Business managers rely on accountants to provide them with financial data and estimates to help them make informed decisions about what a business needs. In retail businesses, accountants can use a technique called the retail inventory method to estimate the cost of inventory after a certain period of time. Cost-to-retail ratio is value calculated while performing the retail inventory method.
Retail businesses often sell large quantities of small items, which makes it difficult to perform an accurate count of inventory. Companies that sell large, expensive items such as cars may be able to count every individual item that they have for sale in a reasonable amount of time. For retailers that sell small items, however, a hard count is often impractical. Instead of actually trying to count inventory, retailers can attempt to estimate inventory levels. The retail inventory method estimates the cost of inventory based on the total cost and retail value of goods available for sale and the total sales over a certain period.
Calculating Cost to Retail Ratio
Cost-to-retail ratio is equal to the total cost of goods available for sale divided by the retail value of goods available for sale. Goods available for sale include inventory available at the beginning of a period and any purchases of new inventory. For example, if a company’s beginning inventory has a cost of $10,000 and a retail value of $20,000, and it purchases $40,000 worth of new inventory that has a retail value of $80,000, its total cost of goods available for sale is $50,000 and the retail value of goods available for sale is $100,000. In this example, the company's cost-to-retail ratio is $50,000 divided by $100,000 or 50 percent.
Using Cost-to-Retail Ratio to Calculate Ending Inventory Cost
The cost of ending inventory for a certain period can be estimated by subtracting sales for the period from the total retail value of goods available for sale and then multiplying the result by the cost-to-retail ratio. For instance, if the company from the example in Section 2 had $90,000 in total sales over the period, the retail value of its ending inventory would be $100,000 minus $90,000, or $10,000. The cost of its ending inventory would be equal to $10,000 times the cost-to-retail ratio of 50 percent, or $5,000.
The accuracy of inventory estimates can be diminished by various events that reduce inventory. Thefts by employees, shoplifting and damage to inventory are examples of problems that can affect inventory levels. Since these types of events are common in the retail trade, retailers may assume that some amount of inventory will be lost and factor that in to the cost of inventory.