Retail businesses have unique challenges, not least of which are business accounting – in particular for the inventory. Learn 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 is not a special type of accounting process or system, but rather an inventory valuation technique often used by retailers. It differs from “cost accounting” of inventory in that it values inventory based on the sale price rather than the purchase price.
More on this in a moment, but first it is important to understand the importance of accounting for the cost of inventory in your retail business.
Managing the cost of inventory: your biggest challenge
Probably your biggest expense is your retail inventory. But inventory is unique in that it isn’t an expense until you sell it.
If you find this confusing, don’t worry. Inventory is actually considered an asset – something your business owns that is recorded on your business’s balance sheet – until you sell it or report it as a loss due to theft or damage. . At this point, the expense for purchasing inventory is recorded as cost of sales (COS) or cost of goods sold (COGS) on your income statement.
Impact of inventory on profitability
As you can imagine, the cost of your inventory has a significant impact on the profitability of your business. This makes effective management essential to the success of your retail business.
You can have a significant impact on the profitability of your retail business by paying close attention to your gross profit margin. In fact, the gross profit margin measure is so powerful that you can achieve significant increases in your business’ bottom line just by adjusting the gross profit margin by a few points. This means that you can increase the overall profitability of your business without having to make a big effort to increase your sales!
But in order to do that, you need to know the cost of your inventory. This brings us back to inventory valuation methods, including retail accounting.
Calculation of the cost of stocks or valuation methods
A business can choose from five ways to calculate the cost or value of inventory. There is no “wrong” way to value your inventory, but there is a “better” way for your business. Which method you choose largely depends on what you are selling.
The cost of inventory specific identification attaches the cost to specific items in the inventory. This is done using serial numbers or some other unique identifier. The specific method of identifying inventory cost applies primarily to high-priced items, such as automobiles. Typically, retailers that use the specific identification method do not have a large number of items in stock, which makes what might otherwise be a tedious inventory costing task more manageable.
First in, first out (FIFO)
The FIFO inventory valuation method assumes that 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 with grocery retailers.
FIFO inventory cost assumes that any inventory available at the end of the accounting period should be valued at the most recent purchase price. Anything that was purchased at an older price would have been thrown away due to spoilage and expired expiration dates.
Last in, first out (LIFO)
The cost of LIFO inventory is essentially the inverse of the cost of FIFO inventory. The LIFO method assumes that the most recent items entered in your inventory will be the ones to sell first.
The LIFO inventory cost calculation is often used in situations where it is difficult to distinguish one inventory unit from another, and when inventory will not be rotated to ensure that 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 inventory cost method is often used when the inventory is not perishable, but the inventory can still be easily rotated or mixed.
Think of a bin of bouncing balls. Some bullets could have been purchased for $ 0.10 each, and some for $ 0.12 each. There’s really no way of knowing which balls were purchased at what price, 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 of acquiring inventory. The retail method is different – it values inventory based on the retail price of the inventory, less the mark-up percentage. This allows the retailer to quickly arrive at an approximate inventory value, without having to do a physical count or match the cost to items still available.
The retail method only works if the retailer’s markup on inventory is consistent across their inventory. If the items are marked at different percentages, the retail method will not give you an accurate value of your inventory.
Retail accounting: detailed example
Suppose your retail business sells yarn and knitting accessories. Each type of fiber costs a different amount and some knitting needles are more expensive than others. However, you chose to use a Keystone markup strategy, so you know you have a 50% markup on all items, whatever they are.
Suppose you took a physical inventory at the start of the quarter and you know that the actual cost of your inventory on that date was $ 80,000. Looking at the reports from your point of sale system, you see that at the end of the quarter, your sales totaled $ 30,000. Finally, throughout the quarter, you purchased new yarns and accessories for a total of $ 10,000.
With this information, you can determine the final value of your inventory using the retail method:
Starting 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 (retail): $ 30,000
Less – Cost of sales: ($ 30,000 * 50%) = $ 15,000.
Total inventory for sale (at cost) – Cost of sales = Final inventory value
$ 90,000 – $ 15,000 = $ 75,000
You can make a reasonable assumption that the value of your inventory at the end of the quarter is $ 75,000.
Retail accounting: advantages and disadvantages
There are some advantages and disadvantages of using the detail method of accounting for inventory. The main advantage of the retail method is the ease of calculation. You only need a few numbers to calculate your cost of inventory using the retail method, and you don’t need to do a physical inventory to get a good idea of the value of your property. final inventory.
There are, however, several downsides to using the retail method:
The retail method of accounting only works if all items are consistently annotated. Many retailers mark different items at different percentages. Although you can use an average markup in this case, it will make your estimate less reliable.
This method is only an estimate. While this 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 at least once a year to get an actual value for your inventory.
If your company changes the mark-up percentages, your calculation will be correct. In other words, if you initiate a sale after your last physical inventory, you will not be able to rely on your mark-up percentage to calculate the value of your inventory during the current period.
Tax ramifications of the cost of inventory
The IRS allows you to use any method you wish to assess your inventory for tax purposes. The caveat is that once you choose a method, you should stick with it, unless you get permission from the IRS to change your costing method. This rule is in place to prevent business owners from “playing with the system” by frequently changing the method of calculating costs to obtain the best tax benefits.
For tax purposes, you want to use the inventory cost calculation method that will give you the most accurate inventory valuation. While you can use the retail method for tax purposes, you will probably want to use a different method – like the weighted average – to make sure you report the most accurate information.
Before deciding on which inventory costing method to use for your taxes, talk to your accountant. They will be able to recommend the most advantageous costing method for your business.
A version of this article first appeared on Fundera, a subsidiary of TBEN.