The retail inventory method is a method of estimating the value of closing inventory in the absence of a physical inventory count at the end of an accounting period.
As the name implies, the retail inventory method is used primarily by retailers who often maintain their memorandum inventory records at retail values.
Retail Inventory Method Process
The method involves the follows steps.
- Calculate the cost to retail ratio
- Calculate the ending inventory at retail
- Calculate the ending inventory at cost
- Calculate the cost of sales
Calculate the Cost to Retail Ratio
In general, the cost to retail ratio is calculated by the following formula:
For example consider a retail business with the following information from its accounting system:
| Item | Cost | Retail |
| Opening inventory | 20,500 | 30,000 |
| Purchases during the year | 62,000 | 80,000 |
| Goods available for sale | 82,500 | 110,000 |
Based on this information using the retail inventory method, we can calculate the cost to retail ratio as follows:
Cost to retail ratio = (Opening inventory at cost + purchases at cost) / (Opening inventory at retail + Purchases at retail) Cost to retail ratio = (20,500 + 62,000) / (30,000 + 80,000) Cost to retail ratio = (82,500) / (110,000) Cost to retail ratio = 75%
Calculate the Ending Inventory at Retail
Suppose for example a business uses the retail inventory method to value closing inventory, and the sales during the accounting period were 70,000, then the ending inventory at retail is calculated as follows:
Closing inventory = Opening inventory + Purchases - Cost of sales Using retail values Closing inventory = 30,000 + 80,000 - 70,000 Closing inventory = 40,000
As all the numbers used here are retail values, the closing inventory of 40,000 is also at retail value.
Calculate the Ending Inventory at Cost
Under the retail inventory method, the cost to retail ratio is now be used to calculate the closing inventory at cost.
Closing inventory at cost = Cost to retail ratio x Closing inventory at retail Closing inventory at cost = 75% x 40,000 Closing inventory at cost = 30,000
We now have the closing inventory at cost and can use the standard formula to calculate the cost of sales.
Calculate the Cost of Sales
The cost of sales can now be calculated as follows:
Cost of sales = Opening inventory + Purchases - Closing inventory Cost of sales = 20,500 + 62,000 - 30,000 Cost of sales = 52,500
In this simple retail inventory method example, the cost of sales can also be calculated by applying the cost to retail ratio to the sales giving 90,000 x 75% = 52,500.
The retail inventory method process is summarized in the following table.
| Item | Retail | Ratio | Cost |
|---|---|---|---|
| Opening inventory | 30,000 | 20,500 | |
| Purchases | 80,000 | 62,000 | |
| Sales | -70,000 | -52,500 | |
| Closing inventory | 40,000 | 75% | 30,000 |
The retail inventory method is a convenient and quick method for retailers to use as they often maintain their accounting memorandum records at retail price.
Despite its apparent accuracy, it must be remembered that the method only provides an estimated value for inventory as it assumes that closing inventory has the same cost to retail ratio as the opening inventory and purchases. Any significant shift in the type of ending inventory and its cost to retail ratio will cause inaccuracies in the calculation. Regular physical inventory counts should always be carried out so that correcting adjustments can be made.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.