What’s the Difference: Retail Vs. Gross Profit Inventory Methods
One way to determine that your business has its inventory in order is to go and count every single item individually. This is called “physical inventory counting” or doing “physical inventory.” It’s how things were done before computers.
But, today, intelligent inventory management software cuts down the time necessary to take inventory by estimating it after a single physical count is performed. The inventory management system is then able to estimate sales, inventory, and restocking needs. Here are the two most common methods used for “soft” or estimated inventory tracking.
Gross Profit Method
The gross profit method starts with the value of the goods in your inventory based on the last time you performed a physical inventory count. “Value,” in this context, means how much you paid for the inventory.
So, if you paid $100,000 for product, and you’ve sold $250,000 worth of product, it doesn’t necessarily mean you’ve burned through all of your inventory. What did you spend on it that added to non-salable items (e.g. cleaning supplies, print paper, etc.). Now, what was the markup of the goods you sold.
You could still have $50,000, or more, left in inventory depending on what you spent on the merchandise.
If you had a 25 percent profit margin, and $60,000 in sales, then your profit is $15,000 with $45,000 in merchandise sold (costs). You have $55,000 worth of merchandise left. In order to sell $250,000 of products, you’d need a 250 percent markup.
Some industries aren’t well suited for that. Some are. The point of the gross profit method is to give you an idea of what you’re underlying costs are so you can track how much profit is being made relative to what it costs you to obtain stock.
Retail Inventory Method
The retail inventory method works similar to the gross profit method, with a slight difference in what’s being calculated. Let’s say that you make the same $60,000 in sales. At a 25 percent profit margin, you calculate your costs based on what you paid (the cost of the goods to you) and subtract it from the total.
So, you would end up with $48,000 in costs and $12,000 in profit because $12,000 is 25 percent of $48,000. Now, subtract $48,000 from $100,000 and you get $52,000 in inventory.
Both of these methods are valid ways to calculate how much inventory you have left. And, either one can be used and should be used at various times in your calculations.
Gross profit tells you gross inventory value, while the retail method tells you the retail value of your inventory.
It all depends on how you want to calculate the costs versus the profit on your business. Unless you’re a public company, there aren’t many restrictions on how you do this. Just make sure that you choose one method for an accounting period and stick with it. You can keep separate books and do both methods, of course, but make sure that the books are separate and that you’re not calculating one way one month and another way another month.
Max Gardiner is an assistant warehouse stockroom manager. He enjoys writing about his experiences to post online. Look for his articles mostly on industrial and business management sites.