Retail Inventory Method

Inventory is a very important part of the retail business. This is because the stock which retail stores hold on their books is their most important asset. The quality of this asset allows them to generate higher profits as compared to their peers. Hence, the valuation of inventory which is held by the retailer is considered to be a very important financial metric.

Traditionally the value of inventory is calculated using either FIFO, LIFO or Weight average cost method.

However, retailers tend to hold large quantities of goods on their books. It is for this reason that estimating the value of this inventory at closing becomes quite difficult. Since a physical count of inventory can be a very complicated and long process for retail companies, they use a method known as the retail inventory method (RIM) to draw a rough estimate of the value of the inventory which is held by the company.

What is the Retail Inventory Method?

The retail inventory method is a method of estimating the closing retail inventory. The purpose of this method is to allow retail companies to use financial information present with them to calculate financial inventory without actually undertaking a physical count. This method uses information such as retail price and cost price of the inventory to come up with a monetary estimate of the value of ending inventory.

The primary advantage of this method is that it gives retailers a reliable estimate of the ending inventory value without the need for them having to go through each of their warehouse shelves.

The implementation of technology has made this concept somewhat redundant for large retailers who can afford to track their inventory real time. However, this concept still has large scale implications for smaller retailers whose technological systems are not as advanced.

Who Should Use the Retail Inventory Method?

Even though the retail inventory method is touted as being a convenient method to estimate the closing value of the retail inventory, it cannot and should not be used by all retailers. This method is generally suited for retail businesses which have certain characteristics. A couple of these important characteristics have been mentioned below:

  1. Retail inventory method is only valuable if there is a consistent markup which is used by the retailer. For instance, if a retail company generally sells their goods at 50% markup, then this method can be quite useful for them. However, if their sales price and their markup fluctuate between 25% and 100%, then using the retail inventory method may not be the best decision

  2. Retailers which sell goods across fewer categories are more suited towards using the retail inventory management system. This is because the cost ratio used in this system can vary across product lines. There is an implicit assumption in this method that the cost ratio from the past will also be relevant in the future. However, if the retailer is selling a large number of products, changing the product mix or changing the proportion in which the products make part of the overall mix can change the cost ratio.

    For example, if a retailer sells furniture at 40% markup and furnishings at 25% markup, then the cost ratio of such a retailer may depend upon how much of their sales are being derived from the furniture category or the furnishing category. If the company was earlier deriving 75% of its sales from furniture, and now they derive only 40% of their sales from this category, then their cost ratio will change which will in turn impact the valuation of ending inventory.

  3. It is important to realize that the retail inventory method provides a rough estimate using historical accounting values. The output of this method cannot be considered to be adequate. Hence, only retail companies which need an estimated accounting value of their ending inventory should use this method.

    If the company needs accurate values, then they would be better off using methods where there is a physical count and estimation involved for different types of inventories.

Impact of Technology on Retail Inventory Method

Retail inventory method was considered to be a useful tool for estimating the price of inventory. However, estimation was only required since tracking inventory as well as prices was difficult in real time. However, nowadays most retailers use software and barcodes in order to track their inventory. As a result, they now have real time data available wherein they can accurately determine the cost of their inventory using LIFO, FIFO, Weighted average or any other method. Hence, physical counting of inventory is no longer required since barcodes provide a reliable estimate of the value of goods present in the warehouse.

Hence, it can be said that retail inventory method is an innovative accounting method which is widely used in the retail industry. However, retailers need to carefully evaluate the method to understand whether it is suitable for their business model before adopting the same.

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Finance in Retail