Hawassa University, College Of Business and Economics, Department of Accounting and Finance

Chapter 1
Inventories
Definition of Inventories
Inventories: are “assets
a. held for sale in the ordinary (normal) course of business,
For merchandising company
→has one inventory account on the balance sheet called Merchandise Inventory;
→ the cost of the inventory sold is transferred to Cost of Goods Sold (COGS) on the income
statement
For manufacturing company
→ Finished goods inventory
b. in the process of production for such sales, or
→ work-in-process (goods in process) inventory
c. In the form of materials or supplies to be consumed in the production process or in the
rendering of services”.
→ Raw materials inventory
Its use rather than size is important in defining inventory.

Importance of Inventory Control

An accurate inventory accounting system is important for:
1. Ensuring availability of inventory items.
2. Preventing excessive accumulation of inventory items.
The perpetual system maintains a continuous record of inventory changes.
The periodic system updates inventory records only periodically.

Classification of Inventories
Based on the operation of the business, inventories are classified as:
1. Merchandising inventories
Merchandise inventory represents goods on hand purchased for resale by a retailer or a trading
company such as an importer or exporter for resale. Generally, goods acquired are not physically
altered by the purchaser company; the goods are in finished form when they leave the
manufacturer’s plant. Only one inventory classification, merchandise inventory, is needed to
describe the many different items that make up the total inventory.
2. Manufacturing Inventory Includes:
A. Raw materials inventories: consisting of goods to be used in the manufacture of products.
B. Work-in-process (goods-in-process) inventories: consisting of goods being manufactured but
not yet completed.
C. Finished goods inventory: consisting goods completed and awaiting sale.
D. Factory (Manufacturing) supplies
e.g., → lubrication oil for the machinery
→cleaning materials and
→ other materials that make up an insignificant part of the finished products.
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3. Miscellaneous inventories: includes items such as office, janitorial and shipping supplies.
Regardless of the classification, all inventories are reported under current assets on the balance
sheet.
The Effect of Inventory on the current period’s statements
Inventory determination plays an important role in matching expired costs with revenues of
the period. Inventories affect both the balance sheet and the income statement. The total cost of
merchandise available for sale during a period of time must be divided into two parts at the end of
the period. The cost of merchandise determined to be in the inventory will appear on the balance
sheet as a current asset. The other element, which is the cost of the merchandise sold, will be
reported on the income statement as a deduction from net sales to yield gross profit. An error in the
determination of the inventory amount at the end of the period will cause an equal misstatement of
gross profit and net income, and the amount reported for both assets and owner’s equity in the
balance sheet will be incorrect by the same amount.
Income statement Effects
Both beginning inventory and ending inventories appear on the income statement.
The ending inventory of one period automatically becomes the beginning inventory of the
next period.
Inventory errors affect the determination of cost of goods sold and net income

Cost of goods sold = BI + cost of goods purchased - EI

The effects on cost of goods sold can be determined by entering the incorrect data in the above
formula and then substituting the correct data. If beginning inventory is understated, cost of goods
sold will be understated. On the other hand, an understatement of ending inventory will overstate
cost of goods sold.
The effects of inventory errors on the current year’s income statement are as follows:

Inventory Error Cost of goods sold Net income

Understate beginning inventory -------- Understated Overstated
Overstate beginning inventory----------- Overstated Understated
Understate ending inventory-------------- Overstated Understated
Overstate ending inventory --------------- Understated Overstated

An error in ending inventory of the current period will have a reverse effect on net income of the
next accounting period.

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Balance sheet Effects

The effect of ending inventory errors on the balance sheet can be determined by using the basic
accounting equation:
Assets = Liabilities + owner’s equity
Errors in the ending inventory have the following effects on these components:
Ending Inventory Error Assets Liabilities Owner’s equity
Overstated Overstated None Overstated
Understated Understated None Understated

The Effect of Inventory on the Following period’s statements

The inventory at the end of one period becomes the inventory for the beginning of the following
period. Thus, if the inventory is incorrectly stated at the end of the period, the net income of that
period will be misstated and so will the net income for the following period. The amount of the two
misstatements will be equal and in opposite directions. Therefore, the effect on net income of an
incorrectly stated inventory, if not corrected, is limited to the period of the error and the following
period. At the end of this following period, assuming no additional errors, both assets and owner’s
equity will be correctly stated.
Note: Errors in the inventory of one period affect only the financial statements of two consecutive
periods.

