What is the reason for computing the cost-to-retail ratio in the retail inventory method?

Companies have used the retail method of inventory accounting for many years. According to the Committee on Ways and Means, the retail inventory method has been the best accounting method since 1941. Professor N.P. McNair wrote the first major book detailing the pros of using this method. While some have begun to question the usefulness of this method in recent years, due to advances in tracking costs and inventory, as Smyth Retail points out, it's still used with efficiency by many businesses today.

Basics of the Retail Method

The retail inventory method is one of only two methods accepted for tax reporting purposes and accepted by the American Institute of CPAs under the Generally Accepted Accounting Principles. The direct cost method comprises the other accepted method. RIM also stands as the most widely used method by merchandising companies to calculate inventory values.

According to California State University Northridge, the retail method is especially useful for quarterly financial statements. It is based on the relationship between the merchant's cost and the retail prices of inventory. Additional factors, like mark-ups and mark-downs, as well as employee discounts must be factored into the calculations. However, before you can do that, you need to understand the basics of the retail method.

The Cost/Retail Ratio

The cost/retail ratio makes up one of the main components used to calculate the retail inventory method. Two methods exist for calculating the cost/retail ratio. The first method, called the conventional retail method includes markups but excludes markdowns. This method results in a lower ending inventory value. The second method, simply called the retail method, uses both markups and markdowns to calculate the ratio. This method results in a higher-ending inventory value.

Retail Inventory Method Formula

When using the conventional retail inventory method for inventory costing, the following data inputs create the cost/retail ratio formula: beginning inventory at cost and retail, purchases at cost and retail plus the retail value of any markups:

1. Total the beginning inventory and any purchases using the cost of these items. 
2. Total the beginning inventory, any purchases and the value of any markups using the retail value of these items.
3. Divide the total value calculated of the cost items by the total value calculated of the retail items. 

The product of this calculation equals the cost/retail ratio. For example beginning inventory values are $10,000 at cost and 20,000 at retail, purchases total $40,000 at cost and $80,000 at retail and markups totaled $6,000 at retail. $10,000 + $40,000 = $50,000 total value at cost. $20,000 + $80,000 + $6,000 = $106,000 total value at retail. $50,000 / $106,000 = 0.472 for a cost/retail ratio of 47 percent.

The Retail Method In Action

Once the cost/retail ratio gets determined the small business owner uses that ratio to value his period-end inventory. Using the $50,000 total inventory value at cost and the $106,000 total inventory value at retail, the owner now subtracts all sales and any markdowns from the total inventory value at retail. This gives the owner a total ending inventory value at retail selling price.

To determine the total ending inventory value at cost, the owner multiplies the ending inventory value at retail selling price times the cost/retail ratio. For example, if sales total $75,000 and markdowns totaled $9,000 he subtracts these numbers from the $106,000 leaving $22,000 in ending inventory value at retail. He then multiplies the $22,000 times the cost/retail ratio of 47 percent and gets an ending inventory value at cost of $10,340 ($22,000 x 0.47 = $10,340.)

Because the retail inventory method uses weighted averages to calculate the ending values it does not represent an exact cost value of the inventory. Also, because it uses markdowns, this method gives the most conservative value for inventory valuation. In practice, the retail inventory method, with markups and markdowns, can become complicated to figure out, so it's best to track these using a database or, at the very least, a spreadsheet.

Conceptual Understanding Of Retail Inventory Method

In simple words, the retail inventory method is the approximation of the costs constituting the retail price of goods available for sales. It uses the historical cost percentage markup of the inventory items to assign cost-to-retail price relationships. You should keep in mind the fact that this method relies on a consistent purchase price of the item you are dealing with. For instance, if you are selling Avocado face masks, their purchase price in the previous sales period and the current sales period should remain the same for getting more accurate results.

Statistics Time!

The retail sector in the US operates on an inventory accuracy of 63%.

The beginning inventory and new purchases are summed to get the total cost of goods available for sale. The total sales made in the given period are deducted from this figure, and the resultant amount is multiplied by the cost-to-retail ratio. Since there is no physical count of the inventory, you should periodically conduct manual counting to stay. This figure is used when a proper inventory management system is not utilized. 

Here’s the retail inventory method calculator for you:

Cost-to-retail percentage

Cost of beginning inventory

Cost of goods available for sale

Cost of sales during the period

Just fill in the boxes to get the estimated ending inventory balance using Orderhive’s online retail inventory method calculator.

The Limitations Of Retail Inventory Method (RIM)

The retail inventory method is widely used and is approved by the GAAP (Generally Accepted Accounting Principles), but there are a few limitations. I am listing down the disadvantages of RIM in the below section: 

• The figures obtained through the retail inventory method cannot be used for generating financial statements.
• This method requires the cost price and selling price to remain constant between the subsequent sales period to stay valid.
• The need for physical inventory count cannot be completely removed.
• It does not take inventory shrinkage into consideration.

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