What is the retail inventory method?
The retail inventory method is an accounting method used to estimate the value of a store’s merchandise. The retail method provides a store’s ending inventory balance by measuring the cost of inventory against the price of merchandise. In addition to sales and inventory for a period, the retail inventory method uses the cost to retail ratio.
Key points to remember
- The retail inventory method is an accounting method used to estimate the value of a store’s merchandise.
- The retail method provides a store’s ending inventory balance by measuring the cost of inventory against the price of goods.
- In addition to sales and inventory for a period, the retail inventory method uses the cost to retail ratio.
- The retail inventory valuation method only provides an approximation of inventory value, as some items in a retail store will most likely have been shoplifted, broken, or misplaced.
- The retail inventory method is only an estimate and should always be supported by periodic physical inventories.
Understanding the Retail Inventory Method
Having control over your inventory is an important step in running a successful business. It helps you understand your sales, when to order more inventory, how to manage the cost of your inventory, and how much of your inventory ends up in consumers’ hands, instead of being stolen or broken.
The retail inventory method should only be used when there is a clear relationship between the price at which the merchandise is purchased from a wholesaler and the price at which it is sold to customers. For example, if a clothing store marks up every item it sells by 100% of the wholesale price, it can accurately use the retail inventory method, but if it marks up some items by 20%, some of 35% and some 67%. %, it can be difficult to apply this method accurately.
The retail inventory valuation method only provides an approximation of inventory value, as some items in a retail store will most likely have been shoplifted, broken, or misplaced. It is important for retail stores to periodically perform a physical inventory valuation to ensure the accuracy of inventory estimates to support the retail inventory valuation method.
Calculation of ending retail inventory
The retail inventory method calculates the ending value of inventory by adding the value of goods available for sale, which includes the original inventory and any new inventory purchases. Total sales for the period are subtracted from goods available for sale. The difference is multiplied by the cost-to-retail ratio (or the percentage by which the goods are marked up from their wholesale purchase price to their retail selling price).
The retail cost/price ratio, also known as the retail cost/price percentage, indicates how much of a good’s retail price is made up of costs. If, for example, an iPhone costs $300 to manufacture and sells for $500 each, the cost-to-retail ratio is 60% (or $300/$500) x 100 to move the decimal.
Disadvantages of the retail inventory method
The main advantage of the retail inventory method is the ease of calculation, but some of the disadvantages include:
- The retail inventory method is an estimate only. The results can never compete with a physical inventory.
- The retail inventory method only works if you have a consistent profit margin on all products sold.
- The method assumes that the historical basis of the mark-up percentage continues into the current period. If the markup was different (as may be caused by a sale after the holidays), the calculation results will be inaccurate.
- The method does not work if an acquisition has been made and the acquiree holds large amounts of inventory at a mark-up percentage significantly different from the rate used by the acquirer.
Retail inventory method example
Using our previous example, the iPhone costs $300 to manufacture and sells for $500. The cost/retail ratio is 60% ($300/$500 * 100). Let’s say the iPhone had total sales of $1,800,000 for the period.
- Initial inventory: $1,000,000
- New purchases: $500,000
- Total assets available for sale: $1,500,000
- Sales: $1,080,000 ($1,800,000 sales x 60% cost-to-retail ratio)
- Final inventory: $420,000 ($1,500,000 – $1,080,000)