In some situations, it is impossible to determine the actual cost of the ending inventory. For example, a firm’s inventory may be destroyed by fire or flood, and the cost of the inventory lost must be estimated. The gross margin method can be used in such circumstances. For a retail store, taking inventory at cost is difficult, if not impossible. The inventory is thus valued at retail and then converted to cost. this is referred to as the retail inventory method.
Methods of estimating ending inventory
1. The gross margin method
The gross margin method is used when a firm wishes to estimate its ending inventory without actually taking a count. For example, firms that wish to determine their ending inventories on a monthly basis certainly do not want to take a physical inventory. Some firms have inventories in so many locations that a complete physical count would be impossible. And when there are losses from such disasters as fire or flood, it may be impossible to take an ending inventory. In all these cases, the gross margin method can be used to estimate ending inventories.
The gross margin method is based on the fact that most firms have a gross margin percentage that remains stable. The firm’s past gross margin percentage, therefore, can be used to estimate ending inventories. To illustrate, assume that the Wong Company began the month of January with an inventory of $20,000 and made net
purchases of $170,000 during January. Net sales for the month totaled $200,000 and the firm’s gross margin percentage has remained at 20%. A 20% gross margin implies that cost of goods sold is 80% of sale.
If we put this data into the normal formula to calculate cost of goods sold, we can easily show how to use the gross margin percentage. Goods available for sale of $190,000 can be determined from existing records by adding the amount of beginning inventory to the purchases for the period. The cost of goods sold is equal to 80% of sales, or $160,000. The ending inventory of $30,000 is the difference between the goods available for sale of $190,000 and the coat of goods sold of $160,000.
2. The Retail Inventory Method
Retail firms such as department stores and grocery stores use the retail method to determine their ending inventories. In essence, the inventory is taken at retail prices and then converted to cost. Because the inventories that are displayed on the shelve are priced at retail, the entire inventory for a store, such as a large market, can be taken at retail in just a few hours.
Two or three individuals read the quantity of the items and their retail prices into tape recorders. The tapes are then transcribed and extended, and the result is the total inventory at retail prices. That is, a listing of the tape noting the quantity and prices is made. When the prices and quantities are multiplied, the total inventory at retail is determined. This inventory is then converted to cost by using a cost-to-retail percentage. This process is considerably less time-consuming than trying to determine the cost of each particular item, even using some cost flow assumption.
The heart of the retail method is determining a cost-to-retail percentage. This percentage is often calculated by dividing goods available for sale at cost by goods available for sale at retail. This means that a firm using the retail method must keep track of both inventories and purchases at cost and at retail. This is not as difficult as it seems because most retailers know the retail prices they are going to set on the goods they buy.
The retail method can be used to estimate ending inventories even if a physical inventory has not been taken. This is done by first determining goods available for sale at retail and then subtracting sales which are at retail. The result is an estimated ending inventory at retail. The ending inventory at cost is then determined by applying a cost-to-retail percentage to the ending inventory at retail.
This procedure is illustrated for the Martinez Grocery Store. In this case, the cost-to-retail percentage is 80%, or goods available for sale at cost of $190,000 divided by goods available for sale at retail of $237,500. The ending inventory at retail of $37,500 is multiplied by this ratio to determine the ending inventory at cost of $30,000.
Although this example is a simplified version of the retail method, it does indicate the theory behind its application, In practice, different cost percentages can be used to cost inventories at FIFO, LIFO, and average cost, and other complications are considered in intermediate accounting textbooks.