Inventory Estimation Techniques

If inventory has been destroyed or stolen, it is clearly impossible to take a physical count to determine ending inventory/cost of goods sold as opposed to the inventory quantity that has been destroyed/stolen.  Even if a physical count is possible, it may not be practical due to time constraints (e.g., for quarterly financial statements) Additionally, it is useful for managerial control purposes to have a second measure of what ending inventory should be, compared to the actual inventory on hand. 

To methods are used to estimate ending inventory:

• The gross profit method
• The retail inventory method

The gross profit method is based on an understanding of the historic relationship between revenue, cost of goods sold and gross profit.  

Historic Average data

cost of goods sold

gross profit

2,000

3,000

40%

60%

Available information:

goods available for sale (records)

historic cgs percentage: 40% of revenue

estimated ending inventory

actual ending inventory

inventory destroyed

7,000

1,200

5,800

2,000

3,800

Note that this method is only acceptable in exceptional circumstances (in the absence of any other possibility). It is not considered reliable enough for normal financial reporting purposes, since the estimate is based on historic relationships which may not be present in the current period.   Instead of the gross profit method, an acceptable method of estimating ending inventory/cost of goods sold is the Retail Inventory Method.