Page 304 - Accounting Principles (A Business Perspective)

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LCM on
Unit Unit Total Total Item-by-Item
Item Quantity Cost Market Cost Market Basis
1 100 units $10 $9.00 $1,000 $ 900 $ 900
2 200 units 8 8.75 1,600 1,750 1,600
3 500 units 5 5.00 2,500 2,500 2,500
$5,100 $5,150 $5,000
Exhibit 62: Application of lower-of-cost-or-market method

Merchandise inventory, 2010 $ 40,000
January
Net cost of purchases 480,000
Cost of goods available for sale $520,000
Less estimated cost of goods sold:
Net sales $700,000
Gross margin (30% of $700,000) 210,000
Estimated cost of goods sold 490,000
Estimated inventory, 2010 $ 30,000
December 31
Exhibit 63: Inventory estimation using gross margin method
A company using periodic inventory procedure may estimate its inventory for any of the following reasons:

• To obtain an inventory cost for use in monthly or quarterly financial statements without taking a physical
inventory. The effort of taking a physical inventory can be very expensive and disrupts normal business
operations; once a year is often enough.
• To compare with physical inventories to determine whether shortages exist.
• To determine the amount recoverable from an insurance company when fire has destroyed inventory or the
inventory has been stolen.
Next, we introduce two recognized methods of estimating the cost of ending inventory when a company has not

taken a physical inventory—the gross margin method and the retail inventory method.
Gross margin method The steps in calculating ending inventory under the gross margin method are:
• Estimate gross margin (based on net sales) using the same gross margin rate experienced in prior
accounting periods.
• Determine estimated cost of goods sold by deducting estimated gross margin from net sales.
• Determine estimated ending inventory by deducting estimated cost of goods sold from cost of goods
available for sale.
Thus, the gross margin method estimates ending inventory by deducting estimated cost of goods sold from
cost of goods available for sale.

The gross margin method assumes that a fairly stable relationship exists between gross margin and net sales. In
other words, gross margin has been a fairly constant percentage of net sales, and this relationship has continued
into the current period. If this percentage relationship has changed, the gross margin method does not yield
satisfactory results.
To illustrate the gross margin method of computing inventory, assume that for several years Field Company has
maintained a 30 per cent gross margin on net sales. The following data for 2010 are available: The January 1
inventory was USD 40,000; net cost of purchases of merchandise was USD 480,000; and net sales of merchandise

were USD 700,000. As shown in Exhibit 63, Field can estimate the inventory for 2010 December 31, by deducting
the estimated cost of goods sold from the actual cost of goods available for sale.

Accounting Principles: A Business Perspective 305 A Global Text