What is the Retail Inventory Method?

The retail inventory method is used by retailers that resell merchandise to estimate their ending inventory balances. This method is based on the relationship between the cost of merchandise and its retail price. The method is not entirely accurate, and so should be periodically supplemented by a physical inventory count. Its results are not adequate for the year-end financial statements, for which a high level of inventory record accuracy is needed.

When to Use the Retail Inventory Method

The retail inventory method is most useful in a more complex, multi-store environment where it can be difficult to simultaneously conduct counts across all stores. It is also useful in cases where a store is operating during all hours of the day, making it difficult to shut down for a physical inventory count. Further, it should only be used when there are similar markup percentages being applied across products, since this issue is incorporated into the calculation.

How to Calculate the Retail Inventory Method

To calculate the cost of ending inventory using the retail inventory method, follow these steps:

Calculate the cost-to-retail percentage, for which the formula is (Cost ÷ Retail price).
Calculate the cost of goods available for sale, for which the formula is (Cost of beginning inventory + Cost of purchases).
Calculate the cost of sales during the period, for which the formula is (Sales × cost-to-retail percentage).
Calculate ending inventory, for which the formula is (Cost of goods available for sale - Cost of sales during the period).

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Example of the Retail Inventory Method

Milagro Corporation sells home coffee roasters for an average of $200, and which cost it $140. This is a cost-to-retail percentage of 70%. Milagro’s beginning inventory has a cost of $1,000,000, it paid $1,800,000 for purchases during the month, and it had sales of $2,400,000. The calculation of its ending inventory is:

Beginning inventory
$1,000,000
  (At cost)

Purchases
+ 1,800,000
  (At cost)

Goods available for sale
= 2,800,000
 

Sales
- 1,680,000
  (Sales of $2,400,000 x 70%)

Ending inventory
$1,120,000
 

Retail Method Disadvantages

The retail inventory method is a quick and easy way to determine an approximate ending inventory balance. However, there are also several issues associated with it, which are as follows:

Only yields an estimate. The retail inventory method is only an estimate. Do not rely upon it too heavily to yield results that will compare with those of a physical inventory count.
Requires a standard markup. The retail inventory method only works if you have a consistent mark-up across all products sold. If not, the actual ending inventory cost may vary wildly from what you derived using this method.
Requires consistent usage of a markup. The method assumes that the historical basis for the mark-up percentage continues into the current period. If the mark-up was different (as may be caused by an after-holiday sale), then the results of the calculation will be incorrect.
Does not work for merged inventories. The method does not work if an acquisition has been made, and the acquiree holds large amounts of inventory at a significantly different mark-up percentage from the rate used by the acquirer. In this case, however, it may be possible to separately apply the retail method to the acquiree and the acquirer.

In short, you should be aware of the limitations of the retail method, and only use it for those situations in which the preceding issues do not arise.