7.6 Estimating Inventory
Although a business will normally take an inventory count at least once per year to verify the perpetual inventory records, there may be circumstances where an inventory count is either impractical or impossible. For example, when a company prepares interim unaudited financial statements, it may be too costly to conduct an inventory count, as operations would have to cease during the count, and staff would need to be reallocated to this purpose. Or, in the case where a disaster strikes, such as a warehouse fire, inventory may be destroyed, making a count impossible. In these situations, the company may choose to use an estimation method to determine the inventory. The estimated balance can be used for the interim financial statements or for making an insurance claim in the case of a disaster. Several methods can be used to estimate inventory. We will focus on the gross profit method.
This method attempts to estimate the inventory balance at a point in time using past relationships between the cost of goods sold and sales and then applying the cost of goods sold formula to determine the ending inventory balance. Consider the following scenario for PartsPeople. On May 17, 2019, a fire caused by faulty electrical wiring completely destroyed one of the company’s warehouses and all of the contents. Fortunately, this loss was covered by the company’s insurance policy, but in order to make a claim, the company needed a credible estimate of the amount of inventory destroyed. Assume that the inventory on January 1, 2019, was reported at a cost of $250,000, which was verified by a count. As well, assume that between January 1 and May 17, 2019, the cost of all inventory purchases was $820,000, and sales for this period were reported at $1,200,000. Based on analysis of the previous year’s results, the company knows that its gross profit percentage is 25 percent. Based on this information, the company could have estimated the cost of the destroyed inventory as follows:
| Estimation Process | ||
|---|---|---|
| Inventory on January 1 | $250,000 | |
| Purchases | $820,000 | |
| Goods available for sale | $1,070,000 | |
| Sales | $1,200,000 | |
| Less gross profit (25% × $1,200,000) | $300,000 | |
| Estimated cost of goods sold | $900,000 | |
| Estimated inventory on May 17 | $170,000 | |
PartsPeople could have used this information to make a claim in the amount of $170,000 for inventory damaged in the fire. There are some obvious limitations in using this technique. First, the gross profit percentage used here was based on the previous year’s results. If the company had made changes to its pricing or purchasing strategies in 2019, the percentage would need to have been adjusted. Second, a single gross profit percentage has been used for all inventory items. It is quite likely that individual inventory items would have different amounts of gross profit built into their pricing, depending on consumer demand, purchasing dynamics, and so on. This blanket rate is based on an average of all inventory items, but depending on the product mix of both sales and purchases during the intervening period, this rate may not be appropriate.
Because this technique provides only an estimate, it should not be used for annual financial reporting purposes. In the circumstances noted above, however, it can be useful, but the calculated amount should be compared with the perpetual inventory records to determine the reasonableness of the estimate. Management should consider the suitability of the single gross profit percentage and consider any adjustments that may be appropriate.
Important: gross profit percent is different than percent markup on cost.
