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The retail method of accounting (RMA) has long been a convenient option for retailers that wish to quickly calculate the value
of their inventories and goods sold. Invented before the introduction of computerized inventory systems, RMA allowed retailers
to simplify their accounting practices by calculating the “cost complement,” which is the ratio between the wholesale cost of
beginning inventory and purchases and the retail selling price of beginning inventory and purchases, and multiplying it by the
retail selling price of their ending inventory.
Despite the obvious drawbacks and potential for abuse of such an approximate system, the retail method eliminated the need
to calculate unit costs for each item sold and reduced headaches for retailers who lacked the resources or financial expertise to
support more thorough accounting practices. However, because the RMA is an approximation, retailers must periodically
conduct a physical inventory count for accuracy of these estimates and its results are not adequate for the year-end financial
statements, for which a high level of inventory record accuracy is needed.
Thanks to the advent of modern accounting systems and superior retail merchandising practices, retail accounting has largely
run its course as a viable accounting method. Thousands of U.S. companies, including many notable retailers, are in the process
of transitioning to the more accurate and flexible cost method of accounting (CMA), a system that enjoys the support of the
International Financial Reporting Standards (IFRS).
Meanwhile, the Securities and Exchange Commission has come out strongly in favor of CMA and continues to explore the
feasibility of merging American accounting protocols with those of the IFRS – a move that could compel retailers to accelerate
their transition from retail to cost accounting. Even in the absence of a mandate, the greater accuracy and superior key
performance indicators (KPIs) offered by CMA make a clear case for its adoption.
While the thought of a significant change in accounting practices is likely to give most business owners pause, the leap from
retail to cost accounting is not an overwhelming prospect when enabled by the appropriate technology.
The following sections will:
a) Explain both RMA and CMA in detail
b) Outline the IFRS’s stated position on the two methods
c) Explain how retailers can transition from RMA to CMA
d) Discuss the clear benefits of making the transition
e) Offer a Q&A with Mi9 Retail’s CTO
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What Is the Retail Method of Accounting?
Retail accounting has long been used by major retailers to arrive at approximate valuations for inventory, gross margins
and GMROI. Under Section 1.471-8 of the IRS's Income Tax Regulations, this method must use a "cost complement" or
"cost-to-retail ratio" to determine the approximate markup price of all inventory items sold at retail. For each accounting
period, this ratio is calculated as follows:
(Value of beginning inventory + Cost of purchases during the period) / (Average retail selling price of beginning inventory
+ Initial retail selling price of purchases)
In other words, the cost complement is a blunt way of calculating the retailer's gross margin during a particular accounting
period. To determine the value of ending inventory, the retailer multiplies the cost complement by its actual selling price.
It is easy to reduce the apparent value of ending inventory by marking down its retail price towards the end of the
accounting period.
 RMA’s Significant Drawbacks
Prior to the advent of modern computer software and the development of complex metrics to quantify and track the
performance of employees, vendors and marketing channels, the retail method was an acceptable – though still inferior –
means of retail merchandising. In a competitive economy in which gross margins can turn on small changes in firms' key
performance indicators, RMA is no longer suitable for most businesses. Its most noteworthy drawbacks include:
Lack of Precision: Since RMA produces an approximate figure that does not capture values for specific items of inventory,
it cannot readily account for losses due to breakage, theft or other events. This makes it less than ideal for low-margin
retailers for whom loss management is a top priority.
Powerful Incentives for Retail Markdowns: Retail accounting causes the value of inventory to fluctuate proportionally
to retail prices, not the actual wholesale cost of each item. Over time, this creates a perverse incentive for firms to mark
down retail prices in perpetuity and conditions customers to expect the same value at a lower cost. This is a dangerous,
unstable game for retailers that worry about cheapening their brand and preserving their image.
Potential for Abuse: On the other side of the equation, RMA encourages buyers and planners to manipulate the
numerator of the cost complement ratio by delaying purchases. This reduces the cost complement, shrinking the apparent
retail value of ending inventory and potentially obscuring weakness in the sales pipeline – whether caused by unappealing
products, poor employee performance or subpar marketing.
