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Retail inventory method: Useful explanation and its examples

Retail inventory method: Useful explanation and its examples

For retailers, understanding the inventory balance is very crucial. It can help them manage and come up with more effective business plans. As a result, retail inventory method can greatly benefit retailers. But before implementing it to your store, we need to understand it.

What is retail inventory method?

It is an accounting method to calculate the ending inventory balance of retailers by comparing the cost of inventory to the price of merchandise. 

Retail inventory method
What is retail inventory method?

Retail inventory method utilize many statistic to estimate the ending inventory balance. Here is how you use retail inventory method

  • Cost – to – retail ratio ( Cost / Retail price)

For example, to produce a phone, you need to spend $300. Then, you sell it at $500. Then, cost – to – retail ratio will be 60% ( 300/500 *100%)

  • Cost of goods available for sales ( Cost of beginning inventory + cost of good purchases)
  • Cost of sales during the period ( Sales * cost-to-retail ratio)
  • Ending inventory ( Cost of goods available for sales – cost of sales during the period)

One thing to keep in mind is this method only give you the approximate value of inventory. Some goods might be missing, lost or damaged during the period. Therefore, retailers should check ending inventory balance periodically. This can help avoid flaws in the inventory estimation.

Benefits of retail inventory method

Let’s come to some of this method’s benefit

No requirements for physical inventory

You only need retail price of products to use this method. As a result, retailers don’t have to close the store to get an accurate count. 

Also, for retailers having multiple stores, it’ll be costly and time-consuming to perform physical inventory.

physical inventory
There’s no need for physical inventory

Prepare financial statements

Retail inventory method let you create inventory value report for budget. Also, the statistic will be helpful for preparing financial statements as well

Disadvantages of retail inventory method

  • This is only the estimation as there might be loss, broken or damaged goods. As a result, the final result might not as accurate as that of physical inventory
  • The markup should be consistent across all products. If not, the final result won’t be correct
  • The calculation might be incorrect if the markup different between periods, for example after the holiday sales
  • You can’t use retail inventory method if an acquisition has been made. The main reason is large additions of inventory. 

When to use retail inventory method

To avoid incorrect entry, you should consider carefully before implementing this method. So when should you use this.

  • When the relationship between cost of goods sold and cost of good purchased is clear. In simple terms, when there’s a change in the markups, you shouldn’t use this method
  • Retailer has multiple stores will find this method more cost-effective than physical inventory. 
  • When you don’t have too much goods in transit
  • If you only need approximate number, then this method might be helpful

Retail inventory method example

To understand this method better, let’s consider this example

You spend $300 to manufacture a computer, and sell it at $500. Therefore, the cost-to-retail ratio will be 60% ( $300/$500  * 100).

Now, assume this computer has

  • Total sales of $1,800,000
  • Beginning inventory: $1,000,000
  • New purchase $ 500,000
  • Then, we have total goods available for sale = $1,500,000 ( $1,000,000 + $ 500,000)
  • Sales = $1,080,000 ( total sales $1,800,000 * 60% cost-to-retail ratio)
  • Finally, we calculate ending inventory: $420,000 ( $1,500,000 – $ 1,080,000)

In conclusion

We hope to deliver the basic understanding of retail inventory method. Just like anything, this methods has both benefits and drawbacks. Therefore, you should consider carefully before adopting it to your business.

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