I'm Larry Walther.
This is principlesofaccounting.com, Chapter 8.
In this module, we will look at the best inventory estimation techniques,
in particular, the gross profit method and then a retail method of inventory.
>From time to time, recognize that a physical count of inventory
should occur to determine what goods are actually on hand at a particular business
probably at least once each year, if not more frequently than that.
And any differences between the physical count and amounts reflected in
the accounting records should be adjusted to reflect what the physical count shows.
That is the physical count is assumed to be correct.
Things can happen that cause the accounting records to be out of sync,
loss, spoiled goods, inventory that's stolen, errors in the accounting records.
And so that's the importance of this physical count from time to time.
Sometimes though a physical account may not be practical or cost effective such as
at an interim financial statement date at the end of the month, at the end of
the quarter, or perhaps in the event of a fire or some other event that's
destroyed the inventory and you're trying to estimate the amount that was lost.
And so that gives rise to the gross profit estimation technique.
I hesitate to call it a method.
It's not a method that's used for financial reporting purposes,
it's an estimation technique.
It might be used on occasion for financial reporting purposes when
you're not able to take a physical count, but it is just an estimating technique.
So, as I already pointed out, it can be used for interim financial reports.
It might be used in the event of a catastrophic loss that destroyed
the inventory.
It requires knowledge of the company's normal gross profit rate.
Gross profit rate recall is the gross profit divided by the sales,
or the percentage, or markup, or margin as it might be called.
We need that number to be able to use the gross profit technique.
And so here's an example.
Tiki's inventory was destroyed by fire.
Sales for the year, up to the date of the fire or
prior to the fire totaled $1,000,000.
Normally, there's a 40% gross profit rate for Tiki's business.
The beginning of the year inventory was $500,000 and
up to the date of the fire we learned from our vendors or
from other sources that $800,000 of inventory purchases had occurred.
And the question becomes, how much is the fire loss?
And so while this diagram might look complicated, it's really not.
Let's start with Step 1.
Here, we're going to determine relative percentages.
We've got 100% is the sales amount,
60% is the cost of goods sold, and 40% is the gross profit rate.
We apply that to our known sales amount.
We had $1,000,000 in sales at a 40% gross profit rate, so
our gross profit would have been $400,000 to that point in the year.
And our cost of goods sold would have been 600,000 or
60% of sales to that point in the year.
Now the final step is really just fill in the known values to the form you're
familiar with.
Beginning inventory plus purchases gives us cost of goods available for
sale minus cost of goods sold gives us ending inventory, or vice versa,
minus ending inventory gives us cost of goods sold.
Well here we know the beginning inventory at 500,000 plus the purchase is
800,000 gave us the cost of goods available, 1 million, 3.
600,000 of those goods had been sold.
So the other 700,000 was in ending inventory.
That was our fire loss, 700,000, the cost of the goods presumed to be burned up.
Now another method is the retail method.
This is used by merchandising firms to estimate their ending inventory.
And it works well when inventory is sold at a consistent markup.
Maybe everything in the store is marked up 40% or 50% or 60%.
We need that condition to be present for this to make sense.
So we determine the cost to retail percentage that is multiplied by
ending inventory at retail to determine ending inventory at cost.
Ending inventory at retail can be determined by a physical count of goods
on hand at retail or by reference to our actual sales information.
Sales from the retail register minus goods available for sale at retail.
So let's look at this.
Crock Buster sells pots that cost $7.50.
They're able to resell them for $10.
This yields a cost to retail percentage of 75%.
This is not the profit margin.
This is the cost to retail percentage, seven and a half divided by $10.
To be clear on that, we are a cost to retail percentage.
Beginning inventory had a cost, not its retail value, but its cost of 200,000.
We purchased an additional 300,000 of goods for resale.
Sales for the period totaled 460,000.
In the following illustration, the givens are going to be shown in yellow.
And the rest of the numbers are manipulated from
the percentage information that we have.
Now in this case, we know our beginning inventory was 200,000 at cost.
And we know that our purchases were 300,000 at cost.
We also know that that's 75% of what we marked the goods up to sell at.
So if I divide by 0.75 I'll come up with 266,667 and
$400,000 as the retail value of the inventory that
was in beginning inventory and purchased during the period.
If I further total I'll find that I have 666,667
as the retail value of goods available for sale carrying a cost of 500,000.
By reference to our sales information, we sold $460,000 at retail during the period.
75% of that is 345,000, the cost of the goods that were sold.
And the difference between those numbers gives us 206,667, the presumed
ending inventory at retail which has a cost 75% of that amount, $155,000.
And so
we got the 206,667 by backing out sales from goods available for sale.
We might have also gotten to that number by actually going through the store,
physically counting the goods in stock available for resale, and
determining their retail value.
Summing up, we would have come up with 206,667.
And by inference, we would determine that 155,000 was their cost amount for
reporting on the balance sheet.
And so the retail method is an excellent tool to enable the determination,
fairly quickly, of what the cost amount of inventory is for financial reporting
purposes in a retail environment where there's a consistent markup.