Inventory is undoubtedly the most important asset in direct-to-consumer (DTC) retail. So, it just makes sense to keep tabs on your inventory value. This way, you can make the best (and most profitable) decisions about what SKUs, how much, and when to reorder.
Although there are many ways you can determine and track the value of your inventory, the retail inventory method is among the most common techniques used today.
But what is the retail inventory method? And how does it inform your purchasing decisions and boost your brand’s revenue? Let’s find out.
The retail inventory method (RIM) helps retailers estimate the value of their merchandise. More specifically, the retail inventory method calculates your ending inventory balance. It does this by measuring the cost of your inventory relative to its retail price.
This particular method is an important part of your DTC operations because it helps you better understand your sales, shows you when it’s time to reorder, and supports you in managing your variable inventory costs. Plus, the retail inventory method also highlights how much inventory ends up with your customers (and how much is lost or stolen).
That said, the retail inventory method can only be applied when there’s a consistent relationship between supplier price and the price you sell it at.
For example, if your sneaker brand marks up every pair of shoes by 100% of the wholesale price, you could successfully use the retail inventory method. By contrast, if you mark up some styles by 50% and other designs by 75%, it’ll be difficult to use this method effectively.
Moreover, because the retail method is an estimation (not an exact calculation), it’s not always the most accurate accounting method. That’s why most retail businesses that use the RIM will supplement their estimates with a physical inventory count.
The retail inventory method follows a 4-step formula that helps DTC merchants arrive at their ending inventory value.
Below you’ll find a breakdown of the retail inventory method formula, in addition to 3 retail valuation methods that can impact this process.
There are 4 steps within the retail inventory method formula (which we’ve described in more detail for you here).
Cost-to-retail percentage is also known as the cost-to-retail ratio. This number tells you how much of a product’s retail price is made up of costs.
cost-to-retail percentage = (cost ÷ retail price) x 100
Say it costs $50 to manufacture your sneakers, and you sell each pair for $200. The cost-to-retail percentage in this scenario is 25% since ($50 ÷ $200) x 100 = 25%.
This number is the total value of your current/beginning inventory, plus the cost of inventory production (namely, the amount you spent manufacturing those finished goods).
cost of goods available for sale = (value of inventory + cost for producing inventory)
For example, say you have $4,000 worth of sneakers ready to sell, and those shoes cost $1,000 to produce. Then, the total cost of goods available for sale is $5,000 since ($4,000 + $1,000) = $5,000.
Cost of sales (COS) is the amount spent on products purchased from a supplier. Meaning, it’s only used by companies who do not manufacture their own inventory.
cost of sales = (sales during the period x cost-to-retail percentage)
If your brand sold $12,000 worth of sneakers last year, then your cost of sales for that time frame would come out to $3,000 since ($12,000 x 0.25) = $3,000.
Ending inventory is the total value of products available for sale at the end of your designated accounting period (usually a fiscal year).
ending inventory = (cost of goods available for sale – cost of sales during the period)
In this sneaker example, your ending inventory value comes in at $2,000 since ($5,000 – $3,000) = $2,000.
And there you have the complete retail inventory method — which, as you remember, helps estimate your brand’s ending inventory balance. To get the most effective estimates possible, make sure you follow these steps in order every time you run your calculations.
Generally speaking, 3 inventory valuation methods can influence your retail inventory method calculations: FIFO, LIFO, and WAC.
First-in, First-out (FIFO) is where the first items your brand acquires are also the first to be sold, used, or disposed of. For most retailers, FIFO is the preferred way to keep inventory levels fresh since your oldest inventory takes priority over newer items.
The FIFO method is a strong indicator of ending inventory value. Because your older inventory has already been sold and shipped out, your newer products remain on your warehouse shelves. Those SKUs are more likely to reflect the current selling price.
In other words, they give you a more accurate valuation of the cost of purchases and the cost of goods available for sale (which is needed for Step 2 in the retail inventory method formula).
Additionally, FIFO makes it less likely that retailers will be left with dead stock – a major win no matter what you sell.
Last-in, First-out (LIFO) is where the products you received last have priority over anything else. Retailers who use LIFO take their most recently received items and sell or ship them first.
While the LIFO method can prevent perishable items from going bad, unfortunately, it’s not a good indicator of ending inventory value.
Because the last units purchased are sold first, your ending inventory valuation would be based on the cost of your oldest units. This is not always an accurate reflection of the current sales price.
The main reason retailers use LIFO (instead of FIFO) is to adapt during times of rising prices. Some brands find LIFO beneficial when this happens because it can save on taxes and better match their revenue to the latest costs (even while prices are increasing).
Weighted average cost (WAC) helps to calculate the average cost of your inventory per unit.
Calculating WAC is pretty simple. All you have to do is divide your cost of goods sold (COGS) by the total number of units currently in inventory.
Often, weighted average is used alongside FIFO or LIFO to create a more well-rounded costing method. That said, WAC is best used when it’s too complicated to figure out what you paid for each unit in your inventory.
In those cases, it’s much easier to use the WAC formula to understand the average value of goods rather than looking at individual inventory items.
