To know what the business has in its inventory, the best way to find out is to count every single item. However, counting the inventory one by one and doing a physical inventory is simply impractical. If you are running a big company, it is just hard to do a physical count. There will be more errors while counting the exact numbers. There is a way to estimate the value of inventory and this is by gross profit method and retail inventory method.
Doing a physical inventory is important. At the same time, it needs a lot of time and can be very expensive too. Other businesses close for a day to perform inventory while some pay extra for employee overtime. These things can limit the number of inventory done within a certain interval. This means you have to do a major count of the items once or twice a year or depending on your company policy.
Inventory will give you information on how you can plan your budget and prepare financial reports. In cases of fire or robbery, it is not possible to do a physical inventory because the items are gone. However, it is still possible to get an estimate on the amount of the lost inventory to make an insurance claim or get some deductions from taxes.
Retail Inventory Method is used to estimate the value of the inventory. This gives the ending inventory balance by measuring the cost and the price of the item.
The retail inventory method is also called the cost-to-retail percentage wherein this is the measurement as to how much the item's retail price is made of up cost.
However, the retail method can only give an estimate since not all in a retail store will be available. Some might be stolen, broken, or misplaced. This method works if your markup is the same on all the products.
This method of calculation starts from the last time you did a physical inventory. The value of the inventory is the cost and not the retail price. If you have an inventory that is amounting to $10,000 from the last time, add the amount spent on items after that inventory. If you spent $10,000, the total cost of goods for sale is $20,000.
Each method will depend on how the cost acquired and the selling price. Gross profit uses the profit margin of the company. The retail inventory method uses markup.
The method that you choose will depend on how you operate your business. If you are consistent with your sales and use the same markup across all the products, then retail inventory is the simplest method to choose from. If you have a lot of products with different markups, gross profit is a better choice.
Each of the methods has its advantages and disadvantages so you have to choose according to your business operations to get it right.