One of the more beautiful aspects of accounting is that it’s a great equalizer. Companies that follow Generally Accepted Accounting Principles do, generally, the same things every month to close their books and prepare financial statements.
One industry that stands apart, however, is retail. Unlike many other groups, retailers have one big thing that gets in their way of quick and easy accounting: inventory. The solopreneur with a laptop and minimal expenses probably only has a few transactions to classify each month and can figure out her quarterly tax obligation without any headaches.
A retailer, however, not only has to consider the many transactions that took place over the course of the accounting period but also must take into account how much each item of inventory cost to procure. In other words, there’s a lot of work that goes into calculating the cost of goods sold (COGS) line on their income statements that the average solopreneur can skip right over.
So how do they do it? As we’ll see later, they definitely don’t do it by hand. But if you are a retailer, it’s a good idea to know the basics of how inventory is valued for accounting purposes and to familiarize yourself with a term that’s thrown around quite a bit—the retail method.
What Is the Retail Method?
First things first. The retail method and retail accounting are often used interchangeably, though it’s a little misleading to call it “accounting” since it deals only with how inventory is valued (and not the full accounting process).
Instead, the retail method is one of several different inventory valuation processes that could help retailers determine their cost of goods sold. As we’ll see, there are pros and cons to each of these methods, depending on what you’re hoping to see on your income statement. But keep in mind that the ultimate goal is accuracy.
The more accurately you’ve calculated your costs, the more you know how your business is really doing.
Let’s break each method down using an example of a beauty supply store. Your store buys lipsticks for about $1.50-$2.00 each. Sometimes this goes up or down slightly based on what the makeup manufacturer charges. Here are your per-unit costs for the last two months.
|Cost per Unit||$1.50||$1.75|
|# of Units Purchased||500||400|
LIFO, or last-in, first-out, is one way of finding the cost of inventory, though it’s not a popular method. Under this method, if you were to sell a tube of lipstick on March 1, you would “sell through” your February inventory first, followed by your January inventory.
Now, technically all these pieces of inventory are the same—you’re not going to the back room and pulling from a box marked “February Stock” only. When a customer buys a lipstick, regardless of when it arrived in your store, this inventory method will say that it cost what the most recent (last-in) batch of lipsticks did. In this case, that means $1.75 per lipstick.
If your business were to sell more than the 400 lipsticks you ordered in February, then you’d switch to January pricing. In other words, the 401st lipstick would cost $1.50.
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FIFO, or first-in, first-out, is more commonly used than LIFO. It flips what we described above so that you would “sell through” your January inventory first. In other words, the first lipstick you sell after gathering up this inventory would cost you $1.50. Then, after you’ve sold through the first 500 lipsticks (the amount you purchased in January at that rate), your 501st lipstick sold would cost $1.75.
This method makes a lot more sense than LIFO because you’re presumably adding more inventory all the time. Retailers don’t wait until they sell out of stock completely to order more. And if costs continue to go up month after month, LIFO may not give you a very accurate understanding of your current COGS since you’re still selling through inventory that you acquired months ago.
The weighted average method combines the best of both LIFO and FIFO. Rather than “selling through” one set of inventory at a time, this method takes an average of your inventory costs based on each purchase order’s price and quantity. So whether it’s the fifth tube of lipstick you sell or the 500th, the per-unit cost will be the same.
To find the weighted average cost of your entire lipstick inventory from January and February, you would first find the total cost each month by multiplying the per-unit price by the units purchased. You’d then add those two totals together and divide by the total number of units.
[($1.50 x 500) + ($1.75 x 400)] / (500 + 400) = $1.61 per unit
It may look a little hairier to calculate, but the result is likely going to be the most accurate.
Last up is the retail method, which takes an entirely different approach. Rather than calculating the cost per unit, the retail method looks at the total value of your inventory. In other words, how much are all those tubes of lipstick worth if you were to sell them?
Then, it backs into an estimated cost by eliminating your markup. So in our lipstick example, let’s assume that your beauty supply store generally charges a 50% markup on all items.
If you see that you’ve made $2,000 from lipstick sales (looking at the retail price only), you could multiply by 50% to find your approximate cost. In this case, that would be $1,000 in costs once the markup has been removed.
The key here is to recognize that the retail method only approximates your cost of goods sold. It can’t determine your costs exactly.
The Pros and Cons of Retail Accounting
If retail accounting is not a perfect science, why do some retailers care about it? Like all methods of inventory valuation, there are pros and cons to using it. Here’s a short overview of some of the biggest ones.
|Pros of Retail Accounting||Cons of Retail Accounting|
|It’s quick and easy to calculate. Need to do a quick calculation on the fly to get a sense of costs? The retail method does the trick.||It’s only an estimate, meaning it’s not a great fit for developing your financial statements or any official accounting work.|
|Because it’s easy to perform, it might have value to managers and decision-makers at a company.||The retail method assumes your company marks up all items at the same rate. If you mark up one product more than others (which many retailers do), the math falls apart.|
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Inventory Valuation Methods & Accounting Best Practices
While we’ve shared two pros and two cons above, make no mistake that when it comes to your official accounting, the retail method is likely not the way to go. Your financial statements should be as accurate and thorough as possible because they’re the best historical record your business has of what happened and how you did. Undercutting that with an estimate of your cost of goods sold won’t do you any favors in the long run.
So what should you do to get the most accurate numbers? We’re glad you asked.
- Use a POS System: Make sure that you have an inventory management system in place. These are often referred to as POS (point of sale) systems, and if set up correctly, they’ll automatically calculate your cost of goods. Many of these systems will automatically select the inventory valuation method for you, and they often lean toward the weighted average method.
- Hire Help: Managing your inventory is no joke. High-volume retailers will likely need someone on hand to oversee their inventory management system and ensure that processes are being followed, operations are moving along, and manual counts are conducted regularly.
- Perform Physical Counts Quarterly: Counting every piece of inventory by hand is a time-consuming process, but it’s the only way to ensure the numbers your POS system is giving you are accurate. Try to do a physical count at least once a quarter. If you find any discrepancies between what your POS system’s reports say and what you have in stock, your accountant can make an inventory adjustment entry to get your books back in order.
- Choose Your Inventory Method with Caution: If you are in a position to choose your inventory valuation method (read: your POS system doesn’t make the decision for you), know that it’s not easy to switch between them. In fact, you have to submit a request with the IRS to change.
While deciding on an inventory valuation method may seem daunting, the truth is that many inventory systems will do the heavy lifting for business owners. In many cases, all they’ll need to do is download a report at the end of the month and pass that along to their accountants to have an accurate understanding of their costs.
The retail method can be a nice check to those reports, and it can be a valuable tool for creating forecasts or making on-the-go decisions. But it’s best left to managerial work.
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