Retail Inventory Method
This method is used to estimate ending inventory/cost of goods sold and is acceptable (and widely used) for financial reporting purposes, especially for quarterly financial statements. The retail method can be used with FIFO, LIFO, or the weighted average cost flow assumption. It is based on the (known) relationship between cost and retail prices of inventory. In addition it is used in conjunction with the dollar value LIFO method. A number of factors, such as mark-ups, mark-downs, (and their cancellation), employee discounts, etc. must be considered in real situations. For now, ignore these factors until you are comfortable with the basic method.
The following example shows the results under each cost flow assumptions:
To determine cost of goods sold/ending inventory the following information is needed:
The beginning inventory and purchases at both cost and retail prices (from records); with this information the ratio of cost/retail can be determined. Also needed are sales (again, from records). Keep in mind that sales = cost of goods sold at retail. Once this information has been compiled, it is quite simple to determine ending inventory at retail. To determine ending inventory and cost of goods sold at cost, the appropriate cost/retail ratio is then applied. The appropriate ratio depends on the cost flow assumption used: I.e., under FIFO the ending inventory consists (probably) only of the goods purchased in the current period. Under LIFO, the beginning inventory is assumed to be still at hand and only a new layer is assumed to have come from recent purchases:
Note that inflation is ignored in this case. Consequently, (due to the change in the cost/retail relationship) LIFO gives the lowest cost of goods sold. This will not do! Therefore, we will now incorporate the Dollar Value LIFO technique: