Retail Inventory Method

Chapter 14
 RETAIL INVENTORY METHOD
The retail inventory method is the other method of estimating the value of
inventory.
PAS 2, paragraph 22, provides that this method is often used in the retail
industry for measuring inventory of large number of rapidly changing
items with similar margin for which it is impracticable to use other costing
method.
In other words, the retail inventory method is generally employed by
department stores, supermarkets and other concerns where there is a wide
variety of goods.
This is so because keeping track of unit cost at all times is difficult.
The retail inventory method came to its name because the selling price or
retail price is tagged to each item.
The term retail simply means selling price.
 Information required
The use of the retail inventory method requires that records be kept
which must show the following data:

a. Beginning inventory at cost and at retail price

b. Purchases during the period at cost and at retail price
c. Adjustments to the original retail price such as additional markup,
markup cancelation, markdown and markdown cancelation
d. Other adjustments such as departmental transfer, breakage
shrinkage, theft, damaged goods and employee discount
 Basic formula
In principle and procedure wise, the formula for the retail inventory method is
very similar to the gross profit method. The difference is that under the gross
profit method, the ending inventory is stated at cost while under the retail
inventory method, the ending inventory is expressed in terms of selling price.
Observe the following basic formula for the retail method:
Goods Available for sail at retail or selling price xx
Less: Net Sales (gross sales minus sales return only) xx
Ending Inventory xx
Multiply by cost ratio xx
Ending inventory at cost xx

Cost ratio = Goods available for sate at cost

Goods available for sale at selling price
 Illustration using assumed figures
Cost Retail
Beg. Inventory 150,000 230,000
Purchases 400,000 650,000
Freight in 10,000
Purchase Return (55,000) (80,000)
Purchase allowance (5,000)
Purchase Discount (20,000)
Good Available for sale (GAS) 480,000 800,000

Cost Ratio (480,000/800,000) 60%

Less: Sales 630,000
Sales Return (30,000) 600,000
Ending Inventory at retail 200,000
Ending Inventory at cost (200,000 x 60%) 120,000
 Treatment of items
a. Purchase discount - deducted from purchases at cost only.
b. Purchase return-deducted from purchases at cost and at retail
c. Purchase allowance - deducted from purchases at cost only.
d. Freight in addition to purchases at cost only.
e. Departmental transfer in or debit - addition to purchases at cost and at retail.
f. Departmental transfer out or credit - deduction from purchases at cost and
retail.
g. Sales discount and sales allowance - disregarded, meaning not deducted
from sales.
h. Sales return - deducted from sales.
If the account is "sales return and allowance", the same should be
deducted from sales.
 Treatment of items
i. Employee discounts - added to sales.
Employee discounts are special discounts usually not recorded because
the employee discounts are directly deducted from the sales price.
Only the net sales price is recorded. Consequently, the amount of
sales is understated. Thus, the employee discounts are added back to sales.
j. Normal shortage, shrinkage, spoilage, breakage – deducted from goods
available for sale at retail.
Any normal shortage is usually absorbed or included in cost of goods
sold.
k. Abnormal shortage, shrinkage, spoilage, breakage
The amount is deducted from goods available for sale at both
cost and retail so as not to distort the cost ratio.
Any abnormal amount is reported separately as loss.
 Items related to retail method
Accordingly, in the determination of the inventory at retail and for purposes of computing the
cost ratio, the following items should be considered:
The original sales price is frequently raised or lowered particularly at the end of the selling
season where replacement costs are changing.
a. Initial markup - original markup on the cost of goods.
b. Original retail - the sales price at which the goods are first offered for sale.
c. Additional markup - increase in sales price above the original sales price.
d. Markup cancelation - decrease in sales price that does not decrease the sales price below the
original sales price.
e. Net additional markup or net markup - markup minus markup cancelation.
f. Markdown - decrease in sales price below the original sales price.
g. Markdown cancelation - increase in sales price that does not increase the sales price above the
original sales price.
h. Net markdown - markdown minus markdown cancelation. i. Maintained markup - difference
between cost and sales price after adjustment for all of the above items.
Sometimes, maintained markup is referred to as "markon".
 Illustration
Cost 200
a. Initial markup 40
b. Original retail or sales price 240
c. Additional markup 60
New sales price 300
d. Markup cancelation 40
New sales price (not below the original sales price) 260
e. Net Markup (60-40) 20
Markup cancelation 20
f. Markdown (decrease in sales price below the original sales price 30 50
New Sales Price 210
g. Markdown cancelation (increase in sales price that does not increase the new sales 20
price above the original sales price of 240
New sales price 230
h. Net markdown (30-20) 10
i. Maintained markup (230 – 200) 30
 Approaches in the use of retail method
To obtain the appropriate inventory value under the retail inventory
method, four approaches are followed, namely:
a. Conservative or conventional or lower of cost and net realizable value
approach
b. Average cost approach
c. FIFO approach
d. LIFO approach

