Business owners understand the unique challenges that come with building a company from the ground up.
Retail businesses present distinct difficulties, especially when it comes to retail accounting.
Part of the crux of running a retail business is accurately accounting for current inventory.
Retail accounting provides a way to obtain an exact number of current inventory without requiring a manual count of all the items the business possesses.
Read more for an overview of retail accounting, how it differs from other accounting forms, and the best way to get started.
What is retail accounting?
Retail accounting is a specific method of accounting that assists companies in tracking inventory without manually counting all of the items in the store or warehouse.
This type of accounting method converts current inventory to its estimated retail price and then subtracts the sale numbers from the value of your inventory.
The total number is how much inventory the store currently has on hand.
This method of accounting is useful in determining the percentage markup of sold items as a way to figure out how much inventory is left based on the number of items sold.
Knowing this number is important for various reasons, apart from having products available to customers, such as for tax statements or business valuation.
How does retail accounting work?
First, retail accounting helps businesses determine the cost-to-retail ratio.
This ratio is the difference between the price the business paid for the items and the price they eventually sold for.
Of course, this gets more complicated when there is more than one type of item with different prices.
As a result, retail accounting provides 3 ways to assign value to inventory.
Retail stores can choose any of the following methods to assign the inventory cost and establish the inventory on hand:
- First in, first out
- Last in, first out
- The weighted average method
Let’s dive a little further into these methods.
1. First in, first out (FIFO method of accounting)
The FIFO method works under the assumption that goods are sold in the order in which they are acquired.
For example, if you buy a different type of item each week for 3 weeks at ranging prices, the first in, first out method assumes the items from the first week’s purchase will be sold first.
We’ll take a look at a real-world example.
Let’s say each week you purchased 20 items. The first week they cost $10, the second $20, and the third $30.
By the end of the third week, you had sold 35 items.
Under this method, you assume you sold all of week 1 items for $10 each and 15 from week 2 at $20 each for a total of $500.
Now, you assume you are left with 5 items from week 2 at $20 each and 20 items from week 3 at $30 for a total of 25 and $700.
The two numbers are divided to calculate a price of $28 per item in your inventory.
2. Last in, first out (LIFO method of accounting)
Similar to the first method, last in, first out reverses the order in which the items are calculated.
Using the LIFO inventory costing method means you assume the items purchased recently are the first ones sold.
Of all the inventory costing methods, LIFO is beneficial if the front of the store or the first products on shelves holds the most recently purchased inventory.
Customers are more likely to purchase the products they see first, but it is still only an estimate.
3. Weighted average method of accounting
This inventory valuation technique averages the cost of all items without worrying about the order in which the inventory was purchased.
The weighted average strategy for accounting is best for retailers who sell items at a similar pace regardless of when the inventory was obtained.
Using weighted averages to find the inventory value is helpful to stores that sell a variety of items at different prices.
The difference in cost could make for tricky calculations, but using this method of accounting simplifies the problem and provides the most accurate inventory valuation.
What are the advantages of retail accounting?
The biggest advantage of using retail accounting for retail stores is that it solves the problem of having to complete a physical inventory count.
Many stores find themselves unable to easily count their entire inventory, and a retail accounting method does all the heavy lifting.
Equations to complete any retail inventory method are also fairly simple, allowing any store in the retail sector to start the process without a hitch.
Tax benefits are another advantage of using a retail method of accounting.
Whether the business is using LIFO, FIFO, or weighted average, each inventory costing method produces different results with various benefits.
Before selecting one, it’s best to explore the options.
What are the disadvantages of retail accounting?
As with any accounting method, the retail method of accounting has its disadvantages.
For example, a retail store selling various goods at different prices won’t get great results with all of the inventory valuation methods available.
Another disadvantage is that the accounting process could prove to be inconsistent, providing estimates rather than a comprehensive account inventory.
A retail business owner has to understand that the numbers these methods provide will not be as accurate as a physical inventory count, but they will save time.