Lack of Insight into Merchandising Trends, KPIs and Margins: Perhaps the most far-reaching drawback of the retail
method of accounting is its lack of insight into the key performance indicators that keep retailers ahead of the competitive
curve. Since it does not break out its calculations by individual inventory item, RMA is only suitable for calculations at the
department or category level. This makes it difficult to determine which products have the highest gross margins and
GMROI. At best, retail accounting offers insight into the relative performance of broad product categories within
departments. For retailers that rely on a relative handful of high-margin products to drive profitability, such vagueness
may be unacceptable.
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What Is the Cost Method of Accounting?
The cost method of accounting is a far more accurate and detailed – but not necessarily more complex – means of
calculating the wholesale cost and retail value of inventory items on a periodic or perpetual basis. It allows the retailer to
calculate the weighted average unit cost for a particular item – and the SKU level – with the following formula:
Weighted average unit cost = (Total cost of inventory / Total units in inventory)
To determine the cost of goods sold for each item, the retailer multiplies its weighted average unit cost by the number of
units sold. To determine the true value of ending inventory for each item, the retailer multiplies the weighted average unit
cost by the number of items on hand.
Note that this remarkably simple approach never introduces retail value into the equation. This removes a key source of
inaccuracy and distortion.
 CMA's Core Advantages
The cost method of accounting has rapidly gained favor with retailers for a number of reasons, including:
Clear, Straightforward Calculations with Fewer Data Points: The basic CMA calculation is far simpler than that of the
retail method. With fewer variables in each calculation, the likelihood of an accidental error decreases. Moreover, the
weighted average unit cost represents the true value of each item for which it is calculated. With RMA, additional data
points are needed to account for losses, vendor returns and other events that can impact inventory calculations.
Greater Insight into Merchandising Trends and KPIs: Since it calculates the true value of items at the inventory level,
CMA offers far more insight into important merchandising trends that can make or break a retailer's performance. For
instance, consistently favorable inventory trends in items under the purview of a particular salesperson may indicate that
that employee is outperforming his or her peers. By contrast, poor performance in a product category that lacks visibility
or marketing support may indicate a need for redoubled promotional activities. In both cases, CMA makes it impossible
for buyers and managers to obscure poor performance through persistent markdowns and other tactics. In a cost
accounting framework, selling is the only means of exerting positive influence on ending inventory values.
More Accurate Gross Margins and GMROI: Unlike category-bound RMA, the cost method of accounting clearly identifies
the gross margin on inventory items at the SKU level. By offering an incisive look at profit trends for individual products,
CMA provides insight into which items offer the best return on investment and which lag within their categories and
departments. This allows retailers to more effectively and flexibly allocate labor resources while adjusting vendor
relationships, buying protocols and marketing spend to reflect consumer behavior.
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How Does the International Financial Reporting Standards View
These Two Methods?
By now, it should be clear that the cost method of accounting is superior to the retail method in several important ways.
Aside from these clear benefits, however, there is another incentive for retailers who have not yet done so to make the
switch from retail to cost: the imprimatur of the International Financial Reporting Standards.
IFRS is used by more than 10,000 major companies in dozens of countries around the world. As the arbiter of global
accounting standards, its recommendations carry tremendous weight among financial regulators, including the Securities
and Exchange Commission. Although its protocols share many similarities with those of Generally Accepted Accounting
Principles (GAAP), the accounting framework used by many public firms in the United States, the two systems are not
identical.
In particular, two IFRS principles – both of which concern the use of inventory markdowns – run directly counter to retail
accounting as commonly practiced by U.S.-based retailers.
First, GAAP permits firms that engage in write-downs for a specific class of inventory to make those write-downs
permanent. This creates a new, lower cost basis that can obscure the true value of inventory and reduce the accuracy of
subsequent calculations of financial performance. By contrast, IFRS requires retailers to reverse write-downs "once the
reasons" – including spoilage or theft – "for the impairment no longer exist." This precludes the creation of a new cost
basis that could have permanently distorting effects.
