Retail Inventory Method: Explained
Inventory management is the backbone of any successful business. Poor inventory management may have far-reaching adverse effects on your average company, perhaps even leading to its closure. The Retail Inventory Method (RIM) is a technique used by business owners to manage their inventory by estimating their ending inventory’s total value after a particular accounting period. It is also known as the Retail Method or the Retail Inventory Estimation Method.
This method is used primarily where a business is not in a position to do a physical count, which can be both time-consuming and expensive. However, it is essential to note that because this method provides an estimated value and should be supplemented with a physical count of inventory every once to provide accurate results.
Because retail businesses sell many different small items, it can get rather complicated to determine what you need to restock and in what intervals. It’s no secret that running a retail business is challenging. On top of monitoring the market and coming up with marketing strategies, business owners are expected to keep an updated inventory schedule to ensure they don’t over or under-stock. The retail inventory method assists in ensuring a business’s inventory is maintained at optimal levels.
This article discusses how to calculate the retail inventory method, who should adopt it, when to use it, and its advantages and disadvantages. Let’s dive right into it.
How To Calculate The Retail Inventory Method
Calculating your ending inventory using the retail inventory method is a pretty simple procedure, as detailed below.
Step 1: Calculate The Business Cost-To-Retail Ratio
To enable you to use the retail inventory method, you need to determine the business’s cost-to-retail ratio. The cost-to-retail percentage of a company is determined by dividing the total amount of goods available for sale by the total value of goods available for sale.
The formula for this is:
Cost-to-retail ratio = cost ÷ retail price
Step 2: Calculate the Cost of Goods Available for Sale
The formula for calculating the cost of goods available for sale is as follows:
Beginning Inventory Costs + Purchase Costs
Step 3: Calculate the Cost of Sales for The Accounting Period
To determine the cost of sales for the accounting period concerned, apply the following formula:
Sales x Cost-To-Retail Percentage
Steps 4: Determine the Ending Inventory
To determine the ending inventory of your business, apply the following formula:
Cost of Goods Available For Sale – Cost of Sales
Let’s apply the steps listed above in an example.
Say Company A sells water dispensers at $200, having bought each at $140. The cost-to-retail percentage for Company A is, therefore, 70%.
Company A’s beginning inventory costs are $2,000,000, and the prices of its purchases for this accounting period are $3,000,000. The corresponding sales for the period are worth $4,000,000. Company A’s ending inventory is, therefore:
Beginning Inventory Costs $ 2,000,000
Purchase Costs +$ 3,000,000
Total Goods Available For Sale $ 5,000,000
Cost of Sales -$ 2,800,000 (Sales of $ 4,000,000 x 70%)
Ending Inventory= $ 2,000,000
Is This Method Right For My Business?
The key to effective inventory management is knowing what techniques are right for your business model and which techniques may not work best for you. This section discusses the types of businesses that would benefit best from using the retail method.
- Businesses that keep stock in warehouses
The retail method works perfectly for any business that wants to determine how much stock they have in their warehouses. Because the cost of products stocked in warehouses remains relatively the same, the retail method would provide such business owners with accurate values of their ending inventory.
- Businesses with a uniform cost-to-retail ratio
The retail method also works best for a business that sells products with a relatively consistent price markup. Suppose you are a business owner who sells similar types of goods. In that case, it means your goods’ cost is relatively identical, and the retail method would therefore provide you with a reasonably accurate value of your ending inventory.
Conversely, suppose your stock is composed of different products spread out across several categories. In that case, the implication is that the products have different markups. Therefore, the retail method would not offer you an accurate representation of your ending inventory value.
- Retailers with multiple stores
Any business that runs several stores in different locations may find it challenging to coordinate stock counts across all stores. The retail method provides these types of companies with a fast way to get an estimated value of their ending inventory.
When Should I use The Retail Inventory Method?
The retail inventory method, just like any other inventory management technique, should be applied at the right time to give results that you can rely on to make decisions.
Ordinarily, a business will use this method based on its accounting schedule. Accounting schedules could be yearly, monthly, or even quarterly, depending on what the management deems fit.
So at what time is it not advisable to use the retail method? For instance, if you are running a sale, your cost-to-retail ratio may vary, and the retail formula would not provide you with accurate values.
Simply put, this method should only be applied where the relationship between the cost of purchasing stock and the selling price can be determined with ease. For instance, if a makeup store marks up all products by 70% of the initial purchasing cost, then it can accurately rely on this method. Conversely, if it marks up some products by 50%, others by 20%, and others by 5%, it would be challenging to apply this formula accurately.
Retail Method v Gross Profit Method
It is impossible to write a detailed piece on the retail inventory method and not mention the gross profit method. The gross profit method is an alternative technique used to value ending inventory that applies a business’s gross profit percentage to calculate the ending stock. Like the retail method, the gross profit method is an alternative for companies that don’t have enough time or resources to conduct a physical inventory count. This method is also commonly used to estimate the value of missing or damaged inventory.
