Each business has its challenges. Specifically pointing to retail, they deal with many transactions and daily incoming and outgoing inventory. Even within the retail industry, there are different types of retailers. There are grocers, pharmacies, and convenience stores dealing with perishable goods and volumes of small-ticket items. There are garment retailers where goods are not perishable, but seasonal trends see the stock losing value.

The Role of Inventory Accounting in Retail

Retailers must account for every item that comes and goes and track for damages, expired products, and inventory losing value. Nothing beats the physical counting and scanning of items. It is a labour-intensive task. However, the skill part of accounting can be automated with various tools and software. That’s where inventory accounting comes in.

Inventory accounting follows specific methods and procedures to accurately record the inflow and outflow of inventory and calculate the value of both sold and unsold products. Both these values are recorded in the financial statements – the cost of goods sold (COGS) in the income statement to determine gross profit and the cost of unsold goods as inventory in the balance sheet.

How Inventory Accounting Works

Inventory accounting begins with determining the method to value the inventory. There are three methods:

• First-In, First-Out (FIFO): This method considers the cost of inventory first stocked to arrive at COGS. Suppose 100 items were sold; it will calculate the cost of the first 100 items purchased.
• Last-In, First-Out (LIFO): This method considers the cost of the latest inventory to arrive at COGS.
• Weighted Average Costs: This method takes the average cost of inventory items. Suppose you have 100 items worth $5,000 available for sale, and the COGS will be calculated as $50 per item, irrespective of when the good was purchased.

Which of the above methods to use depends on the type of inventory. Once you have settled on the method, the accountant will input the technique into the inventory management system. When the employee scans the product, the cost, inventory date, and manufacturing batch get recorded.

The accountant also adds other costs to the inventory:

• The cost of acquiring merchandise after adjusting for discounts and rebates.
• Cost to transporting goods from suppliers/manufacturers to the store. It includes freight charges, customs duties, and logistics fees.
• Cost of storing inventory in the warehouse. It includes warehouse rent, utilities, insurance, and handling charges.
• The damage and spoilage of goods, theft, and other factors make the inventory unfit for sale.

With this, they arrive at the value of the inventory.

Benefits of Inventory Accounting

Detailed inventory accounting can help retailers accurately report fluctuations in consumer demands, seasonal trends, and competitive landscapes. Continuous monitoring allows retailers to replenish stock and fulfill orders on time with minimal wastage. It also improves inventory forecasting accuracy, ensuring sufficient stock is available while minimizing inventory and handling costs. 

Detailed inventory accounting has its benefits, but it is a tedious process. If your business does not need such detailed reports, you can also consider an accounting shortcut. It may not be 100% accurate, but it can give you an average cost of the inventory. This shortcut is called the retail inventory method.

What is the Retail Inventory Method 

The idea behind inventory valuation is to arrive at a COGS and the ending inventory balance. This can be achieved with a simple formula. At the crux of this formula is a cost-to-retail ratio.

• You start with the opening inventory balance and add any new purchases (inflows in inventory) to arrive at the overall inventory cost available for sale.
• The next step is to adjust for sales. Revenue includes the profit margin. Hence, you determine a cost-to-retail ratio (cost price/retail price x 100). Suppose you buy a laptop for $400 and sell it for $600. Your cost-to-retail ratio is (400/600) 66.67%. This gives you an idea of the average cost of the product. You multiply the total sales with this ratio to determine the COGS.
• The final step is simply subtracting COGS from the overall inventory cost available for sale to arrive at the ending balance.

For instance, James started with a $2,000 inventory and stocked up another $1,000 worth of inventory.

The cost of inventory available for sale = $3,000.

His sales were worth $4,000.

Taking the above cost-to-sales ratio, COGS = $2,666.6 ($4,000 x 66.6%).

Ending value of inventory = $333.3 ($3,000 – $2,666).

While the method may look simple, it has its drawbacks. The retail inventory method is unsuitable for retailers with a diverse inventory – from electronics to garments to packaged foods – as these items have considerable differences in cost-to-retail ratio. The technique might work for a clothing store where all products have an almost similar cost-to-retail ratio.

Contact Ford Keast LLP in London, Ontario to Help You with Inventory Accounting Needs

Inventory accounting is a tedious job that is best left to experts. At Ford Keast LLP, our accountants and bookkeepers can help you set up the inventory management system and regularly monitor and audit it to deliver real-time accounting of your inventory. To learn more about how Ford Keast LLP can provide you with the best accounting and bookkeeping expertise, contact us online or call us at 519-679-9330.