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)