Retail Accounting: the Root Cause of So Many Bad Choices

When retailers begin in business, there is one fundamental decision they all make when setting up their books: How will they report the value of the Inventory they carry?  In “Cost Accounting” the inventory value is the same as the cost paid for the product.  Profit is not realized until the item is sold at a price above that cost.  In “Retail Accounting” the inventory is valued at the amount it is expected to sell for.  It instantly recognizes the enhanced value of the product based on the expected profit upon sale.

In other words, if I buy 100 peaches for 10¢ each and expect to sell them for 25¢ each, my books may either reflect that I own $10.00 worth of peaches (in Cost Accounting) or $25.00 worth of peaches (in Retail Accounting.)  Both methods are used throughout the retail industry, are legal and have their proponents.

It may seem like a rather insubstantial decision for a retailer opening the company, but as someone who has been thoroughly versed in retail practices using both methods, I can tell you that the legacy of Retail Accounting leads to some very bad behavior.  Behaviors which at times are at odds with the best interest of customers and shareholders.

Specifically, when cost accounting retailers have old inventory (euphemistically called “Aged Inventory” in the industry – as if it were fine wine that somehow increases in value!) they mark down the product to find the point where customers will take the product home in shopping bags instead of disposing of it.  So my 25¢ peaches may become 5/$1.00 then 2/30¢ and finally, perhaps, 10/$1.00  – at which point I am selling them at cost and basically making no profit on the transaction.   I may eventually have to sell them below cost, but that is a very rare occasion.  My margin rates suffer and I may not be pleased, but now that I have recovered my $10.00 I originally spent on the peaches, I can try to find something else that I can buy for $10.00 that my customers will pay me $25.00 to purchase.  In retail terms, I have freed up my  “open to buy” to acquire more productive inventory.

Given the same situation in retail accounting, I have very different financial decisions.  My peaches are worth $25.00 according to my books.  If I mark them down to 5/$1.00, I have to restate my inventory value by -$5.00 and show a decrement in value.  If I have to sell them at cost, I have to reduce the value of my inventory by $15.00.  In deciding to sale price my peaches I have reduced the value of my company because inventory is an asset on my balance sheet, whereas unrealized profit (in cost accounting) does not show up until it is cash on my income statement.  A decision to mark down the price of my goods will affect my profit rate in cost accounting – but that same decision will affect the value of my company in retail accounting.

It is a deep psychological chasm for most retail accounting merchants to see markdowns as a way to recover unproductive inventory dollars to redeploy on better performing inventory instead of a failure that will cost the company money.  Cost-based merchants tend to be much better able to test and learn from their buying mistakes and to see markdowns as a part of the retail lifecycle.  Retail-based merchants are nearly always penalized for marking down goods at the end of a season or moving out of goods through price reductions.

Over time, retailers who become immobile on this issue find their stores filling with stagnant inventory that customers do not want.  It may seem a generalization, but as a student of the industry I have seen this time and again.

My advice for any prospective retailers is to always choose Cost Accounting.  Your legacy company will thank you decades from now.

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