IFRS expressly prohibits LIFO. However, the LIFO retail

approach is exemplified for theoretical purposes.
 Illustration
Cost Retail
Beginning Inventory 180,000 250,000
Net Purchase 1,020,000 1,575,000
Additional Markup 200,000
Markup Cancelation 25,000
Markdown 140,000
Markdown cancelation 15,000
Sales 1,450,000
Sales Return 50,000
Sales Allowance 10,000
Sales Discount 20,000
Employee discount 40,000
Spoilage and breakage 35,000
 Conservative and average cost
Cost Retail
Beg. Inventory 180,000 250,000
Net Purchase 1,020,000 1,575,000
Additional Markup 200,000
Markup cancelation (25,000)
GAS – conservative 1,200,000 2,000,000
Cost Ratio (1,200,000/2,000,000) 60%
Markdown (140,000)
Markdown cancelation 15,000
GAS average 1,200,000 1,875,000
Cost Ratio (1,200,000/1,875,000) 64%
Less: Sales 1,450,000
Sales Return (50,000)
Employee Discount 40,000
Spoilage and breakage 35,000 1,475,000
Ending Inventory at retail 400,000
Conservative cost (400,000 x 60%) 240,000
Average Cost (400,000 x 64%) 256,000

The ending inventory at retail is same whether conservative approach or

average approach.
 Computation of cost of goods sold
Conservative Average
Goods available for sale 1,200,000 1,200,000
Ending Inventory (240,000) (256,000)
Cost of goods sold 960,000 944,000

Observe the difference between the conservative approach and average cost approach.
The conservative approach includes net markup and excludes markdown in determining the cost ratio in order to arrive a
conservative cost.
Notice that the conservative cost is lower than the average cost. Thus, the conservative approach is also known as the
lower of
average cost or market.
On the other hand, the average cost approach includes both pet markup and net markdown in determining cost ratio.,
The reason for such an approach is to arrive at an inventory that will approximate or equal historical cost.
PAS 2, paragraph 22, provides that the percentage used under the retail method shall take into consideration inventory that
has been marked down to below the original selling price.
An average percentage for each retail department is often used.
Accordingly, the average cost approach shall be applied in conjunction with the retail inventory method.
 FIFO and LIFO retail approach

The FIFO retail and LIFO retail are similar to the average cost approach
in that both net markup and net markdown are considered in computing
the cost ratio.
However, a current cost ratio is determined every year considering the
net purchases during the current year and excluding the beginning
inventory.
The FIFO retail and LIFO retail are based on the assumption that
markup and markdown apply to goods purchased during the current
year and not to beginning inventory.
 Illustration
Beg. Inventory 495,000 900,000
Purchases 1,800,000 3,300,000
Net Markup 300,000
Net Markdown 600,000
Net Sales 2,700,000

FIFO Retail Cost Retail

Beg. Inventory – cost ratio 55% 495,000 900,000
Purchases 1,800,000 3,300,000
Net Markup 300,000
Net Markdown (600,000)
Net Purchases 1,800,000 3,000,000
Current year cost ratio (1,800,000/3,000,000) 60% 2,295,000 3,900,000
Net Sales (2,700,000)
Ending Inventory at retail 1,200,000
FIFO Cost (1,200,000 x 60%) 720,000
The current year cost ratio of 60% is simply multiplied by the ending
inventory at retail of P1,200,000 to get the FIFO cost because under
FIFO, the inventory comes from the most recent or current year
purchases.
LIFO Retail Cost Retail
From beginning inventory 55% 495,000 900,000
From current year purchases 180,000 300,000
LIFO COST 675,000 1,200,000

Under LIFO retail, the ending inventory of P1,200,000 at retail price comes from the
beginning inventory and current year purchases. Accordingly, the portion from the
beginning inventory of P900,000 has the same cost of P495,000. The portion from the
current year purchases of P300,000 is multiplied by the current year cost ratio of 60%.
Actually, there is an increase in ending inventory from P900,000 to P1,200,000 or an
increase of P300,000.