31 May
Managing inventory is one of the most important aspects of running any retail business successfully. Employing the right inventory tracking and costing method can make a huge difference in the profitability and efficiency of your store. The RIM is a conventional Retail Inventory Method and an effective way for retailers to account for and value their inventory.
This article explores what the retail method of inventory is, how it differs from other inventory costing approaches, how it works in practice and the advantages and disadvantages to consider. So if you’re looking for ways to optimize your inventory management as a retailer, keep reading to learn about it.
What is the Retail Inventory Method?
The Retail Inventory Method (RIM) is a calculation used by retailers to determine the value of their ending inventory. It does this by factoring in your beginning inventory, the cost of new items purchased, and your markup percentage.
Here’s how it works at a high level. Let’s say you own a clothing store and you have clothes in three categories: shirts, pants, and dresses. You’ll first determine your markup percentage for each category. For example, maybe shirts are marked up 50%, pants 75%, and dresses 100%.
When new shipments of inventory arrive, you’ll record the cost of the new items purchased. Then, as items are sold, you’ll record the retail price the item sold for.
At the end of an accounting period, like the end of the month, you’ll calculate your ending inventory balance for each category. You take the total retail sales for that category and divide it by one plus the markup percentage. That gives you an estimated cost of goods sold for that category. You then subtract the cost of goods sold from the total cost of inventory purchased to get your ending inventory balance.
The Retail Inventory Method can be a fairly simple way for retailers to estimate their inventory balance and cost of goods sold, especially small businesses without a complex inventory system. But the key downside is the estimates become less accurate the more sales you have.
Also Read: Inventory Reporting for Retail Businesses
A Step-by-Step Guide to the Retail Inventory Method
We already covered the basics of what the Retail Inventory Method is, so let’s dive into the exact steps you’ll take to implement it for your retail business. We’ll walk through a simplified example as we go.
Determine Your Markup Percentages
For each product category: Calculate the markup percentage by dividing the selling price by the cost price and subtracting 1.
Markup percentage= (Selling Price / Cost Price) – 1
For example, if a product costs $10 and sells for $20, the markup is 100% [($20/$10) – 1].
Record New Purchases
When new inventory arrives: Record the cost of the purchases for each product category. Let’s say you purchased $5,000 of new shirts that cost you $2,000. You’d record $2,000 as the cost of new shirt purchases.
Record Retail Sales
As products sell: Record the total retail sales amount for each product category. Continue recording retail sales for the entire retail inventory accounting period.
Calculate the Cost of Goods Sold
At the end of the period: Calculate the cost of goods sold (COGS) for each category. Divide the total retail sales for that category by 1 plus the markup percentage.
COGS= Retail Sales / (1 + Markup Percentage)
For shirts: If you had $10,000 in shirt sales and a 50% markup, COGS is $10,000 / 1.5 =$6,667
Also Read: POS Systems with inventory management: Hana Retail vs. Others
Determine Ending Inventory
Now, how to find the cost of ending inventory? Simply, subtract the COGS from the cost of purchases to get the ending inventory:
Ending Inventory= Cost of Purchases – Cost of Goods Sold
For shirts:
- Cost of new shirt purchases: $2,000
- Cost of goods sold: $6,667
- Ending shirt inventory: $2,000 – $6,667 = -$4,667
You have a $4,667 oversell, meaning you sold more inventory than you purchased.
Repeat these steps and the retail inventory method formula for all product categories to determine your full ending inventory balance.
Benefits of the Retail Inventory Method
While the Retail Inventory Method has some limitations, there are also benefits that make it a good fit for certain businesses.
Simplicity
The calculations are relatively simple. You just have to divide retail sales by one plus your markup percentage to get the cost of goods sold. This makes it an easy inventory method for businesses just starting out or those that don’t need complex systems.
Suits to seasonal businesses
It works well for seasonal businesses. Since estimates are made each accounting period, like at the end of each month, this matches well with businesses that see fluctuations in inventory and sales throughout the year.
Minimal record keeping
You don’t need extensive records. You only need to track retail sales, cost of purchases, and markup percentages for each category. You don’t have to maintain individual item records or track each sale.
For example, a gift shop may only have three categories:
- Home decor: 75% markup
- Art: 100% markup
- Jewelry: 50% markup
The owner only needs to track:
- Cost of new purchases for each category
- Total retail sales for each category
- The markup % for each category
Works for loss leaders
It can work for products sold at a loss. Some retailers offer “loss leader” products to draw in customers that they make little to no profit on. The Retail Inventory Method still works for these items since you’re still tracking the cost of purchases and retail sales.
Common Mistakes and Pitfalls
While the Retail Inventory Method is fairly simple, there are some common mistakes retailers make that can negatively impact results.
