Prior to the early part of the last century, when Professor McNair at NYU developed the Retail Inventory Method (RIM), the only method of evaluating the cost of inventory on hand was the Direct Cost Method (DCM). The DCM involved marking the actual invoice cost of each item in code on the item price tag. The laborious task of taking inventory involved recording the coded cost of each item and then manually transcribing it into dollars and cents in the office.
With the advent of computers, and the increasing speed and constantly lowering cost and practically limitless memory capacity computers possess, this task has been converted into what became known as SKUs (a term coined by IBM in the mid ‘1960s) or stock keeping units. With the advent of optical scanners retailers had the ability to convert SKU numbers first from punch tape then to a stylized print or font and then to an industry-standard bar code.
A SKU number identifies the vendor, size, style, color, size, cost and retail price of an item. Additionally, each SKU can be assigned to a specific merchandise class to provide management information for analysis and buying. The next logical step was to get vendors to apply the SKU number on a label attached to the item – called Vendor Source Marking or VSM. This practice started in grocery stores with the bar code printed on the product container and rapidly spread through the entire distribution chain for every conceivable product and service. With improvement in speed, accuracy and reliability of optical scanning equipment and software, electronic cash registers and other specialized readers became practical and affordable. We now have self check out in super markets and push carts with optical readers mounted on them so customers can do Price Look Up (PLU) and accumulate a total as they shop. Only a fool would try to guess where all this will lead.
Two Basic Inventory Valuation Methods
There still are only two basic inventory valuation methods (Professor McNair, where are you when we need you?). They are (1) the Direct Cost Method (DCM) and (2) some form of calculated cost. Be advised that every method has the capacity for errors and every Calculated Cost Method contains inherent distortions.
Direct Cost Method
As stated above, the current state of the art of development of SKU inventory systems available to the retail industry are based on the DCM. The DCM has a serious fault:
The DCM will cause the inventory to be overvalued. This is due to: (1) the fact that merchandise that has been marked down will still be valued at its original cost, and (2) a reserve for shrinkage has not been built into the system. (The latter shortcoming can be overcome through a generally accepted accounting practice.) For tax reporting and valuation purposes, this is a major disadvantage. For the retailer who is using his inventory to support a credit line, this will not be considered a disadvantage.
Calculated Cost Methods
There are two Calculated Inventory Methods in general use today. The least used is the Average Weighted Cost Method is applied at the class or SKU level by accumulating the cost of each item purchased in the class or SKU and calculating an average. This average is then multiplied times the number of units in inventory in the class or SKU at any given time. The procedure can be made more accurate by weighting the costs based on the number of units bought at each cost.
An insignificant distortion will occur whenever the ratio of costs represented in inventory does not perfectly match the ratio of costs represented in merchandise purchased. A major shortcoming is due to the failure to recognize any inventory that may be marked down. An item in inventory is only worth what it actually cost so long as there is a chance of selling it at the original price. Once an item has been marked down it is worth less than what was originally paid for the item. An item which cost $45 and initially priced at $100 is only worth $36 after being marked down to $80. (45/100 =.45; 80 x .45 = 36). For $36 you can buy a new item to retail for $80. Furthermore, there is a higher probability that once an item has been marked down it will have to be marked down further to sell than a new item will have to be marked down the first time. In other words, of all the merchandise bought more is sold at the initial retail price than is sold at the first marked down price.
The most commonly used calculated cost method is the Retail Inventory Method (RIM). The RIM has been in common usage for nearly a century. For purposes of establishing a value for inventory for financial and tax reporting purposes, it is the best method yet devised.
There are many advantages to using the RIM. It, along with the DCM, are the only two methods accepted for tax reporting purposes and as Generally Accepted Accounting Practices by the American Institute of CPAs. The RIM recognizes the diminution in value of inventory due to markdowns and thereby generates the most conservative value. It is the most economical method of determining the accumulated cost at fair market value and retail price of inventory. The cost of developing and maintaining computer software is less than the DCM. Receiving merchandise and marking it for sale is faster, simpler, more accurate and, therefore, less expensive. It is ideally suited for buying purposes and development of an open-to-buy. Taking a physical count of inventory and reconciling the difference between a perpetually-maintained computer-generated inventory and the physical count is faster and simpler than using the DCM. Customer checkout is simpler and faster. A perpetual inventory level is maintained at all times and is, therefore, available for mid month buying purposes. Since it is maintained at the class level, it is simpler and less time consuming to manage.
There is one deficiency and several limitations to using the RIM. The cost value as computed is based on weighted average calculations and may not be an exact cost value of the total inventory. In my experience the distortion is minimal and quite acceptable. Otherwise, it would not be acceptable to the IRS and AICPA. It is not adequate for order writing where specific style, size, color, etc data is required. Also, it is not adequate for balancing an inventory by the same style, size color, etc. for reordering purposes.
What the Ideal Inventory System Should Provide
If I were shopping for the ideal inventory accounting system it would have the following attributes:
- It would be a real time inventory system with all order, receiving, sale, markdowns, etc updated as they are entered;
- It would provide both SKU, permitting PLU at point-of-sale and info for order writing, and class level info based on the RIM for managing the inventory levels
- It would provide the means to reconcile the accumulated values by class as determined by the DCM and the RIM.
Reconciling the DCM and RIM Values
Except for errors, which will occur in both methods, the only significant difference that should exist between the accumulated inventory determined by the DCM using SKUs and the RIM is due to markdowns on unsold merchandise. This can be reconciled by including in the SKU record a field for current marked retail which would be updated whenever a markdown is taken. If PLU is part of the customer checkout, this field is necessary to look up the current selling price. To convert the original cost of the individual item to current market value (as used in the RIM), the ratio of original cost to original retail is multiplied times the current marked retail. The sums of all these values of the merchandise in a given class should equal the value as determined by the RIM. For this to work the cost as used in the SKU record must be the direct invoice cost without consideration of freight, discounts, etc.
Inventory reconciliation using any method will never be an exact science. There are too many exceptions, such as , merchandise on-hold for customers, merchandise waiting approval for return to vendor, unprocessed invoices or vendor returns, unrecorded markdowns, ‘unsold’ merchandise being altered, merchandise out on-approval to customers, merchandise in transit, merchandise received awaiting vendor invoice, and on and on. The best that can be done are well defined written instructions, rigidly enforced to cover all these contingencies.
I’ve tried to stick to the subject but when discussing inventory in a retail environment it is difficult to do. And I didn’t even digress to the Open-to-Buy. Count yourself lucky.
Gerald H. Smith is a retired Retail Industry Consultant.
November 2004
