Inventory Estimation (Gross Profit Method)

Use of Estimate in inventory valuation -

Inventory is destroyed by fire insurance purpose

Prove the correctness or reasonableness of the physical count of inventory.

Interim financial statements preparation.

Basic Formula for Estimating Inventory Estimation

Income Statement Format

Beginning Inventory

Add: Net Cost of Purchase*

Total Goods Available for Sale

Less: Ending Inventory

Cost of Goods Sold

Formula for Inventory End as Estimated

Beginning Inventory

Add: Net Cost of Purchases *

Total Goods Available for Sale

Less: Cost of Sales

Inventory End (estimated)

* Net Cost of Purchases Includes

Freight In

Less: Purchase Return & Allowances

Purchase Discount

Cost of Goods Sold Computation

By the Gross Profit method, Cost of Sales is computed as follows:

1. When GPR is based on Cost:

COS = Net Sales divided by sales ratio (1+ rate)

2. When GPR is based on Sales

COS = Net Sales multiplied by Cost Ratio (1- rate)

If the problem is silent, GPR is based on sales

Illustration:

Beg. inventory 100,000

Net purchases 500.000

Net Sales 700,000

GPR based on Sales 40 %

Compute INVTY, END

Beginning inventory 100,000

Add: puchases 500,000

Total Goods available for sale 600,000

Less: COS

Net sales 700,000

X Cost ratio (1-.40) .60 420,000

Inventory end 180,000

Another Illustration:

Beginning Inventory 200,000

Net Purchases 1,000,000

Net Sales 1,260,000

GPR based on cost 40%

Beginning Inventory 200,000

Add: Net Purchases 1,000,000

Total Goods Available for Sale 1,200,000

Less: Cost of Sales

Net Sales 1,260,000

Divide by GPR based on Cost (1 + .40) (900,000)

Ending Inventory (Estimated) 300,000

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

To answer this kind of question, just make an assumption, for example assume a net
sale of 1,000,000.

125 %

100%

Net Sale 1,000,000 125 %

Less: Cost of sales 800.000 100%

Gross Profit 200,000 25%

If

200,000/800,000 = 25% based on cost

Then translate: 200,000/1,000,000= 20% based on sales.

Additional Notes:

Sales discounts and sales allowance are ignored in the computation of net sales for
inventory purpose because these items do not involve physical movement of inventory.
Inventory Estimation – Retail Inventory Method

Cost Ratio = Good available for sale at cost / Goods available for sale at selling price

The company’s cost of goods available should be determined at cost and at selling
price.

Illustration (Without markup or markdown) Cost Retail

Beginning Inventory 150,000 230,000

Purchases 400,000 650,000

Freight In 10,000

Purchase Return (55,000) (80,000)

Purchase Allowance (5,000)

Purchase Discount (20,000)

Goods available for sale 480,000 800,000

Less: Sales 630,000

Sales Return (30,000) (600,000)

Ending Inventory at Retail 200,000

Cost Ratio = 480,000 / 800,000

Cost Ratio = 60%

To get the Ending Inventory at Cost, multiply the value of ending inventory at retail to
the cost ratio. So, 200,000 (60%) = 120,000

Illustration (With markup and markdown)

Cost Retail

Beginning Inventory 495,000 900,000

Purchases 1,800,000 3,300,000

Net markup 300,000

Net markdown 600,000

Net Sales 2,700,000

Computation of Ending Inventory with the use of FIFO method

Cost Retail

Beginning Inventory 495,000 900,000

Purchases 1,800,000 3,300,000

Net markup 300,000

Net markdown (600,000)

Goods available for sale 2,295,000 3,900,000

Less: Net Sales (2,700,000)

Ending Inventory at retail 1,200,000

Cost Ratio:

CONSERVATIVE (Considers markup only) = 2,295,000 / 4,500,000* = 51%

*Beginning inventory 900,000

Purchases 3,300,000

Markup 300,000

Goods available for sale at selling price 4,500,000

To get the Ending Inventory at Cost, multiply the value of ending inventory at retail to
the cost ratio. So, 1,200,000 (51%) = 612,000

AVERAGE (Considers markup and markdown) = 2,295,000 / 3,900,000 = 59%

To get the Ending Inventory at Cost, multiply the value of ending inventory at retail to
the cost ratio. So, 1,200,000 (59%) = 708,000

FIFO RETAIL (Remove Beginning Inventory and considers markup and markdown) =
1,800,000 / 3,000,000 = 60%

To get the Ending Inventory at Cost, multiply the value of ending inventory at retail to
the cost ratio. So, 1,200,000 (60%) = 720,000

To get the COST OF SALES

Conservative Average FIFO Retail

Goods available for sale at cost 2,295,000 2,295,000 2,295,000

Ending inventory at FIFO cost (612,000) (708,000) (720,000)

Cost of sales 1,683,000 1,587,000 1,575,000

Treatment of items

1. Purchase discount- deducted from purchases at cost only

2. Purchase return - deducted from purchases at cost and at retail

3. Purchase allowance - deducted from purchases at cost only

4. Freight in - Addition to purchases at cost only

5. Departmental transfer in or debit - Addition to purchases at cost and at retail

6. Departmental transfer out or credit - Deduction to purchases at cost and at retail

7. Sales discount and sales allowance - Disregarded/ignored

8. Sales returns - deducted from sales

9. Employee discounts - added to sales

10.Normal shortage, shrinkage, spoilage, breakage - deducted from goods available for
sale at retail.

11. Abnormal - deducted from both cost of goods available for sale at cost and at retail

- Reported separately as a loss

Illustration

Cost Retail

Beginning Inventory 180,000 250,000

Net Purchases 1,020,000 1,575,000

Additional markup (add) 200,000

Mark up cancellation (Subtract) 25,000

Markdown (subtract) 140,000

Additional markdown (add) 15,000

Sales 1,450,000

Sales return 50,000

Sales allowance (ignore) 10,000

Sales Discount (ignore) 20,000

Employee Discount 40,000

Spoilage and breakage 35,000

Conservative and Average Cost method

Cost Retail

Beginning Inventory 180,000 250,000

Net Purchases 1,020,000 1,575,000

Additional markup 200,000

Mark up cancellation 25,000

GAS – conservative 1,200,000 2,000,000

Markdown (140,000)
Markdown cancellation 15,000

GAS – average 1,200,000 1,875,000

Less: Sales 1,450,000

Sales return (50,000)

Employees Discount 40,000 (1,440,000)

Spoilage and breakage (35,000)

Ending inventory at retail 400,000

To compute for Ending inventory at cost:

Conservative: 400,000 (60%) = 240,000

Average: 400,000 (64%) = 256,000

FIFO Retail: 400,000 (63%) = 252,000

Cost Ratio:
Conservative: 1,200,000 / 2,000,000 = 60%

Average: 1,200,000 / 1,875,000 = 64%

FIFO Retail: 1,020,000 / 1,625,000 = 63%

To get the COST OF SALES:

Conservative Average FIFO Retail

GAS – cost 1,200,000 1,200,000 1,200,000

Less: Ending inventory at cost 240,000 256,000 252,000

Cost of Sales 960,000 944,000 748,000