Retail inventory method
| Retail inventory method |
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The retail inventory method is a management accounting technique used to estimate the cost of ending inventory and the cost of goods sold of a retail business. It uses the average inventory cost of a business's merchandise across a period of time to estimate the ending inventory cost. This method is based on the assumption that the merchandise sold in the period is a representative sample of the average cost of the merchandise held in inventory. It also assumes that the inventory turnover rate remains constant throughout the period. The technique involves tracking the sales of the period, inventory purchases, and the beginning inventory to calculate the estimated ending inventory and cost of goods sold.
Example of retail inventory method
- The Retail Inventory Method (RIM) can be used to estimate the cost of ending inventory and the cost of goods sold for a retail business. For example, a store might use the RIM to estimate the cost of its inventory at the end of the year. The store would track its sales, inventory purchases, and beginning inventory to calculate the estimated ending inventory and cost of goods sold.
- Another example of the Retail Inventory Method is in a restaurant setting. Here, the restaurant would track the cost of its ingredients and the amount of food it has sold to calculate the cost of goods sold and the estimated ending inventory. This method is particularly useful for restaurants that have a large variety of ingredients, as it helps the restaurant to accurately estimate the cost of its inventory.
- A third example is the use of the Retail Inventory Method in a clothing store. The store would track the cost of its clothing items and the amount of clothing sold to estimate the cost of goods sold and the estimated ending inventory. This method is especially useful for stores that carry a large variety of clothing items, as it helps them to accurately estimate the cost of their inventory.
When to use retail inventory method
The retail inventory method is a management accounting technique used to estimate the cost of ending inventory and the cost of goods sold of a retail business. It is most useful in businesses that have a large number of items that are purchased and sold on a frequent basis. The retail inventory method can be used in the following contexts:
- To estimate the cost of goods sold and ending inventory costs when a business does not have a perpetual inventory system.
- To calculate the cost of goods sold when a business has a perpetual inventory system but the cost of sales is not tracked.
- To accurately forecast sales and inventory needs.
- To provide an accurate measure of the inventory turnover rate.
- To help identify inventory shrinkage due to theft or loss.
- To compare the actual cost of goods sold to the estimated cost of goods sold.
Types of retail inventory method
The retail inventory method is a management accounting technique used to estimate the cost of ending inventory and the cost of goods sold of a retail business. There are several types of retail inventory methods, which can be used by businesses to determine their inventory levels and costs. These include:
- The Gross Profit Method: This method estimates the cost of goods sold and the ending inventory based on the gross profit margin. It uses the gross profit percentage to calculate the total cost of goods sold and the ending inventory.
- The Retailer's Inventory Method: This method takes into account the markups and markdowns of the items in the inventory. It estimates the cost of goods sold and the ending inventory based on the selling price and cost of the items.
- The Weighted Average Cost Method: This method uses the average cost of merchandise held in inventory to estimate the cost of goods sold and the ending inventory. It takes into account the costs of purchases, markups and markdowns, and other expenses associated with the inventory.
- The First-in First-out (FIFO) Method: This method assumes that the oldest items in inventory are sold first. It uses the cost of the oldest items in the inventory to estimate the cost of goods sold and the ending inventory.
- The Last-in First-out (LIFO) Method: This method assumes that the most recently purchased items in inventory are sold first. It uses the cost of the most recently purchased items in the inventory to estimate the cost of goods sold and the ending inventory.
Steps of retail inventory method
- Calculate the cost of beginning inventory. This involves multiplying the number of items in the beginning inventory by the average cost per item.
- Determine the cost of goods purchased during the period. This involves multiplying the number of items purchased in the period by the average cost per item.
- Calculate the total cost of inventory. This involves adding the cost of beginning inventory and the cost of goods purchased during the period.
- Calculate the cost of goods sold. This involves subtracting the cost of ending inventory from the total cost of inventory.
- Estimate the ending inventory. This involves multiplying the sales for the period by the average cost of inventory.
- Calculate the ending inventory cost. This involves subtracting the cost of goods sold from the estimated ending inventory.
Advantages of retail inventory method
The retail inventory method offers several advantages to businesses, including:
- Increased accuracy in calculating the value of inventory and cost of goods sold, since it considers the average cost of the merchandise across a period of time.
- Reduction of audit costs, since the method eliminates the need to physically count and value inventory.
- Improved inventory control, since the method allows businesses to keep track of the movement of inventory, enabling them to identify any gaps in their processes.
- Lower costs, since the method allows businesses to reduce the amount of inventory they hold by increasing the frequency of inventory counts.
- Faster inventory turnover, since the method allows businesses to quickly identify any slow-moving products and take remedial action.
Limitations of retail inventory method
One of the main limitations of the retail inventory method is that it does not take into account shrinkage or theft of inventory. Additionally, the method assumes that the inventory turnover rate remains constant, which may not always be the case. Other limitations include:
- The retail inventory method assumes that the average cost of inventory remains constant, which may not be the case if prices or discounts vary over time.
- The method does not consider the specific characteristics of the merchandise, such as quality or condition.
- The method does not take into account inventory that is damaged or obsolete.
- The method does not consider inventory that is held in transit or in warehouses.
- The method does not consider changes in the availability of inventory, such as changes in demand or supply.
The retail inventory method is only one of the inventory costing techniques used by retailers to measure the cost of goods sold and inventory on hand. Other related approaches include:
- The Weighted Average Cost Method, which takes the average cost of the items purchased and multiplies it by the number of units of each item in inventory.
- The First In First Out (FIFO) Method, which assumes that the first items purchased are the first items sold and therefore uses the cost of the oldest items in inventory for cost of goods sold.
- The Last In First Out (LIFO) Method, which assumes that the last items purchased are the first items sold and uses the cost of the most recent items in inventory for cost of goods sold.
- The Specific Identification Method, which assigns the cost of each item based on its purchase.
All of these inventory costing methods offer different ways to estimate the cost of goods sold and inventory on hand for a retailer. The method chosen should depend on the particular needs and goals of the business. A summary of these methods is that they all rely on an estimate of the average cost of items held in inventory and the rate of inventory turnover to calculate the estimated ending inventory and cost of goods sold.
Suggested literature
- Goodwin, D. R. (1990). The open-to-buy system and retail inventory method: the impact on accurate performance measurement /by David R. Goodwin (Doctoral dissertation).
