|So, you want to
by Bean Counter's Dave Marshall
|Introduction||Lesson 1||Lesson 2||Lesson 3||Lesson 4||Lesson 5||Lesson 6|
|Most businesses because of the
time and expenses involved in taking a Physical Inventory (counting
and assigning costs), only take an inventory once a year at the end
of their accounting period.
A weakness of using the Periodic Inventory Method is that since no continuous detail records are maintained, the cost of the goods that are sold are not known until a Physical Inventory is taken. Why is this a weakness ? I don't know about you, but I'd like to have a pretty good idea of whether I'm making money during the year and not have to wait until year end to take an inventory to find out !
Without monthly or at least quarterly Profit and Loss Statements as the old saying goes "the horses may all have already gotten out of the barn". You need to have readily available information in order to adjust plans and take any remedial actions needed to insure the profitability of your company. You are in the business to make a reasonable profit aren't you ? Also, no early information is available for tax planning. At the end of your year it's too late to make any decisions and take any actions that might save you some taxes.
So, if I want to prepare monthly or quarterly financial statements (interim statements), what other options are available that don't require a physical inventory ? You can estimate your Ending Inventory. Can you think of any other reason that might require you to estimate your ending inventory ? God forbid, but what if your inventory was destroyed by a fire. It's very difficult to count ashes and determine what goods were destroyed..
Two common methods used for estimating inventories are:
The Gross Profit Method uses an estimated Cost Of Goods Sold and/or Gross Profit Rate. Let's first define Gross Profit. Gross Profit is the difference obtained by subtracting Cost Of Goods Sold from Sales.
Gross Profit = Sales - Cost
Of Goods Sold
The Gross Profit Percentage Rate is calculated by dividing the Gross Profit Margin Dollars by Sales Dollars and multiplying by a 100.
The actual calculations convert the percentage amounts to their decimal amounts by dividing the stated percentage amount by 100.
The Cost of Goods Sold Percentage Rate is calculated by dividing the Cost Of Goods Sold Dollars by Sales Dollars and multiplying by a 100.
The actual calculations used convert the percentage amounts to their decimal amounts by dividing the stated percentage amount by 100.
Nothing earth shattering here, we learned about decimals and percentages in elementary school.
The calculations are illustrated in the following table.
Bean Counter's Warning:
Quick Lesson in Correctly
Calculating Selling Price
Erroneous Calculation Often
Let's calculate our actual gross
profits (margins) and see why the first method of calculating is
If my goal is to obtain a 20 % Gross Profit (Margin) Percentage I should sell my Product for $1.25 not a $1.20. I'm sure none of you have been calculating your prices incorrectly have you ?
Let's do one more sample
calculation assuming a product cost of $1.00.
Just like a TV show interrupts for a commercial, you've had your word from your sponsor, me, now back to Estimating Inventories and our first topic, the Gross Profit Method .
Gross Profit Method
We use the Gross Profit Method to estimate our ending inventory in the following situations:
The method is not acceptable for tax (IRS) or in meeting annual financial reporting requirements. In other words, the method is used to prepare reports that are used internally.
The underlying rationale for the Gross Profit Inventory Method is based on the premise that Cost of Goods Sold can be estimated from Sales based on calculations obtained from prior analysis of the normal relationship between selling price and cost of goods sold.
Amounts needed in order to estimate our inventory are:
Assume we obtained the following
information from our business records:
Estimate Of Ending Inventory
Calculations Presented As One Schedule
Considerations when performing the calculations:
Retail Inventory Method
The retail inventory method is an aggregate method used to estimate the cost assigned to our ending inventory. The method requires maintaining some detailed records. Records are maintained for purchases and inventories at both cost and retail prices. In other words, the cost of the beginning inventories and purchases are maintained as well as the retail value (sales prices) of the beginning inventories and purchases.
In addition a physical inventory is taken and priced at retail.
Let's prepare a simple table to illustrate the cost and retail data maintained.
We obtained the following information from our detailed records.
Why don't we have a cost amount in our table for Sales ? Easy answer. We don't know ! That amount along with our Ending Inventory Cost is what we're going to estimate using the Retail Method.
Calculation of Goods Available For Sale at Retail
In our illustration, the calculations would be:
Sales obtained from our General Ledger for the period were $120,000.
Calculation of Goods Available For Sale at Cost
Cost Percentage (Cost-To-Retail-Ratio) Calculation:
(Cost-To-Retail-Ratio) = Goods Available For Sale @ Cost / Goods
Available For Sale @ Retail x 100
Estimated Cost Of Ending Inventory = $30,002
What about our Cost Of Goods Sold
So we had Sales of $120,000 with an estimated Cost of $79,998.
Just testing ya. What's our Gross Profit (Margin) and what estimated percentage Gross Profit did we make ?
The steps used in calculating the estimated cost of the ending inventory using the Retail Inventory Method are normally combined into one schedule.
What major benefit did we receive from using the Retail Inventory Method ? If you recall, in our prior Lesson about Costing Methods, we had to determine the unit costs either from invoices, our perpetual records, or our detailed purchases records in order to assign cost to our ending inventory and cost of goods sold.
