Accounting for merchandise inventory has its frustrating moments, but it’s easier than accounting for manufacturing inventory. A merchandising company such as a retail store has only one class of inventory to keep track of: goods the business purchases from various manufacturers for resale.
Here’s the basic flow of inventory for a retailer:
A cookware sales associate at a major department store notices and informs the manager of the department that the department is running low on a certain style of frying pan. The manager follows the department store’s purchasing process, with the end result that the department receives a shipment of frying pans from its vendor.
This transaction is a purchase (cost), but it’s not an expense until the department store sells the frying pans. So the business records the entire shipment of frying pans on the balance sheet as an addition to both inventory and accounts payable, since the department store has payment terms with this vendor and money hasn’t yet changed hands for this transaction.
Say that, in August, the store sells a fancy-pants frying pan to a customer for $95 that cost the company $47 to purchase from the vendor. Sales revenue increases by $95, cost of goods sold increases by $47, and inventory decreases by $47. Matching revenue to the expense portion of its purchase, the effect increases net income by $48 ($95 – $47).
Seems like pretty basic stuff. The retailer buys inventory and sells it, reducing inventory and increasing COGS. Alas, like many intermediate accounting topics, it’s not quite that simple.
Retailers selling many different types of merchandise find the specific identification method impossible to use.
Stepping up to handle the task, the retail inventory method uses a cost ratio to convert the ending inventory from retail to cost. This explanation may sound a bit like gobbledygook. To un-gook this for you, consider an example for ABC, Inc.
To put the retailing inventory method into action, ABC, Inc., needs to have a handle on the following three items:
Total cost and retail value of merchandise purchased for resale. For this example, total cost is $50,000 and retail value is $88,000.
Total cost and retail value of goods available for sale. Going back to Accounting 101, beginning inventory plus purchases equals goods available for sale. For this example, beginning inventory at cost is $25,000 and at retail is $32,000.
Total sales for the period. For this example, total sales are $97,000.
Then goods available for sale at cost is divided by goods available for sale at retail. Multiply sales by the resulting percentage to come up with ending inventory at cost. The following figure shows how to use these facts to figure ending inventory at cost under the retail inventory method.
