Slick Snowboards Company reported sales of $700,000 in the first quarter of 2016. The company has never implemented an inventory system so the controller does not know how much inventory is actually on hand at the end of the quarter.
The company is considering expansion; therefore, a complete set of financial reports for the first quarter of 2016 must be prepared for the bank loan application and shareholders. The company’s accountant says Slick should count the inventory as part of the process, but management believes counting the inventory at the end of each quarter is too costly.
Therefore, the controller decides to estimate the value of inventory on hand. She determines that inventory on hand on January 1, 2016, was $100,000 based on the 2015 year-end financial statements, and she knows that an additional $400,000 of inventory was purchased during the first quarter. The company normally earns a 35% gross margin on sales. Based on this information, and using the gross margin estimation method, the controller arrives at what she thinks is a reasonable estimate of the cost of inventory on hand at the end of the first quarter of 2016.
Required:
a. Calculate the ending inventory estimate at March 31, 2016. Explain how you arrived at your estimate.
b. If the controller believes that the gross margin on sales is likely to be closer to 30% in 2016, recalculate the ending inventory estimate at March 31, 2016. Comment on the sensitivity of your estimate of the inventory on hand to changes in the gross profit on sales percentage.
c. 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?
d. Based on your original estimate of Slick Snowboards’ inventory at the end of the first quarter, what is your assessment of the company’s inventory position? Does the amount seem reasonable? Why or why not? Why might inventory levels change from one quarter to the next?