Along those same lines, weighted average cost can be really helpful in light of price fluctuations. Prices for raw materials and finished goods will undoubtedly ebb and flow over time. But constant markups and markdowns make it hard to know what you paid for each unit.
The WAC method swoops in to simplify your inventory accounting and reveal the average cost of each SKU. This will play into both your cost-to-retail ratio and cost of goods available for sale.
The retail inventory method definitely has its advantages, but there are also some obvious drawbacks. It’ll be important for you to weigh the good with the bad as you decide whether this approach is right for your business.
One of the main benefits of the RIM is that it supports you in exercising inventory control. This means the retail inventory method ties products directly to their sales and then provides an ending inventory count (without much additional work on your end).
In addition, gaining more control over your inventory makes it easier to detect product shortages. Meaning, you can get ahead of stockouts before they have a chance to negatively impact your profit margins.
Another thing to note about the retail inventory method is that it’s a simple, cost-effective strategy for inventory management. In practically no time, this method tells you the number of products you have left compared to what’s already been sold. That way, you can decide what, when, and how much to reorder.
Because the retail inventory method is so easy to use, it also has fewer labor requirements than other accounting techniques. This frees up hours in the workday, so your team can focus on customer relationships or even new product planning. Plus, you can save quite a bit of money when your team isn’t working days on end trying to generate a physical inventory count.
As I’ve mentioned a few times, the RIM is an inventory estimation. So, while it’s less costly and time-consuming than conducting a physical count of your inventory, it’s also less accurate. Moreover, DTC retailers are only eligible to use this method if they have a consistent markup percentage on everything they sell.
This is because the retail inventory method assumes your previous markup will hold true for the current period.
If, for any reason, you have different markups — say, because of an increased price for raw materials — your results will be inaccurate. And these inaccurate results can lead to poor forecasting for your business (meaning stockout or dead stock situations).
All in all, the retail inventory method has several stipulations that make it difficult to rely on. While some retailers might always use the same markup, most experience fluctuations in their pricing. This makes it next to impossible to use the retail inventory method. Why? Because the inconsistency will throw off the accuracy of your financial statements.
Whether you’re about to launch a retail brand or you’ve been in the game for years, you will need inventory accuracy and visibility to achieve operational excellence. Fortunately, Cogsy has all the features you need to stay on top of your inventory and achieve DTC success.
Cogsy knows that inventory accuracy starts with improved demand forecasting. And that’s precisely why the Cogsy platform comes with a demand planning tool. So, you can avoid common forecasting woes and project customer demand with pinpoint accuracy.
In fact, Cogsy makes demand planning easier than ever by automatically collecting and correlating all your data from multiple sources (like Shopify and Amazon). This way, you can replace those worn-out, manually updated spreadsheets with real-time demand data that tells you exactly what to order and when to send in your PO.
You can preserve optimal inventory levels by ordering only what you need to meet demand. This, in turn, keeps your inventory value low (without the inventory risk of being unable to meet customer expectations).
And when your inventory value is low, it’ll free up more working capital, which you can use to invest in product development, marketing campaigns, or wherever else you see fit.
More often than not, manually monitoring your stock levels is a bust. It’s confusing, time-consuming, and error-prone to boot.
But lucky for you, Cogsy keeps an eye on your inventory 24/7. That way, you know exactly when your stock levels are running low and when it’s time for you to call in product reinforcements.
As you get closer to your reorder point, Cogsy will automatically send you a replenish alert, reminding you it’s time to (re)stock your shelves. Thanks to these reliable alerts, you can feel confident you’re ordering the right products at the right time to avoid a stockout.
And if that wasn’t enough, Cogsy takes things a step further by streamlining your POs. With a single click, Cogsy can create a purchase order tailored to your unique inventory needs. Best part? There’s zero guesswork involved.
Production orders are a necessary yet sometimes tricky part of running a DTC business. That’s why Cogsy has worked hard to simplify your production orders and deliver the inventory visibility your brand deserves.
When you team up with Cogsy, you can actually map your brand’s production schedule a whole year out (so you can prepare for all the demand coming your way). Even still, Cogsy can quickly adjust your plan if (correction, when) new information is introduced.
Cogsy’s production orders feature also includes syncing integrations that provide crystal clear product cost visualization. For instance, you can get answers to questions like: How much will this PO cost? Or, how much is my inventory worth?
By gaining these insights into your inventory value, it’ll be much easier for your brand to create a budget that supports its long-term growth (brands that use Cogsy generate 40% more revenue on average).
The retail inventory method helps retailers better understand their sales, reorder inventory at exactly the right time, and manage their variable inventory costs.
A quick method for calculating retail inventory is subtracting your total sales from the total retail value of your inventory. Then, multiply that amount by your cost-to-retail ratio. Keep in mind, however, that retail inventory is an estimate (not an exact calculation) and is, therefore, not a true substitute for a physical inventory count.
You should use the retail inventory method if you need a simple, cost-effective way to manage and track your inventory. This method quickly tells you the number of products you have left compared to what’s already been sold. That way, you can decide what, when, and how much to reorder.