The most common and most accurate method of inventory valuation is to take a physical count of the inventory. Once the inventory is counted and the value determined, the total physical value is then compared to the general ledger account and adjustments are made to the ledger as appropriate.
Other Inventory Valuation Methods
There can be circumstances where taking a physical inventory isn’t practicable. One circumstance maybe that the costs and man-hours to conduct a count are not cost-effective. There can also be more extreme circumstances where a disaster like a flood, earthquake or fire makes it impossible to conduct a physical inventory.
Under these types of circumstances, using the retail or gross profit method could be a viable solution. Instead of taking a physical count, the retail and gross profit methods rely on using specific financial statement records for inventory valuation. Below is an illustration of these two types of inventory valuation.
The Retail Method of Inventory Valuation
The retail method is generally used for a retail company that’s in the business of selling merchandise. In order to use this method, the inventory cost to retail percentage must be consistent. In the following example, we’ll use a cost to retail percentage of 70%.
Current Inventory @ Retail
- Beginning Inventory $150,000
- Plus Purchases $500,000
- Less Sales $450,000
- Ending Inventory $200,000
In the inventory cost example below, the retail figures from above are refigured using the company’s consistent cost to retail percentage of 70%.
Current Inventory @ Cost
- Beginning Inventory $105,000
- Plus Purchases $350,000
- Less Sales $315,000
- Ending Inventory $140,000
To ensure that the figures are correct, the ending inventory at cost should have an amount equal to the cost of retail percentage. In this example, the $140,000 at cost is equal to 70% of the ending retail inventory of $200,000.
The Gross Profit Method of Inventory Valuation
Just like the name indicates, the company’s gross profit percentage is used to calculate ending inventory. Unlike the retail method, the gross profit method doesn’t necessarily have to be a consistent percentage. Instead the historically average gross profit is used. The gross profit taken from the company’s income statement can be used and averaged over time.
As an illustration of the gross profit method to calculate inventory value, we’ll use an average gross profit of 30%. The first step is to determine the cost of goods sold, which normally coincides with inventory cost. Using the same figures from the retail method illustrated above, the inventory value using the gross profit method would be calculated as follows.
- Sales $450,000 = 100%
- Less Cost of Goods Sold $315,000 = 70%
- Equals Gross Profit $135,000 = 30%
- Beginning Inventory $105,000
- Plus Purchases $350,000
- Less Cost of Goods Sold $315,000
- Ending Inventory $140,000
James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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