What is the Retail Inventory Method
The retail inventory method accounting procedure is useful for estimating the value of a store's merchandise. This method calculates a store's total inventory value by taking the total retail value of the items that were originally in inventory, subtracting the total sales, then multiplying that dollar amount by the cost-to-retail ratio (the percentage by which goods are marked up from their wholesale purchase price to their retail sales price).
This method really only provides an approximation of inventory value, however, as some items in a retail store will most likely have been shoplifted, broken or misplaced. Physical inventory valuation must also be performed periodically to ensure the accuracy of inventory estimates.
BREAKING DOWN Retail Inventory Method
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.
Example of the Retail Inventory Method
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.
As a crude but elementary inventory valuation method, under certain scenarios, this technique can prove complimentary to occasional detailed inventory counts.
Drawbacks of the Retail Inventory Method
The retail inventory method's primary advantage is ease of calculation, but 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.