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Chapter9: Inventories: Additional Issues

The Retail Inventory Method

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The retail inventory method relies on the relationship between cost and selling price to estimate ending inventory and cost of goods sold; provides a more accurate estimate than the gross profit method.  is similar to the gross profit method in that it relies on the relationship between cost and selling price to estimate ending inventory and cost of goods sold.

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   As the name implies, the method is used by many retail companies such as Target, Walmart, Sears Holding Corporation, Saks, J.C. Penney, and Macy's. Certain retailers like auto dealers and jewelry stores, whose inventory consists of few, high-priced items, can economically use the specific identification inventory method. However, high-volume retailers selling many different items at low unit prices find the retail inventory method ideal, although with the advent of bar coding on more and more retail merchandise, use of the method is declining. Similar to the gross profit method, its principal benefit is that a physical count of inventory is not required to estimate ending inventory and cost of goods sold.

   The retail method tends to provide a more accurate estimate than the gross profit method because it's based on the current cost-to-retail percentage ratio found by dividing goods available for sale at cost by goods available for sale at retail.  rather than on a historical gross profit ratio.

   The increased reliability in the estimate of the cost percentage is achieved by comparing cost of goods available for sale with goods available for sale at current selling prices. So, to use the technique, a company must maintain records of inventory and purchases not only at cost, but also at current selling price. We refer to this as retail information. In its simplest form, the retail inventory method estimates the amount of ending inventory (at retail) by subtracting sales (at retail) from goods available for sale (at retail). This estimated ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage. This ratio is found by dividing goods available for sale at cost by goods available for sale at retail.

The retail inventory method uses the cost-to-retail percentage based on a current relationship between cost and selling price.

   Let's use the retail inventory method to solve the problem of the Home Improvement Store introduced earlier in the chapter. Suppose the company's bank has asked for monthly financial statements as a condition attached to a loan dated May 31, 2011. To avoid a physical count of inventory, the company intends to use the retail inventory method to estimate ending inventory and cost of goods sold for the month of June. Using data available in its accounting records, Illustration 9-3 shows how Home Improvement can estimate ending inventory and cost of goods sold for June.

ILLUSTRATION 9-3
Retail Method

Goods available for sale (at retail) minus net sales equals estimated ending inventory (at retail).

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   Unlike the gross profit method, the retail inventory method is acceptable for external financial reporting if the results of applying the method are sufficiently close to what would have been achieved using a more rigorous determination of the cost of ending inventory. Also, it's allowed by the Internal Revenue Service as a method that can be used to determine cost of goods sold for income tax purposes.7 Another advantage of the method is that different cost flow methods can be explicitly incorporated into the estimation technique. In other words, we can modify the application of the method to estimate ending inventory and cost of goods sold to approximate average cost, lower-of-average-cost-or-market (conventional method) and LIFO. (The FIFO retail method is possible but used less frequently in practice.) We illustrate these variations later in the chapter.

The retail inventory method can be used for financial reporting and income tax purposes.

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   Like the gross profit method, the retail inventory method also can be used to estimate the cost of inventory lost, stolen, or destroyed; for testing the overall reasonableness of physical counts; in budgeting and forecasting as well as in generating information for interim financial statements. Even though the retail method provides fairly accurate estimates, a physical count of inventory usually is performed at least once a year to verify accuracy and detect spoilage, theft, and other irregularities.8

Retail Terminology

Our example above is simplified in that we implicitly assumed that the selling prices of beginning inventory and of merchandise purchased did not change from date of acquisition to the end of the period. This frequently is an unrealistic assumption. The terms in Graphic 9-4 are associated with changing retail prices of merchandise inventory.

Changes in the selling prices must be included in the determination of ending inventory at retail.

GRAPHIC 9-4
Terminology Used in Applying the Retail Method

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   To illustrate, assume that a product purchased for $6 is initially marked up $4, from $6 to $10, the original selling price. If the selling price is subsequently increased to $12, the additional markup is $2. If the selling price is then subsequently decreased to $10.50, the markup cancellation is $1.50. We refer to the net effect of the additional changes ($2.00 − 1.50 = $.50) as the net markup net effect of the change in selling price (increase, increase, decrease). . Graphic 9-5A depicts these events.

GRAPHIC 9-5A
Retail Inventory Method Terminology

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   Now let's say the selling price of the product purchased for $6 and initially marked up to $10, is reduced to $7. The markdown is $3. If the selling price is later increased to $8, the markdown cancellation is $1. The net effect of the change ($3 − 1 = $2) is the net mark-down net effect of the change in selling price (increase, decrease, increase). . Graphic 9-5B depicts this possibility.

   When applying the retail inventory method, net markups and net markdowns must be included in the determination of ending inventory at retail. We now continue our illustration of the retail inventory method, but expand it to incorporate markups and markdowns as well as to approximate cost by each of the alternative inventory cost flow methods.

 Net markups and net markdowns are included in the retail column to determine ending inventory at retail.

