# 6.5: Estimating the Balance in Merchandise Inventory

• • Contributed by Henry Dauderis and David Annand
• Athabasca University
• Sourced from Lyryx Learning

learning objective

LO4 – Estimate merchandise inventory using the gross profit method and the retail inventory method.

A physical inventory count determines the quantity of items on hand. When costs are assigned to these items and these individual costs are added, a total inventory amount is calculated. Is this dollar amount correct? Should it be larger? How can one tell if the physical count is accurate? Being able to estimate this amount provides a check on the reasonableness of the physical count and valuation.

The two methods used to estimate the inventory dollar amount are the gross profit method and the retail inventory method. Both methods are based on a calculation of the gross profit percentage in the income statement. Assume the following information:

 Sales $15,000 100% Cost of Goods Sold: Opening Inventory$ 4,000 Purchases 12,000 Cost of Goods Available for Sale 16,000 Less: Ending Inventory (6,000) Cost of Goods Sold 10,000 67% Gross Profit $5,000 33% The gross profit percentage, rounded to the nearest whole percent, is 33% ($5,000/15,000). This means that for each dollar of sales, an average of $.33 is left to cover other expenses after deducting cost of goods sold. Estimating ending inventory requires an understanding of the relationship of ending inventory with cost of goods sold. Review the following cost of goods sold calculations. Figure $$\PageIndex{1}$$ The sum of cost of goods sold and ending inventory is always equal to cost of goods available for sale. Knowing any two of these amounts enables the third amount to be calculated. Understanding this relationship is the key to estimating inventory using either the gross profit or retail inventory methods, discussed below. ## Gross Profit Method The gross profit method of estimating ending inventory assumes that the percentage of gross profit on sales remains approximately the same from period to period. Therefore, if the gross profit percentage is known, the dollar amount of ending inventory can be estimated. First, gross profit is estimated by applying the gross profit percentage to sales. From this, cost of goods sold can be derived, namely the difference between sales and gross profit. Cost of goods available for sale can be determined from the accounting records (opening inventory + purchases). The difference between cost of goods available for sale and cost of goods sold is the estimated value of ending inventory. To demonstrate, assume that Pete's Products Ltd. has an average gross profit percentage of 40%. If opening inventory at January 1, 2019 was$200, sales for the six months ended June 30, 2019 were $2,000, and inventory purchased during the six months ended June 30, 2019 was$1,100, the cost of goods sold and ending inventory can be estimated as follows. Figure $$\PageIndex{2}$$

The estimated ending inventory at June 30 must be $100—the difference between the cost of goods available for sale and cost of goods sold. The gross profit method of estimating inventory is useful in situations when goods have been stolen or destroyed by fire or when it is not cost-effective to make a physical inventory count. ## Retail Inventory Method The retail inventory method is another way to estimate cost of goods sold and ending inventory. It can be used when items are consistently valued at a known percentage of cost, known as a mark-up. A mark-up is the ratio of retail value (or selling price) to cost. For example, if an inventory item had a retail value of$12 and a cost of $10, then it was marked up to 120% (12/10 x 100). Mark-ups are commonly used in clothing stores. To apply the retail inventory method using the mark-up percentage, the cost of goods available for sale is first converted to its retail value (the selling price). To do this, the mark-up (ratio of retail to cost) must be known. Assume the same information as above for Pete's Products Ltd., except that now every item in the store is marked up to 160% of its purchase price. That is, if an item is purchased for$100, it is sold for \$160. Based on this, opening inventory, purchases, and cost of goods available can be restated at retail. Cost of goods sold can then be valued at retail, meaning that it will equal sales for the period. From this, ending inventory at retail can be determined and then converted back to cost using the mark-up. These steps are illustrated below. Figure $$\PageIndex{3}$$

The retail inventory method of estimating ending inventory is easy to calculate and produces a relatively accurate cost of ending inventory, provided that no change in the average mark-up has occurred during the period.