Understanding the Retail Inventory Method: Calculation and Applications

What Is the Retail Inventory Method?

The retail inventory method helps estimate the value of a store's merchandise. The retail method provides the ending inventory balance for a store by measuring the cost of inventory relative to the price of the merchandise. The method uses sales, inventory, and the cost-to-retail ratio.

The retail method uses the cost-to-retail ratio specifically because it simplifies inventory valuation. Even though the method is a quick estimation tool, it is necessary to perform the occasional physical counts to ensure accuracy. There are potential issues with variable markup percentages and occasional physical validations, so it's particularly useful when there's a consistent markup on items.

How the Retail Inventory Method Works

Managing inventory is key to running a successful business. It helps you track sales, decide when to reorder, manage costs, and gauge losses from theft or damage.

Use the retail inventory method only if there's a clear link between wholesale and retail prices. If a store marks up all items by 100%, it can use this method effectively, but varying markups make it less accurate.

This method gives an estimate, as some items may be stolen, broken, or misplaced. Stores should do regular physical inventory checks to verify their inventory estimates.

How to Calculate Ending Inventory Using the Retail Method

The retail inventory method calculates the ending inventory value by totaling the value of goods that are available for sale, which includes beginning inventory and any new purchases of inventory. Total sales for the period are subtracted from goods available for sale. The difference is multiplied by the cost-to-retail ratio (or the percentage by which goods are marked up from their wholesale purchase price to their retail sales price).

The cost-to-retail ratio, also called the cost-to-retail percentage, provides how much a good's retail price is made up of costs. If, for example, an iPhone costs $300 to manufacture and it sells for $500 each, the cost-to-retail ratio is 60% (or $300/$500) * 100 to move the decimal.

 Limitations of Using the Retail Inventory Method

The method is easy to calculate, but it has some drawbacks:

• The retail inventory method is only an estimate. Results can never compete with a physical inventory count.
• The retail inventory method only works if you have a consistent markup across all products sold.
• The method assumes that the historical basis for the markup percentage continues into the current period. If the markup was different (as may be caused by an after-holiday sale), then the results of the calculation will be inaccurate.
• The method does not work if an acquisition has been made, and the acquiree holds large amounts of inventory at a significantly different markup percentage from the rate used by the acquirer.

Retail Inventory Method Example in Practice

Using our earlier example, the iPhone costs $300 to manufacture and it sells for $500. The cost-to-retail ratio is 60% ($300/$500 * 100). Let's say that the iPhone had total sales of $1,800,000 for the period.

• Beginning inventory: $1,000,000
• New Purchases: $500,000
• Total goods available for sale: $1,500,000 
• Sales: $1,080,000 (Sales of $1,800,000 x 60% cost-to-retail ratio)               
• Ending inventory: $420,000 ($1,500,000 - $1,080,000)