Inventory investment accounts for at least a third of retail’s total assets—and industrywide that investment is a significant figure. Retail inventories in the US were valued at roughly $612.2 billion by end-of-month October 2020 (the most recent month for which data was available), according to the US Census Bureau.
Accurately accounting for all of that precious stock is a crucial task for any sized business—but this is also one of the most daunting accounting challenges facing all retailers.
Retailers need to have a clearly defined methodology to appraise their inventory at any given time to make forecasting, purchasing, and other crucial business decisions. Standard inventory valuation methods that fall under the US Generally Accepted Accounting Principles (GAAP) include:
- “First-in, first-out,” or FIFO
- “Last-in, first-out,” or LIFO
- “Average cost” (AC)
However, the retail inventory method is by far the most popular accounting practice adopted by US businesses across the board, from major big-box chains and department stores to small-to-medium enterprises (SMEs).
Let’s drill down deeper into what, precisely, the retail inventory method entails and why it’s so popular; how to apply it; and the pros and cons associated with this approach to inventory accounting.
A Closer Look: Defining the Retail Inventory Method
The retail inventory method (or RIM) is an estimate-based averaging technique that allows businesses to value their ending inventories (whether at the end of a quarter, season, or fiscal year) without having to methodically go through the warehouse or dive deep into the books.
Instead, the retail inventory method effectively subtracts total sales from total inventory retail value. It then multiplies the result by an average cost-to-retail percentage (or the cost complement percentage) to generate the ending-inventory value.
The Development and Adoption of the Retail Inventory Method
Harvard Business School professor Malcolm McNair (1894–1985)—a pioneer in the academic study of retail, marketing, and forecasting practices—is commonly credited with inventing the retail inventory method in the early 1900s.
He was trying to find a unique solution to the challenges faced by women’s clothing stores and the fashion divisions of department stores, which face markedly distinct inventory valuation problems due to sudden price drops and rapid inventory obsolescence.
McNair designed the retail inventory method as a less labor- and cost-intensive alternative to physical inventory counts and complicated bookkeeping. Instead, his approach relies on numbers that are easily accessible to the average merchant (i.e., retail prices and total sales figures).
Retailers using RIM could thus quickly approximate the value of their inventory without having to, for example, devote time to researching the current wholesale market prices for the equivalent stock.
The retail inventory method became the topic of rigorous study and refinement in the 1920s and 1930s, and by 1970, just about every major specialty, chain, and department store had implemented the practice.
Today, the retail inventory method has become simpler and more efficient than ever before, thanks to tech-driven inventory management systems like SkuVault.
Retailers can now have instant access to accurate, real-time purchase orders, sales, and inventory-on-hand reports.
Plugging in the numbers
To better understand how the retail inventory method works, let’s break it down into a simple series of steps.
- Step 1: Start with the cost and retail prices of beginning inventories. Let’s say our beginning cost price is $500 and our beginning retail price is $700.
- Step 2: Add the value of purchases at both cost and retail to the above beginning inventory values. Let’s say our cost purchases are $200 and our retail purchases are $300. Adding them to the above values, we can figure out the value of stock available for sale—in this example, $700 at cost and $1,000 at retail.
- Step 3: Derive the cost complement percentage from the available-for-sale balances. This cost complement ratio signifies the relationship between the cost to the selling price. In this case, our cost is $700, and our selling price is $1,00—so our cost complement percentage is 70%.
- Step 4: Subtract sales from available stock at retail. Let’s say our sales are at $400. Subtract that from our retail figure, $1,000, and you arrive at your ending inventory retail value—in this case, $600.
- Step 5: Apply your cost complement percentage to the ending inventory retail value to generate its associated cost-basis. So in this example, that means taking 70% of $600, which is $420. This is your ending inventory cost value.
- Step 6: Subtract that $420 from the inventory available for sale at cost ($700). This generates your cost of sales: in this case, $280.
Seven Factors to Account for When Using the Retail Inventory Method
This is where things get a little more complicated. Any merchant knows that, due to a variety of influences, retail prices fluctuate over time. To keep those fluctuations from skewing your retail inventory method calculations, it’s key to keep track of these seven factors:
- Factor 1: Initial mark-on: The initial mark-on is the original retail value of a stock over its cost. Let’s say one SKU has a recorded cost of $350 and was originally marked at a retail price of $600—here, the initial mark-on would equal $250.
- Factor 2: Markup: This is any additional mark-on that further raises the retail price. For instance, if you decide to increase the retail price from $600 to $640, the markup equals $40, and the initial mark-on has now increased to $290.
- Factor 3: Markup cancellation: Whether implemented to correct an error in a markup, to correct a temporary markup, or to reflect a reorientation in the retailer’s business plan, a markup cancellation represents, as its name suggests, the subtraction of a previous markup from the retail price. This price should never be lowered to below the amount of the initial mark-on.
