ESTIMATING INVENTORY 2019
LECTURE NOTES deducted from the retail value of inventory available
Gross profit method
The gross profit method is an 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 assumptions
that (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.
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.
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.
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 by dividing the cost of
the goods available for sale by the retail value
(selling price) of goods available for sale. Once the
ratio is determined, total sales for the period are
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for sale. The resulting amount represents ending
inventory priced at retail. When this amount is
multiplied by the cost to retail ratio, an
approximation of the cost of ending inventory
results. 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.
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
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 ESTIMATING INVENTORY 2019

quantities of inventory on hand, and (d) for would be three percentage points higher than the
insurance information. one earned in 2018.
Salvaged undamaged merchandise was marked
The retail method is often used in the retail industry
to sell at P120,000 while damaged merchandise
for measuring inventories of large numbers of rapidly
was marked to sell at P80,000 had an estimated
changing items with similar margins for which it is
realizable value of P18,000.
impracticable to use other costing methods.
 The percentage used takes into consideration How much is the inventory loss due to fire?
inventory that has been marked down to below
its original selling price.
 An average percentage for each retail 3. Luna Manufacturing began operations 5 years
department is often used. ago. On August 13, 2019, a fire broke out in the
warehouse destroying all inventory and many
accounting records relating to the inventory. The
PROBLEMS information available is presented below. All
sales and purchases are on account.
1. On May 6, 2019 a flash flood caused damage to January August
the merchandise stored in the warehouse of 1, 2019 13, 2019
Cabanatuan Co. You were asked to submit an Inventory P143,850
estimate of the merchandise destroyed in the Accounts Receivable 130,590 P128,890
warehouse. The following data were established: Accounts Payable 88,140 122,850
a. Net sales for 2018 were P800,000, matched Collections on accounts
against cost of P560,000. rec., Jan. 1- Aug. 13 753,800
b. Merchandise inventory, Jan. 1, 2019 was Payments to suppliers,
P200,000, 90% of which was in the Jan. 1- Aug. 13 487,500
warehouse and 10% in downtown Goods out on consignment
showrooms. at Aug. 13, at cost 52,900
c. For Jan. 1, 2019 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 Summary on previous years’ sales:
warehouse to show-rooms was P8,000, and
net sales from January 1 to May 6, 2019 (all 2016 2017 2018
warehouse stock) were P320,000. Sales P626,000 P705,000 P680,000
Gross Profit 187,800 183,300 231,200
Assuming gross profit rate in 2019 to be the GPR 30% 26% 34%
same as in the previous year, the estimated
merchandise destroyed by the flood was Determine the inventory loss suffered as a result
of the fire.

2. The Bayambang Corporation was organized on

January 1, 2018. On December 31, 2019, the 4. The work-in-process inventory of Burp Company
corporation lost most of its inventory in a were completely destroyed by fire on June 1,
warehouse fire just before the year-end count of 2019. You were able to establish physical
inventory was to take place. Data from the inventory figures as follows:
records disclosed the following: January 1, 2019 June 1, 2019
2018 2019 Raw materials P 60,000 P120,000
Beginning inventory, Work-in-process 200,000 -
January 1 P 0 P1,020,000 Finished goods 280,000 240,000
Purchases 4,300,000 3,460,000 Sales from January 1 to May 31, were P546,750.
Purchases returns and Purchases of raw materials were P200,000 and
allowances 230,600 323,000 freight on purchases, P30,000. Direct labor
Sales 3,940,000 4,180,000 during the period was P160,000. It was agreed
Sales returns and with insurance adjusters that an average gross
allowances 80,000 100,000 profit rate of 35% based on cost be used and
On January 1, 2019, the Corporation’s pricing that direct labor cost was 160% of factory
policy was changed so that the gross profit rate overhead.

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 ESTIMATING INVENTORY 2019

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 400,000 600,000
in
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

8. The records of Binmaley’s Department

Store report the following data for the
month of January:
Beginning inventory at cost 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

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