CHAPTER ONE

Accounting for Inventories

1.1. Definition:
The term Inventories is used to designate:
Any type of good that is held for sale in normal course of business which is termed as
Merchandise Inventory.
Materials in process of production or held for such use, Manufacturing Inventory.
In Merchandising Business, inventories are consists of goods bought for resale.
In Manufacturing Business, inventories are consists:
 Raw Material Inventory,
 Work In Process(WIP) Inventory, and
 Finished Goods Inventory.
Inventory is classified as a current asset since it usually converted in to cash within a year or operating
cycle of the business whichever is longer.

1.2. Importance of Inventories

- It is the largest current asset in amount. The sale of inventory is the principal source of revenue of
firms.
- It is the most active element in the operation of merchandising firms as many of the transactions in
merchandising firms are related to purchase and sale of inventories.
- It appears on financial statements of the business; on balance sheet as major current asset and on
income statement, the Cost of Merchandise Sold (CMS) is the largest item deducted from sales in
determining the net income of the period.
- The accuracy of financial statement is affected by the amount reported as inventory.
1.3. Effect of Inventory Errors on Financial Statements
Any error in inventory count will affect both the balance sheet and the income statement.
 If CMS = BI + Net Purchase – EI, then CMS = CMAS – EI or CMS + EI = CMAS. This implies that at
the end of the period the CMAS is divided in to EI and CMS. Therefore, an error in determining EI
will cause misstatement on CMS. This in turn will affect Gross Profit (GP) and Net Income (NI) on
the income statement of the period; and asset and capital reported on the balance sheet at the end
of the period.
 EI of the current period becomes BI of the next period. Thus, if EI is incorrectly stated at the end of
the current period, the CMS, GP & NI of the current period will be misstated and so will the CMS,
GP & NI for the next period. The amount of the two misstatements will be equal and in opposite
directions. Therefore, the effect on CMS, GP & NI of an incorrectly stated inventory, if not
corrected, is limited to the period of the error (current period) and the next period. At the end of the
next period, assuming no additional errors, both assets and owners equity (capital) will be correctly
stated.
The Relationship of Inventory with Net Income:
1. If EI is Understated, CMS is Overstated, Net Income is Understated
2. If EI is Overstated, CMS is Understated, Net Income is Overstated
3. If BI is Understated, CMS is Understated, Net Income is Overstated
4. If BI is Overstated, CMS is Overstated, Net Income is Understated
Please Note: BI is part of CMS where as EI is not part of CMS; Remember the Formula (CMS = BI + Net
Purchase – EI)

Illustrative Example:
Suppose Beginning inventory, January 1, 2004: Birr 10,000, Net purchase for the year 2004: Birr 130,000;
Then, CMAS = 10,000 + 130,000 = 140,000
 Case 1: EI as of December 31, 2004 is Birr 20,000; Correctly Stated
Case 2: EI as of December 31, 2004 is Birr 12,000; Understated by Birr 8,000
Case 3: EI as of December 31, 2004 is Birr 27,000; Overstated by Birr 7,000

Case 1 Case 2 Case 3

EI as of Dec. 31,2004 Correctly EI as of Dec. 31,2004 Understated EI as of Dec.31,2004 Overstated by
stated by Birr 8,000 Birr 7,000
CMAS………… Birr 140,000 Birr 140,000 Birr 140,000
Less: EI……….. (20,000) (12,000) (27,000)
CMS…………... Birr 120,000 Birr 128,000* Birr 113,000*

Effect of Inventory Error on Current and Next periods Financial Statements

1. If EI of the current period (2004) is understated by Birr 8,000 and no additional error in the next period
(2005).
On Current Period’s Income Statement On Next Period’s Income Statement Net effect of the error over
- CMS will be overstated by Birr 8,000 - CMS will be understated by Birr a two years period
8,000 - Overstatement of CMS
- GP & NI will be understated by Birr is offset by the
8,000 - GP & NI will be overstated by Understatement.
Birr 8,000 - Understatement of GP
& NI is offset by the
Overstatement.
On Current Period’s Balance On Next Period’s Balance Sheet
Sheet - Asset & Capital will be stated
- Asset & Capital will be understated by correctly since the error offsets
Birr 8,000 due to the understatement of each other.
EI and NI.