Using the Retail Inventory Method eliminated the need for determining unit costs and maintaining detailed product cost records. Before you start jumping up and down too much though, we have to maintain detailed sales and price (retail) records.
The reasoning behind the calculation is quite simple and is based on the following simple equation and the relationship between cost and retail values expressed by our Cost To Retail Ratio (percentage calculation).
The calculation assumes that the cost-to-retail-ratio computed from the goods available for sale is a representative average of the goods contained in the ending inventory. In reality, it's very unlikely that all the products in the ending inventory would have the same cost percentage. Actual goods in the ending inventory might have 70%, 65%, 75, etc. cost percentage. In other words, we're assuming that the mix of products contained in the ending inventory is the same as the mix calculated and represented by our cost-to-retail-ratio calculated from our goods available or sale.
(1) Retail Value of Beginning
Inventory + (2) Retail Value of Purchases
In other words, the total of the goods we had On Hand during the year are either Sold or in our Ending Inventory.
Simple algebra allows us to calculate any of the values if we know three of the values.
Since our records provide us with the values for (1)Retail Value of Beginning Inventory, (2)Retail Value Of Purchases, and the (3)Retail Value Of Goods Sold (Sales), we can calculate our (4)Retail Value Of Our Ending Inventory by rearranging our equation as follows:
Retail Value Of Ending Inventory = Retail Value Of Beginning Inventory + Retail Value Of Purchases - Retail Value Of Goods Sold (Sales)
Since we use Cost to value our Ending Inventory all we need to do to convert the Ending Inventory Amount at Retail to Cost is to calculate our Cost-To-Retail Ratio and multiply it by the Ending Inventory Retail Value.
Ending Inventory At Cost = Ending Inventory At Retail x Cost-To-Retail Ratio
Since I like to keep things simple, the basics that are involved in using the Retail Inventory Method are summarized in the following three steps:
The main difference between the Gross Profit Method and the Retail Inventory Method is the data that is used to calculate the cost percentage used to convert sales at selling prices to sales at cost. The retail inventory method uses a cost percentage, called the cost-to-retail ratio , which is based on a current relationship between cost and selling price. The gross profit method relies on past data to estimate the current cost-to-retail-ratio (percentage).
What about those Cost Flow Assumptions we discussed in Lesson 2 ,Average, FIFO, and LIFO ? Whether you were aware or not, we used the Average Cost Flow Assumption with the Retail Inventory Method in our prior example calculations.
The key to using the Retail Method is the calculation of the Cost-To-Sales-Ratio. The calculation is slightly different based on the cost flow assumption that is used with the Retail Inventory Method.
The FIFO Cost Flow assumes that the ending inventory is made up of the latest purchases. Due to this fact, our calculation of our Cost-To-Sales-Ratio normally excludes our Beginning Inventory Cost and Retail Amounts. Our calculation becomes Net Purchase Cost divided by Net Purchase Sales Value.
The LIFO Cost Flow assumes that the ending inventory is made up of the oldest purchases. We normally would calculate two (2) Cost-To-Sales-Ratios. One for the Beginning Inventory Amounts and the other for the Current Purchase Amounts.
I've made the examples up to now very basic in order to illustrate the basic calculations used with the Retail Inventory Method. The real life applications are just slightly more complex. In order to understand, the following examples we need to become familiar with some new terminology.
Examples of usage of the terms:
Markup cancellation is $1.00
($16.00 - $15.00).
Price decreases below our original
selling price are mark downs.
Detailed Example Of Retail Method Calculations assuming FIFO, LIFO, and Average Cost Flows.
We obtained the following information from our detailed Sales and Accounting Records:
Step (2) Calculate our Ending Inventory At Retail by subtracting our Total Retail Value Of Our Goods Sold, Spoiled, or Damaged from our Goods Available For Sale At Retail.
Three versions assuming Average, FIFO, and LIFO of the retail method are illustrated below.
Average Flow Computations
The average method pools the beginning inventory and purchases and assumes that ending inventory is representative of this "pool" to arrive at an Average Cost-To-Retail Ratio which considers both the "mix" of the beginning inventory and purchases.
FIFO Flow Computations
Note:Beginning Inventory Retail Values and Cost are omitted from our calculation. Can you think of a good reason for doing this ? The definition of the FIFO Cost Flow provides an excellent clue. Since FIFO assumes that the oldest or first goods purchased are sold first, the ending inventory is made up of the last or latest goods purchased. Since we assume that are beginning inventory has been sold, our Cost-To-Retail Ratio calculation for converting our ending inventory at retail to cost only uses the Cost and Retail Value of our Current Purchases. In addition, all the Net Markups and Net Markdowns are assumed to relate to our current purchases.
Observation:If in our example our sales had been less than the
Dollar Retail Value Of our Beginning Inventory amount of $1,000, we
would have had two Layers for our FIFO example and two
LIFO Flow Computations
Observation:Actually, the IRS treasury regulations govern the use of the LIFO Costing Method with the Retail Inventory Method. This method is often referred to as the LIFO Retail Method. The example presented was simplified and did not include the use of price indexes which are actually required when using this method.
Dollar Value LIFO