IAS 2-Inventories

Techniques for estimating the cost of goods sold

 & ending inventory

Taking a physical inventory every month would be expensive and time consuming. Therefore if a business using a periodic inventory system prepared monthly or quarterly financial statements is may estimate the amount of its inventory and cost of goods sold except at the end of its annual period. One approach to making these estimates is called the gross profit method, another –used primarily by retails stores- is the retail method

The Gross Profit Method:

It is a simple and quick technique for estimating the cost of goods sold and the amount of inventory on hand. It is assume that the rate of gross profit earned in the preceding year will remain  the same for the current year when we know the rate of gross profit, we can the amount of net sales into two elements first is the gross profit and other cost of goods sold.

We view net sales as 100%. If the gross profit rate, for example, is 40% of net sales, the cost of goods sold must be 60%. The cost of goods sold is determined by deducting the gross profit rate from 100%.

When the gross profit rate is known, the ending inventory can be estimated by the following procedures:

1. Determine cost of goods available for sale.
2. Estimate cost of goods sold by multiplying the net sales by the cost ratio.
3. Deduct cost of goods sold from cost of goods available for sale to determine ending inventory.

Example:

In March of 2009, Matrix’s inventory was destroyed by fire.  Past history shows that Matrix’s normal Gross Profit ratio is 30% of Net Sales.  Here are some other balances in Matrix’s accounting records: Sales were $31,500; Sales Returns were $1,500; Beginning Inventory was $12,000, and the Net Cost of Goods Purchased was $20,500. Let’s estimate the amount of the inventory lost in the fire.

First, determine the Cost of Goods Available for Sale. This is calculated by adding Beginning Inventory and the Net Cost of Goods Purchased.  The Cost of Goods Available for Sale is $32,500.

Second, estimate Cost of Goods Sold by multiplying Net Sales by the cost ratio.  To accomplish this, remember that Net Sales minus Cost of Goods Sold equals Gross Profit.  Since the Gross Profit ratio is 30%, then the Cost of Goods Sold Ratio has to be 70%.  Net Sales is calculated as Sales minus Sales Returns and Sales Discounts.  In this problem, there are only Sales Returns. Seventy percent of $30,000 is $21,000, which is the estimate of the Cost of Goods Sold. 

Third, deduct the Cost of Goods Sold estimate from the Cost of Goods Available for Sale to determine Ending Inventory, which in this case is $11,500.

The Retail Method

The Retail Method of estimating inventory and cost of goods sold id similar to the gross profit method. The basic difference is that the retail method requires that management determine the value of ending inventory at retail prices. The retail value of ending inventory is then converted to its approximate cost using a coat ratio. To determine the cost ratio, , a business must keep track of goods available for sale at both coat and at retail prices.

Example:

Now, let’s use the information provided for Matrix with the Retail Method to estimate Matrix’s inventory and cost of goods sold.

First, we need to determine the cost ratio. This is calculated by dividing Goods Available for Sale at Cost by Goods Available for Sale at Retail.  Matrix’s cost ratio is 65%.

Next, take Matrix’s ending inventory at retail of $22,000 and multiply it by the cost ratio to arrive at Estimated Ending Inventory at cost. For Matrix, this is $14,300.