2. If EI of the current period (2004) is overstated by Birr 7,000 and no additional error in the next period
(2005).
On Current Period’s Income Statement On Next Period’s Income Statement Net effect of the error over
- CMS will be understated by Birr 7,000 - CMS will be overstated by Birr a two years period
7,000 - Understatement of CMS
- GP & NI will be overstated by Birr 7,000 is offset by the
- GP & NI will be understated by Overstatement.
Birr 7,000 - Overstatement of GP &
NI is offset by the
Understatement.
On Current Period’s Balance On Next Period’s Balance Sheet
Sheet - Asset & Capital will be stated
- Asset & Capital will be overstated by correctly since the error offsets
Birr 7,000 due to the overstatement of EI each other.
and NI.

Example: As a result of an error in the physical count of Merchandise on December 31, 1999, XYZ Company
overstated the merchandise on hand (EI) by Birr 25,000. Assume no additional error was committed in the year
2000. Illustrate the effect of the error on the financial statements prepared by XYZ Company during the year
1999 & 2000.
Solution:
 Financial statement items 1999 2000
CMS Understated by Birr 25,000 Overstated by Birr 25,000
GP & NI Overstated by Birr 25,000 Understated by Birr 25,000
Total Assets as of December 31 Overstated by Birr 25,000 Not affected
Capital as of December 31 Overstated by Birr 25,000 Not affected

1.4. Inventory Systems

There are two principal systems of inventory accounting, Periodic and Perpetual.
Periodic Inventory System
- Under this system, increases in merchandise inventory (purchase of merchandise) are
accumulated in an account titled “Purchase”.
Purchase………………xxx
A/P or Cash………………xxx
- Decrease in merchandise inventory is not recorded after each sale; thus there is no
determination of the CMS and the EI after each sale. The only entry recorded at time of sale is:
A/R or Cash…………..xxx
Sales……………………..xxx

- Periodically, usually at the end of the accounting period, for the purpose of preparing balance
sheet and income statement, the merchandise inventory on hand is determined by physical
count. Then, the CMS is determined by deducting the EI from CMAS. i.e.
CMS = CMAS* - EI
*CMAS = BI + Net Purchase
- This system is often used by firms having variety of merchandise with low unit price. Examples:
Retail Stores, Drug Stores, Groceries etc.

Perpetual Inventory System

- Under this system, increases in merchandise inventory (purchase of merchandise) are
accumulated in a control account titled “Merchandise Inventory” and subsidiary ledgers are
maintained for each item.
Merchandise Inventory………………xxx
A/P or Cash………………xxx
- The Cost of Merchandise Sold is recorded after each sale and the inventory account is updated
for the decrease in inventory balance as a result of the sales. Two entries are recorded at time of
each sale:
A/R/Cash…………………………….xxx
Sales…………………………….xxx

Cost of Merchandise Sold…………...xxx

Merchandise Inventory……………………xxx
Thus, accounting records perpetually (continuously) show the EI & the CMS.
- Under this method, physical inventory is conducted for controlling purpose; just to compare
book inventory (Merchandise inventory balance per record) with the actual count.
- This system is frequently used by companies that sell items of high unit price like office
equipments, automobiles etc.

1.5. Determining Actual Quantities in the Inventory

The physical count of inventory is needed under both inventory systems. Under periodic inventory system,
it is needed to determine the cost of merchandise inventory on hand (EI) and the cost of merchandise sold
(CMS). The inventory account under a perpetual inventory system is always up to date. Yet events can occur
where the inventory account balance is different from inventory on hand. Such events include theft, loss,
damage, and errors. The physical count (sometimes called “taking an inventory”) is used to adjust the
inventory account balance to the actual inventory on hand.
At the time of taking an inventory, all the merchandise owned by the business on the inventory date, and
only such merchandise, should be included in the inventory. The merchandise owned by the business may not
necessarily be in the warehouse. However, regardless of the location, all items that belong to the business must
be included in the inventory.

