A Detailed Guide To Retail Accounting

Cost-flow assumptions in retail accounting.

Because your inventory cost significantly impacts your business’s profit and tax liability, the Internal Revenue Service (IRS) requires that you use specific methods to calculate its value on your balance sheet and income statement. Here are the allowable options.

Specific identification

The specific identification cost method is the most straightforward approach to tracking your inventory. It requires keeping track of each item individually. As a result, there’s no need to assume which ones you sell first.

Typically, this method is only possible for retail stores with fewer products, higher prices, and lower transaction volume. For example, a car dealership or jewelry shop could keep track of each item in its inventory, but a grocery store generally couldn’t.

If it’s feasible for your retail business to use the specific identification method, the IRS requires that you do so.

FIFO

If you can’t keep track of every item on hand, you must make an assumption about which ones you sell first to calculate the cost of your inventory. Whichever you sell first is unknowable, but the assumption keeps your books consistent.

These “cost-flow assumptions” are necessary when stores have many interchangeable units. In such cases, it’s unlikely that it costs the same amount to acquire or produce each item since materials, labor, and overhead prices shift over time.

As a result, the order in which you sell your inventory has a significant impact on its value at any given point.

The first-in-first-out (FIFO) method is a common cost-flow assumption among retailers with perishable goods. As the name implies, it assumes the units you purchase or produce first are the ones you sell first.

LIFO

The last-in-first-out (LIFO) cost flow assumption is the opposite of the FIFO method. It assumes that the last units you purchase or produce are the first ones you sell.

LIFO is a controversial cost-flow assumption because it can artificially lower your business’s tax burden. Prices tend to rise over time, causing LIFO to maximize your cost of goods sold (COGS) and minimize your net income.

In addition, few businesses legitimately sell their most recently acquired units first. As a result, the LIFO method isn’t acceptable in countries that follow International Financial Reporting Standards (IFRS) and may eventually become forbidden in the United States.

Weighted average

The weighted average cost flow assumption is the least common approach to tracking inventory. In fact, the IRS considered it inaccurate and prohibited businesses from using it for tax purposes until 2008.

The weighted average method is somewhere between FIFO and LIFO. It assumes that the cost of each unit sold in a given period and left in ending inventory afterward is the weighted average cost of those you had available for sale during that time.

For example, say you buy three hundred units at $100, four hundred units at $115, and three hundred more at $110. These are the only units you had on hand during the year. The first group is 30% of your inventory, the second is 40%, and the third is 30%.

To find the weighted average cost of your inventory, you’d multiply 30% by $100, 40% by $115, and 30% by $110, then add them together. That equals $109, which you’d assume to be the cost of all your units.

Inventory valuation method.

In addition to following a consistent cost flow assumption, retail businesses must use an inventory valuation method to determine their cost of goods sold and the cost of ending inventory.

Retail method

The retail inventory method is popular among retail stores because you can calculate both numbers without knowing the precise number of units you have on hand, which reduces the need to take physical counts.

However, your store must use a consistent markup rate for determining sales prices to save time with the retail method. If you don’t have a standard markup rate, the IRS requires that you track the actual markup percentage for each product.

For example, say your retail store’s inventory on January 1 cost $10,000. During the first quarter of the year, you buy more units for $2,500 and have $5,000 in sales. Every product you sell is similar enough that your retail price is always 30% above cost.

To calculate ending inventory on March 31 using the retail value method, add the cost of your beginning inventory and purchases during the period to get the total available for sale. In this case, that would be $10,000 plus $2,500, which equals $12,500.

Next, calculate your cost of goods sold. Since you mark up all of your products by 30%, you know that it always equals 70% of your sales in a given period. As a result, when you multiply $5,000 in sales by 70%, you get $3,750 for your cost of goods sold.

Finally, you have what you need to calculate the cost of your ending inventory without taking a physical count. It equals the cost of your beginning inventory plus the cost of your purchases minus your cost of goods sold.

In this case, that’s $10,000 plus $2,500 minus $3,750, which equals $8,750.

Pros and cons of the retail accounting method

The retail method of accounting is a popular valuation strategy for retail stores primarily because of its simplicity. If you use a flat markup rate across all products, then you can calculate your ending inventory cost without counting it.

While that’s not necessarily significant for retail businesses that use the specific identification method, it’s helpful for stores with diverse inventories in multiple warehouses. Taking a physical count in these situations is highly labor-intensive. 

Of course, using the retail method, for this reason, has a problematic implication. Namely, using a flat markup rate for all your company’s products usually isn’t a good idea.

It limits your ability to price your products dynamically and strategically to compete in the marketplace. You could miss out on raising the price of one item because you don’t want to increase the prices of others.

Even offering discounts on certain products would throw off your calculations. Many retail stores use these as effective marketing tactics and to incentivize customer behaviors like buying in bulk or paying on time.

Best practices for retail accounting.

Accounting for a retail business can be a significant challenge, especially for stores with complex inventories and high transaction volume. Here are some best practices you should follow to make your accounting system more efficient and effective.

Take advantage of software

Software has made many aspects of running a retail business more manageable. Some of the most beneficial tools include inventory and retail accounting software. These can automate a significant portion of your bookkeeping.

Choose accounting methods carefully

Businesses must get special permission from the IRS to change accounting methods, including cost-flow assumptions and inventory valuation approaches. They don’t want taxpayers trying to game the system by switching constantly.

Because there’s no guarantee you’ll be able to change your accounting methods later, you must choose them carefully the first time. Consider asking an accounting firm for recommendations.

Use retail accounting services

It’s a good idea for most small businesses to consult a knowledgeable accountant, but it’s especially beneficial for retail stores. Accrual accounting and tax rules for companies with inventories are complex, and you shouldn’t try to navigate them alone.

Even if you don’t have the funds to hire a full-time accountant, consider paying for outsourced accounting and tax services with a Certified Public Accountant (CPA) firm. It’s often much more economical for a small business.

In addition, a highly experienced CPA firm can be a surprisingly comprehensive business advisor. Not only can they confirm that you’re taking appropriate deductions, but they can create a personalized tax strategy and give targeted financial advice.

Before selecting a CPA, confirm that they specialize in retail accounting services. If they’ve never had retail clients or have a brand new business advisory practice, they may not be able to help you with your biggest financial difficulties.