modMerchandising Operations, Inventory & Income Statements

Types of Business Entities

• Service Firms
  • Largest sector of U.S. economy.
  • Provide only services; carry little or no inventory.
  • Dominant expense: Salaries & Benefits.
  • Examples: consulting, law, medical, ride-sharing, hair salons, etc.
• Merchandising Firms
  • Buy finished goods and resell them.
  • Two sub-types:
  • Wholesalers (B2B) → sell to other businesses.
  • Retailers (B2C) → sell to final consumers.
  • Single inventory account: Merchandise Inventory / Finished Goods / Inventory.
  • Largest expense: Cost of Goods Sold (COGS).
  • Everyday examples: Walmart, Target, local hardware store, online boutiques.
• Manufacturing Firms
  • Use labor, plant & equipment to convert raw materials → finished goods.
  • Sell mostly to wholesalers/retailers; sometimes to consumers via outlet stores.
  • Largest expense often COGS.
  • Three separate inventory accounts:
  • Raw Materials (RM)
  • Work in Process (WIP)
  • Finished Goods (FG)
  • Examples: Ford, Apple (assembly plants), toy factories, steel mills.

Key Accounts in Merchandising

• Merchandise Inventory (current asset, Balance Sheet).
• Sales Revenue (Sales) (revenue account, Income Statement).
  • Service firms earn Service Revenue; merchandisers earn Sales Revenue.
• Cost of Goods Sold (COGS / Cost of Sales) (expense account, Income Statement).
  • Measures $\text{cost of the goods that have been sold}$.

Operating Cycle Concepts

• Definition: Time it takes to turn cash → inventory/service → accounts receivable → cash.
• Service Firm Cycle
  • Cash paid for salaries & supplies → perform service → A/R created → cash collected.
  • Usually many cycles inside a year ⇒ normal one-year cut-off for current assets/liabilities.
• Merchandising Firm Cycle
  • Cash → purchase inventory → sell inventory on account → collect A/R → cash.
  • Typically longer than service cycle but still < 1 year.
• GAAP rule of thumb: “Current” means 1 year OR 1 operating cycle, whichever is longer.

Inventory Tracking Systems

• Periodic Method
  • No continuous records of quantity or cost.
  • Need physical count to know ending inventory & COGS.
  • Common in small businesses without point-of-sale (POS) tech.
  • Price tags applied with guns; receipt only shows units × price.
• Perpetual Method
  • Real-time tracking with barcodes & POS terminals.
  • Automatically updates inventory records at each purchase/sale.
  • Dominant system in modern retail & warehousing.
• Importance: Accounting entries differ between methods (detailed later).

Price vs Cost – Two Separate Numbers

• Price = what the company sells inventory for.
• Cost = what the company paid to acquire inventory.
• Both amounts must be tracked:
  • Revenue entry uses price.
  • Expense entry (COGS) uses cost.

Journal Entries for a Basic Purchase & Sale (Perpetual)

• Purchase of inventory on account for $\$8{,}000$
  • Debit Merchandise Inventory $8{,}000$
  • Credit Accounts Payable $8{,}000$
• Sale of that inventory for $\$20{,}000$ (on account)
  1. Record revenue (price)
  • Debit Accounts Receivable $20{,}000$
  • Credit Sales Revenue $20{,}000$
  1. Record expense (cost)
  • Debit COGS $8{,}000$
  • Credit Merchandise Inventory $8{,}000$
• Rationale: Matching Principle – match revenues with related expenses to avoid overstating income.

Income Statement Formats

Single-Step Income Statement

• All revenues (and gains) are totaled.
• All expenses (and losses) are totaled.
• $\text{Net Income}=\text{Total Revenue}-\text{Total Expenses}$
• Simple & common for service firms.
• Columns in report are presentation columns, not debit/credit.

Multi-Step Income Statement

• Adds informative subtotals & separates operating vs non-operating items.
• Key layers:
  1. Net Sales Revenue
  • $\text{Net Sales}=\text{Sales Revenue}-\text{Sales Returns\,Allowances}-\text{Sales Discounts}$
  1. Gross Profit
  • $\text{Gross Profit}=\text{Net Sales}-\text{COGS}$
  1. Operating Expenses → Operating Income (a.k.a. Income from Operations, EBIT).
  • $\text{Operating Income}=\text{Gross Profit}-\text{Operating Expenses}$
  1. Other / Non-Operating revenues & expenses (interest, one-time gains/losses).
  • Produces Income Before Taxes.
  1. Income Tax Expense → Net Income.
• Provides higher predictive value for investors; highlights recurring earnings.
• Scenario illustration: company shows $80{,}000$ net income, yet only $45{,}000$ is from operations; remaining $35{,}000$ due to one-time gain.