Inventory Systems (Inventory Procedures)

Inventory procedures: refers to system of accounting for purchases and sales of inventories.
There are two principal systems of inventory accounting:
a) Periodic (physical) inventory system
b) Perpetual (continuous) inventory system
A. Periodic Inventory System
When the periodic inventory system is used, only the revenue from sales is recorded each
time a sale is made. No entry is made at the time of sale to record the cost of merchandise that has
been sold.
Periodic inventory system:
 Adjusts (updates) inventory account and record cost of goods sold on a periodic basis, at the
end of each accounting period (example monthly, quarterly)
 Costing (determining cost of ending inventory and cost of goods sold) is made at the end of
each fiscal period.
 A physical inventory must be taken in order to determine the cost of inventory at the end of
an accounting period.
 Preferable for low unit cost, large volume items which may not require strong internal
control system.

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 Ending inventories are determined by physical count. The periodic system relies on a
physical count of the goods on hand as the basis for control, management decisions, and
financial accounting.
CGS = BI + Net purchase - EI

 Is the CGS equation under Periodic inventory system

 Inventory subsidiary ledger is not updated after each purchase or sale of inventory.
The accounting features of a periodic inventory system are:
• Inventory purchases are recorded as a debit to a Purchases account.
• Cost of Goods Sold and Inventory accounts are not kept up to date.
• The quantity and cost of inventory on hand is determined by taking a physical inventory
count.
• Cost of Goods Sold is determined at the end of the period.
• Under both periodic and perpetual inventory systems, physical counts of inventory are
conducted at least once a year as there is the risk of loss and errors (e.g. waste, breakage,
theft)
• Freight-in, purchase returns and allowances, and purchase discounts are recorded in separate
accounts.

B. Perpetual Inventory System

The perpetual inventory system uses the accounting records that are continuously disclose the
amount of the inventory.
Perpetual inventory system:
 Keeps (tracks) both inventory quantities and inventories costs (i.e., perpetual inventory
system updates inventory accounts after each purchase and sale).
 Costing (determining cost of ending inventory and cost of goods sold) is made through out
the fiscal period.
 A physical count of goods owned by the business must be made periodically to verify the
accuracy of the inventories reported in the accounting records (i.e., to verify the accuracy of
perpetual inventory records).
 Suitable for high unit cost inventory items which require strict internal control system.
 A perpetual inventory system contributes to better control over inventories than periodic
system. Since the inventory records show the quantities that should be on hand, the goods
can be counted at any time to see whether they actually exist. Any shortages uncovered can
be investigated immediately. Further, the maximum quantity shown on the inventory record
helps prevent over investment in inventory and the minimum quantity protects the company
from losing sales on “out-of-stock” items.
 Inventory subsidiary ledger is updated after each transaction.
The accounting features of a periodic inventory system are:
• Purchases of merchandise for resale are debited to inventory rather than to purchases.

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• Freight-in (cost of freight), purchase returns and allowances, and purchase discounts are all
recorded in the Inventory rather than in separate accounts.
• Cost of Goods Sold (COGS) is debited and Inventory is credited when inventory is sold.
• A subsidiary ledger is maintained for individual inventory items on hand.
• Periodic inventory counts are still required to ensure reliability.
• Inventory is a control account that is supported by subsidiary ledger of individual inventory
records. The subsidiary records show the quantity and cost of each type of inventory on
hand.
• Any differences between the inventory balance and the physical count are captured in a
separate account called Inventory Over and Short (or may be recorded as an adjustment to
Cost of Goods Sold).
Advantages of perpetual Inventory system
It makes easy the preparation of interim financial statements.
It provides up-to-date (current) inventory information; accordingly avoids inventory excess
or stock out.
Information availability
Journalizing the Adjusting entry for merchandise inventory under both periodic and perpetual
inventory system: Transactions:
1. Purchase of merchandise for resale:
Under periodic inventory system: Under perpetual inventory system:
Purchases----------------------------xx Merchandise Inventory------------xx
Accounts payable (cash) ------xx Accounts payable (cash) --------------xx

