Inventory is an important asset entity holds and its valuation is critical as it not only affects figures in statement of financial position but also profit calculation. There are several methods to value year end inventory. However financial statements prepared under International Accounting Standards have limited set of methods that can be used to value inventory. One of the includes retail method of inventory valuation. For a list of different methods available please read What are different inventory valuation methods?
Retail inventory valuation method is used in situations where entity deals in massive quantities of stock. Huge number of transactions and thousands of different types of stocks available makes it practically difficult to keep the record of cost for each type of inventory held. Therefore specific identification method will not be a solution to value closing inventory. Specific identification method is used when different inventory amounts can be identified and to each set particular cost is allocated. To learn more about specific identification method please read What is Specific identification method of inventory valuation?
Retail method of inventory valuation follows more of a “reverse evaluation” technique to simplify cost computation. In simple words retail price of inventory is known from which amount of profit is deducted to ascertain cost of inventory. This drastically simplifies the valuation process as specific cost computation is not needed.
Following steps makes the whole valuation process easy to understand:
Goods available for sale at cost i.e. total cost of the goods bought during the period and held at the beginning of period (opening inventory) i.e.
Cost of goods available for sale = Total cost of purchases + Total cost of opening inventory
Goods available for sale at retail price i.e. total retail value of the goods bought during the period and the goods held at the beginning of the period (opening inventory) i.e.
Retail value of goods available for sale = Retail value of purchases + Retail value of opening inventory
With the above information cost to retail ration can be computed using the following formula:
Cost to retail ratio = cost of goods available for sale / retail value of goods available for sale
Calculate closing inventory by subtracting total sales revenue from goods available for sale valued at retail price. This will give the closing inventory in terms of retail value.
Apply cost to retail ratio to compute cost of closing stock
The following example clarifies the valuation approach even more.
Prime Inc. bought goods for 120,000 in a period. Retail price of the goods bought in total is estimated to be 150,000. Some unsold inventory from previous period is also held for which cost is estimated to be 16,000 with a retail value of 20,000. During the period total sales revenue generated was 120,000. Compute value of inventory held at the end of period using retail method.
Total cost of goods available for sale = Opening inventory @ cost + Purchases @ cost => 16,000 + 120,000 => 136,000
Total retail value of goods available for sale = Opening inventor @ retail + Purchases @ retail => 20,000 + 150,000 => 170,000
Cost to retail ratio = 136,000 / 170,000 = 0.8 or 80%
Closing inventory @ retail = total goods available for sale @ retail – Total sales revenue => 170,000 – 120,000 = 50,000
Cost of closing inventory = Closing inventory @ retail x cost to retail ratio => 50,000 x 0.8 = 40,000
As retail method of stock valuation depends heavily on the price as well as cost of the inventory therefore following points need attention as they can affect the valuation:
From price perspective
- The sales returns are deducted from the total sales revenue earned in a period.
- Any short term increase or decrease in prices to adjust demand levels affect the total revenue earned therefore if entity is offering promotional prices the effect of such reduced price shall be incorporated
- Trade discounts have bearing on retail prices. However cash discounts are usually accounted for separately but we need to see the policy of entity regarding how such discounts are treated.
From cost perspective
- The purchases returns are reduced from total purchases during the period. But again we need to consider what policy entity is using to value such returns.
- The discounts received also reduce total purchase value
- Any carriage inwards in connection with the purchases will be added to the cost of purchases. Or any other cost specifically incurred for the purchases will be added. However, any abnormal loss or expenditures which are general overheads in nature are usually reported separately in profit and loss.
- Any tax levied on purchases and their nature. Recoverable taxes are kept separate and not added however, irrecoverable taxes, duties or any charge will be added up.
- Any fine or penalty paid in connection with the purchases.