Retailers often find themselves juggling inventory costs and how it can be a considerable expense and a source of business income. Understanding the different inventory methods is essential to help retailers better estimate their merchandise value.

Inventory costing is an essential part of retail business management. Here are the five different types of inventory methods:

The Impact of Inventory on Retailer Profitability

Inventory is an important consideration. If you don’t have a good handle on what products are moving and which ones aren’t, it cannot be easy to make intelligent decisions about where your business should go.

Knowing how much stock is being sold or lost each day, month and year through frequent cycle counting and accurate inventory management records can help you maintain a healthy bottom line. When too much of the wrong thing has been ordered (or not enough), discounts might be necessary.

1. Retail Inventory Method

The retail method provides the ending inventory balance for a store by measuring inventory cost relative to the price of goods. It determines how much expense should be recognized in this period versus the next.

Abir Syed, CPA of UpCounting, explains that the retail method assumes all inventory has a consistent markup. “So you take the total value of what you have for sale and reduce it by its markup, then use that number as the cost.”

The pros and cons of the retail method

The benefit of this method is that it is easy to compute. The disadvantage is that it’s inaccurate if prices fluctuate too much or if you have products with different markups.

Tim Yoder, a tax and accounting analyst at FitSmallBusiness.com, says that the retail inventory method is best if you have standard markups because your estimate will be more accurate. This estimation won’t work if your markup varies widely among products.

2. Specific Identification Method

Next, we’ll go over the identification method.

When you assign a specific cost to every item in your store, it is easier for customers to understand the value of that particular product. Click To Tweet

This method works best when many different items are bought from various sources.

The pros and cons of the specific identification method

The Corporate Finance Institute (CFI) advises that the specific identification method is not suitable for large businesses because it relies on accurate, real-time inventory information.

You should accurately identify each stock-keeping unit (SKU) in your inventory.

The CFI says this is one of the recommended inventory methods for small businesses. It can provide them with more accurate profit and loss statements, with reliable numbers on income, losses, and inventory spoilage.

3. First In, First Out (FIFO) Method

If you have large quantities of nearly identical items, it may not be worth the effort to distinguish them. FIFO is a suitable method for this situation because when prices fluctuate or you need to sell something quickly, using this strategy will ensure that each sale comes from your oldest batch.

The pros and cons of the FIFO method

This method is a good representation of your inventory, which may be beneficial if you purchase batches of the same item at different prices. Older units tend to sell before newer ones in ideal circumstances.

If you buy a single product with one universal code but purchase it in different batches, tracking each batch’s cost over time is more complicated.

4. Last In, First Out (LIFO) Method

In LIFO, the most recent purchases are assumed to be sold first. Abir found that profits would increase in this inventory management system since you’re selling items at their current market value rather than when they were purchased.

LIFO is when you attribute the cost of individual items or batches to their actual costs and reduce your inventory as they are sold. This only makes sense if it mirrors reality where newer items are being sold first instead of older ones sitting there for a long time.

The pros and cons of the LIFO method

LIFO is not for every retailer. IItcan only is used in the US under the Generally Accepted Accounting Principles or GAAP. Elsewhere, the LIFO method is not allowed by the IFRS (International Financial Reporting Standards).

LIFO requires much work that many retailers don’t want to do because they think it’s too complicated.

The main benefit of LIFO is that it results in a higher cost of goods sold, which means you may reduce your tax liability. It’s always important to check with an accountant or tax advisor before making any decisions.

5. Average Weighted Method

If the prices of goods you buy don’t change too much, a more straightforward method is Weighted Average Costing.

The weighted average method is when you add the cost of each purchase to a pool and then divide that by how many units are left in stock.

The pros and cons of the weighted average method

One of the main benefits of using a lot-based costing system is that it’s much easier and less time-consuming than specific cost analysis. This method allows you to track your inventory without detailed knowledge about which batches were sold, especially when many identical products are on hand.

This method is less accurate than specific costing because you’re blending all your purchases. This can be a problem if, for example, one product has been purchased at very different prices each time it was bought.

Tax Ramifications of Inventory Costing

Retailers can track the cost of inventory purchases throughout the year. However, retailers cannot deduct this on-hand inventory at the end of the year.

The inventory cost on hand should be included on the ending balance sheet as an asset and should be deducted the following year when the inventor is sold. 

Ask an accountant about what these inventory methods mean for your business’s tax obligations.  Click To Tweet

Final Thoughts on Inventory Methods

Inventory management can be as complicated or straightforward as you need to make it. One thing is clear, though; inventory will give you a vitally important picture of the health of your business.

These various inventory methods can provide insights into other costs of goods sold and the time it takes for you to move different kinds of stock.