2. Sale of merchandise:
Under periodic inventory system: Under perpetual inventory system:
Accounts Receivable---------------xx Accounts Receivable---------------xx
Sales---------------------------------xx Sales---------------------------------xx
Cost of goods sold---------------------xx
Merchandise inventory----------------xx

3. Purchase returns and allowance:

Under periodic inventory system: Under perpetual inventory system:
Accounts payable (cash) -----------------xx Accounts payable (cash) ---------------------xx
Purchase returns and allowance---------xx Merchandise inventory--------------------xx

4. Adjusting entries for merchandise inventory

Under periodic inventory system:
 At the end of the year, a physical count of the stock of goods is taken. No changes to merchandise inventory
account until physical count is taken.
 Adjusting entries are made to record the amount of the physical count.
Adjustments for merchandise Inventory:
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Step 1: Remove beginning inventory:

Dr. Income summary---xx
Cr. Merchandise Inventory—xx
Step 2: Enter the new balance from the physical count.
Dr. Merchandise inventory---xx
Cr. Income summary-----------xx
Under perpetual inventory system:
 No entries are necessary. At the end of the year, a physical count of the stock of goods is taken. An adjusting
entry is made to record the difference between the amount of the count and the amount previously recorded.

 Note:- that in a perpetual system, two entries are required when sale occurs. Also no closing
entries are required for the inventory account at the end of an accounting period. The reason is
that the account balance shows the amount of goods that should be on hand. If the physical
inventory count confirms this amount, no entries are needed.
However, if the physical inventory count does not agree with the balance shown in the
control account, an entry will be necessary to make the inventory balance agree with the goods
actually on hand. A difference is usually a shortage caused by spoilage or theft. In such case, an
adjusting entry is made in which merchandise inventory losses is debited and merchandise
inventory is credited.

Determining Which Goods to be included in Inventory

(Determining Actual Quantity in the Inventory)
Which is relevant to determine the actual quantities to be included in inventory?
 Physical possession, or
 Economic control (ownership title)?
Regardless of the system used, the measurement of inventories and cost of goods sold starts with
determining the actual (physical) quantities of goods. All goods under the economic control of the
enterprise are included in ending inventory rather than physical possession.
Items Requiring Special Considerations
A. Goods in transit
Goods are considered to be in transit when they are in the hands of a public carrier, such as a
railroad, trucking, or airline company at the statement date. Goods in transit should be included in
the inventory of the party that has legal title to the goods. Legal title is determined by the terms of
sale (shipment).
Terms of shipment (sale) can be:
 FOB (free on board) shipping point
 FOB (free on board) destination
1. When the terms are FOB shipping point, ownership of the goods passes to the buyer when
the public carrier accepts the goods from the seller.

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Inventory shipped FOB shipping point is included in the buyer’s inventory as soon as the
merchandise is shipped.
2. When the terms are FOB destination, legal title to the goods remains with the seller until the
goods reach the buyer.
Inventory shipped FOB destination is included in the buyers ending inventory only after it
reaches the buyer’s destination.

B. Goods on Consignment (Consigned goods)

Consignment is marketing arrangement where by the consignor (the owner of the goods) ships
merchandise to another party, known as a consignee, who acts as a sales agent only.
Consigned Goods describes products that are in the custody of one party, but belong to another.
Thus, the party holding physical possession is not the legal owner. The person with physical
possession is known as the Consignee. The consignee does not purchase the goods but assumes
responsibility for their care and sale. Up on sale, the consignee remits the proceeds, less a
commission and costs incurred in connection with the sale. The consignor is the party holding
legal ownership/title to the consigned goods in inventory.
Because consigned goods are not owned by the consignee, they should not be included in the
consignee’s physical inventory count. Conversely, the consignor should include merchandise
held by the consignee as part of its inventory. Thus, until the goods are sold by the consignee,
they remain the property of the consignor (owner) and must be included in the consignor’s
inventories at cost including the handling and shipping costs involved in the transfer to the
consignee.

