Handout: Inventory Estimation FAR0_1st Sem_AY2019-20

Methods of Inventory Estimation

1. Gross profit method
2. Retail inventory method

GROSS PROFIT (GP) METHOD

1. This inventory estimation method assumes that the rate of gross profit remains approximately the same from period to
period.
2. Accordingly, the ratio of cost of sales to net sales is also assumed to be relatively constant from period to period.
3. Basic formula under the GP method:

Beginning inventory xx
Add: Net cost of purchases
Purchases xx
Freight in xx
Purchase returns & allowances (xx)
Purchase discounts (xx) xx
Total cost of goods available for sale xx
Less: Estimated cost of sales (see Item No. 4) xx
Estimated cost of ending inventory xx

4. The estimated cost of sales is computed as follows:

a. Gross profit rate is based on sales / selling price:

Estimated cost of sales = Net sales x (100% - GP rate)

b. Gross profit rate is based on cost:

Net sales
Estimated cost of sales =
100% + GP rate

5. The Net Sales, for purposes of inventory estimation, is equal to Gross Sales reduced by any Sales Return during the period.
Sales allowances and discounts, which do not result to physical reduction in units sold, are ignored (not deducted from
gross sales) in the determination of net sales.

RETAIL INVENTORY METHOD

1. This method is often used in the retail industry for measuring inventory of large number of rapidly changing items with
similar margin.
2. It is commonly employed by department stores, supermarkets and other retail concerns which maintain a wide variety of
goods in its inventory.
3. Required information to support the use of the retail inventory method:
a. Beginning inventory at cost and at retail price;
b. Purchases during the period at cost and at retail price;
c. Adjustments to the original retail price such as additional mark up, mark up cancelation, markdown and
markdown cancelation; and
d. Other adjustments such as departmental transfers, breakages, shrinkage, theft, damaged goods and employee
discounts.
4. Basic formula under the Retail Inventory Method:

Particulars Cost Retail

Beginning Inventory xx xx
Net purchases xx xx
Total goods available for sale (TGAFS) xx xx
*Cost ratio (TGAFS @cost divided by TGAFS @ retail)
Net sales (xx)
Ending inventory at retail xx
Ending inventory at cost [ EI @ retail multiplied by the cost ratio*] xx

Approaches in the use of retail inventory method

1. Conservative or conventional or lower of cost and net realizable value approach
 Lowest cost of ending inventory and highest cost of sales value.
 Includes net mark ups and excludes net mark downs for purposes of cost ratio computations
2. Average approach
 Higher cost of ending inventory and lower cost of sales value than the conservative approach
 Includes net mark ups and net mark downs for purposes of cost ratio computations
3. FIFO retail approach
 Disregards beginning inventory information in the determination of the cost ratio.
 Assumes that the cost of the ending inventory is reasonably sourced from the current purchases (FIFO)
 Includes net mark ups and net mark downs for purposes of the cost ratio computations