When might it be useful for a company to use the gross profit method or retail method of estimating inventory?

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 the ending inventory balance for a store by measuring the cost of inventory relative to the price of the merchandise. Along with sales and inventory for a period, the retail inventory method uses the cost-to-retail ratio.

Key Takeaways

• The retail inventory method is an accounting method used to estimate the value of a store's merchandise.
• The retail method provides the ending inventory balance for a store by measuring the cost of inventory relative to the price of the goods.
• Along with sales and inventory for a period, the retail inventory method uses the cost-to-retail ratio.
• The retail method of valuing inventory only provides an approximation of inventory value since 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 period physical inventory counts.

Understanding the Retail Inventory Method

Having a handle on your inventory is an important step in managing a successful business. It allows you to understand your sales, when to order more inventory, how to manage the cost of your inventory, as well as how much of your inventory is making it into the hands of consumers, as opposed to being stolen or broken.

The retail inventory method should only be used when there is a clear relationship between the price at which 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 could accurately use the retail inventory method, but if it marks up some items by 20%, some by 35%, and some by 67%, it can be difficult to apply this method with accuracy.

The retail method of valuing inventory only provides an approximation of inventory value since some items in a retail store will most likely have been shoplifted, broken, or misplaced. It's important for retail stores to perform a physical inventory valuation periodically to ensure the accuracy of inventory estimates as a way to support the retail method of valuing inventory.

Calculating Ending Retail Inventory

The retail inventory method calculates the ending inventory value by totaling the value of goods that are available for sale, which includes beginning inventory and any new purchases of inventory. 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 goods are marked up from their wholesale purchase price to their retail sales price).

The cost-to-retail ratio, also called the cost-to-retail percentage, provides how much a good's retail price is made up of costs. If, for example, an iPhone costs $300 to manufacture and it sells for $500 each, the cost-to-retail ratio is 60% (or $300/$500) * 100 to move the decimal.

Disadvantages of the Retail Inventory Method

The retail inventory method's primary advantage is the ease of calculation, but some of the drawbacks include:

• The retail inventory method is only an estimate. Results can never compete with a physical inventory count.
• The retail inventory method only works if you have a consistent markup across all products sold.
• The method assumes that the historical basis for the markup percentage continues into the current period. If the markup was different (as may be caused by an after-holiday sale), then the results of the calculation will be inaccurate.
• The method does not work if an acquisition has been made, and the acquiree holds large amounts of inventory at a significantly different markup percentage from the rate used by the acquirer.

Example of the Retail Inventory Method

Using our earlier example, the iPhone costs $300 to manufacture and it sells for $500. The cost-to-retail ratio is 60% ($300/$500 * 100). Let's say that the iPhone had total sales of $1,800,000 for the period.

• Beginning inventory: $1,000,000
• New Purchases: $500,000
• Total goods available for sale: $1,500,000 
• Sales: $1,080,000 (Sales of $1,800,000 x 60% cost-to-retail ratio)               
• Ending inventory: $420,000 ($1,500,000 - $1,080,000)

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.

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