Retail accounting method: A comprehensive guide

If you have a retail store, you probably considered using retail accounting. It's a simple way to estimate your inventory balances and value without spending too much time on inventory management. 

But is retail accounting right for you? In this article, we’ll go over what you need to know about accounting for retail business, including which method to use, how to use it, and its pros and cons. 

The importance of retail accounting

Retail accounting helps you track the cost of goods sold and the cost of sales of your business. It’s a simpler way to track inventory allowing you to get an estimate of your inventory costs. 

It also helps you keep track of how much inventory you have left and how much your inventory is selling to maintain your inventory levels and potentially cut down on inventory costs. 

Retail accounting methods

When doing retail accounting, there are a couple of different inventory valuation methods. The method you choose will depend on your business and what you sell. 

Essentially, these methods assign a value to your inventory to find how much you have left in stock. They fall into two categories: cost accounting and retail accounting methods. 

The cost accounting method calculates your inventory based on the price it costs you to buy them. The retail accounting method considers the price you sell your inventory.

First in, first out (FIFO) 

The first in, first out (FIFO) is an inventory costing method that calculates inventory value, considering that the goods you acquired first are the first ones you sell. This method is commonly used by businesses that sell inventory with an expiration date, like food and drinks. 

For example, your business purchased 50 bags of chips for $1 each, then at a later date, decided to buy 30 more, but the price rose to $2 each. By the end of the month, you sold 40 bags of chips. 

With the FIFO method, the cost of goods sold would be $40 because this was the price you purchased the first bags of chips. Your inventory value would be $70 since there were 10 bags left that you bought for $1 and 30 left that you bought for $2. 

Last in, first out (LIFO)

The last in, first out (LIFO) is the opposite of the FIFO method. In this inventory costing method, you’ll calculate inventory value, considering that the goods you acquired last are the first ones you sell. 

For example, your business purchased 30 basketballs for $5 each, then at a later date, you purchased 20 more basketballs, but for $6 each. By the end of the month, you sold 15 basketballs. 

With the LIFO method, the cost of goods sold would be $90 since the last 20 basketballs you purchased cost $6 dollars each. Your inventory value would then be $180 since you have five basketballs left purchased for $6 each and 30 left for $5 each. 

Specific identification

The specific identification is another inventory costing method that tracks the cost of each item you have in stock by assigning a different price to each item, usually with SKUs. This method helps businesses keep track of every item in their inventory without grouping them. 

It’s most common in businesses that sell high-ticket items or have a smaller stock quantity. For example, if your business sells jewelry, you’ll assign a price to each item based on its material and details.

Weighted average

The weighted average is an inventory costing method that averages the cost of your items. This method is the most useful when dealing with goods you rotate or mix up, like smaller identical items in large quantities. 

For example, let’s say your business has a bin of 200 hair ties, each of which you and you purchased at different prices for a total of $40. Using the weighted average, you’ll divide the total cost of the hair ties by the number you purchased, which is 20 cents each. If you sold 120 of them, the cost of goods sold was $24, and you have $16 for the ending inventory. 

Retail method

The retail method is different from the other costing methods since it values the inventory based on the retail price instead of the cost to acquire them. This method helps you get an approximate value for your inventory without having to count the inventory often. The retail method works for businesses that mark up their inventory consistently and at the same percentage. 

You’ll first have to find the cost-to-retail percentage by dividing the cost of your product by the sale price. Then to find the ending inventory, you’ll multiply your sales by the cost-to-retail percentage, then subtract it from your beginning inventory. 

How to use the retail method (with examples)

If your business usually marks up prices consistently across all inventory goods and you want to use the retail inventory method, here’s how it works:

1. Find out your cost-to-retail ratio

First, you have to find your cost-to-retail ratio, which is the percentage of the retail price that makes up its costs. To calculate the cost-to-retail ratio, divide the product cost by the retail price using this formula: 

Cost-to-retail ratio = (Cost price ÷ retail price) X 100

For example, your business buys water bottles for $10 each and sells them for $25. This means your cost-to-retail ratio is 40%. 

2. Determine inventory costs

Next, you’ll calculate your total inventory costs, including your initial inventory and additional inventory purchases, before making sales. For example, considering you can buy each water bottler for $10 and first bought 200 of them, your initial inventory cost is $2,000. 

Then, you decided to buy 100 more water bottles which cost you $12 each, totaling up to $1,200. Your total inventory cost for this period will be $3,200. 

3. Track sales made

The third step is to track your sales to determine how much you made. Using the same example, let’s say you sell 130 bottles of water for $25 each. Your total sales would be $3,750. 

4. Calculate your ending inventory

Now, you want to calculate your final inventory costs. To do that, you have to multiply your cost-to-retail ratio by the total sales and subtract that from the initial inventory cost, using the ending inventory formula: 

Ending inventory = total inventory - (total sales X cost-to-retail ratio)

Using the example above, your inventory was $3,200, total sales were $3,750, and the cost-to-retail ratio was 40%. 

Ending inventory = $3,200 - ($3,750 X 0.4)

This means your final inventory costs $1,700. 

Advantages and disadvantages of retail accounting 

If you’re choosing an accounting method for your retail business, there are also some advantages and disadvantages. 

Starting with the advantages—retail accounting can help you quickly estimate your inventory balance, especially when doing multichannel inventory management. It’s also convenient since you don’t have to physically count inventory every time. 

Because you assume prices are the same, retail accounting is easy to calculate and can lower your expenses without needing to close the store for inventory counts or pay staff to do it for you. 

As for the disadvantages, retail accounting is only an estimate and won’t be as accurate as other methods. Because you assign the same prices and markup for products, it’s also unrealistic, especially if prices change often or if you have discounts and promotions. You might need to find a more accurate method to use with retail accounting to get the exact prices and inventory values.

Streamline your accounting and save time

If you’re a small business looking to understand your inventory value, retail accounting might be a good option. However, if you have to deal with price changes or need a more accurate view of your inventory, investing in retail accounting software will give you better inventory insights and management capabilities.

Retail accounting FAQ

Still have questions about retail accounting? We’ve got the answers.

What is the retail accounting formula?

The retail accounting formula is:

Final inventory = total inventory - (total sales X cost-to-retail ratio)

What’s the difference between retail vs. cost accounting

Retail accounting tracks your inventory costs based on the price you sell each item. Cost accounting tracks your inventory costs based on the amount you paid to acquire each item. 

What are some retail accounting alternatives?

Some alternatives to retail accounting include financial accounting, which analyzes all company transactions in financial statements. As well as managerial accounting which helps you understand your business’s operations.