Secondly, GAAP – and, by extension, the retail method of accounting – is quite lenient on the issue of permanent
markdowns. In this framework, retailers that permanently mark down the retail value of an inventory category do not
have to apply this change to the gross margin used to calculate ending inventory value. This can have the effect of
reducing the apparent cost of inventory to a level lower than any of the acceptable measurements – cost, cost to market
or net realizable value – used in retail accounting.
Again, the distortive and obscurative effects of such a maneuver should be apparent. Under the IFRS framework,
permanent markdowns shrink gross margins and make it impossible to reduce inventory values below a certain point. In
turn, this limits the manipulative potential of markdowns and encourages more accurate financial reporting.
These two IFRS principles are not mere abstractions. The Securities and Exchange Commission has long encouraged U.S.
retailers and other firms to make the switch from RMA to CMA, and the organization continues to weigh whether to
compel this transition outright. Even in the absence of such an action, these principles further reduce RMA's attractiveness
and underscore the case for CMA's adoption. Moreover, the complexity and disruptive potential of this transition may be
overstated.
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Transitioning from the Retail Method to the Cost Method
Accounting and inventory management are fundamental business activities for any retailer, so it’s understandable that
decision-makers consider the prospect of transitioning between significantly different frameworks with trepidation. That
said, the change itself is far less challenging and complex than typically feared, and the long-term benefits of making it
far outweigh any temporary negatives.
 How Can Business Intelligence Streamline the Switch?
Business intelligence, an increasingly critical tool for retailers of all sizes and stripes, has the potential to smooth the
learning curve associated with the RMA-CMA transition. Business intelligence (BI) is the process of interpreting – in large
volumes – a wide range of financial, product-related and human data into KPIs and other useful information that can be
used to illuminate practices and drive decisions. In a data-driven world, retailers who fail to harness the potential of
business intelligence invariably fall behind more nimble, flexible competitors. The days of skating by on the strength of
name recognition and consumer loyalty alone are gone.
The value of pairing a transition from RMA to CMA with the adoption of a comprehensive business intelligence solution
is clear: Although BI offers clear advantages for any retail business, the limitations of the retail method of accounting make
it impossible to achieve such precision in the absence of a superior accounting framework.
 Common Objections to Transitioning from RMA to CMA
Profitable retailers that continue to use retail accounting without any apparent deficits may be reticent to adopt a new
means of accounting for inventory. While this is perfectly understandable, some of the arguments against the transition
lack merit.
RMA Appears to Be Suitable: For financially healthy retailers who have yet to harness business intelligence (BI), the
adoption of CMA may seem superfluous. However, even successful businesses can benefit from the superior accuracy and
flexibility of the cost method of accounting. When coupled with BI's insights, CMA allows for the effective deployment
and reallocation of resources in response to new information about consumer behavior, employee performance,
marketing effectiveness and margin trends. There may be no such thing as maximal efficiency, but the potent BI-cost
method combination gets any retailer – regardless of the quality of their products or the competency of their management
team – closer to this goal than RMA alone.
Disruptive, Costly Transition: Retailers may worry about the financial and time costs of the transition, which is an
understandable sentiment in an industry beset by rapidly changing margins and market conditions. The early stages of
such a transition may require employers to provide instruction and support. However, the superior accuracy and flexibility
of CMA, not to mention the powerful insights offered by a comprehensive business intelligence solution, more than offset
these transient expenses.
Loss of Historical Sales and Inventory Data: Retailers may be concerned that the transition will not be seamless and will
not preserve the critical insights into past sales and inventory data. However, this this is not the case because business
intelligence fully preserves historical data, enabling retailers to draw upon it seamlessly for comparison purposes.
Employee Pay Structure Favors RMA: Retailers that incentivize buyers and managers to meet periodic inventory goals
may fear a drop in employee morale and an increase in turnover after making the switch to CMA. This can be avoided
with relative ease by eliminating incentives that track the approximate value of ending inventory and replacing them with
straightforward sales, customer acquisition and gross margin targets. As an added bonus, such incentives should reduce
the use of markdowns as an inventory-reduction strategy.
