Retail Inventory Method Explained: Formula & How To

Inventory is the lifeblood of retail businesses. U.S. retailers held more than $772 billion of inventory at the end April 2023, according to the Census Bureau. Because inventory ties up so much cash, managing it is a top priority for retailers, who seek to carefully balance between having too little and too much inventory on hand. Too little can cause stockouts and missed sales, while too much ties up cash and increases inventory carrying costs. One way business owners can more easily monitor the value of their inventory is by using the retail inventory method, a valuation approach that is simpler to apply and much less disruptive than taking physical inventory counts every day or week. Understanding this valuation method can help retailers move the needle on profitability and improve their customers’ experience.

What Is the Retail Inventory Method (RIM)?

The retail method is an inventory valuation technique that is commonly used by retail businesses but can be applied to other industries as well. It’s an approved method under U.S. Generally Accepted Accounting Principles (GAAP) and by the IRS for U.S. tax purposes. It’s also available under International Financial Reporting Standards (IFRS). The retail method uses retail selling prices as a way to estimate the value of inventory and cost of goods sold (COGS). Although it only provides a good estimate, its simplicity makes it particularly helpful whenever physical counts aren’t possible or practical. RIM calculations rely on a cost-to-retail ratio, sometimes called the “cost complement,” which reflects the cost of inventory as a percentage of its retail selling price. Using this ratio, retailers can convert cost-basis values into retail terms, and vice versa. This important ratio is calculated by dividing the average cost of inventory purchases by the items’ average retail prices.

Because the retail inventory method hinges on the cost-to-retail ratio, it works best for businesses that have consistent pricing strategies or can group their products into categories that do. RIM breaks down when the relationship between product costs and selling prices are highly variable.

Key Takeaways

• As an alternative to cost-basis methods, the retail inventory method relies on the relationship between inventory cost and retail sales price using a “cost-to-retail ratio.”
• RIM is a useful way to value inventory because it’s easily calculated, doesn’t require physical unit counts and can be used for IRS tax filings and GAAP-compliant financial statements.
• Determining whether RIM is right for a business depends on several factors, including retail pricing strategy and real-world operating practices.
• Even a “simple” method such as RIM can become complex in practice, demanding software that delivers the right, clean data.

Retail Inventory Method Explained

RIM is an alternative to the multiple cost-basis methods of valuing inventory, such as average cost or first-in-first-out (FIFO) . While RIM is an estimate based on a relatively simple mathematical calculation, cost-basis methods require actual historical costs and physical observation of current inventory. This simplicity is a primary reason retailers have used the retail method for decades, especially before automated inventory tracking systems became commonplace. Unlike cost-basis methods, which require detailed record-keeping on purchase costs and inventory flow, RIM requires only three variables: sales dollars, beginning inventory value and costs of inventory purchases. The cost-to-sales ratio does the heavy lifting of making the cost and retail variables compatible.

For example, dividing the cost value of a retailer’s inventory available for sale by the cost-to-retail ratio converts it to its retail value. If a clothing retailer had 1,000 dresses available in inventory at the beginning of April at a cost of $50 per unit and a cost-to-retail ratio of 40%, the cost basis of that inventory would be $50,000 (1,000 x $50) and its retail value would be $125,000 ($50,000 / 0.4), which works out to $125 per dress.

This retail balance can then be reduced by April’s sales to compute the retail value of ending inventory. If the retailer sold 200 dresses in April at $125 each for a total of $25,000, the retail value of ending inventory would be $100,000. The retailer can then multiply that $100,000 by the cost-to-sales ratio of 40% to translate it to the cost value ($40,000), which can also be used to compute COGS for the period. Estimated in this way, the cost values of both ending inventory and COGS can be used for financial reporting and IRS filings.

This ease of calculation makes RIM especially good for interim reporting, such as monthly or quarterly financial statements — although it’s considered a best practice to supplement RIM estimates with physical inventory counts for audited financial statements. RIM also supports the ongoing analysis of purchasing, profitability and other key performance indicators (KPIs) that would typically be included in a retail manager’s dashboard.

Sometimes, there are additional layers to retail method calculations, depending on the nature of the retailer’s business. For example, retailers that sell a wide range of merchandise may need to group products by category based on pricing strategy and do a separate RIM calculation for each category. So a variety store may segment its inventory into groups for health and beauty, appliances and apparel and then do separate RIM calculations for each group, as long as the standard cost-to-retail ratios for the groups are internally consistent. For the same reason, RIM is also useful for retailers with multiple stores, with inventory in more than one location or when each store’s product offerings and pricing are tailored to the local market. Retailers that change prices often, through markups and markdowns, need to factor those in as well.

