What is needed to find the cost of ending inventory in the retail inventory method quizlet?

What Is the Retail Inventory Method?

The retail inventory method is an accounting method used to estimate the value of a store's merchandise. The retail method provides the ending inventory balance for a store by measuring the cost of inventory relative to the price of the merchandise. Along with sales and inventory for a period, the retail inventory method uses the cost-to-retail ratio.

Key Takeaways

• The retail inventory method is an accounting method used to estimate the value of a store's merchandise.
• The retail method provides the ending inventory balance for a store by measuring the cost of inventory relative to the price of the goods.
• Along with sales and inventory for a period, the retail inventory method uses the cost-to-retail ratio.
• The retail method of valuing inventory only provides an approximation of inventory value since some items in a retail store will most likely have been shoplifted, broken, or misplaced.
• The retail inventory method is only an estimate and should always be supported by period physical inventory counts.

Understanding the Retail Inventory Method

Having a handle on your inventory is an important step in managing a successful business. It allows you to understand your sales, when to order more inventory, how to manage the cost of your inventory, as well as how much of your inventory is making it into the hands of consumers, as opposed to being stolen or broken.

The retail inventory method should only be used when there is a clear relationship between the price at which merchandise is purchased from a wholesaler and the price at which it is sold to customers. For example, if a clothing store marks up every item it sells by 100% of the wholesale price, it could accurately use the retail inventory method, but if it marks up some items by 20%, some by 35%, and some by 67%, it can be difficult to apply this method with accuracy.

The retail method of valuing inventory only provides an approximation of inventory value since some items in a retail store will most likely have been shoplifted, broken, or misplaced. It's important for retail stores to perform a physical inventory valuation periodically to ensure the accuracy of inventory estimates as a way to support the retail method of valuing inventory.

Calculating Ending Retail Inventory

The retail inventory method calculates the ending inventory value by totaling the value of goods that are available for sale, which includes beginning inventory and any new purchases of inventory. Total sales for the period are subtracted from goods available for sale. The difference is multiplied by the cost-to-retail ratio (or the percentage by which goods are marked up from their wholesale purchase price to their retail sales price).

The cost-to-retail ratio, also called the cost-to-retail percentage, provides how much a good's retail price is made up of costs. If, for example, an iPhone costs $300 to manufacture and it sells for $500 each, the cost-to-retail ratio is 60% (or $300/$500) * 100 to move the decimal.

Disadvantages of the Retail Inventory Method

The retail inventory method's primary advantage is the ease of calculation, but some of the drawbacks include:

• The retail inventory method is only an estimate. Results can never compete with a physical inventory count.
• The retail inventory method only works if you have a consistent markup across all products sold.
• The method assumes that the historical basis for the markup percentage continues into the current period. If the markup was different (as may be caused by an after-holiday sale), then the results of the calculation will be inaccurate.
• The method does not work if an acquisition has been made, and the acquiree holds large amounts of inventory at a significantly different markup percentage from the rate used by the acquirer.

Example of the Retail Inventory Method

Using our earlier example, the iPhone costs $300 to manufacture and it sells for $500. The cost-to-retail ratio is 60% ($300/$500 * 100). Let's say that the iPhone had total sales of $1,800,000 for the period.

• Beginning inventory: $1,000,000
• New Purchases: $500,000
• Total goods available for sale: $1,500,000 
• Sales: $1,080,000 (Sales of $1,800,000 x 60% cost-to-retail ratio)               
• Ending inventory: $420,000 ($1,500,000 - $1,080,000)

Proper inventory valuation is important when accounting for inventory through financial reporting. If inventory is not correctly valued inventory discrepancies will impact financial statements such as balance sheets, income statements and statements of retained earnings.

When accounting for inventory the recorded amount is the total quantity and value of raw materials, work-in-progress and finished goods that a business owns. The value of this inventory must be calculated correctly because it accounts for a significant share of the business’s current assets. Which in turn determines the amount of profit or loss the business generates.

Accounting for inventory

In each accounting period, any applicable expenses must correspond with revenue earnt to determine the business’ net income. When applied to inventory, the cost of goods available for sale during the period should be deducted from current revenues.

A periodic inventory method works on a system that calculates the cost of the goods sold (COGS). This is done by taking the beginning inventory and adding net purchases to establish the cost of available stock.

The end inventory is subtracted from this stock, to provide the total COGS. The net income for an accounting period will directly depend on the valuation of the ending inventory.

The four common costing methods in the periodic inventory method are:

1. First In, First Out (FIFO)
2. Specific Identification method
3. Weighted Average method – this is the method Unleashed Software uses
4. Last In, First Out (LIFO)

Any of the four costing approaches in the periodic inventory method will produce a different result over the same accounting period. Therefore, it is necessary and often a legal requirement, for one method to be chosen and applied consistently across future reporting periods to maintain accuracy.

At the end of an accounting period, the total value of items to be sold, often acknowledged as stock-in-hand, is recorded as inventory under current assets.

Inventory discrepancies

Inventory discrepancies occur between the value of inventory captured in records and the value of the actual inventory held.

Variations in COGS will have a direct impact on a company’s income statements because the COGS is subtracted from sales to get the gross profit. An overstated inventory will inflate gross profits and conversely understating inventory will have a negative impact on gross profits.

Overstating inventory

Overstated inventory records will indicate more inventory stock is held, rather than the true, physical stock numbers. This discrepancy can be caused by theft, damage, fraud or incorrect inventory counts and administrative errors.

When inventories are overstated it lowers the COGS, because the excess stock in accounting records translates to higher closing stock and less COGS. When ending inventory is overstated it causes current assets, total assets, and retained earnings to also be overstated.

Understating inventory

Understated inventory, on the other hand, increases the cost of goods sold. Lower inventory volume in the accounting records reduces the closing stock and effectively increases the COGS.

An understated inventory indicates there is less inventory on hand than the actual stock amount. This can arise from errors in receipting stock, failure to reconcile the movement of raw materials and finished goods from one location to another and unrecorded transactions.

Inventory adjustments are used to correct these differences to avoid overstating or understating the income statement.

Reconciling inventory discrepancies

When a business misrepresents its ending inventory, the company carries forward that mistake through to the following accounting period because the ending inventory amount of the current year is the beginning inventory amount for the next year.

An adjustment entry for overstated inventory will add the omitted stock, increasing the amount of closing stock and reduces the COGS. Conversely, in understated inventory, an adjustment entry needs to be made to remove the surplus stock, which in turn reduces closing stock to the correct level and increases the COGS.

Inventory reconciliation when accounting for inventory is not simply an adjustment of the book balance to match the physical count. It is necessary to compare the inventory counts recorded to actual quantities on the warehouse shelves and assess why differences have occurred before adjusting the data to reflect this analysis.

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