Small businesses have two choices when considering how to calculate and track inventory: cost and retail accounting. Although the cost method is more popular today, there are valid arguments for using both types of accounting. Learn more about which method might be the right solution for your company.
The Retail Accounting Method
Retail accounting is an inventory valuation technique that is frequently used in financial management. It bases the value of inventory on the selling price, not the acquisition price. Typically, the retail price of the inventory is reduced by the markup percentage in order to arrive at an approximate value.
- A simpler accounting solution
- Does not require labor-intensive inventory counts
- Easy for small businesses to operate
- Only works well if your business marks up its products consistently
- Does not provide an accurate value of your inventory
- Less accurate than the cost accounting method
The Cost Accounting Method
The cost method of inventory accounting assigns a monetary value to inventory based on its cost to the retailer. It is typically done by recording the cost of each item when purchased and then adding them together.
There are three types of cost methods that business in the retail industry can choose from:
- First-in, First-out
- Last-in, First-out
- Weighted Average Cost
- More accurate than the retail accounting method
- Easy to monitor
- Adaptable to the changing needs of a business
- Must track every piece of inventory
- May get complicated for a small business to operate and analyze
- Adjustments may be needed more frequently
Depending on whether you elect to do cost accounting or retail, it could significantly alter the valuation of your inventory. To avoid any confusion on your business income tax return, it’s best to not change from one to the other in the midst of a fiscal year.
Although both methods are allowed by the IRS, it’s helpful to develop a strong understanding of which would be right for your specific business situation. If you have any questions about retail accounting or other financial topics, contact a professional tax advisor.