Download Retail Inventory Method

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Retail Inventory Method
The retail inventory method is a way for companies to compute the cost of their ending
inventory based on the inventory's selling price, where the selling price is referred to as "retail."
The first step in applying the retail inventory method is to estimate the retail value of ending
inventory, based on the following relationship:
Beginning inventory (at retail)
Plus: Purchases (at retail)
Goods available for sale (at retail)
Less: Sales (at retail)
Ending inventory (at retail)
Notice that in order to use the retail inventory method a company must keep records of
not only the cost of beginning inventory and purchased items, but also the retail amount. A
physical inventory is not necessary to apply the retail inventory method.
Retailers often mark down or mark up the retail prices of their products, and these
markups and markdowns are also sometimes cancelled. Therefore, to compute the ending
inventory at retail it is necessary to keep track of not only the original retail price of the products
purchased, but all subsequent markups, markdowns, and cancellations as well.
Here is an example. Assume that a company has the following cost and retail
information about their beginning inventory and purchases for a year:
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Beginning inventory
Purchases
Markups
Markup cancellations
Markdowns
Markdown cancellations
Sales
cost
retail
80,000
160,000
630,000 1,260,000
24,000
9,000
38,000
10,000
1,120,000
Here is the computation of the ending inventory at retail:
Beginning inventory
Purchases
Markups
Markup cancellations
Markdowns
Markdown cancellations
Goods available for sale
Sales
Ending inventory at retail
retail
160,000
1,260,000
24,000
(9,000)
(38,000)
10,000
1,407,000
1,120,000
287,000
The second step in the retail inventory method is to convert the ending inventory at retail
into a cost amount by the use of a cost-to-retail ratio. The numerator of this ratio is the cost of
goods available for sale, which is equal to beginning inventory (at cost) plus purchases (at cost).
The denominator of the ratio is the retail value of the goods available for sale. This is equal to
beginning inventory (at retail) plus purchases (at retail) plus net markups (equal to markups less
markup cancellations). Using only net markups in the cost-to-retail ratio (and excluding net
markdowns) has the effect of approximating lower of average cost or market.1
Here is the computation of the cost-to-retail ratio using the example numbers:
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To compute average cost (rather than lower of average cost or market) markdowns and markdown cancellations
would also be included in the denominator of the cost-to-retail ratio.
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Beginning inventory
Purchases
Markups
Markup cancellations
cost
retail
80,000
160,000
630,000 1,260,000
24,000
(9,000)
710,000 1,435,000
Using these numbers, the cost-to-retail ratio is 710,000/1,435,000 = 49.48%.
The third step in applying the retail inventory method is to multiply the ending inventory
at retail by the cost-to-retail ratio. The resulting amount is an estimate of the ending inventory at
the lower of average cost or market. Using the numbers from the example, the ending inventory
amount is 49.48%  $287,000 = $142,000.
LIFO Retail Inventory
The retail inventory method can also be applied to companies using the LIFO cost flow
assumption, and is known as the LIFO retail inventory method. The first step in the LIFO retail
inventory method is to compute ending inventory at retail in the same way as was done for the
conventional retail inventory method illustrated earlier.
The second step, the computation of the cost-to-retail ratio, is different under the LIFO
retail inventory method. To see the reason for the difference, recall that under LIFO it is only
necessary to compute the current year inventory layer. The current year layer is added to the
beginning LIFO inventory amount to arrive at ending LIFO inventory. Since the LIFO
computation focuses on the current year layer, the cost-to-retail ratio is computed using only
current year purchases. The beginning inventory amount is ignored in the cost-to-retail ratio
computation.
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The numerator of the cost-to-retail ratio is purchases (at cost). The denominator is
purchases (at retail) plus net markups less net markdowns. Both markups and markdowns are
included in the denominator of the cost-to-retail ratio. Including net markdowns results in an
estimate of LIFO cost rather than lower of cost or market. If a lower of cost or market
writedown is required, it must be made after the computation of the LIFO inventory cost. Using
the numbers from the previous example, the cost-to-retail ratio is computed as follows:
Purchases
Markups
Markup cancellations
Markdowns
Markdown cancellations
cost
retail
630,000 1,260,000
24,000
(9,000)
(38,000)
10,000
630,000 1,247,000
The cost-to-retail ratio is 630,000/1,247,000 = 50.52%.
The next step is to use a LIFO price index, similar to the price index used for dollar value
LIFO, to deflate the ending inventory at retail to ending inventory at base year retail. Assume
that the price index for the current year is 1.35. Using the ending inventory at retail amount of
$287,000 from the previous example, the ending inventory at base year retail is equal to
$287,000/1.35 = $212,593.
The ending inventory at base year retail must then be separated into two amounts:
beginning inventory plus the current year layer. Assume that the beginning inventory at base
year retail in this example was $123,000. This means that the current year layer is equal to
$212,593 − $123,000 = $89,593.
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The current year layer is then multiplied by the LIFO price index to convert the layer
back to current year retail. Continuing the example, $89,593  1.35 = $120,950. This is the
current year layer at current year retail. To convert this retail amount to LIFO cost, multiply by
the cost-to-retail ratio: $120,950  50.52% = $61,104.
The final step in the computation is to add the current year layer (at LIFO cost) to the
beginning inventory (at LIFO cost) to arrive at the ending inventory (at LIFO cost). Assume that
the LIFO cost of the beginning inventory in the example is $70,000. The ending LIFO inventory
cost is then $61,104 + $70,000 = $131,104.
Here is a recap of the computation of the ending LIFO retail inventory amount for the
year based on the example numbers used above.
Ending inventory (current year retail)
price index for the year
Ending inventory (base year retail)
Beginning inventory (base year retail)
Current layer (base year retail)
price index for the year
Current layer (current year retail)
cost-to-retail ratio
Current layer (current year cost)
Beginning LIFO inventory (cost)
Ending LIFO inventory (cost)
287,000
1.35
212,593
(123,000)
89,593
1.35
120,950
0.5052
61,104
70,000
131,104
As is the case with dollar value LIFO, in those instances where there is a decrease in the
ending inventory, prior year layers must be eliminated in reverse order, with the newest layers
being removed first.