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Retail Accounting: What You Need to Know About Inventory

business.com editorial staff
business.com editorial staff

What makes retail accounting different from accounting in other industries? Learn the different methods you can use.

  • Retail accounting is more complex than other types of accounting because of the need to track inventory closely.
  • Costing methods are used to calculate how much cash is needed to invest in inventory for your retail store. Calculating LIFO and FIFO helps in the process.
  • Weighted average and the retail method are additional strategies used in the accounting process for a retail store.

While some basics apply to all businesses, accounting is different from industry to industry. Accounting methods for a construction business, for example, differ quite a bit from those of a restaurant or a retail store.

Business owners in the retail industry need to know how to handle their specific accounting needs, and that starts with recognizing the main difference: Retail accounting comes with the added challenge of keeping track of your inventory and knowing exactly how many goods you're buying or selling and how much is left over.

To help, here's a breakdown of the basics you need to know about costing and tracking inventory in retail accounting.

Costing methods: FIFO, LIFO, weighted average, retail method

Part of managing your inventory is keeping track of the cost of the items you sell, as well as the money you have left in your inventory. This can become especially complicated when items have different prices and initial costs, so there are several methods for calculating the cost of your inventory.

FIFO

FIFO stands for "first in, first out" and, according to The Balance, means that the first items to be put in your inventory are also the first to be sold. In other words, the goods left over in your inventory at the end of the year are the most recent items you've put in stock. The FIFO costing method would make sense for a grocery store, for example, because of food expiration dates.

LIFO

On the other hand, LIFO stands for "last in, first out" and means that the most recent inventory you've stocked up on is what sells first. This works well for retail businesses that aren't selling perishable items, according to Investopedia.

Calculating FIFO and LIFO is very similar; the difference is simply in which inventory items you count first. The Balance article explains them both with the same example: Say the items you sold for the year are produced in three batches. For each batch of items, you calculate the unit cost by dividing the cost to produce the items by the quantity. In The Balance's example, Batch 1 consists of 2,000 units at a cost to produce of $4 per item, Batch 2 consists of 1,500 units at $4.67 per item, and Batch 3 consists of 1,700 units at $4.53 per item. That makes the total number of units produced 5,200. Assume you sold 4,000 units during the year.

FIFO assumes that you sold Batch 1 first, meaning that, of the 4,000 units, you sold all 2,000 from Batch 1, all 1,500 from Batch 2, and only 500 of Batch 3's 1,700 units; then you just add up the costs accordingly. LIFO works the same way, except it assumes that you sold the last batch first, so you simply add up your costs in the reverse order.

Weighted average

This is when you determine the average cost of all your inventory items based on the items' individual costs and the quantity of each item in your inventory. According to Chron, with this method, you determine the cost of all your different inventory items and the number of units of each, then multiply the number of units by the corresponding cost. Add up the totals for each different item in your inventory to get one sum. Then, add up the total number of units in your inventory. From there, divide the first sum by the total number of units, and you'll have your weighted average.

Retail method formula

The retail method is a simpler method, in which you divide your purchase and beginning inventory costs by the cost-to-retail ratio (which you can find by dividing the cost of an item by the price you're selling it for). You then multiply the sales total by the percentage and subtract that number from the cost of goods sold, and that gives you your ending inventory total. 

According to accounting software provider FreshBooks, the formula for the retail method is the cost price multiplied by 100 divided by the retail price. This allows you to come up with a cost-to-retail ratio for your business. As an example, if you buy goods for $160 and sell them for $200, your cost-to-retail ratio is 80%.

Tracking methods: Periodic, perpetual

Along with calculating cost, you need a way to track and monitor the actual items in your inventory.

Periodic

The periodic method involves taking occasional physical counts of the items in your inventory along with their costs, according to Investopedia. In this method, you record merchandise purchases in your purchases account, then set up specific time periods (such as every month, every quarter or once a year) to go through and update your inventory account to reflect the cost of goods sold.

To calculate the cost of goods sold every period, add the balance of your inventory to the cost of your inventory purchases, then subtract the cost of your ending inventory.

Perpetual

This is perhaps the easiest method of tracking the number of items in your inventory accurately. According to Investopedia, under this method you simply keep track of your inventory continuously, automatically updating your inventory account and your cost of goods sold as new items come in and go out. This means using a digital system to keep track of everything – and that, so long as you don't face theft or damage of items in your inventory, your inventory account balance should be accurate at all times.

You can find out more about the process of accounting for your retail business – including income statements, balance sheets and cash flow – in our complete Guide to Retail Accounting.

Image Credit: Natnan Srisuwan / Getty Images
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