Chapter 6 — Merchandising Operations
The module's primary reading · ~35–45 minutes · Objective 5 (account for merchandising operations and inventory: record purchases and sales in a perpetual system, compute cost of goods sold and gross profit, and apply FIFO, LIFO, and weighted-average costing and the lower of cost and net realizable value), with Objective 2 (analyze business transactions with the accounting equation and record them in a journal using double-entry bookkeeping, post them to the ledger, and prepare a trial balance) and Objective 4 (complete the accounting cycle: prepare an income statement, a statement of retained earnings, and a classified balance sheet, journalize closing entries, and prepare a post-closing trial balance) called back · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the workshop all build on it.
In plain language
Some businesses sell work, and some sell goods they bought from someone else. This week the bicycle shop starts selling bicycles, so it becomes a merchandising business (a business that buys goods and resells them). You will learn to record what the goods cost, including the freight and any discount, and to record each sale twice: once for the price and once for the cost. The difference between the two is gross profit (what the goods earned before the costs of running the shop). You will see where gross profit sits on an income statement and why it is not the same as net income.
Why you already care about this
Picture the bicycle shop's sales floor. For weeks it has been a repair shop, with work stands and a wheel-truing station. Now the founders order 10 bicycles from a supplier at $400 each, and a freight carrier trucks them in. A few days later, 6 of them leave the floor with new owners at $820 each. Did the shop make $420 on every bicycle? Not quite, and the reason is the freight, the discount, and the 4 bicycles still standing by the window.
You have seen this kind of business all your life, and you have probably bought from one this week. A campus bookstore orders textbooks before the term and sells them to students. A food truck buys bread, cheese, and peppers and sells them as lunch. In each case, someone has to answer two questions: what did the goods cost, and how much was left from each sale after that cost? This chapter gives you the accountant's way to answer both.
By the end of this chapter you will be able to:
- describe the merchandising operating cycle;
- tell a perpetual inventory system from a periodic one;
- read credit terms of 2⁄10, n⁄30 and shipping terms of FOB shipping point or FOB destination;
- record a purchase, its freight, and a payment with a purchase discount;
- record a sale with its cost of goods sold;
- compute gross profit and gross margin and place them on a multi-step income statement.
Carry this sentence with you: the price is not the profit; the cost comes off first.
Where we are
- Already covered: Week 1 set out who reads financial statements. Week 2 analyzed transactions in the accounting equation. Week 3 recorded them with debits and credits. Week 4 adjusted the books at the month's end. Week 5 prepared the statements and closed the books.
- This week: the merchandising operating cycle, perpetual and periodic systems, purchases with credit terms, discounts, and freight, sales with cost of goods sold, gross profit, and the multi-step income statement.
- How they connect: every purchase and sale is a journal entry with equal debits and credits, so Week 3's rules still run the books, and gross profit is a new line on Week 5's income statement.
- Where we're going next: this week begins the unit on merchandising and inventory, and Week 7, Inventory Costing, asks what happens when the same goods are bought at different costs.
Week 3 taught you that assets and expenses increase with debits and that liabilities and revenues increase with credits. That rule decides every entry in this chapter. Week 5 taught you to prepare the income statement first, because its net income feeds the statement of retained earnings. This week your income statement adds one new layer at the top. Keep one more idea from Week 4 close: revenue is recorded when it is earned. A bicycle sold on account is earned when it leaves the floor, even though the cash comes later.
1. Follow the merchandising operating cycle
Think about a food truck owner on a busy morning. The owner buys ingredients, turns them into sandwiches, sells them at lunch, and spends the money on tomorrow's ingredients. The money goes out as goods, comes back as sales, and goes out again. That loop is the heart of every business that sells goods.
The merchandising operating cycle (the loop a merchandiser repeats) runs like this: it buys goods, holds them as inventory (goods a business owns and holds to sell), sells them, often on account, and collects the cash, which it spends on more goods.
A service business sells work. In Month 1, the bicycle shop sold repairs: a customer paid for labor, and the shop recorded Service Revenue. A merchandising business sells goods it bought. When the shop orders bicycles to sell, it adds this second kind of selling to the same business. You will keep both kinds in the same set of books.
Inventory is an asset while the goods sit on the floor. When the goods are sold, their cost leaves the asset side and becomes an expense called Cost of Goods Sold (the cost of the goods a business sold during the period). That move, from asset to expense at the moment of sale, is the one new idea that runs through this whole chapter.
Misconception check. Students often think a merchandiser's goods are an expense the day they arrive, because the business paid for them. It is tempting, since cash went out. The cure is Week 2's rule about assets: the bicycles will bring future benefits when they are sold, so they are an asset, Inventory, until they leave the floor. Only the cost of the goods sold becomes an expense.
