The Retail Inventory Method (RIM) of accounting offers the unique opportunity to devalue inventory by recognizing the cost of markdowns to provide more accurate forecasting, accountability, and lower taxes. However, since it applies a cost to markdowns and sales based on a Cumulative Markup of all inventory in the same class and store, it has a few inherent weaknesses. These weaknesses are rarely an issue for the typical store but do present a challenge when unusual off-price buys are made. Before offering a solution, a closer look at the math is warranted.
Understanding the Issue
It’s a common scenario when using the Retail Inventory Method that when a special off-price buy is made the gross profit (when calculated by the Retail Inventory Method) doesn’t reflect the benefit of the special buy! Let’s say the Initial Markup on the buy is 70% instead of the usual 60% for the inventory classification. When the item is sold, we would expect the gross profit to be 70% instead of the calculated number which is much closer to the usual 60% for that class. What happened?
When using the RIM remember that the purchases of new inventory at a high IMU% is averaged with all the existing inventory (Year Opening Inventory + Purchases + Markups at Retail) to adjust the Cumulative Markup that is used to determine the cost when the average (for each class/store) of all the inventory is sold and/or marked down.
See this example where we have a CMU% of 60% on our existing inventory and make a great off-price purchase at 70%:
| Cost | Retail | CMU% | |
| On Hand + YTD Purchases | $40,000 | $100,000 | 60.00% |
| Off Price Purchase | $3,000 | $10,000 | 70.00% |
| Updated On Hand + YTD Purchases | $43,000 | $110,000 | 60.91% |
Remember that the CMU% for the entire class/store is used to determine cost of sales and markdowns. Before the off price purchase, a sale at $100 has a gross profit of $60 ($100 times 60% CMU).
While the markup for off price goods is 70%, the cumulative effect on ALL the inventory is a gross profit of only 60.91%. The next item sold at $100 (be it the new off price inventory or existing inventory) it has a calculated cost of $39.09 (100% – 60.91% = 39.09% cost factor)!
However, that same ratio is applied to ALL of the remaining inventory’s value. As it is sold (and marked down) it will have a higher markon (60.91% instead of only 60%). In other words, the benefit of the buy is spread across the inventory values of everything in the class/store instead of just the items included in the off price buy! The bottom line is that with RIM, the benefit of the IMU is represented in the inventory value and realized as gross profit as the existing inventory is sold.
This is just how RIM works. It is also one of the inherent problems for RIM – merchandise with wide ranging markups shouldn’t be combined in the same class. Mathematically, the only way to get it to be reflected more accurately is to add a separate class for off price goods with a like initial markup, but unless a store has a lot of this type of sales, the second inherent weakness of RIM will reveal itself – you can’t have very small classes, especially if the inventory drops below zero – strange things can happen with percentages at low numbers. Regardless, neither of these solutions is practical when trying to maintain classifications for the planning benefits that the Retail Method offers.
Of course, merchandise performance reports should always be run using a direct cost method (like Average Weighted Cost) for all merchandise performance lower than the class level. At the class level, all vendors contribute to the same averaged cost that is the basis for the Gross Profit for the whole class in each store when using the Retail Inventory Method.
Planned Markdowns
Let’s say that in our example when we purchased off-price goods at $30 cost and marked them up to $100, knowing that they could be marked down with a 25% Savings and still provide a 60% Markon. In essence the savings is being passed to the customer.
But this just exasperates our cost issue!
| Direct Cost (AWC) |
Retail Inventory Method |
|||||
| Cost | Retail | GP% | Cost | Retail | GP% | |
| Sale at Regular Price | $30.00 | $100.00 | 70.00% | $39.09 | $100.00 | 60.91% |
| Sale at 25% Off | $30.00 | $75.00 | 60.00% | $29.32 | $75.00 | |
| 33% Markdown ($25) | $ 9.77 | |||||
| $39.09 | $75.00 | 47.88% | ||||
If we try to apply the RIM values to the individual off-price merchandise we have some unexpected results! Because the RIM associates a cost with markdowns as well as sales, the item we ended up selling at our modified 60.91% markup really only posted a gross profit of 47.88%!
The Solution
The solution depends upon the situation. There is a tax benefit to letting the Retail Method average off-price buys into the overall Cumulative Markup of all inventory. Merchandising performance can (and should) be reported using a direct costing method (like AWC) anyhow.
However, when this effect is not desired (such as when the intention is to immediately markdown the off-price buy) this issue can be mitigated with a little foresight. The solution is as simple as understanding how the Retail Method works. Instead of receiving the inventory at the Regular Price, receive it in at a retail reflecting the normal Initial Markup for the class. Then create a Markup to the regular price. When the merchandise is sold, the excess markup is reversed as a Markup Cancellation instead of a markdown.
| Controlling the Markup | |||
| Cost | Retail | % | |
| Receive Off Price Goods | $30.00 | $75.00 | 60.00% |
| Record Markup to $100 | $25.00 | ||
| Sale at 25% Off $100 | $30.00 | $75.00 | 60.00% |
| Markup Cancellation | $25.00 | ||
This works because Markups (and Markup Cancellations) do not have a cost – they only affect the retail of purchases used to determine the Cumulative Markup percent. When the price change is taken, the amount of the Markup is taken as a Markup cancellation with no affect on the cost until the price drops below the originally received at price. Instead it reduces the affect on the Cumulative Markup.
