Retail (RIM) vs Cost (CMA) – which method is “right” for your business?
It is not uncommon for Retail companies to go back and forth between the merits of cost and retail method of accounting (but not to make frequent changes to their accounting methods….) The question of which is the “best” method continues to be a topic of debate. Technology has come a long way, tracking inventory at both cost and retail but how to decide when to use retail vs cost?
Understanding the fundamental differences between the two methods will support the Retailer’s decision and help them choose the method most appropriate for their particular business model.
Inventory tracking with the retail method is at a level higher than SKU, usually department and category or class, whereas the cost method assigns a true cost (usually weighted average) to each individual selling SKU. In the retail method inventory valuation at both retail and cost is impacted by markdowns/markups. The price change decision has an immediate impact. In the cost method, there is no cost of recording markdowns, hence the cost value of the inventory remains unchanged. The “hit” so to speak takes place in the future, sometimes slowly as product sells down.
The cost method assigns a cost to sales based on the actual cost or sometimes weighted average of each individual SKU. The cost remains the same no matter what the market value is or when markdowns are taken.
The retail method assigns a cost to sales and markdowns based on the average of the purchases (cumulative markup %) for the class/store. The cost of the sale is net of any cost of the markdown. While this method is inaccurate for any given SKU, it does balance out over time.
The change in the planning process when moving to the cost method of accounting is a fundamental shift in mindset. In the cost method the main focus is margin and sell-through rather than markdown liquidation, as it is with the retail method. In the cost method markdowns do not impact Cost of Inventory sold, thus the gross margin calculation and the GMROI are more accurate. It is important to note that since permanent markdowns do not impact inventory valuation thereby also not impacting OTB, it is possible that inventory aging can become a problem with product sitting on the shelf longer than it should.
For the retail method to be beneficial it requires a proper permanent markdown cadence thereby devaluing inventory before it is sold. The use of a permanent markdown cadence does require discipline but it is an objective and thorough use of markdown dollars. The retail method depreciates inventory, based on quantifiable markdowns. One advantage is that it allows for writing down obsolete inventory. The retail method requires the planning of permanent markdowns to free up open to buy dollars that can be spent on fresh and more profitable inventory.
Cost or Retail? While the cost method is simpler and more accurate at the item level, it would not be correct to assume that using the cost method result in better planning.
A business with a high seasonal and/or fashion component and with a business model that includes planned cycles of full priced sales and a planned markdown cadence may benefit more from adopting the retail method allowing for the liquidation of unproductive and obsolete inventory in order to continue flowing in fresh and seasonally appropriate goods.
If your business is largely comprised of products with no fixed shelf life, a high percentage of basic items that span across seasons/years or you allow for the warehousing of seasonal product for re-introduction the following year at full price then the cost method may be the most accurate and efficient way to plan since inventory aging is not a real concern.
While you sometimes see Finance use the cost method and the merchants work in the retail method it is desirable to have one version of the truth especially when it comes to the profit calculation! There is something described as a “hybrid method” which is sometimes implemented in order to satisfy both finance and merchants. In this scenario the Retailer actively plans markdowns and manages the business using the retail method but does not include reductions in the cost of sale or for the inventory at cost valuation. This can be a little tricky so make sure that you verify the output against the results of your finance system.
For a discussion of Merchandise Planning issues that are of importance to your business, visit the TXT Retail booth at the NRF “Big Show”. We’ll be in booth #2771 ready to show you solutions to your planning challenges. Schedule your meeting here Meet at NRF We invite you to learn more about capabilities of Merchandise Planning and Assortment Planning at TXTRetail.com
TXT Retail provides this posting to provide some insights into different points of view and comparisons. Choosing a fundamental method of accounting is an involved decision with many implications and consequences well beyond the reach of the merchandise office. If you are considering a modification between Cost and Retail accounting, we recommend that you review that decision with knowledgeable Accounting resources who can provide the insights for your particular business situation.