If you sell physical goods, you have dealt with the need to quickly tally up your inventory. If you only sell a few products, this may not be difficult. But what if you have a large number of items to sell, and you don’t have the time to take a manual inventory every time you need to come up with a number for your financial statements? What’s more, you may know the selling price of your items, but do not have the actual costs of the individual items that you sold since you bought the items at different times for different prices. You need a better way to calculate the cost of your inventory.
The Retail Method
There’s a straightforward way to determine the value of your inventory: It’s called the retail method and it involves converting the retail value of your inventory to a cost value. Under this method, a ratio is multiplied by the retail selling prices of the goods on hand. This ratio, called the cost component, is calculated as follows:
Beginning inventory plus cost of purchases
Retail selling price of beginning inventory plus purchases plus any markups or markdowns
The advantages of this method is that you do not have to take physical inventory to get a value of your ending inventory. You only have to record the retail prices of your items in inventory. Additionally, you can easily keep an inventory valuation report to use for budgeting or preparing your financial statements.
How the Method Works
Here’s an example of how this works. Let’s say your beginning inventory at cost was $90,000 and the cost of your new purchases was $330,000. Additionally, the retail value of your beginning inventory and purchases was $130,000 and $460,000, respectively, and you had $10,000 in markups and $40,000 in markdowns. You had sales of $480,000. The calculation of the ratio, using the formula above, would be as follows:
$90,000 plus $330,000
$130,000 plus $460,000 plus $10,000 minus $40,000
The equation is $420,000 divided by $560,000, which gives you a ratio of 75 percent.
Now that you know this ratio, you can convert the retail value of your inventory to an estimated cost of the inventory. The ending retail value of your inventory is:
Now multiply the cost of your ending ending inventory ($80,000) by your ratio (0.75), to cone up with $60,000. This method allows you to come up with an inventory number without having to calculate the cost value of your inventory.
New IRS Rules
The IRS recently came out with some rules related to how to calculate this cost. The big change is that the denominator in the ratio calculation should not be adjusted for any temporary markups or markdowns — only those that are permanent. Additionally, the numerator also should not be reduced by vendor allowances that you may receive that only reduce your cost of goods sold. However, you can reduce the numerator of the ratio by any margin for protection payments you receive that are meant to compensate you for a reduction in your selling price of inventory.
Determining the correct value of your inventory can be tricky, no matter how you go about looking at it. Luckily, there is inventory management software that can take care of the hard parts for you, so you can focus on running your business.