Key Concepts Under the Retail Inventory Method

A business’s pricing strategy has a significant impact on retail method calculations because the relationship between cost and retail prices is RIM’s crucial variable. In practice, retailers often change their prices, discounting to spur sales or adding premiums during periods of peak demand. RIM is more easily calculated and more accurate when prices are steady, but with some modification, it can still be used to reflect the everyday reality of price fluctuations. Along this line, here are some important concepts that are common in the retail industry and affect retail inventory method calculations.

• Initial mark-on:

  The initial mark-on is the difference between the cost of the merchandise to the retailer and the original retail price to the consumer. An item that costs the retailer $10 and is priced to sell at $30 has an initial mark-on of $20.

• Markup:

  A markup is an amount a retailer adds to the original selling price. It can be thought of as a “premium.” Markups might be used to boost revenue when demand is better than expected or to take advantage of seasonality. For example, a recreational retailer might mark up pool floats for two weeks during a summer heat wave, changing the selling price from $30 to $40 — a $10 markup. Markups, net of markup cancellations, are included in the retail prices used to calculate RIM’s cost-to-retail ratio.

• Markup cancellation:

  Markup cancellations reverse a previous markup and bring the retail price back to the original retail price. A cancellation can be for all or part of a previous markup but should not be more than the markup. If the recreational retailer discounted the price of the pool float down to $33, that would be a $7 markup cancellation.

• Markdown:

  Markdowns are reductions below a product’s original retail price. Markdowns are commonly put in place to spur sales for slow-moving inventory and damaged goods, as well as in situations where the retailer is overstocked, facing heightened competition or in an off-season. Some markdowns are meant to be temporary, such as a $3 markdown for a one-day Fourth-of-July sale that reduces the pool float price to $27, and are reflected in RIM during the period of the sale. Other markdowns are permanent, such as end-of-season clearances, and are captured as part of the retail value of inventory available for sale and COGS.

• Markdown cancellation:

  Markdown cancellations reverse previous markdowns and increase a product’s sales price. The markdown cancellation can be full or partial but cannot cause the price to exceed the original retail price. Case in point: On July 5, the retailer does a $3 markdown cancellation and restores the price of the pool float to its original price of $30.

How to Calculate the Retail Inventory Method

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

Ending inventory value = goods available for sale - (sales x cost-to-retail ratio)

However, three preliminary steps are required to determine values for each of the variables in the formula.

1. Calculate the value of goods available for sale at cost. To determine the value of all goods available for sale during a given period, this calculation starts with the value of the period’s beginning inventory and adds the cost of all merchandise the retailer purchased during the period, including freight-in charges (but net of any returns to the supplier). The formula is:

   Goods available for sale = beginning inventory + cost of purchases

2. Calculate the cost-to-retail ratio. First, a retailer must determine whether this can be done in aggregate or by product category, based on the level of consistency of products’ initial mark-ons. The formula is:

   Cost-to-retail ratio = average cost of inventory purchases / retail sales price of the items

3. Determine sales for the period. Aggregate all sales of inventory to customers for the period at retail prices, net of customer returns.

Once the values for goods available for sale, period sales and the cost-to-retail ratio are established, RIM calculations are relatively simple using the first formula listed above.

Example of the Retail Inventory Method

The retail inventory method is useful to estimate ending inventory balances as well as COGS. For retailers with straightforward pricing, the calculations are straightforward. But for many retailers, pricing is more fluid as customer demand fluctuates. The following example illustrates RIM calculations for a business that also uses markups and markdowns.

The CFO of Jennings Gameday Fashions, a hypothetical sports apparel retailer, used RIM to determine estimated inventory balance and COGS values for the six-month interim period ended December 31, 2022. She started by obtaining the cost and retail balances for beginning inventory on July 1 from the retailer’s accounting and inventory management software .

Purchases during the period were significant, as the retailer was building a stock of fan gear for the upcoming fall athletic season. Net purchases, drawn from supplier invoices, were $40,000; their corresponding retail value was $70,000. Recognizing that several pricing changes were made during the period, the CFO took markups and markdowns into account.

Due to an unusual month-long heatwave in August, the company marked up lightweight tank tops in the amount of $6,000. When the weather normalized, it eliminated the markup for the remaining unsold tank tops, causing markup cancellations of $2,000.

In early November, the retailer put all the fall sports attire on clearance, resulting in $5,000 worth of markdowns. In addition, the retailer restored the value of the upcoming winter season sports fan gear, which had been previously marked down during the summer and fall, to their original retail prices, reflecting $4,000 of markdown cancellations. Using information from the point-of-sales systems, total retail sales for the six-month period were $50,000.

Using all of this data, Jennings’ CFO was able to calculate the estimated cost of ending inventory value of $13,487, for inclusion on the unaudited interim balance sheet as of December 31, 2022. She was also able to determine that COGS for the period was $27,513, for inclusion in the unaudited income statement for the six-month period.

Retail Method Advantages

RIM has several advantages, especially compared with the cost-basis method alternatives. It’s the preferred inventory-valuation method for retailers that sell a broad product line, have a high volume of transactions and have inventory in multiple locations. Here’s a rundown of five important advantages:

• Easy to calculate.

  The primary advantage of the retail inventory method is that it’s easy. Estimates of inventory value and COGS can be quickly calculated with only a few necessary data points. As a result, this information can inform internal decision-making without delay.

• Doesn’t require a physical inventory.

  RIM approximates the ending inventory value without needing a physical count. Physical inventory counts are costly, time-consuming and can disrupt normal business operations, especially if the inventory is allocated to multiple locations . When using the retail method, a retailer needs to only do one annual physical inventory to support audited financial statements. And the physical count tends to go faster when done in conjunction with RIM, since only the units need to be counted and crossmatched with a retail price list — staff doesn’t need to look up historical invoice costs.

• Smooths out complex or poor purchasing data.

  RIM can be a good alternative for valuing inventory when purchasing data is not as good as it should be because, in such cases, RIM’s cost-to-retail ratio can be more reliable than cost-basis methods that rely on pristine record-keeping of all purchase costs. Similarly, if purchase costs fluctuate significantly during a period, RIM’s averaging effect can provide a reasonably accurate estimate without the effort needed to attach costs to each layer of inventory, as would be necessary under cost-basis methods such as FIFO.

• It’s an inventory control.

  Performing frequent RIM valuations can act as a financial management control device, letting a retailer keep tabs on inventory values and helping to explain differences in year-end physical inventory counts. Additionally, it can be a helpful data point when making inventory purchases, especially when combined with an inventory management system that tracks stock levels by product for merchandise financial planning

• For insurance purposes.

  RIM is commonly used by insurance adjusters to value inventory that has been destroyed due to fire, flood or other casualties. It can be the basis of an insurance claim to help a business recover from loss.

• Retailers think in retail terms.

  Retail prices are familiar references for those who work in the retail business. From sales teams to warehouse staff, product marketers and executives, the majority of the business thinks in terms of retail prices. Using RIM can help make communication more seamless within the organization, especially when preparing forecasts and budgets.

Retail Method Disadvantages

The retail inventory method has some significant disadvantages, which is why the cost-basis methods are often viewed as the “gold standard” for inventory valuation. Most of the disadvantages stem from the method’s reliance on averages, especially the cost-to-retail ratio. Sometimes business conditions are such that an average cannot accurately reflect the whole. In such cases, RIM is less accurate. Some specific disadvantages of the retail method are:

• It’s not exact.

  RIM only provides an estimate of inventory value. Further, the estimate is most useful for financial reporting purposes. It’s not a substitute for inventory management, which provides detail on inventory unit levels for order fulfillment. For example, RIM cannot help to identify items that have been damaged, stolen, lost or became obsolete, which are issues that are significant for both inventory valuation and for physical inventory management.

• RIM only works with consistent mark-ons.

  The retail method is more accurate when initial mark-ons are consistent and when markups/markdowns are permanent rather than temporary. As the level of price fluctuation and mark-on inconsistency rises, the accuracy of RIM calculations degrades.

• Accuracy is thrown off by seasonality.

  A common phenomenon in many retail sectors, seasonality has a negative effect on RIM’s accuracy. Retailers that adjust initial mark-ons from month to month throughout a high-volume inventory purchasing season can cause the cost-to-retail ratio to be significantly skewed, distorting RIM calculations.

• RIM can quickly become complex.

  The primary advantage of RIM is that it is easily calculated. However, real-world matters and industry trends can quickly complicate the calculations, making them harder and less accurate. RIM’s diminishing returns mean that other inventory valuation methods may be more appropriate as the business’s realities become more intricate. Beyond active markup/markdowns and cancellations, other complexities include items such as vendor advertising allowances and cash discounts, inventory reserves and customer returns.

