Retail Accounting vs. Cost Accounting for Inventory

Retail businesses are as varied as the goods they sell to the world’s diverse spectrum of consumers. Yet, whether they are a local, mom-and-pop grocer on Main Street, a big-box chain or an ecommerce powerhouse, retailers all have at least one thing in common: inventory. Merchandise that’s in stock and available for sale is considered retail inventory, which is often the largest asset on a retailer’s balance sheet — up to 80% for small retailers. Because inventory represents such a significant investment of resources, it’s vital for retailers to manage, safeguard and value it appropriately.

There are several accounting methods for valuing inventory, each with distinct advantages and effects on profitability. Two valuation techniques, the retail method and the cost method, are accepted by the IRS and comply with U.S. Generally Accepted Accounting Principles (GAAP). Understanding both techniques can help retail leaders determine which best fits their business. It’s important to choose wisely because the IRS requires businesses to keep their method consistent, year after year.

What Is Retail Accounting?

The retail method of accounting is a way to estimate the value of a business’s inventory on hand and, indirectly, its cost of goods sold (COGS). This valuation technique uses the inventory’s selling price rather than its historical cost to purchase. Retail accounting is a calculation done on “paper” — that is to say, no one physically counts the items in inventory — using the dollar value of the inventory, purchases and sales. It requires good sales data and demands rigor but is expedient and especially helpful for retailers that: 1) offer a large number of items and price each category consistently, 2) have a high volume of transactions and/or 3) can’t perform periodic physical counts.

The defining characteristic of the retail inventory method is the “cost-to-retail ratio,” which compares the cost to purchase inventory to the corresponding products’ retail sales price. Sometimes called the “cost complement,” the cost-to-retail ratio is calculated by dividing the average cost of inventory purchases by the retail sales price of the item, or a category of items. For example, if an apparel shop purchased dresses for $70 and sold them at $100, the cost-to-retail ratio, expressed as a percentage, is 70% ($70/$100).

Once retail accountants have collected the data and completed the calculations necessary to derive this ratio, which establishes a firm mathematical relationship between retail prices and actual historical inventory costs, they can more easily calculate inventory values and COGS for financial management and reporting. They do this by applying the ratio to the business’s beginning inventory in a given reporting period and its inventory purchases in that period, effectively “grossing up” the inventory available for sale to its retail value. The retail value of sales for the period is subtracted from the value of available inventory to compute the ending inventory’s retail value. Finally, for reporting in financial statements and tax returns, the ending inventory’s retail value is discounted down to its estimated cost value using the cost-to-retail ratio in reverse.

The retail method also yields a calculation for COGS, as the difference between inventory available for sale and ending inventory. COGS and gross profit (i.e., revenue minus COGS) are important metrics for managing profitability and key drivers of the amount of taxes a retail business will pay.

What Is Cost Accounting for Retail Inventory?

Retail cost accounting is done by aggregating what accountants refer to as “product costs” on the cost basis, such as raw materials, labor and direct manufacturing costs — primarily the amount paid to purchase finished-goods merchandise plus any costs incurred to get those products ready for sale, such as shipping (freight in). The cost basis of inventory valuation is different than “cost accounting,” which is a specialized branch of management accounting that deals with examining costs for internal analyses.

When valuing inventory using the cost basis, a company must choose a cost-flow assumption, which can be one of several methods available for assigning costs to inventory when a business makes multiple inventory purchases in the same period. Ideally, the method a business chooses should match how its inventory actually moves, but this is not a GAAP or IRS requirement. Examples of cost methods are:

• Average cost: This method calculates an average purchase cost per unit during a specific period for groups of similar products. For example, an apparel store might tally all costs to purchase dresses during a fiscal quarter and divide that sum by the corresponding number of dresses purchased, yielding an average cost it then uses for inventory valuation purposes. A separate average cost might be calculated for shoes or hats.
• First in, first out (FIFO): The FIFO method assumes that the oldest items in inventory are sold first. By stratifying cost data by date of purchase, an average cost per unit is assigned to each layer of inventory. As sales are made, each layer of inventory is depleted, by unit, in the order of oldest to newest, using the cost per unit attached to each layer. As a result, the units left in ending inventory should reflect the most recent supplier purchases — but only in theory, as there is no direct link between the accounting approach and how inventory actually moves.
• Last in, first out (LIFO): The LIFO method assumes that the newest items added to inventory are sold first. It’s essentially FIFO in reverse, resulting in ending inventory that is valued at the cost from oldest supplier purchases (again, in theory).
• Specific identification: With specific identification, retail accountants assign specific costs to each individual item in inventory. This method is the most accurate but has limited application because, in practice, it’s extremely hard to do. Nonetheless, retailers of unique, distinguishable products, such as automobiles, jewelry and fine art, tend to choose this method.

Key Takeaways

• Various inventory valuation methods can yield different values for the assets on a retailer’s balance sheet and the net income on its income statement — which impacts the income tax it must pay.
• The retail method for inventory accounting is a simple approach to estimate ending inventory and cost of goods sold using the “cost-to-retail ratio.”
• The cost-basis method is more accurate but requires maintaining a lot of granular purchasing data.
• The right software can easily capture the necessary data, providing retailers with the flexibility to choose either method as well as valuable insights to help boost profitability.

Retail Accounting vs. Cost Accounting

Retail accounting and cost-basis accounting are two different approaches to value inventory. They also impact COGS, and, therefore, affect a business’s net income and tax liability. While the two approaches share similar uses, they have considerable differences, which are illustrated below.

Calculating the Retail Method

The retail method calculates ending inventory by subtracting the retail value of goods sold during the period from total goods available for sale (also at retail value), using the following formula:

Ending inventory = goods available for sale – (sales * cost-to-sales ratio)

Where:

• Goods available for sale include the value of beginning inventory at the start of a period plus all inventory purchases made during the period, net of any returns to the supplier.
• The sales variable represents the sales of inventory to customers for the period at the retail prices, net of any customer returns.
• The cost-to-sales ratio is the average cost of inventory as a percentage of the sales price.

This is a simplified formula. In practice, the retail method also factors in markups and markdowns. Markups and markdowns happen when retailers change sales prices. Unlike initial mark-ons, which represent the amount over the cost of an item used to set retail price, markups and markdowns are subsequent changes to retail selling prices. Considering the earlier dress example, the initial mark-on is the $30 difference between cost ($70) and sales price ($100). If the dress shop subsequently raises the retail price to $120 because of higher-than-expected demand, the markup is $20 ($120 less $100). If the shop lowers the retail price to $90 to encourage sales of slow-moving inventory, the markdown is $10. The retail method is more accurate when initial mark-ons are consistent and markups/markdowns are permanent rather than fluctuating.

Calculating the Cost Method

There are two steps in calculating inventory value using the cost-basis method. The first step is accumulating the right costs. Product costs, such as amounts paid to purchase stock and incoming freight, are compiled from supplier invoices. Some retailers also layer on allocated costs of labor and overhead directly involved with selling inventory, such as wages for salesclerks and warehouse employees. As a rule, “period costs” are specifically excluded when costing out inventory, such as marketing, administrative and selling costs (for example, the cost of shipping goods to customers). The second step is to apply the chosen cost-flow assumption. The formulas for valuing inventory and COGS under the cost-basis method are different depending on the cost-flow assumption in use. The formula below is applicable when using the average cost method, which is the simplest cost-flow assumption. It is also one of the two most commonly used assumptions (the other being FIFO).

Inventory cost per unit = (total cost of beginning inventory + total product costs for new purchases) / total units available for sale

Total units available for sale is the sum of the units in inventory at the beginning of the period plus the units purchased during the period. The resulting inventory cost per unit would be multiplied by the number of units on hand at the end of the period to determine the ending inventory value for inclusion on the company’s balance sheet. That formula is:

Ending inventory value = inventory cost per unit * remaining number of units on hand

After ending inventory has been determined, COGS for the period can be calculated, as shown in the two following examples.

Retail Method of Accounting Example

The chart below illustrates the retail method calculation for the hypothetical dress shop mentioned above. The CFO used the retail method to calculate inventory for the six-month interim financial statements because the company does physical inventory counts only at the end of each year.