Non-Public Firms Have No Incentives to Switch: While much has been made of the SEC's proposed adoption of
International Financial Reporting Standards, it is unlikely that its protocols would immediately apply to private companies
in the United States. As the IFRS framework becomes more entrenched, however, a consensus in its favor may emerge
among larger retailers and financial institutions that support them. Retailers that fail to follow the lead of their larger
and/or publicly traded competitors and adopt CMA may well find it increasingly difficult to secure financing at favorable
terms. If the SEC does eventually mandate IFRS compliance, privately held retailers that wish to go public at any point in
the future must bring their accounting practices in line with its standards before doing so.
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View from the Inside: Q&A with Roger Johnson, CTO at Mi9 Retail
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Q: With all the great benefits of the Cost Method of Accounting, why are retailers still using the Retail Method?
A: In short, the retail method is easy and convenient. It allows retailers to simplify their accounting methods especially
when they lack the resources or financial expertise to support more thorough accounting practices.
Plus, for those retailers who don’t have an appropriate team in place, the transition from retail to cost method can be
overwhelming. Still, it doesn’t make business sense to remain on the retail method because it does a poor job of
measuring margin and does not really provide a proper accounting foundation for multi-channel retailers. In essence,
any challenges a retailer will face during the transition from the retail to cost method will be worth it in the long run
because it will deliver more insight into the business.
Please note, however, with the right technology, such as Mi9 Retail’s Merchant and BI products which include a set of
intuitive financial controls, the transition from the retail method to the cost method can be dramatically simplified.
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Q: How can Mi9 Retail’s financial controls simplify the transition from Retail Method to Cost Method of
accounting?
A: Mi9 Retail is the only retail analytics and merchandising platform that provides both an Inventory Daybook, a daily
ledger of activity maintained at the level of SKU/Store/Day, and a Stock Ledger, a periodic ledger of activity maintained
at the level of SKU/Store/Period. Our Daybook provides a true version of what happened so merchandising can accurately
manage SKU profitability at a granular level while our Stock Ledger provides a financial version so finance can accurately
audit the accounts.
The Daybook offers a ‘true time’ representation, is not limited by accounting rules such as the accounting restriction on
making changes to closed periods, and is used to feed applications such as replenishment, allocation and planning. The
Stock Ledger is an instrument for use by finance which must comply with accounting rules and will therefore never restate
a closed period. A key feature of both the Daybook and the Stock Ledger is the level of detail held and the auditability
provided.
Plus, Mi9 Retail can support both the retail method and cost method. Typically, retailers utilizing the retail method
calculate inventory costs in the stock ledger by department code and use average margin to compute cost and cost of
inventory, which is depleted accordingly. By doing so, they do not capture which SKU’s are more profitable than others.
However, Mi9 Retail’s Daybook and Stock Ledger keep the records at SKU level, even when the retailer is using the retail
method, allowing retailers to capture which SKU’s are more profitable.
Mi9 Retail’s Daybook is particularly helpful for companies that want to switch from the retail method to the cost method
because it can be completely recalculated from cutover, without impacting the historical stock ledger. Hence, with Mi9
Retail, retailers can close a fiscal period in the Stock Ledger which would freeze the historical data calculated in the retail
method and then switch to the cost method for all the new transactions. Therefore, converting from the retail method to
the cost method is quick and easy with Mi9 Retail and can be done midstream in only a few weeks’ time.
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Q: How does Mi9 Retail support both the Retail and Cost Methods of Accounting?
A: Simply put, with both a Daybook and a Stock Ledger, historical information can be converted for merchants, but not
converted for finance, thus maintaining audit integrity. By restating from a merchandising perspective, all this year/last
year comparisons are meaningful and it is possible to measure true profitability by product.
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Q: What is the main benefit of having both a Daybook and a Stock Ledger?
A: Because Mi9 Retail offers a Daybook, we not only provide an accurate version of the truth for merchants, but we can
also eliminate the manual labor required for Stock Ledger adjustments by automatically adjusting the cost of goods sold
and current inventory for prior periods by comparing the true values given by the Daybook to the values currently
represented by the Stock Ledger and computing the difference.
In addition, the Daybook solves the following issues inherent in a retail Stock Ledger:
 Lack of granularity
 No true margin by product
 The financial reporting/accounting rules that the stock ledger follows does not reflect the real world of the merchant
because you cannot make adjustments to closed periods (e.g., prior quarter or year)
 Manual labor required to apply adjustments in the current period for events that occurred during a closed period
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Q: How does the Mi9 Retail Daybook and Stock Ledger handle inventory cost?
