9.3 Retail Inventory Method and Gross Profit Estimation

Retail Inventory Method and Gross Profit Estimation

In many business environments, it is impossible or highly impractical to perform a physical inventory count every time financial statements are prepared (such as for monthly or quarterly interim reporting). In other situations, such as a fire or natural disaster, inventory may be destroyed, requiring estimation techniques. Under US GAAP, two primary estimation techniques are the Retail Inventory Method and the Gross Profit Method. Additionally, Dollar-Value LIFO is used to account for inflation in inventory pools, and understanding how inventory errors ripple through financial statements is a high-frequency testing topic on the CPA exam.

1. Retail Inventory Method (RIM)

The Retail Inventory Method is widely used by retailers (e.g., department stores) with high volumes of transactions and diverse inventories. It estimates the cost of ending inventory by first determining ending inventory at retail prices, and then applying a cost-to-retail percentage.

To apply RIM, companies must track transactions at both cost and retail:

• Original Retail Price: The initial price set for sale to customers.
• Markups: Increases in the selling price above the original retail price.
• Markup Cancellations: Decreases in the selling price that reduce a markup (but do not reduce the price below the original retail price).
• Net Markups: Markups minus markup cancellations.
• Markdowns: Decreases in the selling price below the original retail price.
• Markdown Cancellations: Increases in the selling price that reduce a markdown (but do not increase the price above the original retail price).
• Net Markdowns: Markdowns minus markdown cancellations.

The crucial exam distinction is how the cost-to-retail ratio is calculated:

1. Conventional Retail Method (Approximates LCM): Excludes net markdowns from the denominator of the cost ratio. By omitting markdowns, the denominator is larger, resulting in a lower cost ratio. When this lower ratio is multiplied by ending inventory at retail, it results in a lower, more conservative ending inventory value (approximating LCM).

   Cost Ratio (Conventional) = (Cost of Beg. Inv. + Cost of Purchases) / (Retail of Beg. Inv. + Retail of Purchases + Net Markups)

2. Average Cost Retail Method: Includes both net markups and net markdowns in the denominator.

   Cost Ratio (Average) = (Cost of Beg. Inv. + Cost of Purchases) / (Retail of Beg. Inv. + Retail of Purchases + Net Markups - Net Markowns)

Retail Inventory Method Example:

• Beginning Inventory: Cost $20,000; Retail $30,000
• Purchases: Cost $110,000; Retail $160,000
• Net Markups: Retail $10,000
• Net Markdowns: Retail $20,000
• Sales (at retail): $140,000

Step 1: Calculate Ending Inventory at Retail Retail Goods Available = $30,000 + $160,000 + $10,000 - $20,000 = $180,000 Ending Inventory at Retail = $180,000 - $140,000 = $40,000

Step 2: Calculate Cost-to-Retail Ratio

• Conventional (LCM) Ratio: Ratio = ($20,000 + $110,000) / ($30,000 + $160,000 + $10,000) = $130,000 / $200,000 = 65%
• Average Cost Ratio: Ratio = $130,000 / ($200,000 - $20,000) = $130,000 / $180,000 = 72.2%

Step 3: Calculate Ending Inventory at Cost

• Conventional (LCM): $40,000 * 65% = $26,000
• Average Cost: $40,000 * 72.2% = $28,880

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2. Gross Profit Method

The Gross Profit Method estimates ending inventory based on the historical relationship between cost of goods sold and sales. Under US GAAP, it is not acceptable for annual financial reporting but is widely used for interim reports or calculating inventory losses from casualty (fire, flood).

Step-by-step estimation:

1. Determine Cost of Goods Available for Sale (Beginning Inventory + Net Purchases).

2. Calculate Estimated Cost of Goods Sold by applying the cost ratio (1 - Gross Profit %) to Net Sales:

   Estimated COGS = Net Sales * (1 - Gross Profit Percentage)

3. Subtract Estimated COGS from Cost of Goods Available for Sale to find Estimated Ending Inventory.

If the gross profit is stated as a markup on cost, convert it to a gross profit margin on sales:

Gross Profit Margin on Sales = Markup on Cost / (1 + Markup on Cost)

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3. Dollar-Value LIFO (DVL)

Dollar-Value LIFO determines inventory layers in terms of total dollar value rather than physical quantities. This protects companies from LIFO liquidations that might occur from minor changes in product mix.

Step-by-Step Methodology:

1. Determine ending inventory at current-year costs (ending retail/market).

2. Deflate ending inventory to base-year costs using the ending price index:

   Ending Inventory at Base-Year Cost = Ending Inventory at Current-Year Cost / Price Index

3. Compare Ending Inventory at Base-Year Cost to Beginning Inventory at Base-Year Cost to find the increase (new layer) in base-year dollars.

4. Inflate the new layer back to current costs by multiplying by the price index of the year it was created, and add it to the beginning LIFO inventory.

Example: Beginning Inventory at Base-Year Cost = $100,000 (Index = 1.00). Ending Inventory at Current Cost = $126,000 (Index = 1.05).

1. Deflate ending inventory: $126,000 / 1.05 = $120,000.
2. New base-year layer: $120,000 - $100,000 = $20,000.
3. Inflated layer: $20,000 * 1.05 = $21,000.
4. Ending Inventory under Dollar-Value LIFO: $100,000 (base layer) + $21,000 (Year 1 layer) = $121,000.

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4. Inventory Errors

Inventory errors affect both the balance sheet and the income statement. Because ending inventory of one period becomes beginning inventory of the next, errors are counterbalancing (self-correcting) over two periods.

• Ending Inventory Overstated (Year 1):
  • Year 1 COGS is understated (since ending inventory is deducted).
  • Year 1 Net Income is overstated.
  • Year 1 ending assets (inventory) and retained earnings are overstated.
  • Year 2 beginning inventory is overstated (since Year 1 ending becomes Year 2 beginning).
  • Year 2 COGS is overstated.
  • Year 2 Net Income is understated.
  • Retained earnings is correct at the end of Year 2.

At the end of Year 2, Retained Earnings is correct because the overstatement of Net Income in Year 1 is exactly offset by the understatement of Net Income in Year 2. However, the financial statements for both individual years remain misstated and must be restated if discovered.