LECTURE NOTES ON INVENTORY ESTIMATION

Gross profit method

 This 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 following assumptions:

(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.

The estimated ending inventory of a trading company is computed as follows:

Inventory, beginning Pxx
Purchases, net xx
GAS xx
Cost of goods sold ( xx)
Inventory, ending Pxx

The cost of goods sold is computed as follows:

If GPR is based on sales:

Net sales x Cost ratio (1 – GPR)

If GPR is based on cost:

Net sales / (1+GPR)

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.

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 as follows:
GAS at cost / GAS at retail

The estimated ending inventory is computed as follows:

Inventory, beginning at retail Pxx
Purchases, net – at retail xx
TGAS at retail xx
Sales (+/- sales adjustments) ( xx)
Inventory, ending at retail xx
x cost ratio %
Inventory, ending at cost Pxx

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.
Differences in applying retail method:

Conventiona Average FIFO

l

Net Exclude Include Include

markdown (Deduct) (Deduct)

Inventory, Include Include Exclude

beginning

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.

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.

PROBLEMS
1. On May 6, 2015 a flash flood caused damage to the merchandise stored in the warehouse of
Cabanatuan Co. You were asked to submit an estimate of the merchandise destroyed in the
warehouse. The following data were established:
a. Net sales for 2014 were P800,000, matched against cost of P560,000.
b. Merchandise inventory, Jan. 1, 2015 was P200,000, 90% of which was in the warehouse and
10% in downtown showrooms.
c. For Jan. 1, 2015 to date of flood, you ascertained invoice value of purchases (all stored in the
warehouse), P100,000; freight inward, P4,000; purchases returned, P6,000.
d. Cost of merchandise transferred from the warehouse to show-rooms was P8,000, and net
sales from January 1 to May 6, 2015 (all warehouse stock) were P320,000.
Assuming gross profit rate in 2015 to be the same as in the previous year, the estimated
merchandise destroyed by the flood was

2. The Bayambang Corporation was organized on January 1, 2014. On December 31, 2015, the
corporation lost most of its inventory in a warehouse fire just before the year-end count of
inventory was to take place. Data from the records disclosed the following:
2014 2015
Beginning inventory,
January 1 P 0 P1,020,000
Purchases 4,300,000 3,460,000
Purchases returns and
allowances 230,600 323,000
Sales 3,940,000 4,180,000
Sales returns and
allowances 80,000 100,000
On January 1, 2015, the Corporation’s pricing policy was changed so that the gross profit rate
would be three percentage points higher than the one earned in 2014.
Salvaged undamaged merchandise was marked to sell at P120,000 while damaged merchandise
was marked to sell at P80,000 had an estimated realizable value of P18,000. How much is the
inventory loss due to fire?
3. Luna Manufacturing began operations 5 years ago. On August 13, 2015, a fire broke out in the
warehouse destroying all inventory and many accounting records relating to the inventory. The
information available is presented below. All sales and purchases are on account.
January 1, August 13,
2015 2015
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
Summary on previous years’ sales:
2012 2013 2014
Sales P626,000 P705,000 P680,000
Gross Profit 187,800 183,300 231,200
GPR 30% 26% 34%
Determine the inventory loss suffered as a result of the fire.

4. The work-in-process inventory of Burp Company were completely destroyed by fire on June 1,
2015. You were able to establish physical inventory figures as follows:
January 1, 2015 June 1, 2015
Raw materials P 60,000 P120,000
Work-in-process 200,000 -
Finished goods 280,000 240,000
Sales from January 1 to May 31, were P546,750. Purchases of raw materials were P200,000 and
freight on purchases, P30,000. Direct labor during the period was P160,000. It was agreed with
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.
The work in process inventory destroyed by fire is

Use the following information for the next two questions.

Pugo uses the retail inventory method. The following information is available for the current year:
Cost Retail
Beginning inventory P 1,300,000 P 2,600,000
Purchases 18,000,000 29,200,000
Freight in 400,000
Purchase returns 600,000 1,000,000
Purchase allowances 300,000
Departmental transfer in 400,000 600,000
Net markups 600,000
Net markdowns 2,000,000
Sales 24,700,000
Sales returns 350,000
Sales discounts 200,000
Employee discounts 600,000
Loss from breakage 50,000

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

6. The estimated cost of inventory at the end of the current year using the average retail inventory
method is

7. The estimated cost of inventory at the end of the current year using the FIFO retail inventory
method is

Conventional Average FIFO

GAS at
cost

GAS at
retail

Cost ratio

EI at cost
8. The records of Binmaley’s Department Store report the following data for the month of January:
Beginning inventory at cost P 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

SOLUTION GUIDE:
Cost Retail
Beginning inventory
Purchases
Purchase returns
Freight in
Additional mark up
Mark up cancellations
Mark down
Mark down cancellations
GAS

9. Yumul Company provided the following data:

Cost Retail
Beginning inventory P 160,000 P 400,000
Purchases 2,800,000 3,200,000
Freight in 40,000
Markup 300,000
Markup cancellation 30,000
Markdown 160,000
Markdown
cancellation 40,000
Sales 3,000,000
Physical inventory at
year end 500,000
Estimated normal
shrinkage is 4% of
sales
Assuming the company uses the average retail inventory method, the estimated inventory
shortage is