A: The Daybook represents what has actually happened and is absolutely accurate in terms of units, cost and retail.
Therefore the Daybook shows true profitability of inventory.
Like the Daybook, each entry in the Stock Ledger contains the opening balance in units, cost and retail, all of the
movements such as receipts and sales, and the closing balance in units, cost and retail.
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Q: How is financial data generated from the Stock Ledger?
A: For every inventory transaction, the Mi9 Retail system creates a journal entry recording the user, date and time as well
as information pertinent to the particular transaction. For example, a receiving journal would record the receiver number,
the PO number and the vendor ID whereas an adjustment journal would record the adjustment reason code.
In addition, each journal is also assigned a debit and a credit GL code. If investigating a GL account, one can drill down
to individual journals to see the impact the journals have on the GL. This provides auditability all the way from a detailed
transaction level to the general ledger and vice-versa. GL codes are determined according to configurable chart of
accounts definitions at both the transaction type and sub-type level.
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Q: How does Mi9 Retail handle backdated transactions and is this important in the conversion process?
A: With the Daybook, each entry contains the opening balance in units, cost and retail, all of the movements such as
receipts and sales, and the closing balance in units, cost and retail. If a back-dated transaction is processed (for example
an invoice cost adjustment or a back-dated receipt), the transaction is processed as of the true business date, and the
Daybook is recalculated from the business date to the current date for the particular SKU concerned. The reason this is
so important in the conversion process is because we are able to restate the daybook without impacting the Stock Ledger.
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 The Cost Method of Accounting: Delivering More Meaningful KPIs
Compared to the retail method of accounting, the cost method offers a superior approach to retail analytics. When coupled
with a comprehensive suite of business intelligence solutions, either as part of Mi9 Retail's Business Intelligence or
Merchant packages, it serves as the foundation of a responsive, flexible retail merchandising framework that benefits its
users in several key ways. Many of these benefits stem from CMA's use of SKU-level cost calculations, which are far more
useful than RMA's category and department-level approximations.
Identifying Valuable Customers: Mi9 Retail allows retailers to view recent and historical sales data from individual
customers, providing insight into their behavior and permitting the isolation of particularly frequent or high-budget
customers. Using customer-level data, nimble retailers can design promotions that target small cohorts of customers – or
even individual customers themselves – to boost conversion rates, reduce costs per sale and improve GMROI.
Tracking and Rewarding Employee Performance: Using employee-level sales data, retailers can isolate employees that
consistently outperform their peers in total sales volumes as well as sales of high-margin goods. This allows for the
implementation of more sophisticated, targeted incentive programs that go beyond traditional sales or inventory goals.
Illuminating Margins: With item-level cost information and analytics, CMA and business intelligence help retailers identify
inventory items with high or low gross margins shortly after introduction. This makes it easy to isolate and discontinue
poorly performing items before they generate a significant loss. Conversely, the ability to quickly identify high-margin
items facilitates the development of effective, highly targeted marketing and promotion – and boosts GMROI to boot.
Identifying Productive Vendor Relationships: The same principle applies to vendor-level cost analysis. Retailers can
quickly end relationships with vendors that offer limited value – whether due to low margins, slow-selling products or
other causes – while deepening connections to high-value vendors that offer favorable gross margins.
Improving Marketing Performance on a Channel-by-Channel Basis: Retailers can use Mi9 Retail's Business Intelligence
solution to analyze the effectiveness of individual marketing campaigns and channels. By analyzing SKU-level sales data,
margins and other indicators for items grouped by campaign, firms can determine how best to allocate limited marketing
dollars in the service of higher gross margins for individual items and improved GMROI across all inventory categories.
 Make the Transition from CMA to RMA with Mi9 Retail
Make a change that will pay lasting dividends by switching from the retail method of accounting to the cost method of
accounting and leveraging Mi9 Retail's comprehensive end-to-end retail suite to help with the transition. For more
information about Mi9 Retail, visit http://www.mi9retail.com.
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