Using the Retail Inventory Method to Estimate Ending Inventory at Cost: FIFO, FIFO-LCM, Average Cost, Average Cost-LCM,

LIFO
The retail method of estimating inventory concentrates on the relationship between historical cost of inventory and selling price of inventory, but an advantage of this method is that it uses current period cost and selling price in the estimation procedure. Additional records must be kept. Not only must a company track the cost of inventory, it must also track the selling price and changes in the selling price during the period. The following data is from EX 9-20, and shows how the company should set up the information about inventory to facilitate use of the retail method. Beginning Inventory Purchases Purchase Returns Freight on purchases Cost $ 30,000 48,000 (2,000) 2,400 Retail $ 46,500 88,000 (3,000) ______ $131,500 $10,000 (1,500) 8,500 140,000 9,300 (2,800) (6,500) $133,500 (97,000) $ 36,500 ????

SUBTOTAL $ 78,400 Changes in selling price during the period Markups Markup cancellations Add Net Markups SUBTOTAL Markdowns Markdown cancellations Subtract Net Markdowns GOODS AVAILABLE FOR SALE $78,400 DEDUCT NET SALES ($99,000 - $2,000) Ending Inventory at Retail Estimate EI at COST

The above table is always the starting point for using the retail method. To estimate ending inventory at cost, multiple the retail figure ($36,500 in this example) by the appropriate Cost/Retail Percentage. The calculation of the cost/retail percentage varies depending on the underlying inventory system you wish to estimate (average cost, average cost-LCM, FIFO cost, FIFO cost-LCM, LIFO) In all cases, you have $78,400 available for sale at cost, and this amount must be allocated to goods sold (COGS) or goods remaining (EI). As your estimate of EI changes, so does your allocation to COGS.

FIFO cost: FIFO cost, or First-in, First-Out, assumes that the beginning inventory is
sold before any current period purchases. Because the beginning inventory is assumed to be sold, all of the ending inventory is assumed to come from current period purchases. The cost/retail ratio for FIFO cost uses all of the relevant data for the current period only. Cost: Goods available for sale beginning inventory = 78,400 30,000 = 48,400 Retail: Goods available for sale beginning inventory = 133,500 46,500 = 87,000 Cost/Retail = 48,400/87,000 = .556 Estimate of EI = (36,500)(.556) = $20,294 COGS = $78,400 - $20,294 = $58,106 Lower of Cost or Market is a more conservative inventory valuation. LCM will therefore yield either an identical or a lower inventory estimate. To estimate LCM, the effect of net markdows is eliminated from the cost to retail ratio. There isnt a great reason! Net markdowns only affect the retail value of the inventory, so this change will only affect the denominator of the cost to retail ratio. For FIFO cost, the denominator was $87,000. IF we add back net markdowns of $6,500, the denominator becomes $87,000 + $6,500 = 93,500 (This is also the subtotal for EI retail after net markups shown on the chart above, $140,000, less beginning inventory of $46,500 The cost to retail percentage for FIFO cost-LCM is 48,400/93,500 = .518 FIFO cost-LCM estimate of EI = ($36,500)(.518) = $18,907 COGS = $78,400 - $18,907 = $59,493

Average cost methods add together all of the inventory values for beginning inventory
and current period purchases and use this average to value both ending inventory and COGS. For average cost, therefore, all of the information about inventory is included in the cost to retail percentage. Cost = good available for sale at cost, $78,400 Retail = goods available for sale at retail, $133,500 Cost/retail ratio = 78,400/133,500 = .587 EI-Average Cost = ($36,500)(.587) = $21,426 COGS = $78,400 - $21,426 = $56,794

Average cost LCM again leaves net markdowns out of the calculation of the cost to retail percentage. This is known as the Conventional Retail Method. Reading the numbers off the table above Cost = goods available for sale at cost, $78,400 Retail = subtotal before net markdowns, $140,000 Cost/Retail ratio = 78,400/140,000 = .560 EI Average cost-LCM = ($36,500)(.560) = $20,440 COGS = $78,400 - $20,440 = $57,960 SUMMARY OF RULES FOR CALCULATING THE COST TO RETAIL PERCENTAGE FOR FIFO, FIFO-LCM, AVERAGE COST, AND AVERAGE COSTLCM: Beginning Inventory FIFO FIFO-LCM Average cost Average cost-LCM Exclude Exclude Include Include Net Markdowns Include Exclude Include Exclude

LIFO: Under LIFO, inventory potentially has to be divided into layers. First, compare
the ending inventory at retail to the beginning inventory at retail to determine if there has been a net increase or a net decrease in inventory. Net decrease: LIFO assumes that all of the purchases are sold first before dipping into beginning inventory. In the example of EX 9-20, inventory at the end of the period was $36,500, and at the beginning of the period was $46,500. That means that all of the current period purchases were sold and that some of beginning inventory was sold, with some of the beginning inventory still remaining. In this case, the cost to retail ratio should be calculated based only on beginning inventory numbers: Cost/Retail = 30,000/46,500 = .645 EI LIFO = ($36,500)(.645) = $23,543 COGS = $78,400 - $23,543 = $54,857

SUMMARY of EI Estimates and COGS values for EX 9-20: EI FIFO FIFO-LCM AV COST AV COST-LCM LIFO $20,294 $18,907 $21,426 $20,440 $23,543 COGS $58,106 $59,493 $56.794 $57,960 $54,857 Goods Available for Sale $78,400 $78,400 $78,400 $78,400 $78,400

LIFO, net increase

Assume net sales of $80,000 instead of $97,000 in the above example. Under this new assumption, the ending inventory at retail would bethe ending inventory at retail number in the above example would be: GOODS AVAILABLE FOR SALE DEDUCT NET SALES ($99,000 - $2,000) Ending Inventory at Retail Estimate EI at COST ???? $78,400 $133,500 (80,000) $ 53,500

The beginning inventory at retail was $46,500, so there is more inventory at the end of the period than at the beginning of the period. All of the beginning inventory is still intact (there has been no dipping into a LIFO layer) and some of the current period purchases are still on hand. The net increase in inventory at retail is $53,500 - $46,500 = $7,000. The layer of $7,000 added in the current period is converted to cost using current period information. The current period purchases at cost are goods available at cost, $78,400, minus beginning inventory at cost, $30,000, or $48,400. The current period purchases at retail are goods available at retail, $133,500, less beginning inventory at retail, $46,500, or $87,000 Cost/Retail = 48,400/87,000 = .556

(Note: This is the SAME cost to retail ratio that we used for FIFO. BUTinstead of applying this ratio to the entire ending inventory at retail, we only apply it to the net increase in inventory during this period, $7,000) The current period layer is ($7,000)(.556) = $3,892 Cost Beg. Inv. Layer Layer from current year Ending Inventory, LIFO Ending Inventory, Retail $30,000 3,892 $33,892 $53,500 Retail $46,500 7,000

COGS = $78,400 - $33,892 = $44,508