C. Goods Sold on Installment

When goods are sold on the installment plan, the seller usually retains legal title to the goods
until full payment has been received; however, such goods are excluded from the inventories of the
seller. The exception is that customers will make payment in the ordinary course of the business;
therefore, strict adherence to the “passing-of-title” rule is not considered a realistic approach to the
recording of installment sales transactions.
Thus, Goods sold on installment are included in the buyer’s ending inventory because the seller
assumes that the buyer will make all periodic payments under normal (ordinary) condition
exceptions to the passage of title.

Determining the cost of Inventory

All expenditures necessary to acquire the goods and to make them ready for sale or use are
included as inventoriable costs. Inventory costs include “all costs of purchases, costs of conversion
and other costs incurred in bringing the inventories to their present location and condition.
Inventoriable costs may be regarded as a pool of costs that consists of two elements:
1) the cost of the beginning inventory and
2) the cost of goods purchased during the year.

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The cost of merchandise inventory is made up of purchase price and all expenditures incurred in
acquiring such merchandise, including transportation, custom duties, and insurance against losses in
transit.
The cost of inventories includes:
Purchase price less any cash (purchase) discounts available to the purchaser (i.e., Net invoice
cost).
Freight charges paid by purchaser (FOB shipping point)
Insurance cost incurred by the buyer while the goods are in transit (FOB shipping point)
The cost of unloading, unpacking and preparing merchandise inventory for sale or raw
material inventory for use---etc.
For manufacturing company, the cost includes:
 Direct materials cost
 Direct manufacturing labor cost
 FOH (factory overhead) cost
Methods of Determining inventory cost (Cost flow Assumptions)
Cost flow: refers to system of assigning costs to units sold and units remaining on hand. During a
specific accounting period, such as a year or a month, identical goods may be purchased or
manufactured at different costs. Accountants then face the problem of determining which costs
apply to items in inventories and which apply to items that have been sold.
The critical issue in accounting for inventories is summarized below:
A major objective of accounting for inventories is the proper determination of income
through the process of matching appropriate costs against revenues.
The assumed flow of costs to be used in the assignment of costs to inventories and to goods sold
need not conform to the physical flow of goods-that is, there is no accounting requirement that the
cost flow assumption be consistent with the physical movement of the goods. Cost flow
assumptions relate to the flow of costs, rather than to the physical flow of goods. The question of
which physical units of identical goods were sold and which remain in inventories is not relevant to
income measurement and inventory valuation.
All methods of inventory valuation are based on the cost principle; no matter which method is
selected, the inventory is stated at cost. In selecting an inventory valuation method (or cost flow
assumption), accountants are matching costs with revenue, and the ideal choice is the method that
“most clearly reflects periodic income”.
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The most widely used inventory costing methods are:

1) First-in, First-out (FIFO) method
2) Last-in, First-out (LIFO) method
3) Average cost method
4) Specific identification
1. First-in, First-out (FIFO) method
 The method assumes that cash flow in the order of expenditure.
 The first-in, first-out (FIFO) method of costing inventory is based on the assumption that
costs should be charged against revenue in the order in which they were incurred. Hence the
inventory remaining is assumed to be made up of the most recent costs.
 The FIFO method gives (produces) the same result whether the periodic or perpetual
inventory system is used because each withdrawal of goods is from the oldest stock on
hand.
 The method is systematic and is easy to apply; it adheres to the cost principle (i.e.,
inventories are reported on balance sheet at recent costs); and the cost assigned to
inventories is likely to be in close harmony with the current prices being paid for inventory
replacements.
 The method assumes that the earliest goods purchased are the first to be sold.
 Earliest inventory costs become cost of goods sold.
 Latest (recent) costs become cost of ending inventories.
 In most businesses, there is a tendency to dispose of goods in order of their acquisition.
This would be particularly true of perishable merchandise and goods in which style or
model changes are frequent. Thus, the FIFO method is generally often parallels (in harmony
with) the physical flow (movement) of merchandise in an enterprise. To the extent that this
is the case, the FIFO method approximates the results that would be obtained by specific
identification of costs.
Advantages of FIFO method:
• Attempts to approximate physical flow of goods.
• Ending inventory made up of most recent costs, therefore close to its replacement cost.
• Does not permit manipulation of income.
Disadvantages of FIFO method:
• Current costs not matched to current revenues, as oldest cost of goods are used with current
revenue.
• When prices are changing rapidly, gross profit and net income are distorted.
• The recognition of “inventory” or “paper” profits-that is, inventory or paper profits are
equal to the current replacement cost to purchase a unit of inventory at time of sale minus
the units historical cost.
• A heavier tax burden if used for tax purposes in periods of inflation.

