Slick Surf Boards Company reported sales of $595,000 in the first quarter of 2011. Because the company does not keep a running tally of the cost of inventory sold, the controller does not know how much inventory is actually on hand at the end of the quarter. The company, for the first time, is going to prepare quarterly financial reports to issue to its shareholders, but counting the inventory at the end of each quarter is too costly. Therefore, the controller decides to estimate how much inventory is on hand. By looking at the last annual balance sheet, the controller is able to determine that inventory on hand on January 1, 2011, was $88,200, and he knows that an additional $420,000 of inventory was purchased during the first quarter. The company normally earns a 36% gross profit on sales. Based on this information, and using the cost-to-sales method, the controller arrives at what he thinks is a reasonable estimate of the cost of inventory on hand at the end of the first quarter of 2011.
Required:
a. What would you estimate as the cost of Slick Surf Board's inventory on hand at the end of the first quarter of 2011? Explain how you arrived at your estimate.
b. If the controller believes that the gross profit on sales is likely to be closer to 34% in 2011, estimate the cost of Slick Surf Board's inventory on hand at the end of the first quarter of 2011. Comment on the sensitivity of your estimate of the inventory on hand to changes in the gross profit on sales percentage.
c. What other factors might reduce the reliability of using this method to estimate inventory?
d. If the gross margin estimation method works reasonably well for interim estimates of inventory on hand, why not use it at year end as well and avoid altogether the cost of an annual inventory count?
e. Based on your original estimate of Slick Surf Board's inventory at the end of the first quarter, what is your assessment of the company's inventory position? Does the amount seem reasonable? Why might inventory levels change from one quarter to the next?