Inventory and
Cost of Goods Sold

There are two methods for estimating ending inventory:

1.   Gross Profit Method
2.   Retail Method

1.  Gross Profit Method. The gross profit method for estimating inventory uses the information contained in the top portion of a merchandiser's multiple-step income statement:

ABC Company Income Statement (partial) For the Year Ended Dec. 31, 2007 Sales $100,000 100.0% Cost of Goods Sold Beginning Inventory $ 22,000 Purchases - net    83,000 Cost of Goods Available 105,000 Less: Ending Inventory    25,000 Cost of Goods Sold    80,000   80.0% Gross Profit $ 20,000   20.0%

Let's assume that we need to estimate the cost of inventory on hand on June 30, 2008. From the 2007 income statement shown above we can see that the company's gross profit is 20% of the sales and that the cost of goods sold is 80% of the sales. If those percentages are reasonable for the current year, we can use those percentages to help us estimate the cost of the inventory on hand as of June 30, 2008.

While an algebraic equation could be constructed to determine the estimated amount of ending inventory, we prefer to simply use the income statement format. We prepare a partial income statement for the period beginning after the date when inventory was last physically counted, and ending with the date for which we need the estimated inventory cost. In this case, the income statement will go from January 1, 2008 until June 30, 2008.

Some of the numbers that we need are easily obtained from sales records, customers, suppliers, earlier financial statements, etc. For example, sales for the first half of the year 2008 are taken from the company's records. The beginning inventory amount is the ending inventory reported on the December 31, 2007 balance sheet. The purchases information for the first half of 2008 is available from the company's records or its suppliers. The amounts that we have available are written in italics in the following partial income statement:

ABC Company Income Statement (partial) For the Six Months Ended June 30, 2008 Sales $ 56,000 100.0% Cost of Goods Sold Beginning Inventory $ 25,000 Purchases - net 46,000 Cost of Goods Available Less: Ending Inventory Cost of Goods Sold  80.0% Gross Profit  20.0%

We will fill in the rest of the statement with the answers to the following calculations. The amounts in italics come from the statement above. The bold amount is the answer or result of the calculation.

Step 1.	Cost of Goods Available	=	Beginning Inventory	+	Net Purchases
	Cost of Goods Available	=	$25,000	+	$46,000
	Cost of Goods Available	=	$71,000

Step 2.	Gross Profit	=	Gross Profit Percentage (or Gross Margin)	x	Sales
	Gross Profit	=	20%	x	$56,000
	Gross Profit	=	$11,200

Step 3.	Cost of Goods Sold	=	Sales	–	Gross Profit
	Cost of Goods Sold	=	$56,000	–	$11,200  (from Step 2.)
	Cost of Goods Sold	=	$44,800

         This can also be calculated as 80%  x  Sales of  $56,000  =  $44,800.

Inserting this information into the income statement yields the following:

ABC Company Income Statement (partial) For the Six Months Ended June 30, 2008 Sales $56,000 100.0% Cost of Goods Sold Beginning Inventory $25,000 Purchases - net   46,000 Cost of Goods Available 71,000 Less: Ending Inventory            ? Cost of Goods Sold   44,800  80.0% Gross Profit   11,200  20.0%

As you can see, the ending inventory amount is not yet shown. We compute this amount by subtracting cost of goods sold from the cost of goods available:

Ending Inventory	=	Cost of Goods Available	–	Cost of Goods Sold
Ending Inventory	=	$71,000	–	$44,800
Ending Inventory	=	$26,200

Below is the completed partial income statement with the estimated amount of ending inventory at $26,200. (Note: It is always a good idea to recheck the math on the income statement to be certain you computed the amounts correctly.)

ABC Company Income Statement (partial) For the Six Months Ended June 30, 2008 Sales $56,000 100.0% Cost of Goods Sold Beginning Inventory $25,000 Purchases - net   46,000 Cost of Goods Available 71,000 Less: Ending Inventory   26,200 Cost of Goods Sold   44,800  80.0% Gross Profit $11,200  20.0%

2.  Retail Method. The retail method can be used by retailers who have their merchandise records in both cost and retail selling prices. A very simple illustration for using the retail method to estimate inventory is shown here:

Cost Retail Beginning Inventory $ 11,000 $ 15,000 Purchases - net + 69,000 + 85,000 Goods Avail. & Cost Ratio 80,000 100,000 Less: Sales at retail  - 90,000 Est. ending inventory at retail 10,000 Est. ending inventory at cost $   8,000

As you can see, the cost amounts are arranged into one column. The retail amounts are listed in a separate column. The Goods Available amounts are used to compute the cost-to-retail ratio. In this case the cost of goods available of $80,000 is divided by the retail amount of goods available ($100,000). This results in a cost-to-retail ratio, or cost ratio, of 80%.
To arrive at the estimated ending inventory at cost, we multiply the estimated ending inventory at retail ($10,000) times the cost ratio of 80% to arrive at $8,000.

Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances.

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