Retail Inventory Adjustments for Freight, Returns, and Shortages

Retail inventory adjustments are the special items in the retail inventory method: freight-in, purchase returns, purchase discounts, employee discounts, and shortages. Freight-in and purchase discounts change the cost column only. Purchase returns and abnormal shortages come out of both cost and retail before the cost-to-retail ratio. Employee discounts and normal shortages reduce retail after the ratio.

The retail inventory method estimates ending inventory by tracking goods in two columns, one at cost and one at retail, which means selling price. The cost-to-retail ratio is goods available at cost divided by goods available at retail.

A few terms first. Freight-in is the shipping cost a retailer pays to receive merchandise. A shortage, also called shrinkage, is merchandise lost to theft, breakage, or damage. Net markups are price increases above the original selling price, less cancellations. Net markdowns are price decreases below it, less cancellations.

Placement matters as much as the sign. A deduction taken one row too early can change the percentage applied to every item still on hand. The worksheet below uses the conventional retail method, which adds net markups before the ratio and deducts net markdowns after it, and shows exactly where to draw the line.

This guide covers the accounting method taught in intermediate accounting courses. It does not cover how to post a stock count adjustment in a point-of-sale system.

Watch how to place adjustments in the two columns

In this 11-minute Farhat Lectures lesson, the special items start at 5:26. Key moments:

• 3:17 Cost-to-retail ratio
• 5:26 Purchase returns
• 5:56 Freight
• 6:31 Normal spoilage and employee discounts
• 7:01 Markups and markdowns
• 9:31 Abnormal shortages

Watch the lesson on YouTube.

Where do retail inventory adjustments go?

Ask three questions about each item. Does it change what the goods cost you? Does it change the selling price value of the goods on hand? Does it belong before or after the cost-to-retail ratio? A delivery charge changes cost only. A return to a supplier or a transfer from another department changes both columns before the ratio. A sale to an employee at a discount changes retail only, after the ratio.

Two quick notes on the table. The purchase discount row assumes purchases are recorded at the full invoice price, which is called the gross method. If purchases are already recorded net of the discount, do not deduct it again. In Harbor’s worksheet, net sales are $47,000 of gross sales less $2,000 of customer returns, or $45,000.

For the distinction between net markups and net markdowns, see the conventional retail method comparison. For the basic formulas, see the retail inventory method worked example.

Worked example: how to calculate the cost-to-retail ratio

Suppose Harbor Desk Supply estimates its stationery department’s closing inventory. The cash register records employee sales at the amount employees actually pay. The department uses the conventional method. All amounts are hypothetical dollars. Parentheses indicate deductions.

Draw the ratio line here. Dividing $42,000 by $75,000 gives 56%. The supplier discount reduced the invoice without changing a single price tag. The abnormal loss removed merchandise with known cost and retail amounts before the department calculated that average.

Worked example: how to calculate ending inventory at retail and at cost

Harbor records net markdowns of $2,500. Its register shows $47,000 of sales before $2,000 of customer returns, so net sales are $45,000. It also identifies $500 of employee price concessions omitted from that sales figure and $1,000 at retail of normal shrinkage. None of those four deductions changes the conventional ratio just calculated.

Why do markdowns wait until after the ratio? Leaving them out of the ratio produces a lower percentage, so ending inventory approximates the lower of cost or market. Under the FASB Accounting Standards Codification (ASC) 330-10-35-1A through 35-1C, inventory measured with the retail inventory method is still measured at the lower of cost or market, not the lower of cost or net realizable value.

Estimated cost of goods sold is $42,000 of goods available at cost minus $14,560 of ending inventory, or $27,440. The $900 abnormal loss is not in that figure. It left the cost column before the ratio and is reported separately as a loss.

Why did the employee concession need a separate line? If a $100 item sells to an employee for $80, the register removes $80 through sales. The remaining $20 must also leave the retail records because the entire $100 item left the department. If the sales figure already includes the full $100 ticket, a second $20 deduction would remove the discount twice.

Normal vs. abnormal shortage: what is the difference?

Normal shrinkage is the ordinary level of breakage, damage, or theft expected in the business. Deduct its retail amount after calculating the ratio. A separately identifiable, unusual loss, such as stock destroyed in an exceptional warehouse incident, is removed at its cost and retail amounts before computing the ratio. The identified cost can then be accounted for separately as a loss. Avoid charging the same goods to normal shrinkage as well.

How do sales returns and sales discounts affect the retail inventory method?