Using this information, Kensington’s COGS for the period, which is always reflected on the income statement at cost, can also be calculated using the formula:

COGS = beginning inventory + purchases – ending inventory

$80,500 = $30,000 + $80,000 - $29,500

Cost Method of Accounting Example

The hypothetical dress shop’s competitor, Brixton Boutique, uses the cost basis of inventory valuation and the average cost cost-flow assumption. Brixton’s calculation looks a little different than the retail method. Most importantly, the behind-the-scenes process is significantly different. First, all cost information would need to be aggregated from various different sources. Second, a physical count of inventory on hand would be performed at the end of the period. The Brixton CFO values ending inventory as follows:

Using this information, Brixton’s COGS for the period is calculated using the same COGS formula:

COGS = beginning inventory + purchases – ending inventory

$77,400 = $20,000 + $82,000 - $24,600

Why Use the Retail Method of Accounting?

The retail method is a simplified approach to valuing inventory that is convenient, reliable and uses concepts and terms that are familiar to retailers.

• Retail accounting is convenient. It approximates the inventory value without needing a physical count, thus avoiding the cost and interruption to business operations that inventory counting requires. As such, it is especially useful for interim reporting. It is also helpful in cases where the inventory is dispersed in several locations or isn’t accessible — for example, if it’s in a remote warehouse location — or in cases where inventory has been destroyed (which is why insurance companies often use the retail method).
• The retail method is reliable. For retailers with a fairly consistent mark-on pattern, the retail method can provide reliable inventory valuation estimates. The retail method is an especially helpful alternative to the cost-basis method when costs of inventory purchases from suppliers fluctuate significantly, which complicates the recordkeeping of cost details.
• Retail prices are familiar. Those in the retail industry think in terms of retail prices and mark-ons, so dealing with inventory in those terms is familiar. Forecasting and budgeting are easier when everyone across the organization is on the same page.

Why Use the Cost Method of Accounting?

The cost-basis method of valuing inventory simply yields more accurate values for ending inventory as well as for COGS. That’s why it’s considered the gold standard. The cost basis is a better option for retailers who offer a wide range of products with different initial mark-ons or fluctuating mark-ons, which would cause the retail method to be grossly inaccurate. Tracking at a SKU level provides the most accurate cost information, which, in turn, can show business leaders which products contribute to gross profit and which do not. But this approach requires cost and unit data from every stock purchase to be carefully tracked. Maintaining these records manually can be cumbersome, although accounting and inventory management software can make it easier.

Business Considerations for Retailers

Inventory is a significant asset for retailers, so selecting the best-fitting inventory-valuation method is important to a retailer’s financial strategy and its merchandise financial planning. Different methods yield different values, impacting both the balance sheet and income statement. While cost-basis tends to be a default method for retailers, the retail method is also acceptable. Once a method is selected, the IRS requires businesses to be consistent every year. For retailers, several considerations common to the industry can help guide the selection of the cost-basis versus retail method, including:

• The nature of the inventory: Do the inventory categories remain consistent over time?
• Stock purchases: Are costs easily matched to units? Do they fluctuate significantly?
• Sales prices: Are initial mark-ons consistent over time and within inventory categories? Are markups and markdowns frequent and are they temporary or permanent?
• Business cycle: Does seasonality have a significant impact on stock purchasing and sales prices?
• Availability of data: Are systems able to capture cost data, and at the right level?

The answers to these questions may lead a retailer to lean toward the retail method when product categories and mark-ons are consistent, especially if cost data isn’t easily captured or attributable to products. However, if retail pricing is volatile and margins are inconsistent, using the cost-basis method may be more appropriate. It’s important to note that whichever method a business chooses, it only applies to reporting the value of inventory for financial statements — it has nothing to do with inventory management, which is an entirely separate discipline.