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2. Average cost method

The method assumes that items sold and items remaining in inventory come from a mixture
of goods available for sale.
This method produces a result, for both inventory valuation and income measurement that
result achieved average.
The method is simple to apply, objective, less subject to income manipulation.
Ending inventory cost on balance sheet is made up of average costs.
The average cost method does not produce an inventory value consistent with the current
cost of the items in inventory; by its nature it lags behind market prices. During a period of
rising prices the inventory cost tends to be below the replacement cost; during a period of
falling prices it tends to be above replacement cost.
When the periodic inventory system is used, the average cost method gives the result of a
weighted average unit cost (WAUC), which is calculated as:
WAUC= cost of goods available for sale (CGAFS)
Units available for sale
Ending inventories (EI) = units remained on hand x WAUC
Cost of Goods sold (COGS) = units sold x WAUC
Or = CGAFS-EI
When the perpetual inventory system is used, the average cost method gives the result of a
moving weighted-average. Under the perpetual system, a new weighted-average unit cost is
computed after each purchase, and for this reason is known as the moving-weighted-average
method. Units sold are priced at the latest weighted-average unit cost. When each time
additional purchase is made, a new average is computed and used for valuing units sold and
units remained on hand till the next purchase.

3. Specific identification method

 The method is not assumption rather it is based on actual physical flow of goods.
 Each item sold and purchased is individually identified.
 Actual cost flows are identified and used for costing goods sold and unsold. Although such
a technique might be possible for a business enterprise handling a small number of items,
for example, an automobile dealer, it becomes completely inoperable in a complex
manufacturing enterprise when the identity of the individual item is lost. Practical
considerations thus make specific identification inappropriate in most cases.
 Even when specific identification is a feasible means of valuation, it may be undesirable
from a theoretical point of view.
 The method permits income manipulation when there are identical items acquired at
varying prices. By choosing to sell the item that was acquired at a specific cost,
management may cause material distortions in income.
 Required (used) for:
 Goods that are not ordinarily interchangeable; and that are produced and
segregated for specific projects.
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 High value, easily distinguishable items.

Advantages of specific identification method:
 Matches actual costs with revenue.
 Ending inventory reported at specific cost.
Disadvantages of specific identification method:
 May be costly to implement and maintain.
 May lead to income manipulation.
 May be difficult to allocate certain costs (e.g. storage, shipping) to specific
inventory items.
Comparison of Inventory costing Methods
During a period of inflation or rising prices,
 The use of the FIFO method will result in:
 A higher amount of inventory at the end of the period.
 A lower amount of cost of merchandise sold.
 A higher amount of gross profit than the other two methods because the costs of the
units sold are assumed to be in the order in which they were incurred, and the earlier
unit costs were lower than the more recent unit costs. Much of the benefit of the
larger amount of gross profit is lost however, as the inventory is continually
replenished at ever higher prices.
In a period of deflation or falling price levels, the effect described above is reversed.
 The FIFO method yields the lowest amount of gross profit.
 The LIFO method yields the highest amount of gross profit.
Changing Inventory Methods
Generally, Companies may use the inventory method that best fits their individual circumstances.
However, this freedom of choice does not include changing inventory methods
Departure from Cost Basis of Inventory Measurement
(Valuation of Inventory at Other than Cost)
Cost is the primary basis for the valuation of inventories. Under certain circumstances, however,
inventory is valued at other than cost. Two such circumstances arise when:
1) The cost of replacing items in inventory is below recorded cost, and
2) The inventory is not salable at normal sales prices because of imperfections, shop wear,
style changes or other causes.
Valuation of Inventory at Lower of cost or market (LCM)
If inventories decline in value below its original cost for whatever reason (obsolescence, price-
level change, damage or deterioration), the inventory should be written-down to reflect this loss.
The general rule is that the historical cost principle is abandoned when the future utility (revenue-
producing ability) of the assets is no longer as great as its original cost. A departure from cost basis
of pricing inventory is justified since a loss of utility should be charged against revenues in the
period in which it occurs. Inventories are valued therefore on the basis of the lower of cost or
market instead of original cost.

