Why the Retail Inventory Method Isn’t Obsolete

There have been several posts claiming that modern technology has made the Retail Inventory Method (Retail Method) obsolete for valuing inventory. While all these articles have valid claims regarding the retail method’s limitations, it doesn’t mean the valuation method is obsolete. The difference is to know when the Retail Method should be used, and when it shouldn’t be.

The Retail Method came about long before automation when retailers needed a way to associate a cost to every sale. When selling cars, this isn’t that difficult, but when dealing with dozens or hundreds of transactions daily with thousands or tens of thousands of items in the store, more direct cost methods are too cumbersome. One of the most common methods was to convert the cost to a code that could be printed on the tag. For example, the letters P-A-T-H-F-I-N-D-E-R are used to translate the corresponding numbers of 1 to 0 (P=1, A=2, T=3, etc.). For example, the key is used to print “PRRR” on the merchandise tag to represent the cost of $10.00. While certainly a burdensome manual complexity of the era that automation easily solves, it was still easily deciphered by savvy customers. The Retail Method allows for a computation of cost of sales based on the relationship between the retail and cost of purchases. Hence costs are only recorded when goods (plus markups and net transfers) are received which must be recorded to pay vendors anyhow. Before the day of SKU level automation, it easily allowed for Merchandise Management at the classification or group level, which is still the most important way to manage dollar control, especially for fast changing fashion retailing. As then, it still provides for an elegantly simple way to track costs and manage cash flow – even using a simple paper and pencil ledger. Just because the Retail Method is a century old doesn’t mean it’s not valuable – at least I hope that being old doesn’t necessarily make something obsolete!

Before analyzing the pros and cons of the Retail Method, it behooves us to compare the Retail Method to a direct cost method to understand the difference. While direct costing methods associate, as close as possible, the actual cost to every item (or SKU, serialized or not), the Retail Method assigns a cost to sales (and markdowns) based on the average of purchases for the Class/Store. While the Retail Method might be inaccurate for any given item, in the long run, it balances out.

Cost Method

The cost method associates the cost to the sale based on the actual (or perhaps weighted average) for each individual SKU. Serialized inventory systems track each piece, even if the SKU is the same, but the costs are directly associated to the individual item.

Cost Method	Cost	Retail	MU%
Purchase	$40.00	$100.00	60%
Markdown		$20.00	No Cost
Sale	$40.00	$80.00	50%

In direct cost methods, there is no cost of recording markdowns. In fact, some direct cost systems in the market don’t even report markdowns. A direct cost method is certainly intuitive, and modern automation makes this quite simple to track. With such accuracy, it might seem apparent that we can stop here – what could be better?

Retail Method

When using the Retail Method the Cost of Sales and Markdowns (when taken) is based on the Cumulative Markup Percentage of all purchases for each class/store.

Retail Method	Cost	Retail	MU%
Purchase	$40.00	$100.00	60%
Markdown	*$8.00	$20.00	60%
Sale	*$32.00	$80.00	60%

* The Cost of Sales and Markdowns (when taken) is based on the Cumulative Markup Percentage of all purchases for the class store.

This example makes an assumption that isn’t usually true – that the Cumulative Markup percentage of all purchases for the class store are the same as the cost of the individual item sold. This isn’t usually the case but the average, over time, will balance out. The important point here is to recognize that a cost is associated to the Markdown as well as the sale. With direct cost methods, the cost is the cost no matter what the final sale price is or when the markdowns are taken. With the Retail Method, the cost of the sales is net of costs recorded for the markdown (and still end up being $40 in the example above).

Advantages of the Retail Method

Unlike direct cost methods, the Retail Method associates a cost with markdowns and this capability is what allows the retailer to devalue or depreciate inventory to a lower of cost or market value, based on quantifiable markdowns. The biggest advantage here is that the Retail Method provides a time proven “Generally Accepted Accounting Principle” for fairly writing down obsolete inventory. Remember that lowering Inventory values will lower profit and hence lower taxes on that profit. And it isn’t cheating to say that the inventory value isn’t what you paid for merchandise when it isn’t sold promptly. Consider the previous example; if you wanted to maintain a 60% markup, would you pay $40 or $32 to replace an item that you can only sell for $80? And we all know that if forced to liquidate inventory it would still be only pennies on the dollar for what is being carried on the books, even if the value of markdowns are considered.