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GRAPHIC 9-5B
Retail Inventory Method Terminology

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Cost Flow Methods

Let's continue the Home Improvement Stores example into July with Illustration 9-4 and see how the retail inventory method can be used to approximate different cost flow assumptions. We'll also use the same illustration to see how the retail method can be modified to approximate lower of cost or market.

ILLUSTRATION 9-4
The Retail Inventory Method—Various Cost Flow Methods

Home Improvement Stores, Inc., uses a periodic inventory system and the retail inventory method to estimate ending inventory and cost of goods sold. The following data are available from the company's records for the month of July 2011:

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1Purchases at cost less returns, plus freight-in.
2Original selling price of purchased goods less returns at retail.
3Gross sales less returns.

APPROXIMATING AVERAGE COST.   Recall that the average cost method assumes that cost of goods sold and ending inventory each consist of a mixture of all the goods available for sale. So when we use the retail method to approximate average cost, the cost-to-retail percentage should be based on the weighted averages of the costs and retail amounts for all goods available for sale. This is achieved by calculating the cost-to-retail percentage by dividing the total cost of goods available for sale by total goods available for sale at retail. When this average percentage is applied to ending inventory at retail, we get an estimate of ending inventory at average cost. If you look back to our simplified example for the month of June, you'll notice that we used this approach there. So, our ending inventory and cost of goods sold estimates for June were estimates of average cost.9

To approximate average cost, the cost-to-retail percentage is determined for all goods available for sale.

   Now, we use the retail inventory method to approximate average costs for July. Notice in Illustration 9-5 that both markups and markdowns are included in the determination of goods available for sale at retail.

ILLUSTRATION 9-5
Retail Method—Average Cost

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APPROXIMATING AVERAGE LCM—THE CONVENTIONAL RETAIL METHOD.    Recall from our discussion earlier in the chapter that, however costs are determined, inventory should be reported in the balance sheet at LCM. Fortunately, we can apply the retail inventory method in such a way that LCM is approximated. This method often is referred to as the conventional retail method applying the retail inventory method in such a way that LCM is approximated. . We apply the method by excluding markdowns from the calculation of the cost-to-retail percentage. Markdowns still are subtracted in the retail column but only after the percentage is calculated. To approximate lower of average cost or market, the retail method is modified as shown in Illustration 9-6.

 

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To approximate LCM, markdowns are not included in the calculation of the cost-to-retail percentage.

ILLUSTRATION 9-6
Retail Method—Average Cost, LCM

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   Notice that by not subtracting net markdowns from the denominator, the cost-to-retail percentage is lower than it was previously (63.2% versus 64%). This always will be the case when markdowns exist. As a result, the cost approximation of ending inventory always will be less when markdowns exist. To understand why this lower amount approximates LCM, we need to realize that markdowns usually occur when obsolescence, spoilage, overstocking, price declines, or competition has lessened the utility of the merchandise. To recognize this decline in utility in the period it occurs, as LCM does, we exclude net markdowns from the calculation of the cost-to-retail (market) percentage. It should be emphasized that this approach provides only an approximation of what ending inventory might be as opposed to applying the LCM rule in the more exact way described earlier in the chapter.

The logic for using this approximation is that a markdown is evidence of a reduction in the utility of inventory.

   Also notice that the ending inventory at retail is the same using both approaches ($198,000). This will be the case regardless of the cost flow method used because in all approaches this amount reflects the ending inventory at current retail prices.

   The LCM variation is not generally used in combination with LIFO. This does not mean that a company using LIFO ignores the LCM rule. Any obsolete or slow-moving inventory that has not been marked down by year-end can be written down to market after the estimation of inventory using the retail method. This is usually not a significant problem. If prices are rising, LIFO ending inventory includes old lower priced items whose costs are likely to be lower than current market. The LCM variation could be applied to the FIFO method.

THE LIFO RETAIL METHOD.   The last-in, first-out (LIFO) method assumes that units sold are those most recently acquired. When there's a net increase in inventory quantity during a period, the use of LIFO results in ending inventory that includes the beginning inventory as well as one or more additional layers added during the period. When there's a net decrease in inventory quantity, LIFO layer(s) are liquidated. In applying LIFO to the retail method in the simplest way, we assume that the retail prices of goods remained stable during the period. This assumption, which is relaxed later in the chapter, allows us to look at the beginning and ending inventory in dollars to determine if inventory quantity has increased or decreased.

   We'll use the numbers from our previous example to illustrate using the retail method to approximate LIFO so we can compare the results with those of the conventional retail method. Recall that beginning inventory at retail is $160,000 and ending inventory at retail is $198,000. If we assume stable retail prices, inventory quantity must have increased during the year. This means ending inventory includes the beginning inventory layer of $160,000 ($99,200 at cost) as well as some additional merchandise purchased during the period. To estimate total ending inventory at LIFO cost, we also need to determine the inventory layer added during the period. When using the LIFO retail method, we assume no more than one inventory layer is added per year if inventory increases.10 Each layer will carry its own cost-to-retail percentage.

If inventory at retail increases during the year, a new layer is added.

