Accounting Principles I

Companies sometimes need to determine the value of inventory when a physical count is impossible or impractical. For example, a company may need to know how much inventory was destroyed in a fire. Companies using the perpetual system simply report the inventory account balance in such situations, but companies using the periodic system must estimate the value of inventory. Two ways of estimating inventory levels are the gross profit method and the retail inventory method.

Gross profit method. The gross profit method estimates the value of inventory by applying the company's historical gross profit percentage to current‐period information about net sales and the cost of goods available for sale. Gross profit equals net sales minus the cost of goods sold. The gross profit margin equals gross profit divided by net sales. If a company had net sales of $4,000,000 during the previous year and the cost of goods sold during that year was $2,600,000, then gross profit was $1,400,000 and the gross profit margin was 35%.

If gross profit margin is 35%, then cost of goods sold is 65% of net sales.

Suppose that one month into the current fiscal year, the company decides to use the gross profit margin from the previous year to estimate inventory. Net sales for the month were $500,000, beginning inventory was $50,000, and purchases during the month totaled $300,000. First, the company multiplies net sales for the month by the historical gross profit margin to estimate gross profit.

Next, estimated gross profit is subtracted from net sales to estimate the cost of goods sold.

Alternatively, cost of goods sold may be determined by multiplying net sales by 65% (100% – gross profit margin of 35%).

Finally, the estimated cost of goods sold is subtracted from the cost of goods available for sale to estimate the value of inventory.

The gross profit method produces a reasonably accurate result as long as the historical gross profit margin still applies to the current period. However, increasing competition, new market conditions, and other factors may cause the historical gross profit margin to change over time.

Retail inventory method. Retail businesses track both the cost and retail sales price of inventory. This information provides another way to estimate ending inventory. Suppose a retail store wants to estimate the cost of ending inventory using the information shown below.

The first step is to calculate the retail value of ending inventory by subtracting net sales from the retail value of goods available for sale.

Next, the cost‐to‐retail ratio is calculated by dividing the cost of goods available for sale by the retail value of goods available for sale.

Then, the estimated cost of ending inventory is found by multiplying the retail value of ending inventory by the cost‐to‐retail ratio.

One limitation of the retail inventory method is that a store's cost‐to‐retail ratio may vary significantly from one type of item to another, but the calculation simply uses an average ratio. If the items that actually sold have a cost‐to‐retail ratio that differs significantly from the ratio used in the calculation, the estimate will be inaccurate.