The final cost of inventory may be elusive to calculate in some cases. For instance, estimating the cost of lost inventory after a fire has destroyed a company’s stock might be challenging.
In cases like this, the gross margin approach can be applied. Taking inventory at cost is challenging, if not impossible, for a retail establishment.
As a result, the stock is first assessed at retail before being adjusted for cost. The term for this approach is “retail inventory.”
Techniques for Predicting Closing Stock
One: The Gross Margin Approach
If a company doesn’t want to count its final stock but still needs an estimate, it might use the gross margin approach.
Companies, for instance, that need to know their monthly stock outs, would rather not do a physical inventory.
Because of the dispersed nature of some companies’ stock, a full physical count is just not feasible.
Furthermore, it may be impossible to do a final inventory if there have been damages due to disasters like fire or flood.
Estimates of final stocks can be made in all these situations using the gross margin technique.
Most businesses, the gross margin approach assumes, maintain a constant gross margin percentage.
Thus, the company’s historical gross margin percentage can be utilized to forecast final stock levels.
Let’s pretend the Wong Company had $20,000 in stock at the beginning of January and spent $170,000 on new purchases.
The company’s gross margin percentage for the month stayed unchanged at 20%, resulting in net sales of $200,000. If your gross profit is 20%, then your COGS is 80% of your selling price.
Using the standard formula for determining the cost of goods sold, we can simply demonstrate the value of the gross margin %.
Based on historical data, we know that the sum of the starting inventory and the purchases during the time amounts to $190,000.
Eighty percent of sales, or $160,000, goes toward covering the cost of items supplied. Difference between stock on hand of $190,000 and cost of goods sold of $160,000 equals ending inventory of $30,000.
Using Retail Inventory as an Example
The retail approach is used by retailers such as supermarkets and department shops to calculate their final stock levels. The inventory is essentially counted at retail before being adjusted to cost.
The whole stock of a business, such as a major supermarket, may be purchased at retail in a matter of hours since everything on the shelves is priced at retail.
The numbers of products and their retail prices are read into tape recorders by two or three people.
The retail stock is calculated when the recordings are transcribed and their lengths increased.
In other words, the tape is catalogued together with its quantity and cost. The retail stock is calculated by multiplying the unit prices by the unit quantities.
The percentage of the inventory’s cost to its retail price is then applied.
In comparison to calculating the costs of each individual item, even with some cost flow assumptions, this method is far more efficient.
Establishing a cost-to-retail proportion is the crux of the retail approach. Products available for retail sale are divided by total inventory to arrive at this figure.
A retailer must maintain accurate records of both its cost and selling prices in order to use the retail approach.
Most stores have already decided what they will charge customers for the products they purchase, so this is easier than it sounds.
If a physical inventory is not available, the retail approach can be used to estimate stock at the conclusion of the period.
To do this, we first ascertain the quantity of retail-saleable products and then deduct the amount actually sold.
This provides a forecast for the retail market’s final stock. Applying a cost-to-retail percentage to the final retail stock yields the corresponding cost inventory.
To further understand this, let’s use the Martinez Grocery Store as an example.
items available for sale at a cost of $190,000 divided by items available for sale at retail of $237,500 yields a cost-to-retail percentage of 80%.
Multiplying the $37,500 in total retail inventory on hand by this ratio yields the $30,000 in total inventory cost.
This is obviously an oversimplified version of the retail method, but it does show how it works in principle.
Costing inventory using FIFO, LIFO, or average cost can be complicated by other factors, and intermediate accounting texts address these nuances.