Generally, the quantity of ending inventory includes:

1. Physical Inventory: items available and counted in the warehouse/store (inventory on hand
that are owned by the company on inventory date)
2. Goods in Transit: goods purchased but not yet received by the company. Here, the legal title to
the merchandise in transit on the inventory date is known by examining purchase and sales invoices
of the last few days of the current accounting period and the first few days of the following /next
accounting period. The legal title to the merchandise in transit on the inventory date depends on
shipping terms (agreements). If the agreement is FOB shipping point, the ownership passes to the
buyer when the goods are shipped (when the goods are loaded on the means of transportation, i.e.
at the seller’s point). Hence, goods in transit purchased on FOB shipping point terms are included in
the inventories of the buyer and excluded from the inventories of the seller. But if the agreement is
FOB destination, the title passes to the buyer when the goods arrive at their destination, i.e. at the
buyer’s point. Therefore, goods in transit purchased on FOB destination terms are included in the
inventories of the seller and excluded from the inventories of the buyer.
3. Goods on Consignment: it is a case where merchandises are sold through agent. The owner of
the merchandise is the consignor; the agent is consignee. Therefore, unsold merchandises in the
hands of the consignee (consignment out) should be included in Ending Inventory (EI) of the
consigner (the owner of the merchandise).

1.6. Inventory Costing Methods Under a Periodic System

The prices of many kinds of merchandises are subject to frequent change. At various date during a
period, an identical item can be acquired at deferent price. The question is which unit price is used to
determine the cost of merchandise inventory on hand (EI) and the cost of merchandise sold (CMS); the
earliest, the latest or average? What should be the cost of EI and the CMS that will appear on year-end
balance sheet and income statement respectively? To determine these figures there are three most widely
accepted inventory costing methods. These are:
1. First in First out(FIFO) Method
2. Last in First out(LIFO) Method
3. Weighted Average Method

1. First in First out (FIFO) Method

- It is based on the assumption that items acquired first are assumed to be sold out first; or each
sale is made out of the oldest goods in stock and ending inventory consists of the most recently
acquired goods.
- The cost of merchandise sold is computed by the oldest unit costs, this implies the cost flow is in
the order expenditures were made. Ending inventory cost is computed by recent unit costs.
2. Last in First out (LIFO) Method
- It is based on the assumption that items acquired last are assumed to be sold out first; or each
sale is made out of the recent goods in stock and ending inventory consists of the oldest goods.
- The cost of merchandise sold is computed by recent unit costs, this implies the cost flow is in the
reverse order of the expenditures on goods. Ending inventory cost is computed by earlier/oldest
unit costs.
3. Weighted Average Method
- It is based on the assumption that the cost flow is an average of expenditure on goods.
- Both the cost of merchandise sold and ending inventory are computed by using the weighted
average unit cost. There are steps to apply this method:

Step 1: Compute the Weighted Average Unit Cost (WAUC) as follows:

WAUC = Total cost of merchandise available for sale (CMAS)
Total units available for sale
Step 2: Applying the weighted average unit cost on both units on hand and units sold.

Illustration:
The following data referring to the beginning inventory and purchase of “Item A” is taken from the
records of ABC Company that uses Periodic inventory system

January 1 Inventory (BI)………………………………. 200 units @ 9/unit = Birr 1,800

March 10 Purchase……………...…………………….. 300 units @ 10/unit = 3,000
September 21 Purchase………………..……………… 400 units @ 11/unit = 4,400
November 18 Purchase……………...……………….. 100 units @ 12/unit = 1,200
Units available for sale = 1000 units CMAS= 10,400

Assume units on hand at the end of the year were 300 units.