Physical Inventory Count – Special Issues

• Goods in Transit
  • FOB Shipping Point → buyer owns as soon as shipped.
  • FOB Destination → seller owns until buyer receives.
• Consignment Goods
  • Owned by consignor, held & sold by consignee.
  • Remain in consignor’s inventory until sold.
• Damaged or Obsolete Goods
  • Excluded unless they can still be sold.
  • If salable, valued at Net Realizable Value (NRV) = expected cash to be collected.

Valuing Inventory: Quantity × Cost

• Total inventory value $=\text{Units on Hand}\times\text{Assigned Cost per Unit}$.
• Quantity determined by physical count; cost determined by one of four costing methods.

Inventory Costing Methods

1. Specific Identification (Specific Unit Cost)

• Tracks exact cost of each unique item sold & on hand.
• Ideal for low-volume, high-unit-value, easily identifiable items (cars, jewelry, real estate).

2. FIFO – First-In, First-Out

• Assumption: oldest costs → COGS; newest costs → Ending Inventory.
• Often mirrors physical flow of perishables.
• During rising prices:
  • Lowest COGS, Highest Gross Profit, Net Income, Ending Inventory.

3. LIFO – Last-In, First-Out

• Newest costs → COGS; oldest costs → Ending Inventory.
• Rarely mirrors physical flow but allowed for tax/reporting (U.S. GAAP).
• During rising prices:
  • Highest COGS, Lowest Gross & Net Income, Tax advantage (lower taxable income).

4. Average Cost (Weighted or Moving Average)

• $\text{Average Cost per Unit}=\dfrac{\text{Total Cost of Goods Available}}{\text{Total Units Available}}$
• Same cost applied to both COGS & Ending Inventory.
• Results fall between FIFO & LIFO.

Selecting a Method – Comparative Impacts (Rising-Price Environment)

• FIFO: maximize reported profits & assets.
• LIFO: minimize taxes, improve cash flow.
• Average: middle-ground, smoother earnings.
• Consistency Principle: once chosen, stick with method unless justified change; aids comparability.

Worked Examples (Condensed)

A. Specific Identification (Perpetual)

• Data snapshot:
  • Beg Inv 200 @ $10$; Purchase 300 @ $20$; …
• Sale March 10: 400 units, sales $20{,}000$, COGS $7{,}000$ (100×10 + 300×20).
• Sale March 25: 300 units, sales $15{,}000$, COGS $8{,}000$.
• Ending Inv: 400 units, $12{,}000$.
• Perpetual record maintains running balances after each entry.

B. Moving Average (Perpetual)

• Compute new average after each purchase.
• After Beg Inv + March 4 purchase → Avg $16$.
• Sale March 10: COGS $6{,}400$ (400×16); Inv left 100 units @$16$.
• Re-average after March 20 purchase → Avg ≈$27.67$.
• Sale March 25: COGS ≈$8{,}300$.
• Ending Inv: 400 units, $12{,}300$ (300 @27.67 + 100@40).

C. FIFO (Periodic)

• All 1,100 units & $27{,}000$ available for sale.
• Units sold: 700 → assumed oldest 700.
  • 200 (Beg) + 300 (Mar 4) + 200 (Mar 20) = 700
  • COGS = $2{,}000 + 6{,}000 + 6{,}000 = 14{,}000$
• Ending Inv: 400 units (300 from March 20 @30 + 100 from March 30 @40) = $13{,}000$.
• Cost-of-goods-sold model:
  $\text{COGS}=\text{Beg Inv}+\text{Purchases}-\text{End Inv}$
  $=27{,}000-13{,}000=14{,}000$ (checks).

Ethical, Philosophical & Practical Implications

• Choice of inventory method can manipulate reported profits without changing cash flows → ethical responsibility to disclose & be consistent.
• LIFO conformity rule (U.S.): LIFO for tax ⇒ LIFO for financials; deters opportunistic switching.
• Inventory overstatement (e.g., ignoring obsolete goods) inflates assets & gross profit, misleading investors; can breach Sarbanes-Oxley internal-control requirements.
• Accurate operating cycle assessment helps liquidity planning & credit negotiations.

Connections & Real-World Relevance

• Operating cycle length influences working-capital management & current-ratio analysis.
• Retail analytics rely on perpetual data for just-in-time (JIT) restocking.
• Multi-step statement subtotals (gross profit %, operating margin) often featured in analyst reports & valuation models.
• Inventory methods interplay with tax legislation (e.g., potential repeal of LIFO) – corporate lobbying importance.