| LO1 - Describe merchandizing and explain the financial statement components of sales, cost of goods sold, merchandize inventory, and gross profit; differentiate between the perpetual and periodic inventory systems. |
A merchandizing company, or merchandizer, differs in several basic ways from a company that provides services. First, a merchandizer purchases and then sells goods whereas a service company sells services. For example, a car dealership is a merchandizer that sells cars while an airline is a service company that sells air travel. Because merchandizing involves the purchase and then the resale of goods, an expense called cost of goods sold results. Cost of goods sold is the purchase price of items that are then re-sold to customers. For example, the cost of goods sold for a car dealership would be the cost of the cars purchased from the manufacturer. A service company does not have an expense called cost of goods sold since it does not sell physical items. As a result, the income statement for a merchandizer includes different details. A merchandizing income statement highlights cost of goods sold by showing the difference between sales revenue and cost of goods sold, which is called gross profit or grossmargin. The basic income statement differences between a service business and a merchandizer are illustrated in Figure 5.1.
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 $2,000 and then sells it for $3,000, the gross profit would be $1,000, as follows:
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 33.3% gross profit percentage ($1,000/3,000). That is, for every $1 of sales, the company has $.33 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 merchandizer relates to the balance sheet. Since a merchandizer purchases goods for resale, goods held for resale by a merchandizer are called merchandize inventory and are reported as an asset on the balance sheet. A service company would not normally have merchandize inventory.
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