Manage Accounting for Your Store with NetSuite

Valuing inventory for accounting purposes requires good clean data regardless of which method is used. The retail method demands sale prices and quantities and mark-on, markup and markdown information. The cost-basis approach needs traceable purchase detail. Both cases call for an automated solution like NetSuite for Retail, which is purpose-built to handle the unique needs of retailers and marries inventory valuation with physical inventory management. Furthermore, combining NetSuite for Retail with NetSuite Financial Management allows financial data, such as customer sales and procurement expenses, to be captured at the SKU level in the accounting software. This provides real-time visibility into sales and inventory, facilitating better inventory accounting, especially when the business has multiple locations and selling channels.

Inventory is the largest asset for most retailers. Valuing it appropriately is important for financial reporting, paying taxes and running a successful business. The retail method for valuing inventory relies on the relationship between retail selling prices and cost in order to estimate inventory values and COGS. The cost-basis method incorporates a choice of possible cost-flow assumptions, but they all require careful tracking of the costs to obtain merchandise available for sale. Understanding the requirements and impact of the different methods can help a retailer determine the approach that best fits their business. The right software delivers the data easily for either method, enabling more effort to be focused on delivering the best experience for the customer and growing sales.

Retail Accounting vs. Cost Accounting FAQs

What is the difference between retail and cost planning?

The retail method of accounting estimates the value of a business’s inventory on hand and its cost of goods sold, based on a “cost-to-retail ratio.” This ratio shows the cost to purchase inventory as a percentage of the products’ corresponding retail price. The cost-basis method is a more conservative approach that includes all “product costs” — primarily the amount paid to purchase the merchandise plus any costs incurred to get those products ready for sale — at actual historical cost.

What are the key differences in reporting requirements for retail accounting and cost accounting?

Both methods yield values for ending inventory and cost of goods sold (COGS). Ending inventory is reported on the balance sheet as a current asset, while COGS is reported as an expense on the income statement. The retail method calculation uses data on sales prices and quantities along with mark-on, markup and markdown information. There are various cost-basis approaches, all of which require traceable purchase details and periodic physical inventory counts.

How does retail accounting handle customer loyalty programs and rewards?

“Retail accounting” refers to a method for valuing inventory based on retail sales prices — it has nothing to do with accounting for loyalty programs. The way the retail industry accounts for customer loyalty programs and rewards is guided by ASC606 of U.S. Generally Accepted Accounting Principles (GAAP). The guidance says that every time a loyalty-eligible sale is made, an amount of that sale must be reduced from revenue and accumulated in a liability account. The amount is based on an estimate of costs that will be incurred by the granting company when the rewards are redeemed. The liability should also be adjusted based on an estimated redemption rate for the rewards.

What are the considerations for tax compliance in retail accounting and cost accounting?

Tax compliance for retailers has several components, including income taxes and sales taxes. Because the retail and the cost-basis methods of valuing inventory can produce different results, they can have different effects on the valuation of cost of goods sold (COGS), which, in turn, impacts taxable net income. For example, cost-flow assumptions like FIFO, which is used in the cost-basis method, will cause net income to be higher than other methods during inflationary periods. This is because under FIFO, the items assumed to be sold were older and less expensive than the most recent inventory added to stock. Choosing the right inventory method is part of careful tax planning, especially since the IRS doesn’t require businesses to use the same method for tax purposes as for financial reporting. However, the IRS does require consistency, so retailers can’t change inventory methods from year to year as a way to minimize their tax liability.

What is the retail method of accounting?

The retail method is a simplified approach to valuing inventory based on retail selling prices rather than historical costs, using the following formula:

Ending inventory = goods available for sale – (sales * cost-to-sales ratio)

The defining factor of the retail method is the cost-to-sales ratio, which translates retail-based values to cost-based values. The cost-to-sales ratio, sometimes called the cost complement, is the average cost of inventory as a percentage of the sales price.

What is the difference between retail accounting and cost accounting?

“Retail accounting” is a shorthand reference to the retail method of valuing a business’s inventory for financial reporting purposes, as opposed to the cost-basis method of valuing inventory. The former is an estimate based on retail selling prices and related factors, while the latter is a more precise and detailed calculation incorporating the actual amounts paid by a retailer to purchase its merchandise plus any costs to get those products ready for sale. “Cost accounting,” on the other hand, is an entirely unrelated branch of managerial accounting used mainly by manufacturing companies to assess the efficiency of their production operations.