The conventional retail inventory method is based on the relationship between a product's cost and its retail price. This method is used by businesses to get an idea of the cost of goods they have on-hand at the end of a particular reporting period. Smaller restaurants and retail businesses find this method useful because their inventory is made up of many different components.

The retail inventory method requires a business to know the total cost and retail value of its goods, the total cost and retail value of goods available for sale and the sales for the given period.

The Cost-to-Retail Ratio

The conventional retail inventory method compares the price of purchasing a good at cost vs. how much the business will eventually sell it for. This relationship is referred to as the cost-to-retail ratio and is a major component of the conventional retail inventory method. There are two methods for calculating the cost-to-retail ratio: the retail method and the conventional retail method.

How to Calculate Cost-to-Retail Ratio

  1. Figure out the inventory cost of available goods. Let us assume, for example, that we have a company (Company A) with inventory that cost them $25,000.
  2. Figure out the retail value of the available goods. In this example, suppose that Company A values these goods at $35,000 retail.
  3. Add in the values of any goods purchased during that period. If Company A purchased $5,000 worth of inventory that is worth $15,000 at retail, its new figures are $30,000 inventory cost at $50,000 retail.
  4. Subtract the total sales in that period from the retail value of the goods. If Company A sells $40,000 worth of goods, this figure would be subtracted from the $50,000 retail value, equaling $10,000.
  5. Calculate the cost-to-retail ratio. First, begin by adding the cost of the beginning inventory ($25,000) to the cost of the inventory purchased during the period ($5,000) to get $30,000. Next, add the retail value of the beginning inventory ($35,000) to the retail value of the goods purchased during that period ($15,000) to get $50,000. Finally, divide $35,000 by $50,000 to get 70%.
  6. Figure out the estimated ending inventory at cost. This amount can be found by multiplying the amount of inventory left at retail ($10,000) by the percentage from Step 5 (70%). In this example, it would equal $7,000.

Gross Profit Method

Both the gross profit method and the conventional retail method of inventory involve knowing the difference between the cost of producing a product and the final retail price that consumers pay for it.

The difference between the two, however, is that the gross profit method uses the current profit margins and does not take into account any price markups or markdowns. If a company sells a broad range of products varying widely in profit margins, it may be in their best interest to use the gross profit method.

If a company's products generally have the same margins, the conventional retail method may be a better choice.

Using the Correct Figures

To ensure accuracy in numbers, a business owner must use current price estimates and sale volumes when using the conventional retail inventory method. Because of this, it is important for a business to sell through its older products before selling new products because the older products have older prices associated with them, which can throw off the figures in calculations.

Using old estimates can lead a business to price their products in a way that hinders its revenue potential and causes them to hang onto inventory that is not selling. With money tied up in stagnant inventory, a company's ability to purchase new products is generally limited because of a lack of available cash.