In the part-1 of this subject, i talked about the emergence of IFRS as a global standard that will soon become an imperative for US businesses and how more specifically the retailers will be impacted. In this blog I take you deeper into the two key accounting methods that are used by retailers. I also provide a perspective why Cost Method of Accounting (CMA) will not just bring compliance to IFRS, but more importantly make retailers more competitive in the marketplace.
Cost Method of Accounting (CMA)
Under the Cost Method of Accounting under IFRS, the inventory is stated at the lower of cost and net realizable value (IAS2.9), which is similar in principle to lower of cost or market (LOCOM) in US GAAP.
Cost comprises all costs of purchase, costs of conversion and other costs incurred in bringing items to their present location and condition (IAS2.10). Where individual items are not identifiable, the “first in first out” (FIFO) or weighted average cost formula is used. “Last in first out” (LIFO) is not acceptable (IAS2.25) under IFRS. Net realizable value is the estimated selling price less the costs to complete and costs to sell (IAS2.6).
The cost method of inventory valuation is being increasingly adopted by retailers. Modern inventory accounting systems are able to track the unit inventory at the item – location level. The systems are also able to compute a moving average every time a good receipt is made. The value of the units at moving average cost is relieved at the time of booking sale or other reliefs. Perpetual inventory accounting systems like SAP Retail are able to track units, moving average cost and current owning retail. Not only do they track the cost, but also the retail at each transaction for proper computation of gross margin that is so important to the merchants.
Retail Inventory Method (RIM)
The prevalent method of inventory accounting for retailers has been Retail Inventory Method (RIM). This method hails from an era when computing systems were not adequate enough to track perpetual inventory. RIM is a year to date system that tracks inventory valuation at an aggregated level usually at a class level. The costs are aggregated and so is the retail. A ratio of cost to retail is computed (often called the complement). The relief of inventory (sales and others) happens at retail and cost. While the owning retail is known for the units sold, the cost is derived by multiplying the retail of units relieved by complement.
When the selling retail price changes, the retail value is recomputed for the units on hand within the class. The cost is also recomputed such that the complement remains the unchanged. The difference in old cost and the new cost is booked to Cost of Sales. This revaluation of inventory at the time of retail price change can cause significant divergence from cost, hence may make the RIM method inadmissible under IFRS.
Benefits and Challenges with Cost Method of Accounting (CMA)
CMA provides some significant benefits to the retailers. Many of these benefits provide strategic advantage. There are also challenges that retailers and software providers have to overcome.
- Item-Location Profitability: the move to cost method implicitly requires that revenue and costs are tracked at the item-location level along with tracking of the units. This provides a powerful lever for merchandise planning to arrive at an optimum assortment given the limited shelf space. This is a single most important reason for which retailer will consider CMA.
- Easy to Understand Valuation: cost method is intuitive. True revenue less true costs provides the gross margin. Under RIM, the revaluation due to retail price changes requires additional analysis by merchants as to what caused the shift in gross margin. While experienced merchants can navigate, it is not intuitive to new entrants.
- Consistency across the Business: many retailers have other businesses besides retail, like wholesale, direct to business etc. that does not permit RIM. Similarly many retailers prefer to cost inventory at CMA at the DCs and RIM at the stores. A move to CMA provides consistency of valuation throughout the business.
- Compliant to Standards: CMA conforms to IFRS. While exception under US GAAP were issued for RIM. There is no such exception provided under IFRS. Even one is provided it may not be for perpetuity.
- Treatment of Delayed Costs: The cost method of accounting is built around moving average cost that is based on perpetual tracking of units. Computation logic for moving average requires that most of the procurement costs are available at the time of receipt. This does not always happen. So the delayed costs are not absorbed in the moving average cost because the goods have often moved from the DC to the stores or have been actually sold to the guests.
- Unit tracked for Logistics are Different to Units for Inventory Valuation: this is a unique conundrum facing retailers either on CMA or those intending to move to CMA. The replenishment logic works best if the units at hand in stores and DCs closely represent what is actually available. Either because of shrinkage or misplacement of units or errors in systems, the book inventory may be out of sync with what is observed. Retailers often do special counts at stores to correct the units to expedite replenishment. Often on a subsequent count or the annual physical the units may be located. While this seesaw is easily tolerated under RIM with a separate unit tracking system, it causes distortion under CMA because cost is derived from the units on the books.
We will go into more details of the SAP offering, and how some of the challenges described above are being met.
It is well worth for retailers while the time is still on their sides to complete the evaluation for their respective businesses to see whether cost method is right for them.