October 8, 2020
As a retail business, it can be confusing to understand your inventory valuation and determine the best accounting method. This can leave the business owner wondering how to establish the estimated cost and current inventory value. Inventory management is difficult, relying heavily on the type of inventory system used. The business owner may question whether inventory valuation methods should include counting physical inventory by hand, as it’s time-consuming and potentially expensive in labor costs and lost sales. The store or warehouse likely has to be shut down to complete the count.
That’s where the retail inventory method comes in. The retail inventory method helps a business understand what they have, using an approximation technique. You might also hear the retail inventory method called the retail inventory estimation method or retail method. It’s helpful in understanding ending inventory numbers, based on a retail ratio covering the cost of the merchandise and the retail price. Due to the approximation, this is not a complete substitute for a physical inventory count used in annual financial statements, though it’s a popular method for quarterly financial statements.
The American Institute of CPAs and its Generally Accepted Accounting Principles accepts the retail inventory method. So even though it’s an approximation, it’s still legitimate.
How to calculate the retail inventory method
The retail inventory method involves several steps.
First, divide the cost of goods by the retail price. This will give you the retail value of goods, as a cost-to-retail percentage, or retail ratio. You can use the conventional retail method or the retail method. The conventional retail method includes markups but not markdowns, which means you’ll have a lower ending inventory value. The retail method uses both markups and markdowns in the ratio, and you’ll have a higher inventory value.
Then multiply the cost of sales by this cost-to-retail ratio.
Next, add the cost of beginning inventory and the cost of purchases; this is the cost of goods available for sale.
After that, multiple sales by the cost-to-retail percentage, to give you the cost of sales for the current period.
Next, determine the ending inventory by subtracting the cost of sales during the period from the cost of goods (COGS) available for sale.
Companies using the gross profit method don’t use the markup value to determine the cost-to-retail ratio, but rather the company’s current profit margin. In a nutshell, this considers total cost and total sales to determine the actual profit.
The pros and cons of using the retail inventory method
In terms of pros, the retail inventory method is a time-saving method to avoid a physical inventory count. That often requires a retail business to shut down until the count is completed. The retail inventory method can help if you’re looking for a business selling price or value. And it’s an easy way to determine the ending inventory numbers.
The cons are real, though. The method doesn’t include goods that are out of inventory but haven’t been sold, like those that are stolen or broken. The retail inventory method is best when the markup percentage is consistent. If there is a different markup used across products, the method will be less accurate. If your company becomes an acquirer of a large volume of inventory, like if your business buys another business, this would also affect the validity of the calculations. And though it’s been said before, it’s worth saying again – the method is an estimate.
Who should use the retail inventory method?
Your CPA may recommend this method for quarterly financial reporting, to estimate the ending inventory and cost of goods sold. The method is popular as it’s used with first in first out (FIFO) and last in first out (LIFO) methods. Retail businesses that may want to use it include retailers with multiple locations, like coffee roasters or gift shops. That’s because physical inventory counts are difficult and time-consuming to do in the same accounting period. It’s also helpful for retailers without a lot of inventory in transit. This system doesn’t account for that. The system also works well for retailers who can use estimates on a consistent basis. Consider the retail inventory method as a snapshot in time.
A retailer would still want to complete a regular physical inventory count for an accurate assessment at least on a yearly basis. Your CPA will likely guide you in what inventory method to use – and when.
If your items are in a warehouse, Stord can help with the visibility and inventory management, through our proprietary software. Our goal at Stord is to make your supply chain operate more easily and efficiently, and to do that with transparency. Contact us to see what we can do for you.