A flash flood swept through Hat, Inc.'s warehouse on May 1. After the flood, Hat's accounting records showed the following:

 A flash flood swept through Hat, Inc.'s warehouse on May 1. After the flood, Hat's accounting records showed the following:

Inventory, January 1    $ 35,000
Purchases, January 1 through May 1    200,000
Sales, January 1 through May 1    250,000
Inventory not damaged by flood    30,000
Gross profit percentage on sales    40%
What amount of inventory was lost in the flood?

$55,000
$85,000
$120,000
$150,000

Answer

$55,000
 You Answered Correctly!
The gross margin method of estimating inventory is used to solve this problem. The cost of inventory lost cannot be identified by count but it can be estimated.

First, an estimate of cost of goods sold is subtracted from the cost of goods available on the date of the flood yielding the total amount of inventory that would have been present on May 1.

Second, the amount of inventory not lost is subtracted from the May 1 estimated total inventory. The result is an estimate of the amount lost.

With gross profit being 40% of sales, cost of goods sold must be 60% of sales, on average. Therefore, the estimate of cost of goods sold is $150,000 (.60 × $250,000). Beginning inventory ($35,000) + Purchases ($200,000) = Goods available = $235,000. Subtracting $150,000 of cost of goods sold yields $85,000 of inventory on May 1 ($235,000 − $150,000).

With $30,000 of inventory still accounted for, the amount of lost inventory at cost is $55,000 ($85,000 − $30,000).