Retail Method of Estimating Inventory

The retail method of estimating inventory is a technique used by retailers to estimate the cost of their ending inventory without counting and pricing every item at cost. The business keeps records of goods available for sale at both cost and retail selling price, works out the ratio of cost to retail, and applies that ratio to the retail value of stock remaining at the end of the period.

It is widely used by department stores, supermarkets and other retailers that carry thousands of items whose shelf prices are easy to total but whose individual purchase costs are not. It supports monthly and interim financial statements without a full count, and it can also be used at year end, provided a physical inventory count at retail prices is taken. It is accepted under both US GAAP and IFRS when the results approximate cost.

1. Add beginning inventory and net purchases at cost and at retail to find the cost of goods available for sale on both bases.
2. Divide goods available at cost by goods available at retail to get the cost-to-retail ratio.
3. Subtract net sales at retail from goods available at retail to estimate ending inventory at retail.
4. Multiply ending inventory at retail by the cost-to-retail ratio to estimate ending inventory at cost.

The key ratio is:

Here goods available at cost are beginning inventory plus purchases at what the store paid, and goods available at retail are the same goods at their marked selling prices.

A clothing store has beginning inventory of $80,000 at cost and $130,000 at retail. During the quarter it buys goods costing $220,000 that it marks to sell for $370,000. Net sales for the quarter are $360,000.

• Goods available for sale: $300,000 at cost and $500,000 at retail.
• Cost-to-retail ratio: $300,000 divided by $500,000, or 60 percent.
• Ending inventory at retail: $500,000 minus $360,000, or $140,000.
• Estimated ending inventory at cost: $140,000 times 60 percent, or $84,000.

Cost of goods sold is therefore $300,000 minus $84,000, or $216,000. If a count at shelf prices finds only $134,000 of stock, the $6,000 retail difference, about $3,600 at cost, points to inventory shrinkage from theft, damage or recording errors.

Retail prices change after goods arrive. Additional markups raise selling prices above the original markup; markdowns cut them for sales or clearance. How these are treated in the ratio produces different versions of the method:

• The conventional retail method, also called the lower of cost or market approach, includes net markups but excludes markdowns from the denominator. This gives a lower ratio and a more conservative inventory figure that approximates the lower of cost or market.
• The cost method includes both markups and markdowns, giving an estimate closer to average cost.
• LIFO retail and dollar-value LIFO retail apply the method in layers for retailers that use LIFO, adjusting for price-level changes with indexes.

Whichever variant is chosen must be applied consistently, and US tax rules also permit the retail method for income tax purposes.

The retail method assumes that the mix of goods in ending inventory has roughly the same cost-to-retail relationship as all goods available. If high-margin and low-margin lines sell at different speeds, the estimate can be distorted, so large retailers often apply the method separately by department. It also depends on accurate records of markups and markdowns. For these reasons it is complemented by periodic counts and, for quick estimates where retail records are not kept, the gross profit method, which uses a historical gross margin instead of a cost-to-retail ratio, as part of overall inventory valuation.