Retail Inventory Method

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What Is The Retail Inventory Method?

The Retail Inventory Method refers to an accounting approach followed by retailers to determine the value of unsold inventory. This method depends on the correlation between the retail price of the merchandise and its cost price to calculate the ending inventory at a certain period.

The retail method simplifies inventory management by eliminating the need for physical counting of the stock, which can be time-consuming and tedious. While the objective of stock-keeping can be achieved through this method, periodic physical evaluation can be supplemental to ensure accuracy and responsiveness.

What is the Retail Inventory Method?

The retail inventory method, or the retail inventory estimation method, is an accounting method to estimate the value of a retailer's merchandise without physically counting the number of stock units.
This method considers the cost and retail price of the inventory for a particular period, not the number of units.
The value of the ending inventory can be computed as the difference between the Cost of goods available for sale and the Cost of goods sold.

Retail Inventory Method Explained

The retail inventory method of accounting is a standard inventory valuation method resorted to by retailers. This method is prominent as it directly considers the cost and retail price of the inventory and not the number of units. So, there is no need to tally the stock units while computing the value of ending inventory.

However, this method doesn't alleviate the need to count the units physically. Once in a while, it is good to count the units to detect theft, damage, misplacements, etc. Also, it is essential to remember that the ending inventory value so determined is an estimation and only partially accurate. For this reason, it is not advised to show this value in the financial statements.

Mark-ups and mark-downs are frequent in retail inventories. Mark-ups increase the retail price, whereas mark-downs decrease the price. The retail method facilitates valuation in such situations, though there might be complexity in calculations.

The retail inventory method formula is derived using the following steps:

First, calculate the cost-to-retail ratio. For this, divide the cost price of merchandise by its retail price. The cost-to-retail ratio is often mentioned as a percentage.
Now, arrive at the cost of goods available for sale by adding the value of opening inventory (merchandise at the beginning of the year) and the purchase value of merchandise bought during the period under consideration. Note that the value considered here is the cost price.
Next, estimate the cost of sales by multiplying the total sales value in the period and the cost-to-retail ratio.
Finally, the ending inventory value can be determined as the difference between the cost of goods available for sale and the cost of sales.

Examples

Consider the following examples to understand the topic better.

Example #1

Now, let us work out a calculation example. Use the following information to determine the ending inventory of retailer XYZ selling a single type of mobile phone for March 2023:

Particulars	Amount
Cost Price	$ 800
Retail Price	$ 1000
Beginning Inventory (At Cost)	$ 100,000
Purchases during the month (At Cost)	$ 150,000
Sales	$ 225,000

Cost-to-retail ratio:

= Cost price/ Retail price

= $ 800/ $ 1000

= 0.8 = 80%

Cost of goods available for sale:

= Beginning Inventory + Purchases during the month

= $ 100,000 + $ 150,000

= $ 250,000

Cost of sales:

= Sales during the month x Cost-to-retail ratio

= $ 225,000 x 80%

= $ 180,000

Ending inventory:

= Cost of goods available for sale – Cost of sales

= $ 250,000 - $180,000

= $ 70,000

Note: This calculation is relatively simple since there is only one product type and no price changes. But in reality, a retailer may sell different products at different prices. Moreover, the prices might constantly fluctuate due to market conditions. Thus, the occasional mark-ups and mark-downs will also need help in computation.

Example #2

In December 2022, U.S. businesses saw a positive 0.3% uptick in their inventories, reflecting an accumulation of goods available for sale. When viewed year-over-year, inventories experienced a substantial surge, reaching 12.7%. Notably, this surge was most prominent in the retail sector, initially accompanied by price increases but ultimately necessitating discounts to manage excess merchandise.

While wholesalers and manufacturers showed modest increases in their inventories, with 0.1% and 0.4% growth, respectively, business sales slightly declined 0.6% in December, following a more significant 1.2% drop in November. These trends indicate that businesses are taking longer to sell their inventory, with December experiencing the longest shelf-clearing duration since November 2020. This extended inventory holding period invites a closer look at economic health, encouraging consideration of potential economic challenges.

Advantages

Here is why the retail inventory estimation method is beneficial to businesses:

The retail method is known for its simplicity.
It is a quick way to arrive at the merchandise value. Especially if the inventory is uniform, i.e., only one type of stock, the job becomes very easy.
There is no need to count the stock units physically.
Inventory management is a highly significant task to re-order inventory and avoid stock-outs.
It also plays an essential role in budgeting and cash management.

Disadvantages

Here is what businesses should remember while using this method:

The retail method produces an estimate of the merchandise value. So, relying on something other than this estimate is essential while making important decisions.
There can be complications in the calculation if products are priced differently or have varying mark-ups and mark-downs.
Due to these factors, the merchandise valuation determined through this method must be revised for financial statements.

Retail Inventory Method vs Cost Method

This table concisely compares the critical differences between the Retail Inventory Method and the Cost Method, highlighting their distinct approaches to inventory valuation and management.

Basis	Retail Inventory Method	Cost Method
Merchandise Valuation	Based on the retail price.	Based on the cost price (weighted average).
Inventory Recording System	Periodic; calculated for a specific period.	It is perpetual: records stock changes continuously in real-time.
Consideration of Units	It focuses primarily on value, not units.	Considers both value and quantity of units.
Cost of Goods Sold Calculation	It considers mark-ups or mark-downs on merchandise.	It considers the selling price. More suitable for mark-up-centric businesses.
Accuracy vs. Labor Intensity	It is less labor-intensive but may need to be more accurate.	It is more accurate but can be more labor-intensive due to unit tracking.
Ending Inventory Calculation	It is computed as the difference between the cost of goods available for sale and the cost of sales.	Determined as the weighted average cost sum.

Frequently Asked Questions (FAQs)

1. When the conventional retail inventory method is used?

The retail inventory estimation method is used when the merchandise is subject to frequent mark-ups and mark-downs due to price fluctuations in the industry or market. Specifically, the conventional method only allows for mark-ups and not mark-downs.

2. Who uses the retail inventory method?

Retailers across various industries, such as clothing stores, supermarkets, and department stores, commonly use this method. Businesses with diverse inventory and frequent price changes often find this method beneficial for estimating inventory values efficiently. It is a versatile approach employed by both large and small retail establishments to streamline inventory management.

3. Does GAAP allow for the retail inventory method?

Yes, GAAP (Generally Accepted Accounting Principles) permits using this method for inventory valuation. However, ensuring that the method is applied consistently and complies with GAAP principles and guidelines is essential. Consultation with accounting professionals may be necessary to ensure proper implementation.