Required: - Determine the cost of Ending Inventory (EI) and the Cost of Merchandise Sold (CMS),
under the following inventory costing methods
1. First in First out (FIFO) Method
2. Last in First out (LIFO) Method
3. The Weighted Average Method
Solutions:

Units sold = 700 units (1000 units available for sale – 300 units on hand)

1. Under the Periodic FIFO Method, the EI and CMS are computed as follows:
Cost of Ending Inventory, 300 units Cost of 700 units sold (CMS)
From 3rd Purchase :100 *12 = Birr 1200 Sold-From Beg. Inventory: 200 * 9 = Birr 1800
From 2ndPurchase :200 *11 = 2200 Sold-From 1st Purchase : 300 *10 = 3000
Total Cost of EI, 300 units = Birr 3,400 Sold-From 2 Purchase : 200 *11 =
nd
2200
Total Cost of 700 units sold(CMS)=Birr 7,000
Or, CMS = CMAS – EI; 10,400 – 3,400 = Birr 7,000

2. Under the Periodic LIFO Method, the EI and CMS are computed as follows:
 Cost of Ending Inventory of 300 units Cost of 700 units sold(CMS)
Beg. Inventory: 200 * 9 = Birr 1800 Sold- From 3rd Purchase : 100 *12 = Birr 1200
From 1 Purchase : 100 *10 =
st
1000 Sold- From 2nd Purchase :400 *11 = 4400
Total Cost of EI, 300 units = Birr 2,800 Sold- From 1st Purchase : 200 *10 = 2000
Total Cost of 700 units sold(CMS)=Birr 7,600
Or, CMS = CMAS – EI; 10,400 – 2,800 = Birr 7,600

3. Under the Weighted average method, the EI and CMS are computed as follows:

Step 1: Computing the Weighted Average Unit Cost (WAUC)

WAUC = Total cost of merchandise available for sale (CMAS)
Total units available for sale

WAUC = Birr 10,400

1,000 units

WAUC = 10.40 per unit

Step 2: Applying the WAUC on both units on hand and units sold.

Cost of Ending Inventory of 300 units Cost of 700 units sold

Total Cost of EI = 300 * 10.40 = Birr 3,120 Total CMS = 700 * 10.40 = Birr 7,280
Or, CMS = CMAS – EI; 10,400 – 3,120 = Birr 7,280

Comparison of Inventory Costing Methods

Refer to the data that pertains to ABC Company to its “Item A” in the above illustration, each of the three
assumptions to cost flow provides deferent ending inventory and CMS figures. The method that provides
highest ending inventory provides lowest CMS and vice versa.

FIFO Method Average Cost Method LIFO Method

CMAS………….. Birr 10,400 Birr 10,400 Birr 10,400
EI…………. 3,400 3,120 2,800
CMS……………. 7,000 7,280 7,600

FIFO Method:
 During the period of rising price, inflation, FIFO method reports highest ending inventory and
lowest cost of merchandise sold, as a result it reports higher net income. This is because the cost of
merchandise sold is computed by earlier costs, which is lower. Refer to Item A’s data the price of
the item is rising, FIFO reports higher EI Birr 3,400 and lowest CMS, Birr 7000.
 When the trend in price is declining, FIFO method reports lowest ending inventory and higher cost
of merchandise sold; as a result it reports lower net income.
 In the period of rising price the use of FIFO method results in higher income tax because of higher
net income.
LIFO Method:
 During the period of rising price, inflation, LIFO method reports lowest ending inventory and
highest cost of merchandise sold, as a result it reports lower net income. This is because the cost of
 merchandise sold is computed by recent costs, which is higher. Refer to Item A’s data the price of
the item is rising, LIFO reports lower EI Birr 2,800 and higher CMS, Birr 7600.
 When the trend in price is declining, LIFO method reports highest ending inventory and lower cost
of merchandise sold; as a result it reports higher net income.
 In the period of rising price the use of LIFO method results in lower income tax because of lower
net income.
Weighted Average Method:
 Under this method, the effect of price trend is averaged. However, the time required to collect and
organize purchase data of each item is more than other methods.
1.7. Inventory Costing Methods Under a Perpetual System
Under Perpetual Inventory System, the inventory costing methods is applied each time sale of merchandise
is made. The Cost of Merchandise Inventory on hand (EI) and the Cost of Merchandise Sold (CMS) is
calculated at the time of each sale. This means the merchandise inventory account is continually updated to
reflect purchase and sales. Perpetual records may be maintained based on the First in, First out (FIFO), the
Last in, First out (LIFO), and Moving Average Methods.

