Notes

Learn about merchandising companies. Understand what a merchandising company is, learn what a retail company is, and identify how their income statements work.
Merchandising Company Defined
Kayleigh and Lilly are both business owners. Kayleigh is the owner of Gifts Galore, a unique little gift shop that sells directly to the public. Lilly is the owner of Lilliana's Warehouse, a company that only sells its merchandise to business owners. Kayleigh orders a good bit of the merchandise she sells in her shop from Lilly.

Both of these businesses are merchandising companies. Do you know what I mean when I use the term merchandising company? A merchandising company is a company that buys goods and then resells them, generally for a higher price than they were purchased. There are two types of merchandising companies - retail and wholesale. A retail company is a company that sells products directly to customers, where a wholesale company is a company that buys items in bulk from manufacturers and resells them to retailers or other wholesalers.

Now that you know what retailers and wholesalers are, can you distinguish between Kayleigh and Lilly's businesses? Since Kayleigh sells directly to the public, she owns a retail shop. Lilly doesn't sell her merchandise to the general public. She only sells to businesses. That makes her the owner of a wholesale company.

Merchandising Activities
Regardless of whether a company is a retail or wholesale company, there are a few activities that are common among the two - purchasing, selling, and the operating cycle. Purchasing means that you buy a good from someone in exchange for cash. It depends on how big or small a company is as to how complex the purchasing system is.

For Kayleigh, who is a small business owner, purchasing is simple. She decides what items she wants to sell in her store, places the order, receives the order, verifies the order, and then places items in inventory.

It's a little different for Lilly. Her warehouse acts as a supplier to a number of different retail stores, so it is a much bigger company than Kayleigh's. Because of the importance of keeping items in stock for her customers, Lilly has created a department that is solely in charge of purchasing. Her purchasing manager, Jill, decides on the items that need to be purchased and fills out a purchase requisition for the items. She turns that requisition over to Lilly, who then approves or denies the requisition. Upon approval, Jill orders the merchandise and makes sure that upon receipt everything is as ordered.

Selling is pretty simple. It simply means that someone buys a good from you in exchange for cash.

One more concept that is common among both retail and wholesale companies is the operating cycle. The operating cycle for a product is the amount of time that exists between the purchase of the item and the sale of the same item.

If Kayleigh buys an item today and sells it in 2 weeks, then the operating cycle for that item is 2 weeks.

Inventory Systems and Reporting
All merchandising companies have to have some type of system to keep up with their inventory. They have two options to choose from: a perpetual system or a periodic system. A perpetual system is a system that updates inventory as each sale is made, while a periodic system is a system that updates inventory at a specific point in time. The common time frame for updating a periodic system is once a quarter. Perpetual systems are ideal because they give you actual inventory counts at any given point and time, but they usually have a very expensive initial cost to implement. Periodic systems are much less expensive to implement but lack the capability of giving you an up-to-date inventory count at any given time.

Since Kayleigh's company is a small company, what inventory system do you think she should use? If you guessed periodic, you're correct. Why? Well, for two reasons. First of all, her company is small enough that she doesn't have to keep a large inventory of items in stock. She can count her inventory with no problem and would not benefit from the expense of installing a perpetual inventory system.

Lilly, on the other hand, has a much bigger operation than Kayleigh. She has a massive inventory that must be maintained for the benefit of her business associates. She would benefit from the perpetual inventory system. Why? Because of the high volume of inventory she must keep and the large amount of purchases and sells that occur in her company, there is a need for up-to-date inventory counts. It would be a wise investment for Lilly to implement the perpetual inventory system.

Reporting Inventory
Since inventory is something that a business owns, it is considered an asset and reported as such on the balance sheet. The dollar value that corresponds to the inventory account depends on the valuation method that's used. One method commonly used is called FIFO, which is short for First In, First Out. In this type of valuation, you assume that the first items that are added to inventory are the first ones sold. Another method is the LIFO method. In this method, the assumption is that the last items added to inventory are the first items sold.

So, let's calculate the value of one inventory item at Lilly's warehouse at the end of the accounting period based on the following information:

There were 100 framed prints purchased for inventory during this accounting period. Their purchase dates and prices were:

On April 10, 2014, Lilly purchased 15 framed prints at $4.49 each.

On April 22nd, she purchased 10 more framed prints at $3.99 each.

On May 13th, she purchased 30 more at $3.09 each.

On May 26th, Lilly purchased 20 more framed prints at $3.59 each.

On June 19th, she purchased 25 more at $3.30 each.