How do you use retail accounting for your retail business?
The retail method of accounting is all about inventory management.
The best way to understand this method is to walk through a step-by-step scenario.
Step 1. Determine the cost-to-retail percentage
The first step for small businesses is to determine the cost-to-retail percentage.
This number shows the in-between of how much the business paid for purchased inventory and the selling price.
We’ll go over an example below.
Let’s say you purchased an item for the store at $50.
The item’s retail price is $100.
Divide $50 by $100 to determine that the ratio is 0.5 (50%).
The higher the percentage, the better for the business.
Step 2. Track inventory cost
Managing inventory cost is the next step in the retail accounting method.
Essentially, retail business owners need to determine the actual cost of purchased inventory.
For example, if the beginning inventory was worth $1,000 and the business purchased $2,000 more, you need to track the total cost of $3,000.
At this point, the cost of goods sold does not need to be tracked.
Step 3. Determine the sales completed
The next step is to determine how much you made in sales from the store’s inventory.
Check the accounting books or retail accounting software for the correct information.
It’s important to get this number as correct as possible.
We’ll work with $2,000 for the purpose of our example.
Step 4. Calculate your numbers
After gathering the data, you’ll perform the following calculation:
Final inventory = beginning inventory – sales (cost-to-sales ratio)
Taking the numbers from our example above, this is what we get:
Final inventory = 2,000
With the calculation complete, you can see that the final inventory costing method brings us to a total of $2,000 in ending inventory.
Manual vs automated tracking inventory methods
Unless you are attached to completing a physical inventory count, the best way to track inventory is through the use of a point-of-sale (POS) system.
A POS system helps track items sold as the change to the inventory occurs in real time. The same thing is true of inventory purchases.
Any retail store will benefit from a POS system that tracks individual items through barcodes.
Working with accounting software and a POS system will streamline the process and assist with the chosen costing method, maintain accurate records, and procure financial statements.
What does the accounting cycle look like for retail stores?
Fine-tuning the accounting process is an important step in understanding retail accounting.
Here are the necessary steps in the accounting cycle:
Step 1. Record all transactions
As with any other accounting method, the first step in the retail method of accounting is to record all transactions.
Whether through the use of cash basis accounting or accrual accounting, all transactions going in and out of the business accounts need to be accounted for appropriately.
Step 2. Generate financial statements
Generating financial statements for the retail store is a key step to keeping the business on track throughout the accounting period.
Some of the statements are as follows:
- Cash flow statement
- Profit and loss statement
- Balance sheet
- Shareholders’ equity statement
Step 3. Reconcile financial records
The accounting process is not complete until reconciliation is complete.
This step is crucial to ensuring all information entered throughout the year is accurate.
Without checking this data, it’s impossible for the business owner to trust the information they have concerning their business and make good decisions. Read our related article where we discuss accounting for an LLC.
Frequently asked questions
There are slight differences between retail accounting and cost accounting.
Retail accounting tracks inventory based on the price of each item sold to customers.
Cost accounting for retail tracks each item based on the total cost paid for purchased inventory.
Of the two, cost accounting is considered more complicated since it tracks a variety of factors involved in obtaining inventory, such as shipping, production costs, and development costs.
Due to the intricacies in its calculation, cost accounting is the more accurate method, however, it requires complex calculations.
Retail accounting is easy to use and maintain while still providing accurate records.
The retail accounting method helps businesses understand the value of their inventory and provide information for good decision-making in the future.
Without a solid accounting system built around the retail method, businesses would be forced to determine beginning inventory and ending inventory information manually.
With the inventory costing method, it becomes possible to automate these steps, using calculations to understand retail prices and having a last physical inventory count without completing untold hours of manual work.
Business owners need to ensure they understand this method and choose the best way forward when calculating inventory information.
Agata Kaczmarek has held a passion for writing since early childhood. A professional writer for many years, Agata specializes in writing articles and blogs focused on finance as someone who holds a Master’s Degree in Accounting and Finance.
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