In the absence of a fully costed perpetual inventory, many companies opt to report month-end inventory balances by using the gross profit method. The gross profit method allows companies to estimate an end-of-period inventory balance by rolling forward inventory activity for a specific period. Net purchases, plus any additional costs adding value to inventory, are added to the beginning inventory balance to obtain cost of goods available for sale. Sales, at cost, are then subtracted from the cost of goods available for sale to obtain a period ending estimated inventory balance. Although this technique for estimating a company’s ending inventory balance is GAAP approved, there are several potential risk factors to consider. Below is a typical inventory roll forward using the gross profit method:
- Purchase Returns
+Labor and Overhead
+Duty, Freight, Insurance
= Costs of Goods Available for Sale
- Sales at Cost (see below for equation)
= Ending Inventory
Sales, at cost, are calculated as follows:
Net Sales for the period
x Historical Cost of Goods Sold %
= Sales at Cost
The most important risk factor in using the gross profit method is the reliance placed on the company’s beginning inventory balance. If a company’s beginning inventory balance is based on a recent physical inventory, certified by an independent source, the beginning balance can be relied upon. However, if the beginning balance is not based on a recent physical inventory or if the recent physical inventory is not certified by an independent source, the beginning balance could potentially be misstated. Errors in counting, costing, and other mathematical errors could significantly affect the inventory roll forward calculation. In addition, general management reserves may be applied to reduce beginning balances. Inventory risks can be mitigated by performing periodic physical inventories, which would identify the need for slow moving and obsolete inventory reserves. Requiring companies to perform periodic physical inventories and having Bourget & Associates, Inc. observe the process, would significantly reduce risks and strengthen the reliability of the company’s beginning inventory balance.
Another area of potential risk involved with relying on an inventory roll forward using the gross profit method is the assumption of the company’s historical cost of goods sold percentage. Most companies use a cost of goods sold based on the previous year’s fiscal year-end financial statements. All things being equal, this assumption should be accurate. However, due to changing market conditions and product mix, this assumption could potentially be flawed. Increases in costs related to inventory purchases may fundamentally alter a company’s gross profit if these costs are not passed on to the customer. Also, variations in customer’s buying habits may essentially change the company’s product mix, causing the gross margin to fluctuate or even decline. Companies need to consider these variables and make necessary adjustments to cost of goods sold percentages throughout the year in order to accurately estimate inventory balances using the gross profit method.
Inventory roll forwards can be a useful vehicle to estimate inventory balances between physical inventories in the absence of a fully costed perpetual, providing that companies remain diligent in addressing these variables mentioned above. It is important, however, to understand that inventory roll forwards only provide an estimate of inventory balances in a static environment. Requiring physical inventories that are observed by an independent source and identifying and addressing changes to related industry environments will help in maintaining a relevant and accurate inventory balance.
Bourget & Associates, Inc. has extensive experience in performing and observing physical inventories related to diverse array of industries.
Call us at 401-769-6762 to discuss your questions and your needs.