employee discounts 200,000
Theft and other losses 100,000
Using the average retail inventory method,
Binmaley’s ending inventory is

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