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Proper accounting is crucial for your store’s success—and solid planning is the first step. This guide will explain the basics of retail accounting, how it differs from cost accounting, and how you can use certain retail accounting practices to improve your business.
Cost accounting vs. retail accounting
Retail accounting—also known as the retail inventory method—helps store owners determine the value of their inventory and keep their finances in order. Unlike cost accounting, which tracks all the costs to make products, retail accounting focuses on the selling price of the items. This makes it easier for retailers to keep track of inventory and calculate profit margins.
For a quick take on cost accounting vs. retail accounting, take a look at this chart.
| Retail accounting | Cost accounting |
| Based on the price of selling inventory | Based on the actual cost of acquiring or producing inventory |
| Simpler and faster to implement, ideal for small- to medium-sized retailers | More detailed and accurate, suitable for businesses with complex inventory needs |
| Can be less accurate, especially if there are significant variations in markups | Generally more accurate as it tracks the actual cost of each item |
| Easier to calculate profit margins using selling prices | More accurate profit margin calculation as it uses actual costs |
| Best for retailers with a consistent markup across products | Best for manufacturers and businesses with diverse or high-value inventory |
Calculating the cost of inventory
The core of retail accounting lies in estimating the value of your inventory. This involves calculating the cost of goods sold (COGS) and the ending inventory value using different methods.
Here’s a basic formula for estimating inventory cost:
Cost of goods available for sale = beginning inventory + purchases
Ending inventory = cost of goods available for sale − cost of goods sold
Using these formulas, you can effectively estimate the value of your inventory and manage your finances accurately.
Choosing the best retail accounting method
When it comes to retail accounting, choosing the right method will affect how you manage your finances and understand your profits. Below is a breakdown of some common retail accounting methods, along with practical tips. Different systems suit different use cases, so let’s imagine you run a home decor shop, and you’ll get a sense of how and why they are implemented.
FIFO (first in, first out)
Definition: FIFO assumes that the oldest inventory items are sold first.
Use case: FIFO is especially useful when prices are rising. It matches older, lower costs with current revenues, resulting in higher profit margins.
Example: You bought many pairs of bookends last year for $20 each. This year, due to rising material costs, the same ones cost you $30 each. Under FIFO, you’ll sell the $20 ones first. This boosts your profit margins because your COGS is lower compared with your current selling price.
Tip: FIFO can help show higher profits on paper, which is great for attracting investors or securing loans.
LIFO (last in, first out)
Definition: LIFO assumes that the newest inventory items are sold first.
Use case: LIFO can be beneficial during inflation as it matches higher recent costs against current revenues, potentially lowering taxable income.
Example: Your most popular drinkware items were $15 each last month, but now they cost $18 each. Using LIFO, you sell the $18 items first. This increases your COGS and reduces your taxable income.
Tip: LIFO might lower your tax liability, but it’s not allowed under international accounting standards, so consider this if you have international business operations.
Specific identification
Definition: This method tracks the actual cost of each specific item in inventory.
Use case: Ideal for businesses with high-value, unique items.
Example: You sell rugs and doormats that range from very affordable to more luxurious. Using specific identification, you track each one by its specific cost. When a customer buys a large handmade rug, you know exactly how much that particular rug cost you.
Tip: Specific identification provides the most accurate inventory tracking but can be time-consuming. It’s best for stores with fewer, higher-value items.
Weighted average
Definition: This method calculates an average cost for all inventory items.
Use case: Suitable for businesses with large quantities of similar items.
Example: You sell a lot of throw pillows, and the prices vary slightly. Using the weighted average method, you calculate an average cost for all pillows in stock. This way, your COGS reflects a smoothed-out average price, making accounting simpler.
Tip: Weighted average is easy to apply and reduces the impact of price fluctuations on your financial statements.
Retail inventory method
Definition: Estimates inventory value based on the retail price of goods, adjusted for the cost-to-retail ratio.
Use case: Simplifies inventory valuation for retailers by applying a consistent markup.
Example: You have $100,000 worth of storage and organization items at retail prices, and you know that your cost-to-retail ratio is 60%. Using the retail inventory method, you estimate your inventory’s cost as $60,000. This method is quick and gives you a reliable snapshot of your inventory’s value.
Tip: The retail inventory method is great for quick estimates, but be aware it relies on consistent markups across your products. It’s less accurate if your markup percentages vary widely.
Six steps to savvy retail accounting
Estimating your retail accounting for taxes doesn’t have to be a daunting task. Follow these six steps to get it done efficiently and accurately.
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Calculate the total cost of goods available for sale: To do this, add the cost of your beginning inventory (the value of what you had at the start of the year) to any new purchases you made throughout the year. This gives you a clear picture of the total cost of goods you have available to sell.
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Calculate the total retail value: Next, determine the total retail value of these goods. This involves adding up the retail prices of all your inventory items. It’s like tallying up the price tags of everything in your store, giving you the total retail value.
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Determine the cost-to-retail ratio: Now, take the total cost you calculated in step one and divide it by the total retail value from step two. This will give you the cost-to-retail ratio. This ratio is crucial because it helps convert retail prices into cost figures, making your accounting more accurate.
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Estimate ending inventory at retail: To estimate your ending inventory at retail, subtract the total sales for the year from the total retail value of goods available for sale. This step helps you understand how much inventory you have left, based on retail prices.
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Apply the cost-to-retail ratio: With your ending inventory at retail determined, it’s time to convert this figure into a cost value. Multiply the ending inventory at retail by the cost-to-retail ratio you calculated in step three. This gives you the ending inventory at cost.
- Use for tax reporting: Finally, use the ending inventory at cost figure for your tax reporting. This ensures that your inventory’s value is accurately reflected in your financial records, helping you stay compliant with tax regulations and avoid any surprises.
Bookkeeping basics
Effective bookkeeping might seem daunting at first, but with practice and the right tools, it becomes second nature. By keeping your financial records up to date, you’ll be better prepared to make smart business decisions, ensuring your retail business remains profitable and sustainable. For a deeper dive, you might find our e-commerce accounting guide helpful.
To get you started, let’s look at some definitions of phrases you’ll encounter in retail accounting.
Income statement
Think of the income statement as your business’s report card. It tracks your revenue (the money you bring in) and your expenses (the money you spend) to show whether you’re making a profit or a loss over a specific period.
Tip: Regularly reviewing your income statement helps you understand your profitability and identify areas where you can cut costs or boost sales.
Balance sheet
Your balance sheet is like a snapshot of your business’s financial health at a specific point in time. It lists your assets (what you own), liabilities (what you owe), and equity (your ownership interest in the business).
Tip: A strong balance sheet with more assets than liabilities indicates good financial health. Review it regularly to ensure you’re on solid ground.
Cash flow statement
Your cash flow statement shows how money moves in and out of your business, broken down into operating, investing, and financing activities. It helps you understand your liquidity and manage cash effectively.
Tip: Positive cash flow means you have enough cash to cover your expenses. Keep a close eye on this statement to avoid cash crunches, especially during slower sales periods.
Bringing it all together
By understanding and regularly updating your income statement, balance sheet, and cash flow statement, you can keep your finances in check and your business running smoothly.
Tip: Use retail accounting software like QuickBooks or Xero to automate these tasks, making it easier to stay organized and accurate.
Final Thoughts
Mastering retail accounting and bookkeeping basics can ensure your retail business runs smoothly and remains financially healthy. Whether you are exploring different costing methods or managing your day-to-day financial records, understanding these concepts is key to your success as a retailer.
