Estimating Inventories

In certain circumstance companies may need to estimate inventories. For example, in case of a fire, a company may need to report to their insurance company the value of inventory destroyed.  A company using a perpetual inventory system would simply report the value of their lost inventory as show in the account balance. However, a company using a periodic inventory system wouldn’t have an up to date account balance for inventory. Other circumstances where a company may want to estimate inventories include estimating inventories for interim reports or testing the resonableness of the cost calculated by some other method. 

In these circumstances there are two generally accepted ways of estimating inventories: the gross profit method and the retail inventory method.

Gross Profit Method

The gross profit method estimates the current value of a company’s inventory using the company’s previous gross profit margin and current net sales and cost of goods sold.



For example, assume a company has a historical gross profit margin of 35%. We can calculate ending inventory by doing the following:

Step 1: Beginning Inventory + Purchases = Cost of Goods Available for Sale

Step 2: Current Sales x (1 - Historical Gross Profit Margin) = Estimated Cost of Goods Sold

Step 3: Cost of Goods Available For Sale – Estimated Cost of Goods Sold = Estimated Ending Inventory

Note: Sometimes we refer to (1 - Historical Gross Profit Margin) as the 'Cost of Goods Sold Percentage.' It is always the complement of the gross profit percentage.

Retail Inventory Method

Many retail businesses track both the purchase price of merchandise as well as the retail value of merchandise available for sale. We can estimate ending inventory using the retail value of costs available for sale and the amount of sales recorded.

Step 1: Goods Available for Sale (Retail Value) – Sales = Ending Inventory (Retail)

Step 2: Cost-to-Retail Ratio = Goods Available for Sale (Cost)/Goods Available for Sale (Retail Value)

Step 3: Ending Inventory (Cost) = Ending Inventory (Retail) x Cost-to-Retail Ratio