Most business owners who stick to the Generally Accepted Accounting Principles (GAAP) every month close their books and prepare financial statements using the same rules. However, the situation is contrasting when it comes to retail accounting.
It gets harder for businesses in the retail sector to account for their stocks. A merchant must look at all the transactions that took place during the accounting period and the cost of each inventory item. Determining the price of products sold (COGS) requires much work.
One of the tools retailers use is the retail accounting method. Check out our article about the basics of retail accounting to learn more about the method and how it works.
Understanding retail accounting
“Retail accounting” and “retail method” are interchangeable terms. However, the term “accounting” is a bit misleading because the technique mainly deals with how an accountant evaluates the inventory rather than the entire accounting procedure.
The retail method enables the bookkeeper to monitor how much stock a company has without manually counting all items in the store. This accounting method translates all company’s existing stock to its projected retail price. The technique subtracts the business’s sales figures from that amount to evaluate how much inventory a retailer has.
The retail method enables an accountant to estimate the stock based on the sales data and then apply that amount to determine how much markup a retailer uses when selling goods.
Retail method formula
The entire costs of inventory and the total value of the merchandise up for sale are added, and the expenses are then divided by the retail value. The following is the cost-to-retail formula:
(Full cost (of a beginning inventory) + total cost (of the purchased inventory)) / (retail value (of a beginning inventory) + retail value of products of the period)
The estimation is relatively simple and requires far less tracking to perform it. A retailer doesn’t need an advanced accounting system to calculate inventory costs.
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Retail accounting for inventory management
So, how do accountants evaluate inventory when applying the retail accounting technique? They use four primary methods to value inventory:
- LIFO (last-in, first-out)
- FIFO (first-in, last-out)
- Weighted average
- Specific identification
Small businesses follow the FIFO method. Most companies prefer using the oldest materials to produce finished products in manufacturing. However, high-tech facilities may use the newest materials to produce goods, indicating that they use the LIFO technique.
Let us delve into the details of each technique. We will use an imaginary accessories supply store. The retailer buys phone cases for around $4-$5 each. The costs differ depending on the manufacturer’s charges. Here’s a table we will use to explain each method:
|Cost per item||$4||$4.5|
The number of purchased items
LIFO is an approach used to determine inventory costs, albeit it is not widely used. If a business sells a phone case on September 1st, it would “sell through” August’s inventory first, then September’s inventory.
Technically, all these phone cases are the same. A retailer doesn’t have boxes labeled “August” or “September”. When a consumer purchases a phone case, regardless of when it arrived in your inventory, this accounting technique reports that it costs as the most recent (last-in) batch of cases.
In our example, the accountant reports the cost of the case sold as $4.5, not $4. If the retailer sells all 200 cases, the 201 would be reported as $4.
FIFO is more popular in accounting. The method relies on “selling through” August’s inventory first and then selling September’s items. The first phone case you sell after stockpiling this inventory will cost $4.
Upon selling the first batch of cases (300 goods), the 301 item you sell will cost $4.5. This method makes more sense since retailers keep adding more items to the inventory. Companies don’t wait until they are entirely out of stock before ordering more items.
If costs continue to rise every month (as seen in the table), LIFO may not provide a realistic picture of a business’s current COGS since it “sells” items purchased months ago.
The benefits of FIFO and LIFO are combined in the weighted average technique. The current approach averages your inventory costs based on the cost and quantity of each purchase order rather than “selling through” one item of inventory at a time. Therefore, whether you sell the seventh or 300th case, the cost per item will remain the same.
How to estimate the weighted average cost of the entire phone case inventory in August and September? First, calculate the total monthly cost (August and September) by multiplying the per-item price by the number of products purchased.
Second, add these two totals (August and September), and divide by the total number of items (300 + 200). Here’s the ratio to use:
[($4 x 300) + ($4.5 x 200)] / (300 + 200) = $4.2 per item
It may seem like more work, but it’s worth it because of more accurate results.
The specific identification technique is the most straightforward tracking option. It implies keeping track of each item separately. Retailers don’t have to guess which phone case they sell first since they track each item.
This strategy is best for retailers with fewer goods, higher pricing, and smaller transaction volume. For instance, it’s logical for a car dealership to use this method rather than all three techniques mentioned above. The IRS requires you to use specific identification if it’s feasible for your business.
Advantages and disadvantages of retail accounting
Retail accounting is not a perfect science, even though many retailers prefer this method. Like any other technique, the retail method has its benefits and flaws, as shown in the list of pros and cons.
- It’s quick and simple.
- It doesn’t need time-consuming inventory evaluations.
- Small companies find it simpler to run.
- It only works if the company constantly marks its items.
- It doesn’t offer an accurate inventory value.
- It’s less accurate than the cost accounting technique.
The technique hinders a retailer’s capacity to dynamically and strategically set prices on items to compete on the market. A retailer may miss out on raising the price of one product because they don’t want to raise the costs of other items.
Offering discounts on specific goods would also throw your estimates off. Many retail shops employ these as effective marketing methods and to encourage consumer behaviors such as bulk purchasing.
Retail Vs. cost inventory accounting
Another accounting strategy retailers employ to manage their operations is cost accounting. The process differs somewhat from retail accounting. Depending on the price you charge your customers for each item, retail accounting maintains inventory. Depending on the total price you paid for an item, cost accounting keeps track of each product.
Cost accounting is more difficult to perform since it covers many aspects, including manufacturing expenses, shipping, development costs, etc. While cost accounting is more precise than the retail method, it also leads to more sophisticated calculations.
The significant advantage of retail accounting is that it is easy to establish the retail price of your inventory because that is the amount clients pay the company. However, it’s challenging to keep an eye on the numerous cost accounting aspects because many of them are outside your control.
Decent retail accounting practice elements
Regardless of your chosen accounting method, ensuring you’re keeping everything in order is critical. However, if you select a retail method, several elements indicate you’re taking good care of accounting:
- Proper record keeping. You won’t be able to calculate anything without good bookkeeping accurately.
- Having a separate bank account for business. It’s much easier to keep track of financial transactions when dividing personal and business accounts.
- Tracking expenses. Having a habit of recording all transactions immediately helps reduce the tax burden, thanks to reimbursements.
- Proper payroll schedules and systems. Retail is never about one person. Most companies have a few employees and vendors. Thus, it’s critical to maintain proper payroll.
- Taking care of taxes. Every business pays taxes slightly differently depending on its registered business model. Paying taxes on imported goods. Importing items from other countries requires paying taxes. Thus, it’s critical to keep track of taxes on imported items.
- Setting up several payment methods. Most retailers encourage customers to buy goods by offering all popular payment methods. It’s a relatively easy task to set up everything when you’re selling goods on a marketplace (like Amazon or eBay), but it’s challenging when setting up your own payment system. You should consider contacting your bank to secure payment gateways.
You can take care of bookkeeping yourself, but it’s best to choose an accountant to take care of more advanced calculations. Some accounting firms offer free consultations to clients in the United States to determine the best accounting practice. Naturally, accounting services come at a price.
Author: Charles Lutwidge