Retail inventory method: a simple worked example

On this page

1. The idea
2. What you need
3. A worked example
4. Checking it against a count
5. Where it helps
6. What throws it off
7. A note on variations
8. A monthly routine

To know your gross profit for a month, you need the cost of what you sold. To get that, you need to know what your remaining inventory cost you. That’s the hard part. Your shelves are labeled with retail prices, and looking up the cost of every item on every shelf takes a long time.

The retail inventory method gets around this. You track inventory at retail, which is easy to see, and convert it to cost using the relationship between what you paid and what you charge. It works department by department and gives you a reasonable estimate between full counts.

The idea

Within a department, cost tends to be a fairly steady share of retail. If the goods you had to sell this month cost you 60 cents for every dollar of retail, then the retail value left on the shelf at month end probably cost you about 60 cents on the dollar too. Multiply the retail on hand by that ratio and you have an estimate of your inventory at cost.

What you need

• Beginning inventory at cost and at retail, from your last count or last month’s ending figures.
• Purchases for the period at cost and at retail. Cost comes from the invoice. Retail is the quantity on each line times your shelf price.
• Net sales for the department, from the register.
• Markdowns: price cuts, deal discounts, employee discounts and anything else that sold below the shelf price.
• Markups on goods you already had, if you raised prices during the period.

The method works best when the items in a department have similar margins. More on that below.

A worked example

Here is a hypothetical grocery department for one month.

	At cost	At retail
Beginning inventory	$6,000	$10,000
Purchases	$12,000	$20,000
Goods available to sell	$18,000	$30,000

During the month the register shows $18,500 in net sales for the department, and deal discounts and price cuts add up to $500.

Step 1: Find the cost ratio. Divide goods available at cost by goods available at retail. $18,000 divided by $30,000 is 0.60. For every dollar of retail, you paid 60 cents.

Step 2: Find retail on hand. Start with goods available at retail and subtract sales and markdowns. $30,000 minus $18,500 minus $500 leaves $11,000 of retail that should still be in the store.

Step 3: Convert to cost. $11,000 times 0.60 is $6,600. That’s your estimated ending inventory at cost.

Step 4: Find cost of goods sold. Subtract ending inventory at cost from goods available at cost. $18,000 minus $6,600 is $11,400.

Step 5: Find gross profit. Subtract cost of goods sold from net sales. $18,500 minus $11,400 is $7,100.

That’s a monthly gross profit for the department without looking up a single item’s cost.

Checking it against a count

The estimate assumes everything that left the shelf was either sold or marked down. Shrink doesn’t show up until you count.

Say you count the department at month end, multiply each item by its shelf price and get $10,600. The book said $11,000, so $400 at retail is missing. At cost, that’s $400 times 0.60, or $240.

Using the count, ending inventory at cost becomes $10,600 times 0.60, which is $6,360. Cost of goods sold rises to $11,640, and gross profit falls to $6,860. The $240 gap between the two gross profit figures is your shrink at cost.

Where it helps

• Monthly gross profit by department, without waiting for a full count.
• Spotting a margin slide early. If a department’s cost ratio creeps up month after month, your costs are rising faster than your prices.
• Deciding what to count. A department whose book and count drift far apart is the one to count more often.
• A quick estimate when someone asks for one, such as a lender or an insurance adjuster, built from records you already keep.

What throws it off

Price changes that never get recorded

When you raise or cut shelf prices, the retail value of what’s on hand changes. Record markdowns and markups, or the book drifts away from the shelf. In the example above, forgetting the $500 in markdowns would put book retail at $11,500. Against a count of $10,600, you’d think $900 went missing when the real gap is $400.

Deals and discounts

If your register records department sales after deal discounts, the items still left the shelf at full retail value. Count deal discounts and other price reductions as markdowns, or they’ll look like shrink.

Departments that mix very different margins

Suppose a department holds both high-margin and low-margin items, and one month the low-margin items sell faster than usual. What’s left on the shelf is mostly high-margin stock, which cost less per retail dollar than the department’s average ratio. The method then overstates your inventory and your profit. Split departments where margins are far apart.

Purchases missing their retail side

Every invoice needs a retail value as well as a cost. An item received that isn’t in your pricebook, or an invoice entered at cost only, leaves a hole in the retail column.

Sales rung in the wrong department

If a cashier rings a candy bar on the grocery key, the sale lands in one department while the stock leaves another. Both departments’ numbers go wrong.

Things that don’t belong

Leave fuel, lottery, money services and other pass-through sales out. They have their own tracking, and their margins have nothing in common with your shelves.

A note on variations

Accountants use a few versions of this method. They differ in details such as whether markdowns go into the cost ratio. The simple version above is fine for running the store and spotting problems early. For your financial statements and taxes, use the version your accountant recommends.

A monthly routine

1. Keep beginning inventory at cost and at retail for each department.
2. Enter every invoice with both its cost and its retail value.
3. Pull net sales by department from the register.
4. Total your markdowns, including deal discounts.
5. Work through the five steps above.
6. Compare the result with a physical count whenever you do one, and look into any gap.