Chapter 5: Appendix 2

Estimating Inventory Using the Retail Inventory Method and Gross Profit Method 1. Retail Inventory Method: The retail inventory method estimates the cost of ending inventory based on the cost-to-retail ratio. This method involves three key steps: 1. Calculate the total goods available for sale at cost and retail: o Determine the total cost of goods available for sale (beginning inventory + purchases). o Also calculate the retail value of the goods available for sale. 2. Determine the cost-to-retail ratio: o This is calculated as the total cost of goods available for sale divided by the total retail value of goods available for sale. 3. Estimate ending inventory: o Subtract net sales (at retail) from the total goods available for sale (at retail) to determine the ending inventory at retail. o Multiply the ending inventory at retail by the cost-to-retail ratio to estimate the ending inventory at cost. Example: Let’s assume the following data: • • • • • • • Beginning Inventory (at cost): $10,000 Purchases (at cost): $50,000 Total Goods Available for Sale (at cost): $60,000 Beginning Inventory (at retail): $15,000 Purchases (at retail): $85,000 Total Goods Available for Sale (at retail): $100,000 Net Sales (at retail): $70,000 Steps: 1. Goods Available for Sale (at retail): $100,000 2. Net Sales: $70,000 o Ending Inventory (at retail) = $100,000 − $70,000 = $30,000 (retail value). 3. Cost-to-Retail Ratio = $60,000 (cost) ÷ $100,000 (retail) = 0.60 4. Estimated Ending Inventory (at cost) = $30,000 (retail) × 0.60 = $18,000 2. Gross Profit Method: The gross profit method estimates ending inventory by applying the gross profit ratio to net sales to calculate the cost of goods sold (COGS). This estimate is then subtracted from the total cost of goods available for sale to estimate ending inventory. Steps: 1. Calculate Cost of Goods Available for Sale: o This includes the beginning inventory and purchases during the period. 2. Estimate Cost of Goods Sold: o Multiply net sales by the cost ratio (1 − gross profit ratio) to estimate the cost of goods sold. 3. Estimate Ending Inventory: o Subtract the estimated cost of goods sold from the total cost of goods available for sale to get the ending inventory. Example: Assume the following data: • • • • Beginning Inventory: $12,000 Purchases: $20,500 Net Sales: $30,000 Gross Profit Ratio: 30% Steps: 1. Cost of Goods Available for Sale = $12,000 + $20,500 = $32,500 2. Cost of Goods Sold (COGS): o Gross Profit Ratio = 30%, so Cost Ratio = 70% o Estimated COGS = $30,000 (Net Sales) × 70% = $21,000 3. Estimated Ending Inventory: o $32,500 (Goods Available for Sale) − $21,000 (COGS) = $11,500 Summary of Methods: Method Ending Inventory (at Cost) Retail Inventory Method $18,000 $11,500 Gross Profit Method The retail inventory method bases the estimate on the cost-to-retail ratio, while the gross profit method uses the historical gross profit ratio to estimate COGS and ending inventory. Each method is useful in different contexts, such as interim reporting or in cases where physical inventory counts are not feasible.