Illustration:
The Beginning Inventory, Purchases and Sales of ABC Company for its “Item B” during the month of January
were as follows:
Units Cost
Jan. 1 Inventory 15 Birr 10
6 Sale 5
10 Purchase 10 12
20 Sale 8
25 Purchase 8 12.5
27 Sale 10
30 Purchase 15 14

Required: - Determine the Cost of Ending Inventory (EI) as of January 31 and the Cost of Merchandise
Sold (CMS) for the month, under the following inventory costing methods:

1. Perpetual FIFO Method

2. Perpetual LIFO Method
3. Perpetual Weighted Average Method
Solutions:

1. Perpetual FIFO Method

Purchases Cost of Merchandise Sold Inventory
Date Qty. U.Cost T. Cost Qty. U.Cost T. Cost Qty. U.Cost T. Cost
Jan. 1 15 10 Birr 150
6 5 10 50 10 10 100
10 10 100
10 10 12 120 10 12 120
2 10 20
20 8 10 80 10 12 120
2 10 20
10 12 120
25 8 12.5 100 8 12.5 100
2 10 20 2 12 24
27 8 12 96 8 12.5 100
2 12 24
8 12.5 100
30 15 14 210 15 14 210
Total 33 Birr 430 23 Birr 246 25 Birr 334

So, the Cost of EI and CMS under Perpetual FIFO Method are Birr 334 & Birr 246 respectively.

2. Perpetual LIFO Method

Purchases Cost of Merchandise Sold Inventory
Date Qty. U.Cost T. Cost Qty. U.Cost T. Cost Qty. U.Cost T. Cost
Jan. 1 15 10 Birr 150
6 5 10 50 10 10 100
 10 10 100
10 10 12 120 10 12 120
10 10 100
20 8 12 96 2 12 24
10 10 100
2 12 24
25 8 12.5 100 8 12.5 100
8 12.5 100
27 2 12 24 10 10 100
10 10 100
30 15 14 210 15 14 [210
Total 33 Birr 430 23 Birr 270 25 Birr 310

So, the Cost of EI and CMS under Perpetual LIFO Method are Birr 310 & Birr 270 respectively.

3. Perpetual Moving Average Method

Purchases Cost of Merchandise Sold Inventory
Date Qty. U.Cost T. Cost Qty. U.Cost T. Cost Qty. U.Cost T. Cost
Jan. 1 15 10 Birr 150
6 5 10 50 10 10 100
10 10 12 120 20 *220/20= 11 220

20 8 11 88 12 11 132

25 8 12.5 100 20 *232/20=11.6 232

27 10 11.6 116 10 11.6 116

30 15 14 210 25 *326/25=13.04 326

Total 33 Birr 430 23 Birr 254 25 Birr 326
 So, the Cost of EI and CMS under Perpetual Moving Average Method are Birr 326 & Birr 254
respectively.

Assume the periodic inventory system is used: the Cost of Ending Inventory (EI) and CMS of “Item B” for
January using FIFO, LIFO, and Average cost methods are as follows:
Remember 25 units on hand as of January 31.

Solutions:
First arrange the data as follows.

Jan. 1 Inventory……………..15 units @ 10 ………. Birr 150

10 Purchase……………...10 units @ 12 ………… 120
25 Purchase…………….. 8 units @ 12.5 ……….. 100
30 Purchase……………...15 units @ 14………… 210
Units Available for sale = 48 units CMAS = Birr 580

1. EI & CMS under Periodic FIFO

Value of EI, 25 units CMS =CMAS –EI

15 units *14 = Birr 210 CMS = Birr 580 -334
8 units *12.5 = 100 CMS = Birr 246
2 units *12 = 24
Cost of EI=Birr 334

2. EI & CMS under Periodic LIFO

Value of EI, 25 units CMS =CMAS –EI

15 units *10 = Birr 150 CMS = Birr 580 -270
10 units *12 = 120 CMS = Birr 310
Cost of EI=Birr 270

3. EI & CMS under Periodic Weighted Average

Value of EI, 25 units CMS =CMAS -EI

WA unit cost = Birr 580/48units CMS = Birr 580 -302
= Birr 12.08 per unit CMS = Birr 278
EI Cost= 25 units * 12.08 = Birr 302

