1.

The retail inventory method explained

The retail method provides the ending inventory balance for a store by measuring
the cost of inventory relative to the price of the goods. In essence, it determines
how much expense to recognize this period versus the next period.

The retail method assumes that all your inventory has a consistent markup,
explains Abir Syed (CPA) of UpCounting. “So you take the total value of what you
have for sale, reduce it by its markup, and use that number as your cost.”

The pros and cons of the retail method

The benefit of this method, explains Abir, is that it’s extremely easy to calculate
and can work when you have weak inventory cost tracking. “The main con is that
it’s generally not very accurate, especially if you have prices that fluctuate at
different times of the year (which most retailers do), and if you have products with
different markups.”

FitSmallBusiness tax and accounting analyst Tim Yoder says the retail inventory
method works best if you have a standard markup, within broad product lines. “If
your markups vary widely among products, then your estimate won’t be very
accurate,” says Tim.

Retail inventory method formula

Here is the retail method formula, courtesy of AccountingCoach.

Example of the retail inventory method

As AccountingCoach explains in the above example, the cost of goods available of

$80,000 is divided by the retail amount of goods available ($100,000). This results
in a cost-to-retail ratio (or cost ratio) of 80%. To get the estimated ending
inventory at cost, you multiply the estimated ending inventory at retail ($10,000)
times the cost ratio of 80% to arrive at $8,000.

2. The specific identification method explained

Next up is the specific identification method.

This is when you assign a specific cost to each and every item in your store. Abir
says this method makes the most sense for retailers that have a lot of different
items, especially if they were bought from various sources. “A good example
would be an antique dealer,” says Abir.

The pros and cons of the specific identification method

The pros and cons of the specific identification method depend on the size of your
retail business, according to the Corporate Finance Institute (CFI). For the specific
identification method to suit your retail business, you need to be able to
confidently and accurately identify the location, cost, and sale amount of every
stock-keeping unit (SKU) in your inventory. The bigger your business and its
inventory, the harder that becomes.

The CFI suggests specific identification is better suited to small businesses because
it can give them a more accurate profit and loss statement, with reliable numbers
on income and losses and normal spoilage of inventory (due to things like
accidental damage).

Specific identification method formula

Here is a simplified specific identification method formula, based on the following

values:

(A) Purchase quantity = 3,000

(B) Units sold = 1,000

(C) Balance = 2,000 (C = A – B)

(D) Price = $5.00

Closing inventory = $10,000 (C x D)

Cost of Goods Sold = $5,000 (B x D)

Example of the specific identification method

“Let’s say someone sells unique paintings that they buy from local artists and then
sells,” says Abir.

“This person has one painting in stock worth $150. They then buy three paintings
for $100, $200, and $350. So their total cost of inventory is the sum of all the
individual costs ($150 + $100 + $200 + $350 = $800).”

“If they then sell the $200 painting, their cost of inventory would be $800 – $200 =
$600. Each item’s cost is tracked separately.”
3. The First In, First Out (FIFO) method

When you have large numbers of nearly identical items, specific identification may
not be worth the effort. First In First Out, or FIFO, might be better. FIFO assumes
that any sale of an item is from the oldest batch on hand, and is relevant when the
prices you bought it at fluctuate.

The pros and cons of the FIFO method

“This method will give you a very accurate representation of your inventory, which
can be beneficial if you buy batches of the same item at varying prices,” says Abir.
“It will often mirror reality as older units of a stock-keeping unit (that scannable
barcode) tend to be sold before the newer ones in ideal circumstances.

“The downside is that it takes more effort to track different costs within the same
stock-keeping unit for different batches of purchases. For example, if you sell a
particular shirt with one universal product code (UPC) that was bought in three
batches, it’s harder to track a different cost for each batch than one cost for the
entire UPC.”

FIFO method formula

As Freshbooks explains, you can calculate FIFO by multiplying the cost of your
oldest inventory by the amount of that inventory sold.

Example of the FIFO method

“Let’s say someone sells leather jackets,” says Abir. “They buy 10 for $100 each,
and then later 10 more for $90 each. The total value of the inventory will be ($100
x 10) + ($90 x 10) = $1,900. Even if all jackets were identical and sitting on the
same rack, if they were to sell three jackets, they would calculate the Cost of
Goods Sold (COGS) by deducting it from the older batch purchased at $100/each
—regardless of which batch they were actually sold from.”

