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Tariffs and Rising Costs

As President Donald Trump’s tariffs on imported goods take effect, U.S. retailers are grappling with rising costs that could impact profitability. Retailers including Walmart, Target, and Home Depot are preparing to report quarterly earnings, but a specific accounting method may distort the financial picture.

The retail inventory method (RIM) of accounting, used by nearly a quarter of U.S. retailers, calculates profit using an average cost-to-retail ratio across broad product categories rather than item-level costs. This method can temporarily make profitability appear higher than it truly is when input costs increase due to tariffs.

Ali Furman, PwC’s U.S. consumer markets leader, explains, “RIM is less responsive to initial product cost changes compared to cost accounting, and can initially overstate profitability. This effect normalizes over time depending on how much cost retailers absorb.”

How RIM Affects Retail Earnings

Because RIM averages costs across many SKUs, the immediate financial impact of tariffs may not fully show in reported earnings. For example, Walmart’s upcoming fiscal second-quarter results will include inventory purchased both before and after new tariffs, creating a temporary mismatch in costs versus revenue. TD Cowen analyst Oliver Chen estimates that roughly half of Walmart’s quarter will reflect these tariff effects, which could distort gross margins.

Retailers sometimes pass the full tariff cost to customers. In these scenarios, RIM can still overstate short-term profitability because it does not track SKU-level cost changes immediately. Conversely, if tariffs are reduced and retailers lower prices, RIM can temporarily understate profitability until the cost-to-retail ratio realigns.

Real-World Example of Distorted Margins

PwC created a simplified scenario to illustrate the difference between RIM and traditional weighted average cost accounting:

• Base Case (No Tariffs): Weighted average cost accounting shows a 46% gross margin, while RIM shows 53%, overestimating profitability.
• Tariff Case 1 (Costs Rise, Prices Constant): Gross margin drops under both methods but remains higher under RIM.
• Tariff Case 2 (Prices Raised to Offset Tariffs): Margins increase under both methods, but RIM exaggerates the short-term boost.
• Tariff Case 3 (Prices Raised, Units Sold Fall): Weighted cost accounting shows gross margins falling to 27%, while RIM maintains 47%, giving a misleading impression of profitability.

Why Retailers Still Use RIM

RIM is an older method designed for retailers managing large inventories before digital tracking systems existed. It simplifies accounting by using averages rather than tracking individual SKU costs. Large chains like Macy’s and Nordstrom have switched to cost accounting, but such transitions typically take two to three years and require restating prior financials, which can cost millions.

Despite the challenges, roughly half of RIM users have considered moving to cost accounting, recognizing the benefits of more accurate margin reporting, especially during periods of high cost volatility.

Implications for Investors and Analysts

For investors, the takeaway is clear: short-term earnings may not fully reflect the impact of tariffs under RIM. Analysts and shareholders should monitor upcoming earnings reports carefully, understanding that reported margins could temporarily overstate or understate the economic reality.

Furman adds, “Companies might be navigating sourcing challenges, managing suppliers, and mitigating tariffs effectively, but those operational efforts often aren’t reflected in financials. This misalignment is particularly pronounced for retailers using RIM.”

Retailers and investors alike must balance operational performance with accounting interpretations to get a true picture of profitability during periods of escalating trade tensions.

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