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An In-Depth Look at the Retail Accounting Method

An In-Depth Look at the Retail Accounting Method

It’s been a shockingly tough year for retailers so far, with a coronavirus pandemic leading to high profile bankruptcies for household names such as JC Penneys, GNC and Aldo. 

From struggling to move goods across disrupted supply chains to having to shut physical stores for long periods, retailers face a business climate like no other in living memory.  

It’s no surprise that business continuity is top of mind for retailers everywhere. You’ve every right to think that retail accounting methods are far from the everyday realities and pressures of trading right now, but it is still worth getting up to speed on.

This article will guide you through the retail accounting method and hopefully put it into some context given the pressures of trading throughout 2020. Here’s what you’ll learn to help decide if using this method is right for your business:

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What is retail accounting?

At its most basic, retail accounting counts the cost of inventory relative to the selling price. 

In fact, calling it retail accounting makes it sound as if there is a special discipline of accounting, especially for retailers. 

There isn’t really. 

When you hear retail accounting, keep inventory in mind: Because this is really what it’s all about. 

In other words, retail accounting is a way of tracking inventory cost that is especially simplified compared to the other available methods.

“[Retail accounting] is not always appropriate for companies, but when it is it can make accounting much simpler,” says Montreal-based CPA Abir Syed, of UpCounting

“The basic premise is that you assume a consistent margin across everything you sell, and then apply that figure to the retail value of all your inventory to calculate the cost.”

 

Managing inventory costs with retail accounting

Zach Reece, an Atlanta-based CPA and COO of Atlanta roofing company Colony Roofers, says there are plenty of different methods available for managing inventory, such as First In First Out (FIFO), Last In First Out (LIFO), Specific Identification, and Weighted Average. 

“FIFO is great for perishable things like groceries, says Zach. “LIFO is great for stuff like concrete where the inventory isn’t easily distinguishable. Specific identification is useful for big-ticket stuff that moves slowly. Weighted average is good for something like lumber, which is non-perishable and individual but indistinguishable. Your acquisition costs will vary even if the price stays the same.”

You can read more about inventory costing in this dedicated guide

 

What is the retail method of accounting? 

Retail accounting software can provide a comprehensive account inventory at the item’s retail price in order to detect losses, damages and theft of stock.   This helps business owners to track the cost of sales (COS), also known as Cost of Goods Sold (COGS).  The retail method can also help you keep account of the goods you’re buying or selling, know how much is left over, and maintain the right amount of inventory at all times.

 

Retail method accounting formula

With the retail method, you total up the total costs of inventory and the total value of goods for sale, and then divide costs into retail value. 

Here’s what that looks like:

“Due to the simplicity of the calculation, it requires far less tracking to perform the calculation. That means that a company doesn’t need a sophisticated accounting system to calculate their inventory costs, “ said Abir.

 

Example of the retail method of accounting

That’s the formula. What would this look like in practice? Here’s an example from Abir:

Let’s say someone sold tables and chairs. They sell the tables for $400 each and chairs for $200 each and they’re both sold at a 40% markup from the purchasing price. A table costs $160 each, while a chair costs $80. 

For this example, let’s say you have 10 tables and 5 chairs in beginning inventory and you purchased an additional 5 tables and 6 chairs mid-month. 

Total cost (beginning inventory)

Total cost (beginning inventory) = (10 x 160) + (5 x 80)

Total cost (beginning inventory) = (1,600) + (400)

Total cost (beginning inventory) = $2,000

Total cost (purchased inventory)

Total cost (purchased inventory) = (5 x 160) + (6 x 80)

Total cost (purchased inventory) = (800) + (480)

Total cost (purchased inventory) = $1,280

Retail value (beginning inventory)

Retail value (beginning inventory) = (10 x 400) + (5 x 200)

Retail value (beginning inventory) = 4,000 + 1,000

Retail value (beginning inventory) = $5,000

Retail value of goods of period

Retail value of goods of period = 5,000 + (5 x 400) + (6 x 200) 

Retail value of goods of period = 5,000 + (2,000) + (1,200) 

Retail value of goods of period = 5,000 + (3,200) 

Retail value of goods of period = $8,200

Now, that we’ve solved for the values we need, we can use the retail method of accounting to find our cost to retail ratio:

Cost of retail ratio formula = 2,000 + 1,280 / 5,000 + 8,200

Cost of retail ratio formula = 3,280 / 13,200

Cost of retail ratio formula = 0.24

The cost to retail ratio for this month’s table and chair inventory is 24%

 

The advantages of the retail method of accounting

Given some of the limitations of the retail accounting method, you might be wondering why it is used. “The advantage is that it’s very easy to calculate and doesn’t require sophisticated tracking of how much someone paid for each SKU they purchased from a supplier,” says Abir. 

Although it should be something you do consistently, you don’t have to count your inventory or run inventory reports to use this method, meaning you can get a sense of your inventory’s value based on a small set of numbers. That’s a bonus for retailers, who might be worried about having to pay staff to do stock checks while keeping the doors closed. 

 

The disadvantages of the retail method of accounting

But the drawbacks may outweigh the speed and ease of the retail method.

“This isn’t a good method if your pricing changes frequently due to things like sales [promotions],” says Abir, “or if your different SKUs have different margins, or if your costs for a given SKU changes over time. The reason it can often work in retail is that retailers will often ensure a consistent margin across all their SKUs, and their costs from wholesalers don’t fluctuate too much.”

It only provides an estimate

Another problem? It’s mostly a guess. “The disadvantage is that it’s not especially accurate, and is only acceptable as an inventory costing method in circumstances where it does a good job of estimating the actual cost,” says Abir. 

It’s not suited to variable markups

“Retail accounting is constrained because it’s an estimate. You need more accurate methods to use in conjunction. It’s also predicated on a consistent markup, which doesn’t work well if you have sales [promotions] or radical differences in markup between products,” says Zach.

 

Wrapping up: Is the retail method right for now?

There’s also the COVID factor, which has led retailers to slash prices to try to inspire consumer confidence, which has been waning throughout the pandemic. “These significant changes in price, and therefore margin, means that the retail accounting method will generate far less accurate inventory cost figures,” says Abir. 

It’s a view shared by Zach. “Price and markup changes make retail accounting much less accurate, and many industries are dealing with those right now. More accurate methods are going to be important,” he said. 

For a full breakdown of the five different methods for costing inventory, read our comprehensive guide.