Retail inventory, shrinkage and the retail method

Retailers hold thousands of product lines across hundreds of locations, and counting and costing every item is impractical. The retail method and shrinkage estimates make it manageable, but each involves judgement that moves gross margin directly. This guide works through a department's closing stock, from selling value to carrying amount.

By Awais Jameel, Chartered Accountant. Reviewed by Muhammad Bilal, Chartered Accountant. 3 minute read.

Short answer

Retail inventory is measured at the lower of cost and net realisable value under IAS 2. Large retailers often use the retail method, calculating cost by applying a cost-to-retail percentage to the selling value of stock, which IAS 2 allows when the result approximates cost. Between stock counts they accrue for shrinkage, the loss from theft, damage and errors, using historical shrinkage rates, and write slow-moving or seasonal stock down to the price it will sell for after markdowns. In this guide's example, stock with a selling value of 1,000,000 is carried at 544,000.

At a glance

Standard
IAS 2 Inventories
Measure
Lower of cost and NRV
Retail method
Selling value x cost-to-retail ratio
Shrinkage
Accrued between stock counts
Markdowns
Reduce NRV of slow stock
Costs included
Purchase price less rebates, freight in
Retail inventory, shrinkage and the retail methodStandard: IAS 2 Inventories; Measure: Lower of cost and NRV; Retail method: Selling value x cost-to-retail ratio; Shrinkage: Accrued between stock counts; Markdowns: Reduce NRV of slow stock; Costs included: Purchase price less rebates, freight in.KEY FACTS AT A GLANCERetail inventory, shrinkage and the retail methodStandardIAS 2 InventoriesMeasureLower of cost and NRVRetail methodSelling value xcost-to-retail ratioShrinkageAccrued between stockcountsMarkdownsReduce NRV of slow stockCosts includedPurchase price lessrebates, freight inTax BakersRetail inventory, shrinkage and the retail methodStandard: IAS 2 Inventories; Measure: Lower of cost and NRV; Retail method: Selling value x cost-to-retail ratio; Shrinkage: Accrued between stock counts; Markdowns: Reduce NRV of slow stock; Costs included: Purchase price less rebates, freight in.KEY FACTS AT A GLANCERetail inventory, shrinkage andthe retail methodStandardIAS 2 InventoriesMeasureLower of cost and NRVRetail methodSelling value x cost-to-retail ratioShrinkageAccrued between stock countsMarkdownsReduce NRV of slow stockCosts includedPurchase price less rebates, freight inTax Bakers
Key facts at a glance, as set out in this guide.

A retail inventory example

A department's closing stock has a selling value of 1,000,000, and its cost-to-retail ratio is 60%. Since the last stock count, sales have been 4,000,000, and recent counts show shrinkage of about 1.5% of sales. Seasonal stock that will need clearance markdowns is expected to sell for 20,000 less than its cost.

From selling value to carrying amountFrom selling value to carrying amount1,000,000Stock atselling prices-400,000Margin-36,000Shrinkage-20,000NRVwrite-down544,000Carryingamount
Cost comes from selling value, then shrinkage and markdowns reduce it.
StepAmount
Closing stock at selling prices1,000,000
Cost at 60% of selling value600,000
Shrinkage accrual: 4,000,000 x 1.5% x 60%(36,000)
Write-down of seasonal stock to net realisable value(20,000)
Carrying amount544,000

The shrinkage accrual of 60,000 at selling prices is converted to cost before it is deducted. When the next stock count is done, the accrual is replaced by the actual shrinkage found, and any difference goes to cost of sales.

Where does shrinkage appear in the income statement?

In cost of sales, reducing gross margin. Retailers often track it as a percentage of sales by department, and a sudden rise is one of the first signs of problems with theft, systems or receiving controls.

How often should retailers count stock?

At least annually, near the year end or with a roll-forward from an earlier count that auditors can test. Many retailers count on a cycle through the year, counting high-value and high-risk departments, such as electronics and cosmetics, more often than others.

When is the retail method acceptable?

When the result approximates cost. The cost-to-retail percentage must be calculated for groups of items with similar margins, usually by department, not for the store as a whole, and must take account of stock that has been marked down below its original selling price. A single average margin across fashion, food and electronics would not approximate cost. Some retailers use standard costs instead, which are also allowed if regularly reviewed.

What goes into the cost of retail inventory?

  • The purchase price, less supplier rebates and settlement discounts; see supplier rebates.
  • Import duties and freight to bring goods to the store or distribution centre.
  • Not storage costs, selling costs or general administration.

Whether costs of distribution centres can be included depends on whether they are necessary to bring the goods to their present location and condition; many retailers include inbound freight but expense the costs of running warehouses.

How is net realisable value estimated?

As the expected selling price less the costs necessary to make the sale, which, following a 2021 IFRS Interpretations Committee agenda decision, include all costs necessary to sell, not only incremental ones. For retailers, that means considering planned markdowns for seasonal and slow-moving lines, damaged goods, and discontinued products. Write-downs are reversed if prices recover while the goods are still held.

How can shrinkage estimates go wrong?

Using an out-of-date shrinkage rate when theft has risen, applying a single rate to departments with very different risks, or counting stores at different times of year without adjusting. Large unexpected shrinkage at a stock count is a common source of year-end surprises, which is why many retailers count high-risk departments more often.

How does US GAAP differ?

US retailers may also use the retail method, and some use LIFO, which IFRS prohibits. Write-downs under US GAAP cannot be reversed. See IAS 2 explained, LIFO explained and retail accounting.

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Questions people ask

What is the retail method of inventory valuation?

A method that calculates cost by applying a cost-to-retail percentage to the selling value of stock, allowed under IAS 2 when the result approximates cost.

How is shrinkage accounted for between stock counts?

By accruing expected shrinkage based on historical rates applied to sales since the last count, converted to cost.

Are supplier rebates part of inventory cost?

Yes. Rebates and settlement discounts reduce the purchase price and so the cost of inventory.

Can inventory write-downs be reversed under IFRS?

Yes, if the circumstances that caused the write-down no longer exist, such as a recovery in selling prices.

Sources

Every fee, date and rule on this page was taken from these official and primary sources.

  1. IFRS Foundation: IAS 2 Inventories

Rules and fees change. If you are reading this long after October 4, 2026, confirm the figures with the source before you rely on them.

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This guide is general information. It is not tax or legal advice for your situation.