A total of 85 prints were sold during this time period. Using the FIFO method, what is the value of the prints still left in stock? To calculate this, we assume that the first 85 were already sold, so that would leave 15 prints in stock from the June 19th purchase date. Since they were purchased at $3.30 each, then the inventory value that would be recorded for the prints is $49.50.

But what would be the value if the LIFO method was used? In this instance, you assume that the last prints added to inventory were the first ones sold. Taking into account that 85 were sold, that would leave the original 15 prints in inventory from the April 10th purchase date. They were purchased for $4.49 each, which would make the inventory value to be recorded in the accounting records $67.35.

Reporting Income
Now that you know what types of activities are involved in merchandising, as well as the need to implement an inventory system, let's get to the grass roots of what any business is all about - money. Now, here is the question of the hour: How is income reported for a merchandising company? The first thing that I can tell you when answering this question is that the amount of money that is collected from a sale is not the amount of money reported in the financial statements as income. There is a specific formula that has to be used to figure out how much money a company actually made during an accounting period. That formula is Sales - Cost of Goods Sold - Expenses = Net Income.

You already know what sales are. Expenses are quite simply the costs associated with running a business. So, now let's talk about the elephant in the room - cost of goods sold. The cost of goods sold is the cost of the merchandise that was sold to customers during a given time period. There is also a formula that is needed to calculate the cost of goods sold. It's Beginning Merchandise Inventory + New Purchases of Inventory - Ending Merchandise Inventory = Cost of Goods Sold.

I know that is a pretty good bit of information to absorb, isn't it? Thank goodness we have examples that can help all this sink in. So, let's figure out the amount of income that will be reported on the income statement from Kayleigh's company.

For the quarter ending June 30, 2014, Gifts Galore had the following:

Sales were $38,000.00.

Beginning Merchandise Inventory was $8,200.00.

Inventory Purchases were $13,169.00.

Ending Merchandise Inventory was $10,279.00.

Expenses were $17,955.00.

What's the cost of goods sold and the net income for Gifts Galore during this accounting period? Since we need the cost of goods sold to calculate the net income, we will figure it first.

COGS = Beginning Merchandise Inventory + Inventory Purchases - Ending Merchandise Inventory

COGS = $8200.00 + $13,169.00 - $10,279.00 = $11,090.00

So, the cost of the goods that were sold during this accounting period totaled $11,090.00.

Now we can calculate the net income that the company had for this quarter.

Net Income = Sales - Cost of Goods Sold - Expenses

Net Income = $38,000.00 - $11,090.00 - $17,955.00

Net Income = $8,955.00

Lesson Summary
When it comes to merchandising companies, there is a lot to learn.

First of all, there are two types of merchandising companies: retail and wholesale. A retail company is a company that sells products directly to customers. A wholesale company is a company that buys items in bulk from manufacturers and resells them to retailers or other wholesalers.

In order for a merchandising company to operate, there are certain activities that must take place. The first thing that has to be done is purchasing. Purchasing means that you buy a good from someone in exchange for cash. The next activity is selling. Selling means that someone buys a good from you in exchange for cash. The amount of time that exists between the purchase of the item and the sale of the same item is called the operating cycle.

Keeping up with the amount of inventory requires that the merchandising company implement an inventory system. There are two systems that a company has to choose from: periodic or perpetual. A perpetual system is a system that updates inventory as each sale is made, while a periodic system is a system that updates inventory at a specific point in time.

Along with deciding what type of system to use to keep up with the amount of inventory that a company has, the decision also has to be made on how to value that inventory. One method commonly used is called FIFO, which is short for First In, First Out. In this type of valuation, you assume that the first items that are added to inventory are the first ones sold. Another method is the LIFO method, short for Last In, First Out. In this method, the assumption is that the last items added to inventory are the first items sold.

All of these specific activities have to be in place in the merchandising company before the company can report income. The amount of income that is reported in the financial statements is not given by the click of a mouse but must be calculated. The formula to calculate net income is Sales - Cost of Goods Sold - Expenses = Net Income. Sales and expenses are generally already known; however, the cost of goods sold must be calculated. The cost of goods sold is the cost of the merchandise that was sold to customers during a given time period. The formula to calculate this is Beginning Merchandise Inventory + New Purchases of Inventory - Ending Merchandise Inventory = Cost of Goods Sold. Once the cost of goods sold is calculated, that number is substituted into the net income equation, and the calculation can be made to determine the amount of money made or lost in the given accounting period.

As you can see, merchandising companies, though simply seen as someplace to buy things from a customer's point of view, are really rather complex.