Pause and think (choose one). (a) Name a business near you that sells goods it bought, and describe its loop from buying to collecting.
(b) Name a business near you that sells only work, and explain what would change in its books if it started selling goods too.
2. Compare perpetual and periodic inventory systems
Picture two ways of knowing what is on your shelves. In the first, you scan every item as it comes in and as it goes out, so a screen always shows what is left. In the second, you count the shelves at the end of the week and work out what must have been sold. Both tell you the truth by the end of the week. They differ in when you know it.
- In a perpetual inventory system, the Inventory and Cost of Goods Sold accounts are updated with every purchase and every sale.
- In a periodic inventory system, cost of goods sold is found at the end of the period from a physical count.
The food truck works like a periodic system. Its owner does not record the cost of each slice of cheese as a sandwich sells. At the end of the week, the owner counts what is left in the cooler. The cost of what the truck started with, plus what it bought, minus what is left, is what it used up.
The bicycle shop tracks each bicycle, so it uses a perpetual system. Every bicycle that arrives goes into Inventory with its cost. Every bicycle that leaves takes its cost out of Inventory and into Cost of Goods Sold, at the moment of the sale. That is the system the rest of this chapter records.
Worked example — the periodic check. The shop had no bicycles before this purchase, so its beginning inventory of bicycles is $0. Section 4 shows that the 10 bicycles cost $4,100. At the end, a count finds 4 bicycles worth $1,640. A periodic system would find cost of goods sold this way:
- beginning inventory $0;
- plus the cost of the bicycles bought, $4,100;
- minus the inventory counted at the end, $1,640;
- so 0 + 4,100 − 1,640 = $2,460.
In words: a count at the end gives the same $2,460 that the perpetual system records at each sale, because both systems are measuring the same 6 bicycles.
Misconception check. Students often think the two systems give different profits. It is tempting, because they record at different times. The cure is the periodic check above: for the same goods at the same cost, both systems reach the same cost of goods sold. The perpetual system tells you sooner, and it lets you compare the books with a count to spot goods that went missing.
3. Record a purchase: credit terms and freight
When you buy something online, the checkout page tells you two things before you pay: when the money is due, and who pays for shipping. A supplier's invoice tells a business the same two things, in accounting shorthand.
The first is the credit terms, the supplier's payment terms. The bicycle supplier's terms are 2⁄10, n⁄30:
- a 2 percent discount if the invoice is paid within 10 days;
- with the full amount due within 30 days.
The second is the shipping terms, which say who owns the goods while they travel and who pays the freight carrier.
- Under FOB shipping point, the buyer owns the goods once they are shipped and pays the freight, which becomes part of the inventory's cost.
- Under FOB destination, the seller owns the goods until they arrive and pays the freight.
The campus bookstore shows the second case. It orders a box of textbooks FOB destination. The textbook supplier pays the freight carrier, so none of the freight enters the bookstore's books. The bicycle shop shows the first case. Its order is FOB shipping point, so the shop pays the freight, and the freight belongs in the cost of the bicycles. A bicycle is not ready to sell until it is on the shop's floor, and the trip there is part of what it costs.
Worked example — the purchase and the freight. The shop (illustrative, Dataset C) orders 10 bicycles at $400 each on account, terms 2⁄10, n⁄30, FOB shipping point.
- What happened: the shop received 10 bicycles and owes the supplier 10 × 400 = $4,000.
- Which accounts change: Inventory, an asset, increases; Accounts Payable, a liability, increases.
- The entry: debit Inventory 4,000; credit Accounts Payable 4,000.
- Then the freight: the terms are FOB shipping point, so the shop pays the $180 freight. Inventory increases by the freight, and Cash decreases.
- The entry: debit Inventory 180; credit Cash 180.
In words: the shop's Inventory now holds 4,000 + 180 = $4,180 of cost, because the freight to bring the bicycles home is part of what they cost, and the shop owes the supplier $4,000.
Misconception check. Students often think the freight is the seller's cost, whatever the terms say. It is tempting, because the seller is the one sending the goods. The cure is to read the terms: under FOB shipping point, the buyer owns the goods once they are shipped, so the buyer pays the freight and adds it to inventory cost. Only under FOB destination does the seller pay it.
4. Record the payment and the purchase discount
Many people have seen a sign that says "pay early, save a little." A supplier makes the same offer to a business, because it would like its cash sooner. A business that has the cash on hand can take the offer and lower what its goods cost.
A purchase discount is the reduction a buyer earns by paying a supplier within the discount period. In a perpetual system, it lowers the cost recorded in Inventory.
