Accounting: The Language of Business (Part 55)

“To be successful, you should concentrate on the world of companies, not arcane accounting mathematics.” —Warren Buffett

Inventories (Part G)

by

Charles Lamson

Estimating Inventory Cost

It may be necessary for a business to know the amount of inventory when perpetual inventory records (Perpetual inventory is a continuous accounting practice that records inventory changes in real-time, without the need for physical inventory.) are not maintained and it is impractical to take a physical inventory. For example, a business that uses a periodic inventory system may need monthly income statements, but taking a physical inventory each month may be too costly. Moreover, when a disaster such as a fire has destroyed the inventory, the amount of the loss must be determined. In this case, taking a physical inventory is impossible. And even if perpetual inventory records have been kept, the accounting records may also have been destroyed. In such cases, the inventory cost can be estimated by using (1) the retail method or (2) the gross profit method.

Retail Method of Inventory Costing

The retail inventory method of estimating inventory cost is based on the relationship of the cost of merchandise available for sale to the retail price of the same merchandise. To use this method the retail prices of all merchandise are maintained and totaled. Next, the inventory at retail is determined by deducting sales for the period from the retail price of the goods that were available for sale during the period. The estimated inventory cost is then computed by multiplying the inventory at retail by the ratio of cost to selling (retail) price for the merchandise available for sale, as Illustrated in Exhibit 9.

When estimating the percent of cost to selling price, we assume that the mix of the items in the ending inventory is the same as the entire stock of merchandise available for sale. In Exhibit 9, for example, it is unlikely that the retail price of every item was made up of exactly 62% cost and 38% gross profit. We assume, however, that the weighted average of the cost percentages of the merchandise in the inventory ($30,000) is the same as in the merchandise available for sale ($100,000).

When the inventory is made up of different classes of merchandise with very different gross profit rates, the cost percentages and the inventory should be developed for each class of inventory.

One of the major advantages of the retail method is that it provides inventory figures for preparing monthly or quarterly statements when the periodic system is used. Department stores and similar merchandisers like to determine gross profit and operating income each month but may take a physical inventory only once or twice a year. In addition, comparing the estimated ending inventory with the physical ending inventory, both at retail prices, will help identify inventory shortages resulting from shoplifting and other causes. Management can then take appropriate actions.

The retail method may also be used as an aid in taking a physical inventory. In this case, the items counted are recorded on the inventory sheets at their retail (selling) prices instead of their cost prices. The physical inventory at selling price is then converted to cost by applying the ratio of cost to selling (retail) price for the merchandise available for sale.

To illustrate, assume that the data in Exhibit 9 are for an entire fiscal year rather than for only January. If the physical inventory taken at the end of the year totaled $29,000, priced at retail, this amount rather than the $30,000 would be converted to cost. Thus, the inventory at cost would be $17,980 ($29,000 X 62%) instead of $18,600 ($30,000 X 62%). The $17,980 would be used for the year-end financial statements and for income tax purposes.

Gross Profit Method of Estimating Inventories

The gross profit method uses the estimated gross profit for the period to estimate the inventory at the end of the period. The gross profit is usually estimated from the actual rate for the preceding year, adjusted for any changes made in the cost and sales prices during the current period. By using the gross profit rate, the dollar amount of sales for a period can be divided into its two components: (1) gross profit and (2) cost of merchandise sold. The latter amount may then be deducted from the cost of merchandise available for sale to yield the estimated cost of the inventory.

Exhibit 10 illustrates the gross profit method for estimating a company's inventory on January 31. In this example, the inventory on January 1 is assumed to be $57,000, the net purchases during the month are $180,000, and the net sales during the month are $250,000. In addition, the historical gross profit was 30% of net sales.

The gross profit method is useful for estimating inventories for monthly or quarterly financial statements in a periodic inventory system. It is also useful in estimating the cost of merchandise destroyed by fire or other disasters.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 369-371*

end