The Retail Inventory Method
Retail Inventory Method Overview
The retail inventory method is sometimes used by retailers that resell merchandise to estimate their ending inventory balances. This method is based on the relationship between the cost of merchandise and its retail price. The method is not entirely accurate, and so should be periodically supplemented by a physical inventory count. Its results are not adequate for the year-end financial statements, for which a high level of inventory record accuracy is needed.
Retail Inventory Method Calculation
To calculate the cost of ending inventory using the retail inventory method, follow these steps:
- Calculate the cost-to-retail percentage, for which the formula is (Cost ÷ Retail price).
- Calculate the cost of goods available for sale, for which the formula is (Cost of beginning inventory + Cost of purchases).
- Calculate the cost of sales during the period, for which the formula is (Sales × cost-to-retail percentage).
- Calculate ending inventory, for which the formula is (Cost of goods available for sale - Cost of sales during the period).
For example, Milagro Corporation sells home coffee roasters for an average of $200, and which cost it $140. This is a cost-to-retail percentage of 70%. Milagro’s beginning inventory has a cost of $1,000,000, it paid $1,800,000 for purchases during the month, and it had sales of $2,400,000. The calculation of its ending inventory is:
|Beginning inventory||$1,000,000||(At cost)|
|Purchases||+ 1,800,000||(At cost)|
|Goods available for sale||= 2,800,000|
|Sales||- 1,680,000||(Sales of $2,400,000 x 70%)|
Retail Method Advantages and Disadvantages
The retail inventory method is a quick and easy way to determine an approximate ending inventory balance. However, there are also several issues associated with it:
- The retail inventory method is only an estimate. Do not rely upon it too heavily to yield results that will compare with those of a physical inventory count.
- The retail inventory method only works if you have a consistent mark-up across all products sold. If not, the actual ending inventory cost may vary wildly from what you derived using this method.
- The method assumes that the historical basis for the mark-up percentage continues into the current period. If the mark-up was different (as may be caused by an after-holidays sale), then the results of the calculation will be incorrect.
- The method does not work if an acquisition has been made, and the acquiree holds large amounts of inventory at a significantly different mark-up percentage from the rate used by the acquirer. In this case, however, it may be possible to separately apply the retail method to the acquiree and the acquirer.
The retail inventory method is also known as the retail method and the retail inventory estimation method.