Retail businesses have unique challenges, not the least of which is business accounting — especially for inventory. Discover the ins and outs of retail accounting to help you stay on top of your bottom line.
Understanding retail accounting
The term “retail accounting” is a bit of a misnomer. Retail accounting isn’t a special kind of accounting process or system, but rather an inventory valuation technique often used by retailers. It differs from “cost accounting” for inventory in that it values inventory based on the selling price rather than the acquisition price.
More on this in a bit, but first it’s important to understand the importance of accounting for the cost of inventory in your retail business.
Managing inventory cost: Your biggest challenge
Your retail business’s inventory likely represents your biggest expense. But inventory is unique in that it isn’t an expense until you sell it.
If you find this confusing, don’t be alarmed. Inventory is actually considered an asset — something your business owns, which is recorded on your business’s balance sheet — until you sell it or account for it as shrinkage from theft or damage. At that point, the expense for the purchase of the inventory is recorded as cost of sales (COS) or cost of goods sold(COGS) on your profit and loss statement.
Inventory’s impact on profitability
As you can imagine, the cost of your inventory has a significant impact on your business’s profitability. This makes effectively managing it critical to the success of your retail business.
You can significantly impact the profitability of your retail business by paying close attention to your gross profit margin. In fact, the gross profit margin metric is so powerful, you can realize significant increases in your business’s bottom line just by adjusting gross profit margin a few points. This means you can increase your business’s overall profitability without having to make a big push for more sales!
But in order to do this, you have to know the cost of your inventory. This brings us back to inventory valuation methods, including retail accounting.
Inventory costing or valuation methods
There are five ways in which a business can choose to calculate the cost or value of inventory. There is no “wrong” method to use to value your inventory, but there is a “best” way for your business. The method you choose depends largely on what you are selling.
Specific identification inventory costing attaches cost to specific items in inventory. This is done using serial numbers or some other unique identifier. The specific identification method of inventory costing applies primarily to high-ticket items, like automobiles. Typically, retailers who use the specific identification method don’t have a large number of items in stock, making what could otherwise be a cumbersome inventory costing task more manageable.
First in, first out (FIFO)
The FIFO method of inventory costing assumes the first items entered into your inventory are the first items you sell. This costing method is most often used when inventory is perishable and is a favorite for food retailers.
FIFO inventory costing assumes any inventory left on hand at the end of the accounting period should be valued at the most recent purchase price. Anything purchased at an older price would have been discarded due to spoilage and lapsing expiration dates.
Last in, first out (LIFO)
LIFO inventory costing is essentially the reverse of FIFO inventory costing. The LIFO method assumes the most recent items entered into your inventory will be the ones to sell first.
LIFO inventory costing is often used in situations where it is hard to distinguish one unit of inventory from another, and when the stock won’t be rotated to ensure the oldest inventory is sold first. Gravel and sand retailers who sell materials by the ton often use the LIFO inventory costing method.
The weighted average method of inventory costing is often used when inventory is not perishable but stock can still easily be rotated or intermingled.
Think of a bin of bouncy balls. Some of the balls might have been purchased at $0.10 each, and some at $0.12 each. There’s really no way of knowing which balls were purchased at which price, and so the retailer will take a weighted average and spread the average cost over all the existing inventory.
The previous four inventory costing methods value inventory based on the cost to acquire the inventory. The retail method is different — it values inventory based on the retail price of the inventory, reduced by the markup percentage. This allows the retailer to quickly arrive at an approximate value of inventory, without having to take a physical count or match cost to items still on hand.
The retail method works only if the retailer’s markup on the inventory is consistent across their entire inventory. If items are marked up at different percentages, the retail method will not give you an accurate value of your inventory.
Retail accounting: In-depth example
Let’s say your retail business sells yarn and knitting accessories. Each type of fiber costs a different amount, and certain knitting needles are more expensive than others. However, you have chosen to use a keystone markup strategy, so you know you have a 50% markup on all items, regardless of what they are.
Let’s assume you took a physical inventory count at the beginning of the quarter, and you know the actual cost of your inventory as of that date was $80,000. Reviewing the reports from your point of sale system you see that, as of the end of the quarter, your sales totaled $30,000. Finally, throughout the quarter, you purchased new yarn and accessories, which cost a total of $10,000.
With this information, you can determine the ending value of your inventory using the retail method:
Beginning Inventory (at cost): $80,000
New Inventory Purchased (at cost): $10,000
Total Inventory for Sale (at cost): $90,000
Total Sales for the Quarter (at retail): $30,000
Less – Cost of the Sales: ($30,000 * 50%) = $15,000.
Total Inventory for Sale (at cost) – Cost of the Sales = Ending Value of Inventory
$90,000 – $15,000 = $75,000
You can make a reasonable assumption that the value of your inventory as of the end of the quarter is $75,000.
Retail accounting: advantages and disadvantages
There are some advantages and disadvantages to using the retail method of accounting for inventory. The primary advantage of the retail method is the ease of the calculation. You only need a few numbers to calculate your inventory cost using the retail method, and you don’t need to take a physical inventory count to get a good idea of what your ending inventory value is.
There are several disadvantages to using the retail method, though:
The retail accounting method only works if all items are marked up consistently. Many retailers mark different items up at different percentages. Although you could use an average markup in this instance, it will make your estimate more unreliable.
This method is only an estimate. Although it can give you a good idea of the value of your inventory on a periodic basis, you will still need to do an actual physical inventory count at least annually to get a true value of your inventory.
If your business changes markup percentages, your calculation will be correct. In other words, if you run a sale after your last physical inventory count, you won’t be able to rely on your markup percentage to calculate the value of your inventory in the current period.
Tax ramifications of inventory costing
The IRS allows you to use any method you want to value your inventory for tax purposes. The caveat is, once you choose a method you have to stick with it, unless you get permission from the IRS to change your costing method. This rule is in place to keep business owners from “gaming the system” by frequently switching costing methods to get the best tax advantages.
For tax purposes, you want to use the inventory costing method which will give you the most accurate inventory valuation. Although you can use the retail method for tax purposes, you will likely want to use a different method — like weighted average — to ensure you are reporting the most accurate information.
Before making a decision about which inventory costing method to use for your taxes, speak with your accountant. They will be able to make a recommendation regarding which costing method is most favorable for your business.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.