To use the gross profit method, you need to calculate your gross profit margin first. For example, suppose a makeup store buys its beauty products for 50 cents then sells the products for $ 1.00. Its gross profit would be 50 cents. To calculate the makeup store’s gross profit margin, we need to divide the gross profit (50 cents) by the selling price ($ 1.00) to get a gross profit margin of 50%.
Because the gross profit method uses historical bases to determine the ending inventory, the value produced may be affected by many variables. However, this method could be beneficial for retailers who resell products; hence, costs are not factors that impact their inventory valuation.
Tips for Using The Retail Inventory Method
If you feel that the retail inventory method is suitable for your business, below are some extra tips you can apply to enhance the accuracy of results:
- Conduct a Physical Inventory Count Occasionally
As indicated earlier, the retail inventory method provides an estimate of your inventory value and may, therefore, not always give an accurate picture. To counter this, it is essential to schedule physical inventory counts to reconcile your inventory register.
- Maintain a Perpetual Inventory
If you are opposed to the idea of conducting a physical inventory count owing to its tedious and time-consuming nature, perhaps you should consider maintaining a perpetual inventory. A perpetual inventory system uses technology such as PoS machines and barcode scanners to update stock in real-time, i.e., after every sale or purchase. This method will save you the time needed to perform a physical count.
- Current Price Estimations
To enhance the accuracy of results, business owners using the retail inventory method should use current price estimations of their products to improve results’ accuracy. If you use older prices, you might end up pricing your products incorrectly and dragging down your revenue streams.
- Ensure You Have Accurate Data
Because of the numerous calculations involved in the retail method formula, a business using this method must have the correct data at all times to ensure the ultimate results are accurate. This means that companies that opt for this method should invest in inventory management software with reporting and analytical capabilities. As indicated earlier, it would be wise to maintain a perpetual inventory system when using this method instead of the periodic inventory system.
For retailers with multiple stores, your stock management system should be able to provide you with real-time data both for individual stores as well as the entire business as a whole.
- Timely Stock Rotation
Companies that use this method should ensure there is a timely reshuffle of stock. What does this mean? Simply put, old stock ought to be sold before new stock to ensure the pricing model is consistent and accurate.
Advantages of Using The Retail Inventory Method
The retail inventory method comes with many benefits attached, key amongst them the fact that it is accepted under the Generally Accepted Accounting Principles (GAAP). Below are some of the advantages of using RIM-
Unlike a physical inventory count where businesses have to be shut down for the tedious task of counting the inventory, this method is fast and takes up minimal time. Further, it does not interrupt normal business operations since you do not have to shut down the business to take stock of your ending inventory.
The retail inventory method is lauded for its simple nature. Basically, with the help of a simple calculation, one can derive an estimated value of their ending inventory. This estimated value can help influence critical decisions such as pricing models and marketing strategies.
- Enhances Inventory Control
A significant advantage of the retail inventory method lies in its ability to provide detailed inventory control records. The process sufficiently links direct inventory to sales and provides an ending stock with ease. It also assists in detecting product shortages and theft as reconciliation can quickly be conducted.
Disadvantages of The Retail Inventory Method
Despite its significant benefits, the retail inventory method has some drawbacks such as:
- The results provided by the retail inventory method are a mere estimate. The implication of this is that the figures derived from the technique can’t be applied in a company’s financial books. It also means that to get entirely accurate results, a company can only avoid conducting a physical inventory count for so long.
- The retail method assumes that there is a uniform price markup across all products being sold by a particular company. This means that companies that sell products with varying price and profit margins cannot benefit from this method.
- The retail inventory estimation method also assumes that the factors that led to a particular price markup were carried forward into the current accounting period. This could translate into inaccurate results, especially where the markup in the previous season was influenced by a non-constant factor such as a holiday sale.
- Because the results derived are just an estimate, they don’t account for inventory that has been taken out of the register either due to damage, theft, or varying other reasons.
- This method does not work where large volumes of inventory have been acquired, such as when a company decides to buy off another company.
Highlights of The Retail Inventory Method
- The retail inventory method is an estimate and can best be described as an ‘educated guess’ of a company’s actual ending inventory. It helps give a snapshot of a company’s ending inventory at the end of an accounting period, though this snapshot is not as clear as the one derived from a physical inventory.
- RIM works best where a company’s stock comprises products with a relatively consistent price markup.
- Companies should use the perpetual inventory management system to enhance the accuracy of results because it updates inventory continuously and in real-time.
- RIM assumes that the factors that influenced profit margins in the previous accounting period have remained constant in the current accounting period.
If you are struggling with inventory management, consider trying EMERGE App’s inventory management software. It helps streamline all your inventory needs, as well as provides you with detailed analytical reports.