Inaccurate Markup Percentages
Using the wrong markup percentages is one of the biggest issues. Markup %’s should reflect your current cost of goods and selling prices. Outdated or inaccurate percentages will throw off your cost of goods sold calculations.
To avoid this, review your markup percentages regularly, especially after price changes or new product launches.
Not Updating for Price Changes
Related to the above, failing to adjust your calculations for price changes can cause major errors.
For example, let’s say you previously marked up shirts by 50% but then increase prices by 15%, giving you an effective 57.5% markup.
If you don’t update your calculations to use the new 57.5% markup, your ending inventory and cost of goods sold will be inaccurate.
So remember to update your records and calculations in your retail inventory software when product prices change.
Excessive Markdowns
Heavy discounting and markdowns can reduce the accuracy of the Retail Inventory Method over time.
Since the calculations rely on the original markup percentage, as you sell more inventory at discounted prices, your estimates become less accurate.
While some discounting is inevitable, try to limit excessive markdowns, especially toward the end of an accounting period. More accurate records also help offset the impact of markdowns.
Inaccurate Purchase Records
Finally, mistakes recording the cost of purchases, either underestimating or overestimating amounts, will obviously skew your ending inventory calculations.
So double-check your vendor invoices, receipts, and accounting records to ensure purchase costs are recorded accurately for each category.
Also Read: A Guide To Handling Dead Stock
Alternatives to the Retail Inventory Method
The retail inventory method is a popular way for retailers to estimate the value of their inventory. However, it has some drawbacks like lack of accuracy. So what are some alternatives for retailers?
Simple Cost Method
The simplest and most basic method is the simple cost method. This involves simply totaling up the cost of all items in inventory. While this method doesn’t consider profit margins, it can work well for retailers who sell items at similar margins.
For example, a clothing store selling t-shirts and jeans at comparable margins could use this method. They would simply add up the costs of all unsold t-shirts and jeans currently in inventory. Though simple, this method ignores differences in profitability between products.
Average Cost Method
The average cost method involves calculating an average cost per unit for all items in inventory. You then multiply this average cost by the number of units still in inventory.
This method solves the issue of products with different costs but ignores differences in the margin. An electronics store could use this to value its inventory of TVs, tablets, and laptops. They would calculate the average cost of all units purchased throughout the year and multiply that average cost by the units still in stock.
Specific Identification Method
The specific identification method matches the cost of specific inventory items to the items that are actually sold. This involves assigning unique identifiers like barcodes or serial numbers to each inventory item.
When items are sold, their specific cost is removed from inventory. A jewelry store could use this method by assigning individual item numbers to each piece of jewelry in inventory. When a specific piece sells, its exact cost is subtracted from inventory. This gives the most accurate view of inventory value.
Weighted Average Cost Method
The weighted average cost method calculates an average cost per unit by weighting the cost of inventory items purchased throughout the year. Newer inventory costs are given a higher weight since they represent a larger portion of the current inventory.
A grocery store could use this method by calculating a weighted average cost for each product based on when inventory was purchased. Produce costs, for example, would have a higher weighting since most of the current product inventory is likely newer purchases.
This method is more accurate than a simple average cost because it considers the timing of inventory purchases. However, it still ignores differences in profit margins between products.
LIFO (Last In, First Out) Method
The LIFO (last in, first out) method assumes the last inventory items purchased are the first items sold. The value of ending inventory is based on the costs of the oldest inventory items still on hand.
A toy store could use this method around the holidays. The last items purchased right before the season would be assumed to sell first. The toys still in inventory after the season would be valued based on the costs of the earliest purchases.
LIFO offers a more conservative view of inventory value since older inventory costs are typically lower. However, LIFO does not accurately reflect the physical flow of inventory.
Standard Cost Method
The standard cost method values inventory based on predetermined standard costs, rather than actual costs. Standard costs are estimated averages based on historical data and expense budgets.
A hardware store could establish standard costs for each product based on the cost of goods sold in prior years, supplier contracts, and expense budgets. These standard costs would then be applied to the current inventory, regardless of actual costs.
While easy to implement, the standard cost method becomes less accurate over time if standard costs diverge significantly from actual costs. It still ignores differences in profit margins between products.
Conclusion
The retail inventory method can be a lifesaver for growing and complex retail businesses looking for an efficient inventory management system. No matter the size or type of retail operations you run, a robust POS and inventory management software like Hana Retail will provide real-time inventory data to accurately calculate your retail inventory and automatically reorder products for you.
Ensure your shop floor and inventory records are always in sync with a powerful retail POS system for small businesses like Hana Retail. With a system that can grow with your business needs, you’ll gain back precious time to focus on delivering an exceptional customer experience. Sign up FREE today!
