Retail Inventory Method | 2 mins read

Retail Inventory Method- 4 Steps Explained

retail inventory method 4 steps explained
Chloe Henderson

By Chloe Henderson

The retail inventory method is a retail management element that measures the cost of stock against its selling price to calculate the total value of goods available for purchase.

While it does not account for any items that may be shoplifted or damaged, it provides an estimate for the ending inventory balance. Therefore, businesses are responsible for cross-examining their calculations with a physical inventory count for the end-of-the-year financial statements.

Not every retail business utilizes the retail inventory method, however, organizations that benefit from the formula include-

  • Companies with multiple locations
  • Organizations with large amounts of stock on hand
  • Retailers that can rely on regular estimates rather than exact values
Therefore, businesses handling inventory should understand how to calculate the stock value to gain insights on available items to promote data-based decisions.

Steps for Retail Inventory Method Calculation

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To calculate the ending inventory, or the value of items still available for purchase after an accounting period, businesses need to understand how much they spend on inventory and their retail value. Once this information is retrieved, management can determine the value of the remaining stock by following four steps-

1. Calculate the cost-to-retail percentage-
(Cost / Retail Price) x 100

2. Calculate the cost of goods-
Cost of Beginning Inventory + Cost of New Inventory Purchases

3. Calculate the cost of sales during the time frame-
Sales x Cost-to-Retail Percentage

4. Calculate ending inventory-
Cost of Goods for sale - Cost of Sales During Time Frame

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For example, a company sells televisions for $300 that cost $175 to make, making the cost-to-retail percentage 58% (after being rounded)-

Step 1- (175 / 300) x 100 = 58%

At the beginning of the accounting cycle, the inventory was valued at $1,600,000, but the company spent an extra $2,000,000 on more stock, making the total cost of goods $3,600,000-

Step 2- $1,600,000 + $2,000,000 = $3,600,000

During the same pay cycle, they generated $2,800,000 in sales, making the cost of sales $1,680,000-

Step 3- $2,800,000 x 58% = $1,624,000

Thus, making the value of the remaining inventory $1,976,000-

Step 4- $3,600,000 - $1,624,000 = $1,976,000


After all sales and purchases within the accounting cycle have been noted, the company still has $1,976,000 worth of televisions on hand. This allows inventory management teams to determine if they need to place reorders for the next sales period.

Pros vs. Cons of the Retail Method

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There are several advantages and disadvantages that businesses should consider when using the retail inventory method. Understanding where the strategy lacks can help retailers avoid stock discrepancies, such as miscounts and unnecessary reorders.

Pros

  • Cost-Effective - The retail inventory method is generally cost-effective and simple to utilize. As it can quickly produce a clear picture regarding the amount of stock left to sell, corporations such as Walmart, Target, and Sears have claimed to rely on this method, as stated in their annual 10K reports.
  • Inventory Control - This formula can be used on individual product lines and similar items to produce inventory control records for future reference.
  • Real-Time Generation - Businesses with inventory management software can program the calculation to generate new metrics when new data is entered. This gives retailers access to updated stock values.
  • Easy to Calculate - With four simple steps, the inventory method formula is easy to calculate manually if retailers do not have access to software tools.

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Cons

  • Only an Estimate - Since this formula only estimates stock value, it should not be used solely to make changes in the supply chain. Therefore, managers are responsible for performing additional measures, such as cycle counts, to ensure accurate information.
  • Needs Consistent Metrics - The formula only works if the retailer maintains a consistent markup across the items measured. If the price is changed, the formula needs to be refigured.
  • Relies on Historical Data - The inventory method assumes that the cost-to-retail ratio remains constant from the previous accounting cycles. Therefore, the formula cannot be used for sales or seasonal periods where the rate changes.
  • Negates Acquisition - The calculation becomes invalid when there is an acquisition, or new stakeholders hold amounts of inventory at different markup percentages. In the case of an acquisition, the formula would need to be applied separately to the stock under the acquiree and acquirer.

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Inventory Valuation and Accounting Best Practices

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While the retail inventory method is a great tool to get a sense of how much inventory is on hand and the cash it can generate, there are additional strategies to gather reliable data. The best inventory control and accounting practices include-

  • Using Inventory Management Software - An inventory control system automatically accounts for the stock within the warehouse, and even throughout different locations through integration. Through sophisticated programming, the software can generate the accurate cost of goods, profits, and markup ratios with real-time metrics. This ensures that the reports and insights produced are based on exact values.
  • Hiring an Inventory Management Team - Proper inventory management requires attention to detail, multitasking, the ability to track high volumes of stock, and excellent communication skills. Therefore, companies should designate a stock team that manages the warehouse to focus on inventory operations.
  • Performing Routine Cycle Counts - Only counting stock by hand is time-consuming and is susceptible to human error. However, performing cycle counts every quarter provides the company with reliable data to pinpoint any discrepancies.
  • Carefully Choosing an Inventory Control Method - Once a business chooses their inventory method, they need to submit a request to the IRS to change it. Therefore, management should carefully research the entailments of each tactic before making the final decision.

Using the retail inventory method allows businesses that handle merchandise to gain insight regarding their turnover and available stock at the end of an accounting cycle. This allows management to see how much capital is held in on-hand inventory to decide on reorder volumes.

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