He adds: “So their ending inventory cost would be $1,900 minus (3 x $100) =
$1,600. The logic here is that the more accurate inventory cost would be the more
recent purchase price, as that’s the price you’re more likely to buy more inventory
at.”

4. The Last In, First Out (LIFO) method

LIFO, as the name suggests, is basically the opposite of FIFO. It treats the last
items bought as the first ones sold. Here’s what Abir has to say about this method.

“LIFO is when you attribute specific costs to individual items or batches of items
based on their actual cost, and you reduce your cost as you sell items with the last
items added being removed from inventory first. This method only makes sense
when it actually mirrors reality where the newest items are sold first, and older
items can sit there for a long time.”

It’s not a particularly common method, he explains, because this rarely happens in
retail.

The pros and cons of the LIFO method

LIFO is definitely not for every retailer. In fact, it can only be used in the United
States under the Generally Accepted Accounting Principles (GAAP). Elsewhere,
this method is not allowed by the International Financial Reporting Standards
(IFRS). It can create an added burden around record-keeping. For many
businesses, it’s a system that is just too complex to justify using.

That said, one of the main benefits is tax. Because LIFO results in a higher Costs
of Goods Sold (COGS), the method may help rein in tax liabilities. Still, it’s
always important to check the exact impacts of LIFO with your accountant or tax
advisor.

LIFO method formula

Investopedia has the following helpful LIFO example, of a furniture store that buys
200 chairs for $10 per unit. Next month the store buys another 300 chairs for $20
each, and at the end of their accounting period, it has sold 100 total chairs.

Cost of goods sold = 100 chairs sold x $20 = $2,000

Remaining inventory = (200 chairs x $10) + (200 chairs x $20) = $6,000

Example of the LIFO method

Here’s a more detailed LIFO example, from the Corporate Finance Institute.

5. The weighted average method

Lastly, if the prices of the products you buy hardly change then you can use an
even easier method called Weighted Average Costing.

With the weighted average method, you use a pool of cost for all units of a
particular stock keeping unit. Any purchase is added to the pool of cost, and the
pool of cost is divided by all units you have on hand.

The pros and cons of the weighted average method

“The benefit is that it’s much easier to track than specific costing because you
don’t need to know exactly which batch a sold unit was part of, which is especially
helpful when you have many identical units,” says Abir. It may also give you a
more accurate costing method than the retail method—which doesn’t compensate
for discounts or differing margins across SKUs.

What is the downside? This method can be less accurate than specific costing
because you’re blending all your purchases together, says Abir. “But this is only a
real problem if you buy a particular stock-keeping unit at very different prices each
time you purchase, which 1. Bulk shipments

This method banks on the notion that it is almost always cheaper to purchase and
ship goods in bulk. Bulk shipping is one of the predominant techniques in the
industry, which can be applied for goods with high customer demand.

The downside to bulk shipping is that you will need to lay out extra money on
warehousing the inventory, which will most likely be offset by the amount of
money saved from purchasing products in huge volumes and selling them off fast.

Pros of bulk shipments

Highest potential for profitability

Fewer shipments mean lower shipping costs

Works well for staple products with predictable demand and long shelf lives

Cons of bulk shipments

Highest capital risk potential

Increased holding costs for storage

Difficult to adjust quickly when demand fluctuates

bulk shipments pros and cons

2. ABC inventory management

ABC inventory management is a technique that’s based on putting products into

categories in order of importance, with A being the most valuable and C being the
least. Not all products are of equal value and more attention should be paid to more
popular products.

Although there are no hard-and-fast rules, ABC analysis leans on annual

consumption units, inventory value, and cost significance. Categories typically
look something like:

Category A

abc-a-2

Items of high value (70%)

and small in number (10%)

Category B

abc-b

Items of moderate value (20%)

and moderate in number (20%)

Category C

abc-c

Items of small value (10%)

and large in number (70%)

The key is to operate each category separately, particularly when selective control,
allocation of funds, and human resources are required.

Pros of ABC inventory management

Aids demand forecasting by analyzing a product’s popularity over time

Allows for better time management and resource allocation

Helps determine a tiered customer service approach

Enables inventory accuracy

Fosters strategic pricing

Cons of ABC inventory management

Could ignore products that are just starting to trend upwards

Often conflicts with other inventory strategies

Requires time and human resources

abc analysis

3. Backordering

Backordering refers to a company’s decision to take orders and receive payments

for out-of-stock products. It’s a dream for most businesses but it can also be a
logistical nightmare … if you’re not prepared.

When there’s just one out-of-stock item, it’s simply a case of creating a new
purchase order for that one item and informing the customer when the backordered
item will arrive. When it’s tens or even hundreds of different sales a day, problems
begin to mount.

Nonetheless, enabling backorders means increased sales, so it’s a juggling act that
many businesses are willing to take on.

As a general rule, the bigger the item value (physically and monetarily), the more
“delivery tolerance” you get from customers.

If you’re a small retailer, it may not be feasible to risk overstocking. In this case,
you might consider labeling the item’s “Buy now” button as “Pre-order” or “Get
yours when it comes back in stock.” This creates a reasonable expectation for
customers that it will take a bit longer to arrive.
Alternatively, some businesses run with a “no-stock” approach which involves
taking only backorders until they’ve generated enough sales to then place a large
bulk in order with a supplier.

Pros of backordering

Increased sales and cash flow

More flexibility for small businesses

Lower holding costs and lower overstock risk

Cons of backordering

Higher risk of customer dissatisfaction

Longer fulfillment times

backordering

4. Just in Time (JIT)

Just In Time (JIT) inventory management lowers the volume of inventory that a
business keeps on hand. It is considered a risky technique because you only
purchase inventory a few days before it is needed for distribution or sale.

JIT helps organizations save on inventory holding costs by keeping stock levels
low and eliminates situations where deadstock - essentially frozen capital - sits on
shelves for months on end.

However, it also requires businesses to be highly agile with the capability to handle
a much shorter production cycle.
If you’re considering adopting a Just in Time inventory management strategy, ask
yourself the following:

Are my suppliers reliable enough to get products to me on time every time?

Do I have a thorough understanding of customer demand, sales cycles, and

seasonal fluctuations?

Is my order fulfillment system efficient enough to get orders to customers on time?

Does my inventory management system offer the flexibility needed to update and
manage stock levels on the fly?

Pros of JIT

Lower inventory holding costs

Improved cash flow

Less deadstock

Cons of JIT

Problems fulfilling orders on time

Minimal room for errors

Risk of stockouts

just in time

5. Consignment

Consignment involves a wholesaler placing stock in the hands of a retailer, but

retaining ownership until the product is sold, at which point the retailer purchases
the consumed stock. Typically, selling on consignment involves a high degree of
demand uncertainty from the retailer’s point of view and a high degree of
confidence from the wholesaler’s point of view.

For retailers, selling on consignment can have several benefits, including the
ability to:

Offer a wider product range to customers without tying up capital

Decrease lag times when restocking products

Return unsold goods at no cost

While most of the risk in selling on consignment falls on the wholesaler, there are
still a number of potential advantages for the supplier:

Test new products

Transfer marketing to the retailer

Collect useful information about product performance

If you consider selling on consignment — as either a retailer or wholesaler — set

terms clearly regarding the:

Return, freight, and insurance policies

How, when, and what customer data is exchanged

Percentage of the purchase price retailer will be taking as sales commission

consignment@2x-1

6. Dropshipping and cross-docking

This inventory management technique eliminates the cost of holding inventory
altogether. When you have a dropshipping agreement, you can directly transfer
customer orders and shipment details to your manufacturer or wholesaler, who
then ships the goods.

Similar to dropshipping, cross-docking is a practice where incoming semi-trailer

trucks or railroad cars unload materials directly onto outbound trucks, trailers, or
rail cars.

Essentially, it means you move goods from one transport vehicle directly onto
another with minimal or no warehousing. You might need staging areas where
inbound items are sorted and stored until the outbound shipment is complete. Also,
you will require an extensive fleet and network of transport vehicles for cross-
docking to work.

drop-shipping@2x-1

cross docking

7. Inventory Cycle counting

Cycle counting or involves counting a small amount of inventory on a specific day

without having to do an entire manual stocktake. It’s a type of sampling that allows
you to see how accurately your inventory records match up with what you actually
have in stock.

This method is a common part of many businesses’ inventory management

practices, as it ultimately helps ensure that customers can get what they want, when
they want it, while keeping inventory holding costs as low as possible.
Pros of cycle counting

More time- and cost-efficient than doing a full stocktake

Can be done without disrupting operations

Keeps inventory holding costs low

Cons of cycle counting

Less comprehensive and accurate than a full stocktake

May not account for seasonality is often not the case.”