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In the expression lower of cost or market, the term “market” refers to the current replacement
cost (the cost to replace the item by purchase or reproduction). Thus, the rule really means that
goods are to be valued at cost or cost to replace, whichever is lower. LCM is an example of the
accounting concept of conservatism. Conservatism means that when choosing among accounting
alternatives, the best choice is to select the method that is least likely to overstate assets and net
income.
The lower of cost or market (LCM) rule provides for the recognition of a loss when prices decline
on new inventory items. Under this rule, the loss is reported in the period when the price declines,
rather than during a subsequent period of the merchandise. This procedure assumes that decreases in
replacement cost will be accompanied by proportionate decreases in selling price. If applicable, the
LCM rule simply measure inventory at the lower (replacement) market figure. Consequently,
reported income decrease by the amount that the ending inventory has been written down. When
the ending inventory becomes part of the cost of goods sold in a future period of lower selling
prices, its reduced carrying value of helps maintain normal profits margin in the period of sale.
Thus, if the replacement price of an item in the inventory is lower than its cost, the use of lower of
cost or market method provided two advantages:
1) the gross profit (and net income) are reduced for the period in which the decline occurred. and
2) an approximately normal gross profit is realized during the period in which the item is sold.
The general rule of lower of cost or market is that inventory is valued at the lower of cost or
market with:
1. Market should not exceed the net realizable value (i.e., estimated selling price in the
ordinary course of business less reasonably predictable costs of completion and disposal) =
ceiling (upper limit)

Net Realizable Value = Estimated selling price – Costs of completion and disposal

2. Market should not be less than net realizable value reduced by an allowance for an
approximately normal profit margin. = floor (lower limit)
Thus, the ceiling is equal to the selling price reduced by the estimated cost of completion and sale;
and the floor is equal to the ceiling reduced by the normal gross profit. Replacement cost is used as
“market” price if it falls between the ceiling and the floor; the ceiling amount is used as “market”
price when the replacement cost is above the ceiling; and the floor amount is used as “market” price
when replacement cost is below the floor.

Application of lower of cost or market (LCM)

The lower of cost or market basis may be applied to
1) Each individual item in inventories (item-by-item approach).
2) Major categories of inventories, or
3) Inventories as a whole (total inventory)

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Regardless of which of the three methods is adopted, each inventory item should be priced at cost
and at market as a first step in the valuation process.
The item-by-item method produces the lowest inventory value, and the application of the LCM
rule to inventories as a whole produces the highest value. For income tax purposes, the item-by-item
method must be used. The common practice is to use individual items in determining the LCM
valuation. This approach gives the most conservative valuation for balance sheet purposes and also
the lowest net income. LCM should be applied consistently from period to period.

Net Realizable Value

Damaged, physically deteriorated, or obsolete merchandise should be measured and reported at
Net realizable value when this value is less than cost. Net realizable value is the estimated selling
price is less the expected cost of disposal.
Estimating Inventory Cost
A company using the periodic inventory procedure may wish to estimate its inventory for any of
the following reasons:
a. Management may want monthly or quarterly financial statements but a physical inventory is
taken only annually (i.e., to obtain an inventory cost for use in monthly or quarterly
financial statements without taking a physical inventory. The effort of taking a physical
inventory can be very expensive and disrupts normal business operations; once a year is
often enough).
b. A casualty such as fire, flood, or earth quake may make it impossible to take a physical
inventory.
c. To compare with physical inventories to determine whether shortages exist.
d. To determine the amount recoverable from an insurance company when fire has destroyed
inventory or the inventory has been stolen.
The need for estimating inventories is associated primarily with a periodic inventory system
because of the absence of detailed inventory records.
There are two widely used methods of estimating ending inventories:
1) the gross profit method and
2) the retail inventory method

