Question

define shrinkage as it applies to a physical inventory count. after using the gross profit method to estimate ending inventory, explain how a company determines ending inventory, explain how a company determines if a loss was due to shrinkage.

explain in detail

Answer 1

• The Ending Inventory is estimated using the Gross Profit methods.
• A physical count of ending inventory is also done.
• The difference between the two is the loss due to shrinkage.
• Explanation through example:
  Suppose, a company earned Sales Revenue of $ 1,000,000. Normally the company earns 10% of gross profits on Sales. This means that Gross Profit = 1000000 x 10% = $ 100,000

--How to calculate/estimate ending inventory from above Gross Profit???
Sales – Gross Profits = Cost of Goods Sold , and
Cost of Goods Sold = Beginning Inventory + Inventory purchased – Ending Inventory.

Hence, Sales – Gross Profits = Beginning Inventory + Inventory purchased – Ending Inventory.

Lets say that everything required in above equation is known, except of course, the Ending Inventory, which is to be estimated.

Ending Inventory would be = Beginning Inventory + Inventory purchased + Gross Profits – Sales
= $ 200,000 + $ 800,000 + $ 100,000 - $ 1,000,000
= $ 100,000 = Estimated ending Inventory

Now, physical inventory would be counted and valued.
Suppose on physical count, the ending inventory came out as $ 99,100.

This would mean that $ 900 of inventory has been a LOSS due to Shrinkage.

• Summary of above concepts

--Gross Profit method is used to calculate estimated ending inventory.
--Goss Profit is reduced from Sales to find Cost of Goods Sold.
--After calculating Cost of Goods Sold, the ending inventory is calculated using formula/equation used above.
Ending Inventory = Beginning Inventory + Inventory Purchased – Cost of Goods Sold.
--Physical count of ending inventory is done.
--The value is compared with estimated inventory calculated earlier.
--Any difference would be a Loss due to shrinkage.