Not only is it incumbent to track markdowns with the Retail Method, one of its biggest advantage is that it encourages the recognition of markdowns to free up open to buy dollars that can be spent on fresh and more profitable inventory. A dollar invested in something doomed to sit on the shelf isn’t nearly as valuable as pennies that can be re-invested in future profits from fresher inventory.

Finally, the retail method allows a very simple tracking method that doesn’t require tagging individual SKUs that is still beneficial for many retailers. The truth is that the biggest bang for a retailer’s dollar in merchandise management is derived from dollar management of future purchases. And the only effective way to manage dollars is by planning classifications of groups of similar merchandise that can be trended and forecasted from year to year. SKU control only tells us what to buy – not how much. For some merchandise classifications, this is still a very effective tool for managing inventory that doesn’t need further breakdowns. Consider neckwear, vendor managed inventories, “bargain bins”, or any group on inventory where item level tracking isn’t practical or critical. Those areas of the store can be tracked by classification only even if other areas tracked in detail.

For small retailers when the buyer is constantly in the store working with customers and the merchandise, SKU level management is often more troublesome than it’s worth. While SKU level control can tell us what isn’t selling, a buyer working the floor can tell us why it isn’t selling! SKU systems are poor substitutes at best for having a buyer on the floor. It’s one thing when a buyer is managing multiple stores, but if stock management takes the buyer off the floor, SKU control can be counterproductive. The retail method is even manageable with paper and pencil, as it has been for a century. It’s a very viable solution for startup operations – low cost, less detailed paperwork and more flexibility in when the accounting work has to be done.

Disadvantages of the Retail Method

The biggest disadvantage of the Retail Method is that it isn’t effective for managing inventory at a more detailed level than the classification. Since costs are established by class/store, merchandise from several vendors in the same class will be costed using the same cumulative markon percentage; making all vendors look like they have the same gross profit. Direct cost methods are always preferred for analyzing vendors, style, buyer, and even customer profitability.
While not really a disadvantage, a limitation of the retail method is that it must be applied to a limited number of classifications of merchandise. It is appealing for many merchants to want to divide merchandise into too many classifications. Simple mathematics suggests that using averages over very small numbers can lead to imperfect results – such as when values move to zero (or even into negative values). Proper application of the Retail Method limits the number of classifications that can be used. The solution is easily solved using additional attributes, characteristics or subclasses that can be tracked below the classification level using the more accurate direct cost methods.

While the retail method requires recording markdowns, to be beneficial it really requires that merchants take sheet or batch markdowns to mark merchandise down before it is sold. If only POS markdowns are used, there is little, if any benefit to using the Retail Method because as with direct cost methods, the cost of markdowns aren’t recorded until the inventory is sold. Such markdowns do require more effort though they often represent a more objective and thorough use of markdown dollars. Sheet markdowns will also be resisted if the retailer put’s back merchandise that isn’t sold during a season’s final clearance to re-appear on the floor at full price for the next season.

Finally, the Retail Method has also been used dishonestly in the past to hide current year losses by treating markdowns as markup cancellations –overstating current margins at the expense of future margins.

Summary

In the final analysis, the Retail Method still has its place in retailing. It’s ideal for realistic inventory valuation, accounts for and even encourages markdown management that helps improve turns and cash flow. In some areas for many stores, and even all areas for some stores, it provides a very simple way to manage inventory, with a minimal systems investment or complexity. Perhaps the irony is that most of the retailers using it now are large department stores but the independent retailers who could benefit the most from it use it the least.

But using one method for financial and planning purposes doesn’t preclude the use of direct costs for more detailed merchandising for vendors, styles, buyer, associate and even customer performance.

To blame technology for making the Retail Method obsolete ignores the fact that technology is also used to overcome these limitations to provide the best of both worlds: accuracy and realistic valuation. Technology should be used to provide the benefits of Retail Method while overcoming its disadvantages. For example, our software tracks inventory at both the cost and retail method so both can be used when appropriate. Assortment and attribute reports allow for more detailed groupings for more refined controls where needed. Controls are in place that can prevent the system from being gamed by those with ill intent. To this aging retail scientist, that makes the retail method mature, not obsolete.