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   Illustration 9-7 shows how Home Improvement Stores would estimate total ending inventory and cost of goods sold for the period using the LIFO retail method. The beginning inventory layer carries a cost-to-retail percentage of 62% ($99,200 ÷ $160,000). The layer of inventory added during the period is $38,000 at retail, which is determined by subtracting beginning inventory at retail from ending inventory at retail ($198,000 − 160,000). This layer will be converted to cost by multiplying it by its own cost-to-retail percentage reflecting the current period's ratio of cost to retail amounts, in this case 64.68%.

ILLUSTRATION 9-7
LIFO Retail Method

Beginning inventory is excluded from the calculation of the cost-to-retail percentage.

Each layer has its own cost-to-retail percentage.

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   The next period's (August's) beginning inventory will include the two distinct layers (June and July), each of which carries its own unique cost-to-retail percentage. Notice in the illustration that both net markups and net markdowns are included in the calculation of the current period's cost-to-retail percentage.

Other Issues Pertaining to the Retail Method

To focus on the key elements of the retail method, we've so far ignored some of the details of the retail process. Fundamental elements such as returns and allowances, discounts, freight, spoilage, and shortages can complicate the retail method.

   Recall that net purchases is found by adding freight-in to purchases and subtracting both purchase returns and purchase discounts. When these components are considered separately in the retail method, purchase returns are deducted from purchases on both the cost and retail side (at different amounts) and freight-in is added only to the cost side in determining net purchases. If the gross method is used to record purchases, purchase discounts taken also are deducted in determining the cost of net purchases.

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   Likewise, net sales is found by subtracting sales returns from sales. However, sales discounts are not subtracted because to do so would cause the inventory to be overstated. Sales discounts do not represent an adjustment in selling price but a financial incentive for customers to pay early. On the other hand, when sales are recorded net of employee discounts, the discounts are added to net sales before sales are deducted in the retail column.

If sales are recorded net of employee discounts, the discounts are added to sales.

   For example, suppose an item of merchandise purchased for $6 is initially marked up to $10. Original selling price is therefore $10. When the item is sold, we deduct sales of $10 from the retail column. But if the item is sold to an employee for $7 (a $3 employee discount) and recorded as a $7 sale, the $3 employee discount must be added back to sales so the full $10 is deducted from goods available at retail to arrive at ending inventory at retail.

   We also need to consider spoilage, breakage, and theft. So far we've assumed that by subtracting goods sold from goods available for sale, we find ending inventory. It's possible, though, that some of the goods available for sale were lost to such shortages and therefore do not remain in ending inventory.

   To take these shortages into account when using the retail method, we deduct the retail value of inventory lost due to spoilage, breakage, or theft in the retail column. These losses are expected for most retail ventures so they are referred to as normal shortages (spoilage, breakage, etc.), and are deducted in the retail column after the calculation of the cost-to-retail percentage. Because these losses are anticipated, they are included implicitly in the determination of selling prices. Including normal spoilage in the calculation of the percentage would distort the normal relationship between cost and retail. Abnormal shortages should be deducted in both the cost and retail columns before the calculation of the cost-to-retail percentage. These losses are not anticipated and are not included in the determination of selling prices.

   We recap the treatment of special elements in the application of the retail method in Graphic 9-6 and illustrate the use of some of them in the concept review exercise that follows.

Normal shortages are deducted in the retail column after the calculation of the cost-to-retail percentage.

Abnormal shortages are deducted in both the cost and retail columns before the calculation of the cost-to-retail percentage.

GRAPHIC 9-6
Recap of Other Retail Method Elements

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CONCEPT REVIEW EXERCISE

RETAIL INVENTORY METHOD

The Henderson Company uses the retail inventory method to estimate ending inventory and cost of goods sold. The following data for 2011 are available in Henderson's accounting records:

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   The company records sales net of employee discounts. These discounts for 2011 totaled $2,300.

Required:

1.

  

Estimate Henderson's ending inventory and cost of goods sold for the year using the average cost method.

2.

  

Estimate Henderson's ending inventory and cost of goods sold for the year using the conventional retail method (LCM, average cost).

3.

  

Estimate Henderson's ending inventory and cost of goods sold for the year using the LIFO retail method.

SOLUTION

1.

  

Estimate Henderson's ending inventory and cost of goods sold for the year using the average cost method.

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2.

  

Estimate Henderson's ending inventory and cost of goods sold for the year using the conventional retail method (LCM, average cost).

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3.

  

Estimate Henderson's ending inventory and cost of goods sold for the year using the LIFO retail method.

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7The retail method is acceptable for external reporting and for tax purposes because it tends to provide a better estimate than the gross profit method. The retail method uses a current cost-to-retail percentage rather than a historical gross profit ratio.

8The retail inventory method also is allowable under IFRS. “Inventories,” International Accounting Standard No. 2 (IASCF), as amended effective January 1, 2009, par. 22.

9We also implicitly assumed no net markups or markdowns.

10Of course, any number of layers at different costs can actually be added through the years. When using the regular LIFO method, rather than LIFO retail, we would keep track of each of those layers.

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