Periodic FIFO Perpetual FIFO

EI Birr 334 Birr 334
CMS 246 246
 Periodic LIFO Perpetual LIFO
EI Birr 270 Birr 310
CMS 310 270
Periodic Weighted Average Perpetual Weighted Average
EI Birr 302 Birr 326
CMS 278 254

Summary:
- Periodic FIFO method results in the same EI and CMS figures with perpetual FIFO method.
- Periodic LIFO method results in a different EI and CMS figures with perpetual LIFO method.
- Periodic Weighted Average method results in a different EI and CMS figures with Perpetual
weighted Average method.

1.8. Valuation of Inventory at other than Cost

Cost is the primary base for recording and reporting inventories. In some cases however, inventory is
recorded and reported at other than cost. This is when:
The replacement cost of inventory is below the recorded cost, and
The inventory is not salable at normal selling price which may be due to imperfections, shop wear,
style changes, and other causes.
In such cases, inventories are valued using:
1. The Lower of Cost or Market (LCM) Method
2. The Net Realizable Value(NRV) Method

1. Valuation at Lower of Cost or Market (LCM)

If the replacement cost of inventory is lower than the original purchase cost, the lower of cost or market
(LCM) method is used to value the inventory. Market, as used in lower of cost or market, is the cost to replace
the merchandise on the inventory date. The use of LCM methods helps to record loss from decline of the
market value of inventories in the period in which the decline occurred. The method avoids overstatement of
assets (inventories) and net income.

Steps in applying the LCM Method:

1. Determining the cost of inventory using FIFO, LIFO or weighted Average Costing Method
2. Checking the current market price of merchandise/replacement cost from suppliers
3. If Market > Cost; report inventory at cost, the lower and ignore the unrealized gain
If Market < Cost; report inventory at market, the lower and record the loss for the deference. The
loss may be added to the cost of merchandise sold or reported as general expense.

LCM may be applied:

- To each item of inventory ( On item by item basis)
- To major categories of inventory
- To inventory as a whole
Illustration: Valuation of inventory at Lower of Cost or Market (LCM) Method.
LCM application

To major category To inventory as

Inventory Category Cost Market To each item a whole
Category 1
Item A * 3,000 5,500 * 3,000
Item B 5,000 * 4,000 * 4,000
Sub total * 8,000 9,500 * 8,000
Category 2
Item C * 7,500 9,000 * 7,500
Item D 9,300 * 7,000 * 7,000
Sub total 16,800 * 16,000 * 16,000
Total * 24,800 25,500 * 24,800
Valuation of inventory at LCM 21,500 24,000 24,800

 Application of LCM on item by item bases results in lowest ending inventory cost, Birr 21,500.
Application of LCM on total inventory bases results in higher ending inventory cost Birr 24,800
 If LCM is applied on item by item bases, the amount of loss is Birr 3,300, that is Birr 24,800 cost - Birr
21,500 LCM; and if perpetual inventory system is used; CMS or general expense is debited and
merchandise inventory is credited for the amount of the loss to adjust the inventory account to LCM
price. The LCM amount is used as a cost of inventory for the following periods.

2. Valuation at Net Realizable Value (NRV)

Merchandises that are spoiled, damaged, out of date, or that can be sold only at prices below cost should be
valued at Net Realizable Value.

NRV = Estimated selling price - Any direct cost of disposition

Example: Assume that damaged merchandise costing Birr 1,500 can be sold for only Birr 1250 and direct
selling expenses are estimated to be Birr 175.
NRV = Birr 1250 – 175
= Birr 1075

 Ending inventory is reported at Birr 1075 and loss of Birr 425 (1500 – 1075 = 425) is added to CMS or
recorded separately as general expense. Under a perpetual system, the inventory account is credited
by Birr 425 to adjust the net realizable value.

