How to Use the Retail Inventory Method
If you own a small retail business, you know the value of quality inventory management. Knowing how much inventory your company has at the beginning and end of an accounting period can help you evaluate its performance and renew merchandise.
For retailers with a lot of inventory, hand-counting items can be a painstaking, expensive process that requires hours of work. That's where the retail inventory method (RIM) comes in. The RIM lets you make an approximation of the worth of your inventory without having to physically count it.
In this guide, we'll go over what the retail inventory method is, how to use it, and why it can be beneficial to your business. When you know how to use the RIM, it'll be much easier to understand your cost of inventory and the retail value of goods that your business has.
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What Is the Retail Inventory Method?
The retail inventory valuation method is an accounting equation that helps you estimate the worth of the products in your store. It calculates your cost of inventory in relation to the retail or selling price (cost-to-retail percentage) and uses it to find your inventory's worth at the end of a sales period, like a month.
It's important to note that while the retail inventory accounting method is recognized by the Generally Approved Accounting Principles (GAAP), it doesn't completely remove the need for physical inventory checks. Its main purpose is to help business owners gauge their company's performance and needs from month to month.
The RIM only gives you an approximation of your inventory and doesn't take into account things like broken or stolen merchandise. Eventually, you'll need to do a physical count of your inventory for your end-of-year financial statements to be accurate.
The gross profit method is another technique for estimating ending inventory that takes into account lost items. It involves taking a business's past gross profit percentages and using them to find the value of its current inventory. It's also a useful way for companies to estimate how much merchandise has been stolen or destroyed in natural disasters (like fires).
Advantages of the Retail Inventory Method
The RIM can be a useful tool for big warehouses and wholesalers that hang on to a lot of inventory of the same type of products. It's important that these businesses don't alter their prices often. For the method to work, all items that the store sells have to have consistent markups.
Physically counting inventory can be time-consuming. Sometimes, larger stores must shut down for their employees to count their inventory. The RIM is much quicker and cheaper. The business can stay open, and it doesn't have to pay employees to count stock.
If you still have to do by-hand counts periodically, what's the point of using the RIM? As a business, you want to limit the amount of physical inventory counts your company performs. You can use the RIM each month to keep track of your business inventory without wasting resources.
Using the Retail Inventory Method to Calculate Ending Inventory
Here's how you can use the RIM to find your ending inventory balance for a given sales period. To use this, you'll need to have a few numbers ready: your cost of goods sold (COGS), the retail value of your goods, your beginning inventory, and your sales for the accounting period.
Divide your COGS by the retail price of goods to find your cost-to-retail ratio.
Cost-to-Retail Ratio = COGS Retail Price of Goods
Multiply your sales for the current period by your cost-to-retail ratio to find your cost of sales.
Cost of Sales = Sales for Set Period × Cost-to-Retail Ratio
Add your beginning inventory and your cost of purchases to find your cost of goods available for sale.
Cost of Goods Available for Sale = Beginning Inventory + Cost of Purchases
Subtract your cost of sales from your cost of goods available for sale to find your ending inventory value.
Cost of Goods Available for Sale = Cost of Goods Available for Sale − Cost of Sales
Retail Inventory Method Example
Here's an example that can show how the process works. This is a simplified example. In reality, a company using the RIM would likely have a much larger inventory of products.
Let's say your business is a wholesaler of coffee mugs and coffee roasters. You sell both items for $20 and they cost you $5 each to buy. This gives you a cost-to-retail ratio of 25%.
You start with $500 in beginning inventory costs. Over the month, your company sells $300 in coffee mugs and you've brought $200 in additional inventory (coffee mugs). Your cost of sales will be $75 (25% x $300).
|$500 (Beginning Inventory Cost)|
|+ $200 (Cost of Purchases)|
|$700 (Cost of Goods Available for Sale)|
|− $75 (Cost of Sales)|
|$625 (Ending Inventory)|
Markups and the Retail Inventory Method
A markup is the percentage of profit you make on an item you sell after taking into account its COGS. To figure out an item's markup percentage, subtract the unit cost (COGS) from its retail price. Divide that by the unit cost. For example, if your company pays $100 to manufacture skateboards and charges $150 for them, the markup would be 50%.
The RIM only works if you have a consistent markup for your items. There are times when you may offer discounts and lower your markup. You won't be able to use the RIM in those situations.
Different markups from month to month will completely throw off your math and give you inaccurate inventory numbers. Here are a few situations where you might change the markup for your item and be unable to use the RIM:
- After-holiday sales events
- When merging with another business as the acquirer of their inventory (with a different markup than your own stock)
- Markdowns for seasonal items (e.g., coats in the summer)
Easy Transaction Tracking With Skynova Accounting Software
You can use the retail inventory method as a shortcut for finding the worth of your business's merchandise. However, it can only give you an estimate of your inventory's worth because it doesn't account for things like lost or stolen items. It also doesn't work if your company frequently changes item markups.
No matter what, though, you'll have to do physical inventory counts periodically for accurate accounting records. Still, the RIM can help you keep track of your stock in between big accounting deadlines, like year-end fiscal reports. It can also protect your company's profit margin and save you time.
Starting your own business is hard enough without worrying about doing your own accounting. Skynova has accounting software that can make things like budgeting much easier and quicker. We'll help you track your sales and create professional-looking financial reports.
Notice to the Reader
This article isn't meant to be professional advice. Rather, it's only a guide introducing the concept of the retail inventory method. It may not be valuable for your specific business situation. You should always seek the expertise of a certified public accountant (CPA) or another accounting professional if you have questions about your business's compliance.