Alternatives to the Retail Inventory Method

Cost-basis inventory valuation is the GAAP- and IFRS-compliant alternative to RIM. This method uses historical costs for purchasing inventory plus the costs involved in getting inventory ready for sale. The information is compiled from supplier invoices and other internal and external data. These costs are then assigned to inventory using a cost-flow assumption, which may or may not match the actual flow of picking inventory to fulfill sales. Typical cost flow assumptions are first-in-first-out (FIFO), last-in-first out (LIFO), average cost and specific identification.

For a more detailed comparison of RIM and cost-basis methods, see “Retail Accounting vs. Cost Accounting for Inventory.”

Manage Your Retail Inventory With NetSuite

Inventory is a vital asset for retailers that must be managed carefully to maximize revenue and optimize profitability. Software solutions that facilitate inventory valuation and analysis of product margins can help retailers better manage their inventory, whether they use the retail inventory method or a cost-basis method. The examples discussed in this article illustrate how business operations in the real world can quickly complicate inventory valuation — and always demand good data. At the same time, retailers must optimize physical inventory to ensure the right amount of stock is available in the right locations. NetSuite for Retail allows retailers to handle these tasks, in parallel and in sync, by marrying inventory valuation with physical inventory management. Additionally, when integrated with NetSuite Financial Management , retailers get real-time access to all the key information they need, such as inventory purchasing and customer sales, at varying levels of detail — from category averages down to individual SKUs.

The retail method is an inventory valuation technique commonly used in the retail industry. Its defining characteristic is the use of retail selling prices as a way to estimate the value of ending inventory through the device of a cost-to-retail ratio. The retail method’s primary advantages are its simplicity and that it can be calculated without a physical inventory count. RIM’s usefulness for tax and financial statement compliance makes it a helpful way to manage the key asset retail inventory. But this ease of use is offset by RIM’s imprecision, as it only provides an estimate. And for retailers with complex and variable pricing strategies, RIM can become unreliable. The right software helps keep this method as a viable option, even as real-world retail operations become more complicated.

Retail Inventory Method FAQs

How is the retail inventory method useful for retailers?

The retail inventory method (RIM) is a useful way for a retailer to value inventory and calculate its cost of goods sold (COGS). It’s relatively easy to calculate, does not require physical inventory counts and has its basis in retail prices, which are familiar references for retail managers. It’s also a useful control device for retailers to easily monitor inventory values.

When should businesses use this method?

The retail inventory method works best for businesses that have consistent pricing strategies, due to its reliance on the cost-to-retail ratio. Other situations where the retail method may be an appropriate choice include when the costs of inventory purchases from suppliers fluctuate significantly, when purchasing record-keeping is inaccurate, in the absence of physical counts and where the inventory is dispersed in several locations or when it isn’t accessible.

What are the 4 inventory methods?

There are four cost-flow assumptions used when valuing inventory using the cost-basis method, which is the alternative to the retail inventory approach:

1. Average cost calculates an average purchase cost per unit during a specific period for groups of similar products.
2. First in, first out (FIFO) stratifies inventory cost data by purchase date and assumes that the oldest items in inventory are sold first. It values sold inventory using the cost-per-unit attached to each layer, by age.
3. Last in, first out (LIFO) is the opposite of FIFO. It also stratifies cost data but assumes that the newest items added to inventory are sold first.
4. Specific identification is the most accurate inventory cost method because it assigns a specific, unique cost to each individual item in inventory. This method has limited application, essentially only to inventory that consists of unique, distinguishable products, such as automobiles, jewelry and fine art.

Who uses the retail inventory method?

The retail inventory method is most likely to be used by high-volume retailers with a large number of items whose mark-ons are consistent, at least within defined categories. It’s especially useful for interim financial reporting and for when physical counts are impractical.

What is the best inventory costing method for retail?

The best inventory costing method for retailers depends on the specific circumstances of the business. The retail inventory method is one approach and cost-basis methods are another. Cost-basis approaches, such as average cost and first-in-first-out (FIFO), tend to be the “gold standard” for retailers since they yield more precise inventory values. However, the retail method is also acceptable and may be more cost-effective to use if the business has consistent cost-to-retail ratios.

Does GAAP allow the retail inventory method?

The retail inventory method is an acceptable inventory valuation approach for U.S. Generally Accepted Accounting Principles (GAAP). It is also allowed by the IRS for U.S. tax reporting.