Estimating Systems for Inventory Whether or not a company employs any type of interim estimating system may be important; as such, a system would be undertaken for periods between physical counts to allow preparation of interim financial statements.  This is because taking a physical inventory is a costly and time-consuming process.    There are numerous situations where an inventory valuation is needed, and management desires to avoid or cannot perform a physical count.  For these situations, several inventory estimation procedures have been developed.  In addition, these procedures allow businesses to estimate the goods on-hand when physical counts are not possible.  Such would be the case with disasters like tornadoes or fires, where inventories are destroyed or heavily damaged, and estimates are needed for insurance claims.  Estimation techniques, if they are reasonable, also permit a business to determine the accuracy of an actual hand count.  A comparison of the hand count with the estimate could reveal gross errors in the counting process.  Two widely used estimating methods are:   1.         The Gross Profit method estimates inventory based on a firm's gross profit rate, that is, gross profit expressed as a percentage of net sales.  The rate, which is the key to the estimation process, is developed from experience.  Naturally, if there are known changes in a firm's recent experience, an adjustment factor should be incorporated.  Once the gross profit rate is established, gross profit for the period can be estimated by applying this rate to the current period's sales.  This computation then permits the user to calculate current cost of goods sold, and the estimated ending inventory.   As an example of this method, assume that Canary Supply Co. desires to prepare financial statements for August without taking a physical inventory.  The following information is available for the period ended August 31.    Net Sales $80,000  Beginning Inventory, Jan 1              $10,000  Net Purchases $40,000  Ending Inventory $84,000  Cost Of Goods Sold $32,000  Estimated Gross Profit Percentage 60%                                                                               Since gross profit is estimated at 60% of net sales, the current gross profit is $48,000, [$80,000 X 0.60].  Therefore, cost of goods sold for August amounts to $32,000, [$80,000 - $48,000].  The ending inventory is now found by the following computation:   Net Sales $80,000 Cost Of Goods Sold Beginning Inventory $10,000 Add: Net Purchases $40,000 Goods Available for Sale  $50,000  Less: Ending Inventory $84,000  Cost Of Goods Sold $32,000  Gross Profit $48,000   Ending inventory is estimated at $18,000, [$50,000 - $32,000], and would be included on any formal financial statements prepared.   2.         The Retail method requires the retail price to be converted to cost, which can be done by identifying the cost-to-retail ratio.  Determining the value of a retail inventory is not as simple as taking the retail price times the quantity on-hand, as inventory is carried at cost or lower-of-cost-or-market.  Therefore, to determine the cost to retail ratio, the following information would be required:               1.         The beginning inventory valued at both cost and retail amounts;               2.         net purchases priced at both cost and retail; and               3.         net sales for the period.   The key to the retail method is the development of an accurate and realistic cost-to-retail ratio, as the assumption is that the ratio observed with the goods available for sale is relevant for the ending inventory.  However, it must be understood that this ratio is an average of many different types of products, thus, it is not likely that all items in the ending inventory would have identical cost-to-retail relationships.   Both department and discount stores carry a variety of items tagged or marked with retail selling prices.  As an example, assume it is the end of an accounting period and a department store takes a count of the inventory on-hand.   Determining the "value" of the inventory would merely require multiplying the quantities found by their readily identifiable retail prices.  Unfortunately, this "value" is not very helpful for financial statements, as financial statements carry inventories at cost or at the lower-of-cost-or-market, not selling prices.  An inventory valued at its retail price could be converted to cost by inspecting numerous individual paid invoices and other records.  However, this task is a rather formidable one for businesses that carry large product lines.  Alternatively, the retail method of inventory valuation can be employed.   To illustrate the retail method, suppose Kinney Sales Organization desires an inventory estimate as of March 31 of the current year.  The required calculations follow:                                     Retail Method Cost Retail  Beginning Inventory, January 1     $ 60,000 $ 88,000  Net Purchases, January  Through March $293.600 $432,000  Goods for Sale $353,600 $520,000  Ratio Of Cost To Retail Prices [$353,600/$520,000]  =  68%  Less: Net Sales $340,000  Estimated Ending Inventory At Retail $180,000  Estimated Ending Inventory At Cost ($180,000 x 0.68) $122,400   To explain, net sales are subtracted from goods available for sale to yield an ending inventory at retail of $180,0004.  To convert this figure to cost, Kinney has computed a cost-to-retail ratio of 68%, indicating $0.68 of inventory cost for every $1.00 of retail valuation.  Thus, the $180,000 estimated ending inventory is multiplied by the 68% ratio to arrive at the $122,400 cost-based valuation.   In this example, the retail method was used to obtain an interim estimate of inventory.  This method can also be employed to study a business's experience with theft and shoplifting.  To illustrate, assume the figures in the Kinney example relate to the entire accounting year, which ends December 31.  A physical count on December 31 revealed the inventory to be $171,000 at retail prices.  Thus, Kinney has a $9,000 shortage at retail, [$180,000 - $171,000], which, on a cost basis, amounts to $6,120, [$9,000 X 0.68].   The key to the retail method is the development of an accurate and realistic cost-to-retail ratio, as this method assumes that the ratio observed, with the goods available for sale, is relevant for the ending inventory.  In addition, this ratio is an average of many different types of products, thus, it is not likely that all items in the ending inventory will have identical cost-to-retail relationships.   This situation is especially true in a department or discount store that carries merchandise ranging from clothes to fine jewelry, to candy, to lawn mowers.  For improved accuracy in the retail method, ratios should be developed and applied to each major product line.                         4            Frequently, additional factors (such as markups and markdowns to original selling prices) are considered when computing the ending inventory at retail.