Which of the following is not required when using the retail inventory method?

The retail inventory method is an accounting procedure that estimates the value of a retail store’s merchandise. This method produces the ending inventory balance for a store by calculating the cost of inventory relative to the price of the goods. In short, it’s one of the most common ways to calculate the value of your stock.

What Is the Retail Inventory Method?

You can use the retail inventory method to quickly estimate the value of your ending inventory over a given time period. 

Since inventory is the bread and butter of your retail store, you likely have a lot of capital tied to your stock. Therefore, it makes sense to keep track of your inventory so you can make effective decisions when it comes to what to order, what to invest in, and when to carry more products.

Although there are many ways to estimate the value of your stock, the retail inventory method is one of the most common and efficient techniques. This method works by taking the total retail value of all the products in your inventory, subtracting the total amount of sales, and then multiplying that amount by the cost-to-retail ratio. 

We understand how challenging it is to run a retail store. You have to manage employees, build staff schedules, implement marketing strategies, and keep an accurate count of your store’s inventory to ensure you don’t run out of any products. Furthermore, you must ensure you aren’t losing money on sales by correctly calculating your cost-to-retail ratio.

The best way to guarantee you don’t run out of inventory or lose any money is by mastering the retail inventory method.

Retail Inventory Method Advantages

The main advantage of the retail inventory method is that it saves retailers the time and expense of shutting down temporarily to conduct a physical inventory. Physical inventories are time-consuming and can impact your business’s bottom line.

During physical inventories, you must pay your staff to help while also shutting down your business from outside customers. Although some retailers perform physical inventories at night time, your staff are prone to errors during a spontaneous graveyard shift.

Furthermore, the retail inventory method is part of the Generally Accepted Accounting Principles (GAAP) provided by the American Institute of CPAs. It’s also useful for determining the value of your retail business since this method creates a report on the value of the inventory on hand.

Retail Inventory Method Disadvantages

Although the retail inventory method has a lot of benefits, there are some drawbacks to be aware of. First of all, it’s important to understand that it’s just an estimate and doesn’t account for items that are stolen, broken, or otherwise taken out of inventory for reasons other than a sale.

Furthermore, the retail inventory method works best when the markup is consistent across all your products. If different products carry different markups, the end result won’t be completely accurate.

For example, if your retail clothing shop marks up every item it sells by 70% of the price you get from wholesale distributors, you can accurately use the retail inventory method. However, if you mark up some items by 15%, some by 30%, and some by 60%, it is difficult to apply this accounting method accurately.

Another disadvantage is that large additions of inventory would throw off calculations. For example, this can occur in the event of acquiring another company. 

Who Should Use the Retail Inventory Method

The retail inventory method isn’t suitable for everyone. All retailers are different, and the retail inventory method is an optimal accounting strategy for specific types of retailers.

Those who will find the most value in the retail inventory method tend to be:

• Retailers with multiple locations since physical inventories are difficult to coordinate for the same time in different locations
• Retailers who don’t usually have large amounts of inventory in transit since it doesn’t account for those
• Retailers who are comfortable with estimates that are regularly available on an on-demand basis
• Retailers who have consistent markups across all their products

How to Calculate the Retail Inventory Method

To calculate your ending inventory value with the retail inventory method, use the following steps:

Step 1: Calculate the Cost-to-Retail Ratio

The first step is determining the cost-to-retail percentage of your retail inventory. The cost-to-retail ratio determines how much your inventory costs in relation to the retail price.

For example, if a sweatshirt costs $15 to manufacture and you sell it for $100, the cost-to-retail ratio is 15%.

Therefore, you can calculate your cost-to-retail ratio with this formula:

• cost-to-retail ratio = (cost of merchandise / retail price of the merchandise) x 100

Step 2: Calculate the Cost of Merchandise Available for Sale

The next step is to determine the exact time period you will be reporting. Then, you must identify the cost of inventory at the beginning of the time period and the cost of any additional inventory purchases made during the course of that time period.

For example, if your shop had a beginning inventory of $30,000 and then you purchased $10,000 of new inventory during that period, your cost of merchandise available for sale is $40,000.

The formula for this calculation is

• Cost of merchandise available for sale = cost of beginning inventory + cost of additional inventory

Step 3: Calculate the Cost of Sales During the Time Period

Next, you need the total merchandise sales and cost-to-retail percentage for your chosen time period. You will use these numbers to calculate the cost of sales, which represents the total cost of goods for all the merchandise you sold during the reporting period.

For example, let’s say your cost-to-retail ratio is 15%, and you had sales of $50,000 over your chosen time period. You can multiply your cost-to-retail ratio by your total sales to find your cost of sales was $7,500.

• Cost of sales = sales during the chosen time period x cost-to-retail percentage

Step 4: Calculate Ending Inventory

Now, you can use the cost of merchandise available for sale and the cost of sales during that period to determine your ending inventory.

Your ending inventory represents the value of merchandise you have available at the end of your reporting period. Once you calculate your ending inventory, you can use it on future balance sheets. However, you must ensure its accuracy if you report your store’s financial information when seeking financing.

• Ending inventory = cost of merchandise available for sale – cost of sales during the chosen time period

Example of the Retail Inventory Method

Let’s pretend your retail business sells home coffee roasters for an average price of $300 and a cost of goods of $150. As such, your cost-to-retail ratio is 50%. 

In this example, let’s also say your beginning inventory costs $500,000, and you paid $200,000 for purchases during the month. During the same time period, you had sales of $1,000,000.

To calculate your ending inventory value:

Additional Retail Inventory Method Tips

If you plan to use the retail inventory method for your business, keep the following tips in mind.

1. Always Have Accurate Data Available

The retail inventory method requires you to use certain numbers, including your cost-to-retail ratio, beginning inventory, and sales. To ensure the calculation is efficient and effective, you need to keep accurate numbers available.

Therefore, you should equip your business with a POS (point of sale) and retail management system with strong reporting and analytics capabilities. 

2. Don’t Ditch Physical Inventory Counts

Since the retail inventory method only gives an estimate of your ending inventory value, it’s not the perfect substitute for physically counting and reconciling inventory.

For this reason, we still recommend scheduling physical inventory counts. However, it doesn’t need to be as frequent after integrating the retail inventory method.

Frequently Asked Questions (FAQs) for Retail Inventory Method

Here are a few common questions retailers have about the retail inventory method.

Who uses the retail inventory method?

The businesses that use the retail inventory method include multi-location retailers, retailers with warehouses, retailers that use markups consistently, retailers that don’t run a lot of sales, and wholesalers with large volumes of similar inventory.

Is the retail inventory method FIFO?

The retail inventory method can be used with LIFO (last in, first out), FIFO (first in, first out), or the weighted average cost flow assumption method.

Is the retail method permitted under IFRS?

The International Financial Reporting Standards require you to use the same costing formula for all inventories of a similar nature. As such, you may not be able to use the retail inventory method if you use multiple costing formulas.

Bottom Line on Retail Inventory Method

Keep in mind that the retail inventory method is more of an educated guess than a concrete calculation of how much value your ending inventory holds. This method provides directionally accurate answers to give you quick snapshots at any given time. It’s cost-effective, quick, and works best when it’s part of your overall inventory management strategy.

Larry Li

About the Author:

Larry is a finance graduate and entrepreneur who loves educating others on various business software through his own experiences. Larry loves to write about all topics, from fashion editorials to tax advice. On his days off, you can find him at a basketball court or gym working up a sweat.

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