5.3: The Basics of Merchandising

learning objective

LO1 – Describe merchandising and explain the financial statement components of sales, cost of goods sold, merchandise inventory, and gross profit; differentiate between the perpetual and periodic inventory systems.

A merchandising company, or merchandiser, differs in several basic ways from a company that provides services. First, a merchandiser purchases and then sells goods whereas a service company sells services. For example, a car dealership is a merchandiser that sells cars while an airline is a service company that sells air travel. Because merchandising involves the purchase and then the resale of goods, an expense called cost of goods sold results. Cost of goods sold is the cost of the actual goods sold. For example, the cost of goods sold for a car dealership would be the cost of the cars purchased from manufacturers and then resold to customers. A service company does not have an expense called cost of goods sold since it does not sell goods. Because a merchandiser has cost of goods sold expense and a service business does not, the income statement for a merchandiser includes different details. A merchandising income statement highlights cost of goods sold by showing the difference between sales revenue and cost of goods sold called gross profit or gross margin. The basic income statement differences between a service business and a merchandiser are illustrated in Figure 5.3.1.

Service Company	Merchandising Company
Revenues	Sales
	Less: Cost of Goods Sold
	Equals: Gross Profit
Less: Expenses	Less: Expenses
Equals: Net Income	Equals: Net Income

Figure \(\PageIndex{1}\): Differences Between the Income Statements of Service and Merchandising Companies

Assume that Excel Cars Corporation decides to go into the business of buying used vehicles from a supplier and reselling these to customers. If Excel purchases a vehicle for $3,000 and then sells it for $4,000, the gross profit would be $1,000, as follows:

Sales	$4,000
Cost of Goods Sold	3,000
Gross Profit	$1,000

The word "gross" is used by accountants to indicate that other expenses incurred in running the business must still be deducted from this amount before net income is calculated. In other words, gross profit represents the amount of sales revenue that remains to pay expenses after the cost of the goods sold is deducted.

A gross profit percentage can be calculated to express the relationship of gross profit to sales. The sale of the vehicle that cost $3,000 results in a 25% gross profit percentage ($1,000/4,000). That is, for every $1 of sales, the company has $.25 left to cover other expenses after deducting cost of goods sold. Readers of financial statements use this percentage as a means to evaluate the performance of one company against other companies in the same industry, or in the same company from year to year. Small fluctuations in the gross profit percentage can have significant effects on the financial performance of a company because the amount of sales and cost of goods sold are often very large in comparison to other income statement items.

Another difference between a service company and a merchandiser relates to the balance sheet. A merchandiser purchases goods for resale. Goods held for resale by a merchandiser are called merchandise inventory and are reported as an asset on the balance sheet. A service company would not normally have merchandise inventory.

Inventory Systems

There are two types of ways in which inventory is managed: perpetual inventory system or periodic inventory system. In a perpetual inventory system, the merchandise inventory account and cost of goods sold account are updated immediately when transactions occur. In a perpetual system, as merchandise inventory is purchased, it is debited to the merchandise inventory account. As inventory is sold to customers, the cost of the inventory sold is removed from the merchandise inventory account and debited to the cost of goods sold account. A perpetual system means that account balances are known on a real-time basis. This chapter focuses on the perpetual system.

Some businesses still use a periodic inventory system in which the purchase of merchandise inventory is debited to a temporary account called Purchases. At the end of the accounting period, inventory is counted (known as a physical count) and the merchandise inventory account is updated and cost of goods sold is calculated. In a periodic inventory system, the real-time balances in merchandise inventory and cost of goods sold are not known. It should be noted that even in a perpetual system a physical count must be performed at the end of the accounting period to record differences between the actual inventory on hand and the account balance. The entry to record this difference is discussed later in this chapter. The periodic system is discussed in greater detail in the appendix to this chapter.