Retail Method

Definition

The financial accounting term retail method refers to an approach to valuing inventory in a retail business setting.  The retail method assumes the relationship between the cost of goods in stores and their retail price is consistent in the current period.

Explanation

The retail method of valuing inventory is often used by retail chains, grocery stores and other retail businesses.  Following a physical or electronic inventory, the store owners will know both the types and numbers of items in stock.

The first step in this process involves pricing the inventory using current retail prices.  Next, additions to inventory are converted to a cost value by using the prevailing mark up percentage.  This is where the retail method differs from the gross profit method.  While the retail method uses the mark up percentage in the current period, the gross profit method uses data from prior periods.

Prior period inventory values at both cost and retail are then added to the additions to inventory to develop a cost of goods available for sale on both a cost and retail basis.  The net sales for the accounting period is then subtracted from the cost of goods available for sales (price basis), resulting in an estimate of the ending inventory on a price basis.

The cost to price ratio is then used to convert the ending inventory on a price basis to an ending inventory on a cost basis.

Example

Company A's inventory on January 1 was $175,000.  Additions during the first quarter of the year were $72,500.  Company A's revenues in the first quarter were $125,000.  The prior period markup was 70%, while the current period's markup is 80%.

The inventory on a cost basis at the end of the first quarter would be:

  Cost Basis Price Basis
Beginning Inventory $175,000 $280,000
Net Additions $72,500 $130,500
Cost of Goods Available for Sale $247,500 $410,500
Less: Net Sales   $125,000
Ending Inventory (Price Basis)   $285,500
Cost Ratio ($247,500 / $410,500)   60%
Ending Inventory (Cost Basis) $170,627  

Related Terms

inventory, cost of goods sold, gross profit method, first in, first out, last in, first out