When running a business, it is important to take stock of physical inventory to determine the financial health of the business. However, due to the size of inventories for many companies, calculating physical inventory on a regular basis may not be feasible, for time and money’s sake. Waiting until the end of a year to determine inventory may complicate tax filing and may also provide an incorrect picture of sales and units available. So, it is important to estimate inventory on a regular basis. There are two methods used to estimate inventories: the gross profit method and the retail method.
The gross profit method estimates ending inventory while using the periodic inventory method. Gross profit may also be used to calculate lost inventory due to fire or theft. Gross profit refers to a business’s sales minus the cost of goods sold. This method depends on the gross margin ratio, which is determined by dividing gross profit by net sales. For example, if a company has a gross profit of $10,000 and net sales of $50,000, it has a gross margin ratio of 20%. A company’s gross profits should be enough to cover expenses. Various industries have different standard gross margin ratios to view in comparison to that of your business.
To make an accurate estimate of an inventory, it is important to have accounts ready for cost of goods available for sale, cost of purchases, cost of beginning inventory, sales, and estimated gross profit percentage. The previous year’s income statement should be on hand as a foundation for the estimate.
The retail method estimates ending inventory and requires detailed, consistent records to do so. This method requires records of the initial costs of and retail prices of merchandise, divided into two columns. Ratios between these two columns are calculated using the amount of goods available. Then, the cost of goods available is divided by retail goods available, leading to a cost ratio. Multiplying estimated ending inventories at retail by cost ratio provides an estimated ending inventory at cost.