Gross Profit Method

The gross profit method uses an estimate of the gross profit realized during the period to estimate
the inventory at the end of the period. By using the rate of gross profit, the dollar amount of sales
for a period can be divided into its two components: (1) gross profit and (2) cost of merchandise
sold. The latter may then be deducted from the cost of merchandise available for sale to yield the
estimated inventory of merchandise on hand.
Advantages of Gross Profit Method
The gross profit method is useful for several purposes:
1. to control and verify the validity of inventory cost;
2. to estimate interim inventory valuation between physical count; and
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3. to estimate the inventory cost when necessary information normally used is lost or
unavailable.
Information needed to apply gross profit method:
o current year
 Beginning inventory
 Net purchases
 Net sales
o Estimated historical gross profit rate
Steps:
1st. Determine historical gross profit rate.
Gross profit rate = Gross profit
Net sales
nd
2 . Determine Gross profit for the current year.
Net sales--------------------------------------------------xxx
Times: Gross profit rate------------------------------ %
Gross profit------------------------------------------------ xx
===
rd
3 . Estimate current year cost of goods sold.
Net sales-----------------------------------------xxx
Less: gross profit-------------------------------xx
Estimated cost of goods sold----------------xx
===
th
4 . Determine estimated cost of ending inventory.
Merchandise Available for sale--------------------------xxx
Less: estimated cost of goods sold-----------------------xx
Estimated cost of ending inventory----------------------xx
===
The gross profit method is based on the assumption that the rate of gross profit will remain
constant from one year to the next. It may not remain constant, though, because of a change either
in merchandising policies or in market conditions. In such cases, the rate of the prior period should
be adjusted to reflect current operating conditions. In some cases, a more accurate estimate may be
obtained by applying this method on a department or product-line basis.
The gross profit method should not be used in preparing a company’s financial statements at the
end of the year. These statements should be based on a physical inventory count.

Disadvantages of Gross Profit Method

The gross profit method has the following significant limitations:
1. The gross margin method assumes that a fairly stable relationship exists between gross
margin and net sales. In other words, gross margin has been a fairly constant percentage of
net sales, and this relationship is assumed to have continued into the current period. If this

Fundamental of Accounting II Accounting for Inventory Valuation and Reporting 14

Hawassa University, College Of Business and Economics, Department of Accounting and Finance

percentage relationship has changed, the gross margin method will not yield satisfactory
results.
2. The past gross profit rate may not approximately reflecting markup changes relating to the
current or future periods.
3. Gross profit rates (markup rates) may vary widely on different types of inventory. A change
during the period in the markup rate on one or more lines or a shift in the relative quantities
of each line sold (shifts in the sales mix) changes the average gross profit rate. This change
affects the reliability of the results.
Thus, the gross profit method provides only an approximation of inventory and is not acceptable
according to generally accepted accounting principles for financial statements.

Gross profit may be expressed as:

 Percentage of sales
 Percentage of markup on cost
 Converting gross profit on sales to markup on cost.

Markup on cost = percentage gross profit on sales

100% - percentage gross profit on sales

 Converting markup on cost to gross profit on sales.

Gross profit on sales = Percentage markup on cost

100% + Percentage markup on cost

Retail Method
o The retail method of estimating the cost of inventories is used primarily by retailing
enterprises, particularly department stores.
o Use the cost to retail percentages based on the current relationship between cost and selling
price.
o The retail method uses a ratio of the cost of goods available for sale at cost to the cost of
goods available for sale at retail. This ratio is used to convert the retail value of goods
remaining at the end of the inventory period to a cost estimate.
o Information needed for application of retail methods are:
 Beginning inventory at cost and retail
 Purchase at cost and retail
 sales

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