Worked example — paying within 10 days. The shop pays the supplier within the 10-day discount period.
- What happened: the shop settles the full $4,000 it owes. The discount is 2 percent of $4,000, or 4,000 × 0.02 = $80, so the shop pays 4,000 − 80 = $3,920 in cash.
- Which accounts change: Accounts Payable, a liability, decreases by the full $4,000; Cash decreases by $3,920; Inventory decreases by the $80 discount, because the bicycles cost $80 less than the invoice said.
- The entry: debit Accounts Payable 4,000; credit Inventory 80; credit Cash 3,920.
- The balance check: the debit of 4,000 equals the credits of 80 + 3,920 = 4,000.
Now total the cost of the bicycles: 4,000 + 180 − 80 = $4,100 for 10 bicycles, so 4,100 ÷ 10 = $410 each. In words: each bicycle cost the shop $410, freight in and discount out, and that is the figure that will leave Inventory when a bicycle is sold.
If the shop had waited and paid on the 30th day, it would have owed the full $4,000, and the bicycles would have kept the freight but lost the discount. The terms reward the early payer; they do not change what the bicycles are.
Here are the purchase entries in journal form, each with its debits first and its credits indented below them.
| Step | Account | Debit | Credit |
|---|---|---|---|
| Purchase | Inventory | 4,000 | |
| Accounts Payable | 4,000 | ||
| 10 bicycles at $400 each on account, terms 2⁄10, n⁄30, FOB shipping point. | |||
| Freight | Inventory | 180 | |
| Cash | 180 | ||
| The shop pays the freight under FOB shipping point. | |||
| Payment | Accounts Payable | 4,000 | |
| Inventory | 80 | ||
| Cash | 3,920 | ||
| Paid within 10 days, less the 2 percent discount. |
One more contrast shows how much the shipping terms matter. Had the terms been FOB destination, the supplier would have paid the freight, and the 10 bicycles would have cost 4,000 − 80 = $3,920.
Misconception check. Students often think a purchase discount is revenue, because the shop "made" $80 by paying early. It is tempting, since the shop ends up $80 better off. The cure is to ask what the shop sold. It sold nothing to the supplier. It paid less for its bicycles, so the $80 lowers the cost in Inventory. Revenue comes only from the shop's own customers.
Honesty note: some businesses record discounts in a separate account, and a periodic system uses its own purchase accounts. This course records the perpetual entries above, where the discount lowers Inventory directly.
5. Record a sale and its cost of goods sold
When a store sells you a bicycle, two things happen at the same moment. You agree to pay the price, and the store gives up the bicycle. The books record both, so a sale in a perpetual system takes two entries.
Worked example — the sale of 6 bicycles. The shop sells 6 bicycles at $820 each on account.
- The revenue entry. What happened: the customers owe the shop 6 × 820 = $4,920. Which accounts change: Accounts Receivable, an asset, increases; Sales Revenue, a revenue, increases. Debit Accounts Receivable 4,920; credit Sales Revenue 4,920.
- The cost entry. What happened: 6 bicycles left the floor at $410 each, so 6 × $410 = $2,460 of cost leaves Inventory. Which accounts change: Cost of Goods Sold, an expense, increases; Inventory, an asset, decreases. Debit Cost of Goods Sold 2,460; credit Inventory 2,460.
Here are the two sale entries in journal form.
| Entry | Account | Debit | Credit |
|---|---|---|---|
| Revenue | Accounts Receivable | 4,920 | |
| Sales Revenue | 4,920 | ||
| 6 bicycles sold at $820 each on account. | |||
| Cost | Cost of Goods Sold | 2,460 | |
| Inventory | 2,460 | ||
| The cost of the 6 bicycles sold, at $410 each. |
Now look at what is left, as you would if you walked the shop's floor yourself. The 4 bicycles still on the floor stay in Inventory at $410 each, or 4 × 410 = $1,640. The Inventory account agrees: 4,000 + 180 − 80 − 2,460 = $1,640. In words: the shop's books show $1,640 of bicycles ready to sell, which matches the 4 bicycles by the window.
| Step | Debit | Credit | Balance |
|---|---|---|---|
| Purchase of 10 bicycles | 4,000 | 4,000 | |
| Freight under FOB shipping point | 180 | 4,180 | |
| Purchase discount | 80 | 4,100 | |
| Cost of 6 bicycles sold | 2,460 | 1,640 |
Misconception check. Students often think cost of goods sold is the cost of everything the business bought. It is tempting, because the shop paid for 10 bicycles. The cure is in the name: cost of goods sold. Only the 6 bicycles that left the floor are an expense this period. The cost of the other 4, $1,640, stays an asset until they sell.
