COMM 201 Chapter 6 Seminotes

Chapter 6: Operating Cycle of Merchandisers

Operating Cycle Overview

• The operating cycle is the series of activities a company undertakes to generate revenue leading to cash inflow.

• Key accounts for merchandisers include:

  • Inventory: Total cost of acquiring unsold goods.

  • Sales Revenue: Total price received for goods sold.

  • Cost of Goods Sold (COGS): Total cost associated with the goods sold during a period.

• Gross profit is calculated as:

  • Gross Profit = Sales Revenue - Cost of Goods Sold

  • Indicates earnings before other expenses (e.g., salaries, depreciation).

Inventory Management

• Goods available for sale can either be sold (reflected in COGS) or retained in inventory (ending inventory).

• The ending inventory for one period becomes the beginning inventory for the next.

• Inventory equation:

  • Beginning Inventory (BI) + Purchases (P) - Ending Inventory (EI) = Cost of Goods Sold (CGS)

  • BI + P - CGS = EI

• Merchandisers can use either:

  • Periodic Inventory System: Updates inventory only at the end of the period.

  • Perpetual Inventory System: Continuously updates inventory with each transaction.

Inventory Systems

• Perpetual Inventory System:

  • Updates in real-time for each purchase/sale/return.

  • Commonly used by large retailers; allows for accurate inventory counts and shrinkage estimates.

  • Shrinkage = Recorded Inventory - Counted Inventory

• Periodic Inventory System:

  • Updates inventory records at the end of the accounting period.

  • Ending inventory is physically counted and used to calculate COGS.

Transportation Costs

• FOB Shipping Point: Sale recorded when goods leave the seller's location.

• FOB Destination: Sale recorded when goods reach the buyer.

• Transportation costs affect the supplier's expenses based on the sale terms (FOB Shipping vs. Destination).

Sales Transactions Components

• Merchandise sales consist of:

  • Selling Price: Amount charged to the customer.

  • Cost: Purchase cost for the merchandiser.

• Transactions in a perpetual system require entries for both sales price and COGS.

Sales Returns and Allowances

• Customers may:

  • Return damaged goods for a refund.

  • Request a cost reduction (allowance) without returning goods.

• Sales returns and allowances are recorded by reducing both the sales revenue and the cost of inventory (with slight variances based on returns/allowances).

• Contra-account method tracks goods returned without directly reducing sales.

Gross Profit Analysis

• Gross Profit Percentage: Measures the profitability of sales independent of operating costs.

  • Higher percentage indicates a larger markup over cost.

• Useful for:

  • Tracking operational changes over time.

  • Comparing companies within the same industry.

  • Ensuring sufficient revenue covers operating expenses.

Purchase Discounts

• Terms of sale may include discounts, like 2/10, n/30:

  • Means a 2% discount if paid within 10 days; full amount due in 30 days if not.

• Sales discounts are accounted for either at the point of sale (net method) or upon receipt of payment (gross method).

Steps for Revenue Recognition

1. Identify the contract.

2. Identify performance obligations (e.g., providing goods/services).

3. Determine the transaction price for the contract.

4. Allocate price to performance obligations based on standalone prices.

5. Recognize revenue when each obligation is satisfied.

Key Merchandising Transactions (Example: Home Depot)

1. Acquisition of inventory on credit.

2. Sale of merchandise to consumers.

3. Recording payments received (cash or credit).

• Critical success factors include:

  • Generating sufficient gross profit.

  • Ensuring sales revenue exceeds COGS and that inflows exceed outflows.

Accounting for Inventory Issues

• Issue #1: Record inventory at acquisition cost and be ready for sale.

• Issue #2: Sales revenue computation considers returns/allowances/discounts to derive net sales and gross profit.

Journal Entries and Multi-Step Income Statement

• Example Transactions involve:

  • Purchase on account, return of damaged goods, and allowances.

• Multi-Step Income Statement provides a detailed breakdown leading to net income:

  1. Sales revenue

  2. Less: Sales returns and allowances

  3. Less: Sales discounts

  4. Net sales

  5. Less: Cost of Goods Sold

  6. Gross Profit

  7. Operating Expenses

  8. Net Income

Evaluating Profitability

• Gross profit percentage informs about the operational efficiency of a company.