Although a physical inventory is taken once a year, there are occasions when the value of the inventory must be known during the year. When interim financial statements are requested, an inventory amount must be estimated. If no physical count is taken, the amount of inventory must be estimated. Also, in the event of fire or any other casualty, an amount must be reported as a loss. Two of the most popular methods of estimating inventory are the gross profit method and the retail method. Through this post we are going to discuss basic technique of both methods.
Gross Profit Method
Gross profit method re-arranges the Cost of Goods Sold section of the income statement. As we have known, the cost of goods sold formula is:
Right from the above formula:
- When you subtract ending inventory from the goods available for sale, the cost of goods sold is determined.
- Conversely, if you subtract the estimated cost of goods sold from the goods available for sale, the value of the ending inventory will result.
- The estimated cost of goods sold figure is arrived at by using the past year’s gross profit percentage and subtracting the resulting amount from sales.
Example: During the past five years, a company’s gross profit averaged 30 percent of sales. If the sales for this interim period are $70,000, the inventory at the beginning of the period is $30,000, and the net purchases are $50,000, you would estimate the ending inventory under the gross profit method as follows:
This method of estimating ending inventory is also useful for determining casualty losses such as fires, flood, or theft, when such a calamity destroys a company’s inventory. It is obvious that a dollar amount must be assigned to the inventory lost before any insurance claim can be made.
Retail Inventory Method
The retail inventory method of inventory costing is used by retail businesses, particularly department stores. Department stores usually determine gross profit monthly but only take a physical inventory on an annual basis. The retail inventory method permits a determination of inventory at any time of the year and also produces a comparison of the estimated ending inventory with the physical inventory ending inventory, both at retail prices. This will help to identify any inventory shortages resulting from theft or other causes.
Retail inventory method (similar to the gross profit method), is used to estimate the dollar cost of the ending inventory when a physical count cannot be done, such as in the case of fire. The procedure for determination under this method is as follows:
- Beginning inventory and purchases must be recorded at both cost and selling prices.
- Total goods available for sale are then computed on both bases.
- Sales for the period are deducted from the goods available for sale at selling price.
- Ending inventory at selling price is the result of step 3.
This amount is then converted to ending inventory at cost by multiplying by the appropriate markup ratio.
The procedure is best illustrated in the example below:
In the above example, the cost percentage is 67%, which means that the inventory and purchases are marked up to yield a gross profit margin of 33%. Certainly not all items in the goods available for sale are marked up by exactly the same percentage, but it is the average. In other words, the retail method will use a percentage that represents an average of markup cost.
The major difference between the gross profit method and the retail method is that the former uses the historical gross profit rates, and the latter uses the percentage markup from the current period. The gross profit method uses past experience as a basis, whereas the retail method uses current experience.
The gross profit method is usually less reliable, because past situations may be different from current ones.
Both Gross Profit and Retail Inventory Method are useful because they allow the accountant to prepare interim financial statements more frequently without taking the time to physically count the inventory. However, the annual physical count is always necessary.