1.9. Presentation of Merchandise Inventory on the Balance Sheet

Merchandise inventory is usually presented in the current asset section of the balance sheet, following
receivables. Both the method of determining the cost of inventory (FIFO, LIFO, or Average Cost) and the
method of valuing the inventory (cost or the lower of cost or market (LCM)) should be shown. The details may
be disclosed in parentheses on the balance sheet or in a foot note to the financial statements. The company may
change its inventory costing methods for valid reason. In such cases, the effect of the change and the reason for
the change should be disclosed in the financial statements for period in which the change occurred.
1.10. Estimating Cost of Inventory
A business may need to estimate the amount of inventory for the following reasons:
 Perpetual inventory records are not maintained.
A disaster such as a fire or flood has destroyed the inventory records and the inventory
Monthly or quarterly financial statements are needed, but physical inventory is taken only once a
year.
There are two widely used methods of estimating inventory cost.
1. The Retail Method
2. The Gross Profit Method
1. The Retail Method of Inventory Costing
The retail method of estimating inventory cost requires costs and retail prices to be maintained for the
merchandise available for sale. A ratio of cost to retail price is then used to convert ending inventory at retail
to estimated ending inventory cost.
Steps in applying this method:
 Step 1: Determine the total merchandise available for sale at cost and retail
 Step 2: Determine the ratio of the cost to retail of merchandise available for sale
 Step3: Determine the ending inventory at retail by deducting the net sales from the merchandise
available for sale at retail
 Step4: Estimate ending inventory cost by multiplying the ending inventory at retail by the cost to
retail ratio.
When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be the same as
the merchandise available for sale. If ending inventory is made up of different classes of merchandise, cost to
retail ratios may be developed for each class of inventory. An advantage of the retail method is that it provides
inventory figures for preparing monthly statements. Department stores and similar retailers often determine
gross profit and operating income each month, but may take physical inventory only once or twice a year.
Thus, the retail method allows management to monitor operations more closely.
Example:
at Cost at Retail
Merchandise inventory, January 1………………… Birr 19,400 Birr 36,000
Net Purchase during January……………………… 42,600 64,000
Net Sales during January…………………………... 70,000

Required: Determine the estimated cost of ending inventory and cost of merchandise sold (CMS).

Solution:
at Cost at Retail
Merchandise inventory, January 1 Birr 19,400 Birr 36,000
Purchase in January (net) 42,600 64,000
Step 1 Merchandise available for sale Birr 62,000 Birr 100,000
Step 2 Ratio of cost to retail price: Birr 62,000
100,000
= 62%
Sales for January(net) (70,000)
Step 3 Merchandise inventory, January 31, at retail Birr 30,000
Step 4 Merchandise inventory, January 31, at cost Birr 18,600
(Birr 30,000 * 0.62)

Estimating EI at cost: Birr 18,600

Estimated CMS = CMAS at cost - Estimating EI at cost
= Birr 62,000 – 18,600
= Birr 43,400
2. The Gross Profit Method of Inventory Costing
The Gross profit method uses the estimated gross profit for the period to estimate the inventory at the end of the period.
The gross profit is estimated from the preceding year, adjusted for any current period changes in the cost and sales prices.

Steps in applying this method:

 Step 1: Determine the merchandise available for sale at cost
 Step 2: Determine the estimated gross profit by multiplying the net sales by the gross profit percentage/rate
 Step 3: determine the estimated cost of merchandise sold by deducting the estimated gross profit from the net
sales.
 Step 4: estimate the ending inventory cost by deducting the estimated cost of merchandise sold from the
merchandise available for sale.

Example:

Merchandise inventory, January 1………………… Birr 57,000

Net Purchase during January……………………… 180,000
Net Sales during January…………………………... 250,000
Estimated Gross profit rate………………………... 30%
Assume the merchandise inventory of the business was lost by fire.

Required: Determine the estimated cost of ending inventory lost by fire.

Solution:

Cost
Merchandise inventory, January 1 Birr 57,000
Purchase in January (net) 180,000
Merchandise available for sale( Step 1) Birr 237,000
Sales for January (net) Birr 250,000
Less: Estimated gross profit(Birr 250,000*0.3)( Step 2) (75,000)
Estimated cost of merchandise sold( Step 3) (175,000)
Estimated merchandise inventory, January 31( Step 4) Birr 62,000