- Factor 4: Markdown: This decreases the retail price, such as for a Black Friday sale. Markdowns may be permanent or temporary, depending on the retailer’s needs. It’s crucial to keep track of those temporal distinctions since a permanent markdown will have a different impact on retail inventory method calculations than a temporary one. It’s imperative to be timely in the recording of all markdowns to make sure they’re adequately reflected in the accounting.
- Factor 5: Markdown cancellation: Again, as the name would imply, this is the revocation of a previous markdown, thus increasing the retail price. The markdown cancellation cannot exceed the markdown that is being revoked.
- Factor 6: Product grouping. How a retailer categorizes its stock (such as by SKU type, material, season, etc.) will also potentially impact retail inventory method calculations.
- Factor 7: Shrinkage. Finally, it’s crucial to account for inventory shrinkage through theft, obsolescence, damage, etc., to obtain a more-accurate end-inventory value.
Three Important Considerations When Applying the Retail Inventory Method
The retail inventory method is considered acceptable under the tenets of the US GAAP because the technique’s calculations take into account markdowns and inventory depreciation and thus generate appropriately conservative price estimates.
However, the Financial Accounting Standards Board (FASB)—the non-profit tasked by the government with setting accounting standards for US companies—cautions that certain best practices must be considered when adopting the retail inventory method.
Here’s the top 3:
- Businesses must use retail prices that correspond to the realizable market price
- There must not be significant deviations from a given product’s average markup
- Retailers must take care to account for markdowns when calculating the cost complement percentage
Feel overwhelmed by all these calculations, factors, and considerations? Inventory management software (like the system offered by SkuVault) keeps the values you need to plug into retail inventory method calculations at your fingertips. Its real-time, highly granular reporting features ensure you don’t go astray when trying to track markups and markdowns over time.
Plugging in the numbers again
In its guidelines for practitioners of the retail inventory method, the FASB offers the below example of what the kind of careful accounting described above (which is a little more complicated than the first example we considered) might look like:
|Beginning retail inventory method at January 1||$9.8||$13.5||$10.2||$15.1|
|Goods available for sale||32.0||44.2||31.6||43.7|
|Ending retail inventory method inventory at December 31||$8.1||$11.2||$9.8||$13.5|
What Advantages Does the Retail Inventory Method Offer Today’s Retailers?
Retailers who adopt the retail inventory method don’t need to worry about keeping detailed inventory accounts on a cost basis and can save time and money since they don’t have to depend on frequent physical stock counts.
McNair designed the RIM with three main goals in mind, each of which represents a significant benefit to any enterprise:
- Pragmatism: The retail inventory method was designed as a practical, real-life solution that can be applied by any retailer, without any special accounting or sophisticated inventory management expertise required.
- Simplicity: The retail inventory method allows retailers to appraise their stock at any given time without having to go through the trouble of conducting a physical count or diving too deeply into the books. (And as noted above, the “simplicity” quotient has now been taken into hyperdrive thanks to inventory management technologies like SkuVault’s)
- Reduction in labor: Thanks to the two points mentioned above, retailers save significantly on clerical costs.
Challenges Inherent to the Retail Inventory Method
Even if the vast majority of US retailers rely on the RIM, the technique isn’t without its drawbacks, which should also be carefully considered:
- Inaccuracy: Because the retail inventory method relies on averages, it also, by consequence, relies on some amount of assumption and estimation. Retailers who aren’t extremely rigorous about their accounting and inventory management practices may end up with skewed, distorted inventory costs.
- Too simple for some cases: There are some situations that the retail inventory method simply isn’t equipped to handle. For instance, in a scenario where there’s a combination of high-markup and low-markup SKUs whose retail prices in the ending inventory significantly departs from the price in the beginning inventory, the retail inventory method can result in inventory valuations that range from 3–7% more than “cost.”
- What about vendor costs? You’ll have already noted from the above examples that the retail inventory method does not support vendor cost analysis, which can lead to further inaccuracies in valuation.
- Tech might be taking its place: Market and retail researchers are finding that advanced technological systems increasingly available to retailers today, such as point-of-sale software and advanced inventory management systems, may be rendering the retail inventory method obsolete.
Tech Assistance for Applying the Retail Inventory Method
As per that last point, though technological solutions (like SkuVault’s Inventory Management System) haven’t yet replaced the retail inventory method for the vast majority of stores in the US, solutions like SkuVault’s do ensure a higher degree of accuracy and efficiency for any enterprise depending on those RIM calculations.
Implementing a robust inventory management system, regardless of your inventory management process, will inevitably lead to lower inventory management costs, more visibility, and more overall profitability.
To learn more about how SkuVault can help your ecommerce business maximize profitably, schedule a demo with our team today.