Accounting – Methods of Estimating Inventory
Estimating inventory is sometimes a necessary process for every business especially when a physical count is impractical or impossible. For example, you may need to know the amount of your business inventory that was destroyed by floods. Businesses that use the perpetual system should report the inventory account (Also see What is Included in Your Inventory Cost?) balance during such situations. However, the companies that use the periodic system of reporting must give the estimated value of the inventory.
The retail inventory method and gross profit method are the two approaches to estimating the value of inventory.
Retail inventory method
The retail inventory method is based on the relationship between the cost of products and their retail price. Note that the estimated value obtained using this method isn’t entirely accurate and therefore, you should supplement it with physical count where possible. Its results aren’t adequate for the preparation of the company’s financial statements, typically the income statement and balance sheet, at the end of the accounting period (Also see Relationship between the Balance Sheet and Income Statement).
Here are the steps involved in the estimation of inventory using the retail inventory method.
- Determine the cost-to-retail percentage using the formula (Cost ÷ Retail Price)
- Determine the cost of goods available for sale using the formula (Cost of inventory at the start of the account period + cost of purchases)
- Determine the cost of sales during the accounting period using the formula (Sales x Cost-to-retail percentage)
- Determine the ending inventory using the formula (Cost of products available for sale – cost of sales during that accounting period.
The gross profit method
The gross profit method helps you to estimate the ending inventory in a reporting period. It can be used in the following cases:
- If the inventory was destroyed and you need to know the ending inventory for the purpose of making a claim for insurance reimbursement
- For interim periods between inventory physical counts
Here are the steps you should follow to estimate the inventory using the gross profit method.
- Calculate the cost of goods available for sale by adding together the cost of inventory at the start of the accounting period and the cost of purchases during that period
- Multiply (1- the estimated gross profits) by the sales to get the estimate of cost of goods sold
- Subtract the estimated cost of goods sold calculated in step 2 from the cost of goods available for sale (that you calculated in step 1) to get the inventory at the end of the accounting period.
Note that these two methods of estimating inventory only give an estimated value and not exact value of inventory. Where possible, conduct a physical inventory count to get the exact amount of inventory available using one of the two methods allowed under FRS 2 Inventories. Contact us today and engage an accounting service in Singapore so to relieve your burden especially if you number crunching is not your edge.