A purchase return sends goods back to the supplier. A customer return goes the other direction. For a resaleable item returned by a customer, reducing gross sales to net sales leaves more merchandise in ending inventory. In textbook schedules that use sales net of returns and allowances, use the stated net figure once. When sales are recorded gross of a prompt-payment cash discount, keep the gross-ticket sale in the retail calculation. Early payment does not put merchandise back on the shelf.

For the journal entries behind those two items, see sales returns and allowances and sales discounts under the gross and net methods.

As a real-world comparison, Kohl’s values most of its merchandise with the retail inventory method. In its Form 10-K for the fiscal year ended January 31, 2026, Kohl’s says it estimates shrinkage as a percent of sales for the period between its last physical count and the balance sheet date. You can read the inventory valuation discussion in its annual report filed with the U.S. Securities and Exchange Commission.

Common mistakes with retail inventory adjustments

Each of these changes the answer. The numbers use the Harbor Desk Supply example above.

• Leaving out freight-in. Without the $600 of freight, cost drops to $41,400 and the ratio falls to 55.2%. Ending inventory becomes $14,352, which is $208 too low.
• Deducting net markdowns before the ratio. That is the average-cost retail method, not the conventional method. The ratio would be $42,000 ÷ $72,500, or about 57.93%, and ending inventory would be about $15,062, which is about $502 higher.
• Forgetting employee discounts that are not in sales. Ending retail would be $26,500 and ending inventory would be $14,840, which is $280 too high.
• Not reading how sales are stated. If a problem says sales are recorded net of employee discounts, deduct the discounts. If sales are already at full ticket price, do not.
• Deducting a sales discount. When sales are recorded gross, the cash discount stays out of the retail column.
• Treating an abnormal loss as normal shrinkage. The loss would stay in the ratio and blend into cost of goods sold instead of showing up as a separate loss.

Key takeaways

• Cost column only: add freight-in, and deduct purchase discounts and purchase allowances when price tags stay the same.
• Both columns, before the ratio: purchase returns, transfers in, and abnormal shortages.
• Retail column only, before the conventional ratio: net markups.
• Retail column only, after the ratio: net markdowns, net sales, employee discounts not already in sales, and normal shortages.
• In the Harbor Desk Supply example, $42,000 ÷ $75,000 gives a 56% cost-to-retail ratio, ending inventory at retail of $26,000, and ending inventory at cost of $14,560.

Practice questions and answers

1. Which amounts leave the worksheet after a vendor return?

The department returns items invoiced at $720 and ticketed at $1,200. Deduct $720 from cost and $1,200 from retail before computing the ratio. Using $720 in both columns would leave $480 of nonexistent merchandise in retail.

2. Does a customer’s cash discount reduce the retail sale?

A customer buys an item ticketed at $200 on credit and earns a $4 discount for paying early. If the worksheet starts with gross sales, remove the full $200 through sales. The $4 reflects collection terms. It does not restore goods to inventory.

3. How much is inventory overstated if Harbor misses normal shrinkage?

The $1,000 retail shortage would remain in the ending balance. At 56%, inventory would be overstated by $560. The ratio would still be 56% because the normal shortage belongs below it.

Frequently asked questions

How do transfers out of a department work?

Reverse a transfer in. Remove the transferred merchandise at cost and retail from the sending department and add it at those amounts to the receiving department. Across the whole store the transfer balances.

Is an employee discount a markdown?

No. An employee discount applies to one sale to one employee. A markdown lowers the recorded selling price of the merchandise for all customers. In the conventional retail method both are deducted from retail after the ratio, but they are tracked on separate rows.

Should every inventory loss use the department percentage?

No. A known abnormal loss comes out at its identified cost and retail amounts before the ratio. For normal shrinkage stated at retail, the ratio converts the reduction in ending retail to an estimated cost effect.

Is freight-in included in the cost-to-retail ratio?

Yes. Freight-in is added to the cost column before the ratio is calculated. It is not added to the retail column, because a delivery charge does not change any price tag.

Are employee discounts included in the cost-to-retail ratio?

No. Employee discounts are deducted from the retail column after the ratio, the same way sales are. Deduct them only when the sales figure does not already include the full ticket price.

What is the difference between a normal and an abnormal shortage in the retail inventory method?

A normal shortage is the expected level of breakage, damage, or theft. Deduct it at retail after the ratio. An abnormal shortage is an unusual loss you can identify separately. Deduct it from both cost and retail before the ratio and report its cost as a loss.

Are sales discounts deducted in the retail inventory method?

No, not when sales are recorded at the gross amount. A cash discount for early payment does not put goods back on the shelf, so the full ticket price still leaves the retail column through sales.