COGS is a critical financial metric for merchandisers, as it directly impacts profitability. It is reported on the income statement, serving as an essential component in calculating gross profit. Gross profit is derived by subtracting COGS from the total revenue, indicating how efficiently a merchandiser is managing its cost structure. Businesses are required to show expenses on the income statement based on either the nature or the function of the expense. The nature of an expense is determined by its basic characteristics (what it is).

1. 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.
2. A service organization is a business that earns revenue by providing intangible products, those that have no physical substance.
3. A gross profit percentage can be calculated to express the relationship of gross profit to sales.

These entries and discussion are covered in more advanced accounting courses. There are differing opinions as to whether sales returns and allowances should be in separate accounts. Separating the accounts would help a retailer distinguish between items that are returned and those that the customer kept. This can better identify quality control issues, track whether a customer was satisfied with their purchase, and report how many resources are spent on processing returns. Most companies choose to combine returns and allowances into one account, but from a manager’s perspective, it may be easier to have the accounts separated to make current determinations about inventory. A purchase return occurs when merchandise is returned and a full refund is issued.

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This simplified income statement demonstrates how merchandising firms account for their sales cycle or process. Sales revenue is the income generated from the sale of finished goods to consumers rather than from the manufacture of goods or provision of services. Since a merchandising firm has to purchase goods for resale, they account for this cost as cost of goods sold—what it cost them to acquire the goods that are then sold to the customer. The difference between what the drug store paid for the toothpaste and the revenue generated by selling the toothpaste to consumers is their gross profit. However, in order to generate sales revenue, merchandising firms incur expenses related to the process of operating their business and selling the merchandise. These costs are called operating expenses, and the business must deduct them from the gross profit to determine the operating profit.

Sales Returns and Allowances

LO7 – Explain and identify the entries regarding purchase and sales transactions in a periodic inventory system. For this course, only one format will be introduced — the classified multiple-step format. This format is generally used for internal reporting because of the detail it includes. An example of a classified multiple-step income statement is shown below using assumed data for XYZ Inc. for its month ended December 31, 2023. 22 Made payment, less allowance, to Teaton Wholesalers for goods purchased on March 9.

In addition to the purchase of merchandise inventory, there are other activities that affect the Merchandise Inventory account. For instance, merchandise may occasionally be returned to a https://business-accounting.net/ supplier or damaged in transit, or discounts may be earned for prompt cash payment. These transactions result in the reduction of amounts due to the supplier and the costs of inventory.

Merchandisers and the Merchandise

For example, Nike produces products that it directly sells to consumers and products that it sells to retailers. An example of a company that fits all three categories is Apple, which produces phones, sells them directly to consumers, and also provides services, such as extended warranties. They are businesses that buy products and resell them, acting as intermediaries between manufacturers and consumers. The the operating cycle of a merchandiser is merchandise they sell can encompass a wide range of products, from clothing and electronics to groceries and home goods. This essay will delve into the concept of merchandisers, the types they can be categorized into, their operating cycle, and the significance of Cost of Goods Sold (COGS). Note that the cost of the vehicle has been reduced to $2,700 ($3,000 – 300) as has the amount owing to the supplier.

Manufacturing firms are more complex organizations than merchandising firms and therefore have a larger variety of costs to control. The manufacturer incurs additional costs, such as direct labor, to convert the raw materials into furniture. Operating a physical plant where the production process takes place also generates costs. Some of these costs are tied directly to production, while others are general expenses necessary to operate the business.

Recording the sale as it occurs allows the company to align with the revenue recognition principle. The revenue recognition principle requires companies to record revenue when it is earned, and revenue is earned when a product or service has been provided. 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.

Figure 2.11 compares and contrasts the methods merchandising and manufacturing firms use to calculate the cost of goods sold in their income statement. The drug store purchases tens of thousands of tubes of toothpaste from a wholesale distributor or manufacturer in order to get a better per-tube cost. Then, they add their mark-up (or profit margin) to the toothpaste and offer it for sale to you. The drug store did not manufacture the toothpaste; instead, they are reselling a toothpaste that they purchased.

Closing Entries (Periodic)

The sales discounts account is a contra revenue account that is deducted from gross sales at the end of a period in the calculation of net sales. Sales Discounts has a normal debit balance, which offsets Sales that has a normal credit balance. Similar to credit terms between a retailer and a manufacturer, a customer could see credit terms offered by the retailer in the form of 2/10, n/30. This particular example shows that if a customer pays their account within 10 days, they will receive a 2% discount. Otherwise, they have 30 days to pay in full but do not receive a discount. If the customer does not pay within the discount window, but pays within 30 days, the retailing company records a credit to Accounts Receivable, and a debit to Cash for the full amount stated on the invoice.

The periodic system is discussed in greater detail in the appendix to this chapter. A service company provides intangible services to customers and does not have inventory. Some examples of service companies include lawyers, doctors, consultants, and accountants. Service companies often have simple financial transactions that involve taking customer deposits, billing clients after services have been provided, providing the service, and processing payments.

These activities may occur frequently within a company’s accounting cycle and make up a portion of the service company’s operating cycle. In a perpetual inventory system, a merchandiser debits Merchandise Inventory regarding the purchase of merchandise for resale from a supplier. Any purchase returns and allowances or purchase discounts are credited to Merchandise Inventory as they occur to keep the accounts up-to-date.

Whether the business is a service or a merchandising company, it tracks sales from customers, purchases from manufacturers or other suppliers, and costs that affect their everyday operations. There are some key differences between these business types in the manner and detail required for transaction recognition. At first it appears that there is no difference between the income statements of the merchandising firm and the manufacturing firm. However, the difference is in how these two types of firms account for the cost of goods sold. Merchandising firms determine their cost of goods sold by accounting for both existing inventory and new purchases, as shown in the Plum Crazy example. It is typically easy for merchandising firms to calculate their costs because they know exactly what they paid for their merchandise.

Morris Supply was running a promotion, and the customer received a \(150 award at the time of sale that can be used at a future date on any Morris Supply merchandise. Unlike merchandising firms, manufacturing firms must calculate their cost of goods sold based on how much they manufacture and how much it costs them to manufacture those goods. This requires manufacturing firms to prepare an additional statement before they can prepare their income statement.