Factors to Consider While Using the Retail Inventory Method

The retail inventory method is used by retail corporations across the globe to obtain a rough estimate of the ending value of inventory held by them. However, the cost price is calculated as a percentage of the sales price.

Since the sales price fluctuates significantly over time, calculating the estimated cost price can become a little bit complicated. As a result, there are certain factors which need to be taken into account while considering the price using the retail inventory method. The details of these factors have been mentioned below:

  1. Product Grouping: A product group is a collection of similar types of products which are clubbed together for different purposes. Sometimes the purpose may be related to accounting. However, other times, products can be grouped together for administrative purposes as well.

    It is very important that products are grouped together only if they have similar financial characteristics. This is because retail inventory method estimates the cost price as a percentage of sales price. If the products have very different cost prices and profit margins, then the calculation may not be accurate. As a result, retailers which deploy the retail inventory method must be aware of their product groupings as well as the impact that such grouping has on the estimated cost.

  2. Shrinkage: In the retail sector, shrinkage refers to the goods and services which may have been lost or destroyed. These goods are not sold and hence do not generate any revenue.

    Whenever a retail company uses the retail inventory method to estimate the cost of their inventory, they implicitly assume that the shrinkage rate of the previous years is likely to continue in the future. This assumption is valid for most years. However, if the shrinkage rate in a particular year varies too much then the results given by the retail inventory method may not be valid anymore.

  3. Initial Markon: There are some terms which are specific to the retail sector which also play a very important part in the retail inventory method. For example, the term markon is used specifically in the retail sector.

    Markon is a term used to denote the gross profit that a retailer plans to obtain by selling a product when they initially price it. This can be better understood with the help of an example.

    Let us assume that the retailer has a cost of $100 and sets an initial price of $170 to sell the product at retail. In such cases, $70 is their initial markon. Since the pricing of products keeps on changing frequently in the retail sector, the initial markon is an important reference point which is used in the retail inventory method.

  4. Markup: The term markup is also an important term used when referring to retail pricing. In fact, it is one of the most widely used terms when we consider the retail sector.

    Markup refers to the increase in the price of the product as compared to its initial markon price. It needs to be understood that markup refers to an increase from the initial price as opposed to an increase from the cost price. The cost price is not considered to be the case and is considered to be irrelevant in this calculation. Since the markup price captures the deviation of the new retail price from the original retail price, it is used widely in the case of retail inventory method.

  5. Markup Cancellation: Markup cancellation is another term used in retail inventory method accounting. A markup cancellation is the opposite of a markup. This means that the retail price is reduced. However, this reduction keeps the new retail price above the initial markon price.

    Once again, the initial markon price is used as the reference point and not the cost price. Hence, if the initial markon of a product was $5, and it was marked up to $8, any reduction in price wherein the new retail price is above $5 will be called a markup cancellation.

  6. Markdown: A markdown is the opposite of a markup. In case of a markdown, the retail price of the product is changed and the new retail price ends up being below the original markon price. Let’s understand this with the help of an example. If the initial price of the product was $5 and the new price of the product is $4, then the reduction in price will be called a markdown.

  7. Markdown Cancellation: A markdown cancellation is the opposite of a markdown. A markdown cancellation results in the increase of the price of the retail product. However, even after the increase the price remains below the initial markon level.

    If the price increases above the initial markon level, it will be called a markup. Hence, if we continue with the aforementioned example, wherein the initial retail price was $5 and the price was marked down to $4, the increase in retail price to $4.75 will be called a markdown cancellation.

All the above mentioned factors as well as terminologies play an important part in the retail inventory method. It is important for any student of retail accounting to familiarize themselves with these terms since these terms are used ubiquitously in retail literature.


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Finance in Retail