You’ve heard all the scary statistics about how 20 percent of small businesses fail in their first year, but did you know there is a straightforward measure you can take to increase your retail store’s chance of survival? Proper inventory management and inventory software can improve cash flow, decrease loss, and help you gain a loyal customer base.
An efficient inventory management method is essential to any retail environment. Inventory for small retailers will differ from grocery store inventory management. How do you know what inventory method for small businesses will work best for you?
This article will cover the four top retail inventory methods. We will go over the benefits, drawbacks, and top use-cases for each method. By the time you finish reading, you should have a solid set of tools to make an informed decision about the best retail inventory method for you.
The 4 Retail Inventory Methods
What processes are included in inventory management, anyways? Put simply, retail inventory management includes whatever steps you take to keep track of what products you have in store, which products are selling, and how fast they’re selling. In other words, proper retail inventory methods will help you ensure you always have the products your customers need on hand and ready to sell.
Information that is usually tracked during inventory includes the quantity of each product, the profit margins on each product, how different seasons influence product sales, the location of each product in the store, and more.
The best way to make sure you’re able to keep track of the inventory in your retail store is to invest in a proper POS system for your small business: a point of sale system with inventory management features. Check out our buyers' guide to see what POS hardware and software might work best for your business.
Now, let’s dive into the four most common methods of retail inventory management.
Method 1: Specific Identification
Specific identification is a method of inventory management characterized by individually assigning a cost to each item rather than grouping items together. There are a few different ways to do this. Large businesses will have a system of scannable tags on their inventory that allows them to log each item quickly. Smaller stores may be able to have staff individually count and log each item.
This method also requires that you associate cost with each piece of inventory in your tracking database. This allows you and your staff to easily connect the price with the item when a sale is made.
Specific identification has upsides and drawbacks. The most significant benefit of using this inventory tracking method is that it allows you to identify and track the location and cost of every item in your store. It affords you a high level of accuracy when it comes to tracking your sales and profits, as well as lost revenue from damaged or stolen items. A drawback of using this method is its time to implement and maintain such a tracking system. The higher your volume, the more difficult it is to track inventory using specific identification.
The best use-cases for specific identification are small businesses with limited inventory or larger companies with a lower volume of high-value item sales.
Method 2: First-In, First-Out (FIFO)
First-in, first-out, or FIFO, is an inventory method that relies on the assumption that the oldest products in your inventory were sold first, rather than physically tracking the sale of each individual item.
For example, if you run a clothing store and paid $5/unit for your oldest stock of a given shirt, but paid $10/unit for your newest shipment of that same shirt, you will calculate your cost of goods sold (COGS) assuming that you’re selling the $5 shirts first. You will calculate the cost of your remaining inventory by subtracting the number of shirts sold from the $5/shirt stock first, only subtracting from the $10/shirt stock once the $5 shirts have all been sold.
One benefit of using FIFO for your inventory tracking system is that it’s a relatively simple calculation that coordinates well with the usual flow of sales and inventory. Essentially, the system makes sense logically. We sell the old stock first, then move onto the new once the old has sold. The main downside to FIFO is that, since you’re not tracking each individual unit’s purchase and sale price, you may end up under- or overestimating your profits.
Many businesses can benefit from using the FIFO model. Suppose your business is required to follow the regulations of the International Financial Reporting Standards (IFRS) Foundation. In that case, you may be required to use FIFO, as that is the inventory tracking method approved by IFRS.
Method 3: Last-In, First-Out (LIFO)
Last-in, first-out, or LIFO, is another inventory tracking method that relies on some level of assumption rather than straightforward calculations for COGS equations. As the name suggests, calculations are done the opposite of FIFO inventory calculations. LIFO assumes that you will sell your most recently acquired inventory first. So, to return to our shirt store example above, in a LIFO inventory method, your store would count the $10 shirts first before selling the shirts purchased for $5.
There are several benefits to using the LIFO inventory method, particularly if prices on the items in your stock are currently rising. Since this method inflates the costs, it lowers the taxable income of your store. If prices of your stocked items are falling, however, the opposite effect occurs. Your income will appear inflated, causing your taxable income to rise. In general, LIFO’s weak point concerns estimating the cost of your remaining inventory, as it underestimates this figure.
Stores with incredibly high volume benefit most from using LIFO. It is used only in the United States, and the IFRS forbids this inventory management method, so if your organization is required to follow IFRS guidelines, you cannot use LIFO for your inventory system.
Method 4: Weighted Average
The last method of inventory management that we will discuss here is weighted average inventory tracking. Like LIFO and FIFO, this method relies on assumptions rather than exact figures to calculate your COGS and on-site inventory value. In a weighted average approach, you will calculate the value of your inventory based on the average cost of the items in your stock.
To return once more to our shirt example, if your inventory contains 10 shirts for $5 apiece and 10 more shirts for $10 apiece, a weighted average method would see you assuming the cost of every shirt as $7.50. Though this sounds perfectly reasonable in the given scenario — and it is, in many cases — an average is not always an accurate representation of your inventory’s value. For example, if the cost of an item suddenly plummets or skyrockets, you may be vastly over- or under-stating your inventory value or profits using this method.
The main benefit of using weighted averages is that it simplifies your calculations significantly. A great use-case for weighted average inventory tracking is if your business has regular turnover of inventory that has relatively stable pricing (in other words, pricing that fluctuates within a known range).
Which Retail Inventory Method is Best?
Simply put, the answer to the question: “Which retail inventory method is best?” is, it depends. Your decision will be impacted by the size of your business, the volume and turnover rate of your inventory, and the regulations and guidelines you are required to follow when it comes to inventory tracking. Regardless of your retail inventory method of choice, you will need a software solution that can help you manage your inventory efficiently. Our point of sale software, CAP Retail by POS Nation, provides you inventory solutions like real-time metrics, so you always know what you have in stock and when it’s time to reorder. Schedule a demo to learn more about our features and see how we can solve your inventory tracking challenges for good.