Sometimes a customer brings goods back, or keeps them at a lower agreed price because of a scratch. You meet these only in words this week. Sales returns and allowances are reductions of sales revenue when a customer sends goods back or keeps them at a lower agreed price. The seller records them in a contra revenue account, which reduces Sales Revenue the way Week 3's contra accounts reduce the account they sit beside. For a return, the seller also moves the goods' cost back from Cost of Goods Sold to Inventory, because the goods are back on its floor.
6. Compute gross profit and build a multi-step income statement
Imagine you sold a used bike for $100 that you had bought for $60. You would say you made $40 on the bike. You would not say you made $40 for the month, because you also paid for the bus, your phone, and the ad you posted. Accountants keep those two ideas apart, and they give the first one its own name.
Gross profit is sales revenue minus cost of goods sold. Gross margin is gross profit divided by sales revenue, written as a percentage: the share of each sales dollar left after the cost of the goods sold.
Worked example — the shop's gross profit. You take the two totals from Section 5, the sales and the cost of the 6 bicycles sold.
- Gross profit: 4,920 − 2,460 = $2,460.
- Gross margin: 2,460 ÷ 4,920 = 0.50, or 50 percent.
In words: the shop paid $4,100 for 10 bicycles, freight in and discount out, and sold 6 of them for $4,920. It earned a gross profit of $2,460, half of every sales dollar, before any of the costs of running the shop. Put as a comparison, sales of $4,920 versus a gross profit of $2,460 is 2 times as large, so the founders keep $1 of every $2 of bicycle sales to cover wages, rent, and everything else.
A multi-step income statement shows gross profit, then operating income, then other revenues and expenses, before net income, so a reader can see each layer of earnings. A single-step income statement groups all revenues together and all expenses together and subtracts one total from the other. Week 5's Month 1 income statement was single-step: one revenue, one list of expenses, one net income. A merchandiser usually shows the steps, because readers want to know what the goods earned on their own.
Here is the top of the shop's multi-step income statement, the part Dataset C fills in. Read it from the top down, the way your lender or your investor would.
| The bicycle shop — Income Statement (top section) — For the period of the bicycle sale | |
|---|---|
| Sales Revenue | $4,920 |
| Less: Cost of Goods Sold | (2,460) |
| Gross profit | $2,460 |
Below gross profit, a full multi-step statement keeps going in this order:
- Operating expenses — the costs of running the business, such as wages, rent, and supplies, are subtracted from gross profit.
- Operating income — gross profit minus operating expenses: what the business earned from its main operations.
- Other revenues and expenses — items outside the main operations, such as interest, are added or subtracted.
- Net income — the bottom line, which flows to the statement of retained earnings as it did in Week 5.
Caveat: Dataset C covers only the bicycle purchase and sale, so it does not give the shop's wages or rent for that period. So the steps below gross profit are shown here by name only, and the worked example stops at gross profit.
Misconception check. Students often read gross profit as net income, because "profit" is in both names. It is tempting, since gross profit is the first total on the statement. The cure is to read the layers in order. The shop's $2,460 gross profit still has to pay the mechanic, the rent, and every other operating expense before any of it is net income.
Pause and think (choose one). (a) Imagine you are a lender reading the shop's statement. Explain which line, gross profit or net income, you would read first, and why. (b) Imagine you are one of the founders. Explain what a gross margin of 50 percent tells you about the price you set for each bicycle.
Key terms
- Merchandising operating cycle — The loop a merchandising business repeats: it buys goods, holds them as inventory, sells them, often on account, and collects the cash, which it spends on more goods. (first used: 1. Follow the merchandising operating cycle)
- Inventory — Goods a business owns and holds to sell to its customers; an asset until the goods are sold. (first used: 1. Follow the merchandising operating cycle)
- Cost of Goods Sold — The expense account for the cost of the goods a business sold during the period, not every good it bought. (first used: 1. Follow the merchandising operating cycle)
- Perpetual inventory system — A way of tracking inventory in which the Inventory and Cost of Goods Sold accounts are updated with every purchase and every sale. (first used: 2. Compare perpetual and periodic inventory systems)
- Periodic inventory system — A way of tracking inventory in which cost of goods sold is found at the end of the period from a physical count. (first used: 2. Compare perpetual and periodic inventory systems)
- Credit terms — The supplier's payment terms; 2⁄10, n⁄30 offers a 2 percent discount if the invoice is paid within 10 days, with the full amount due within 30 days. (first used: 3. Record a purchase: credit terms and freight)
- FOB shipping point — Shipping terms under which the buyer owns the goods once they are shipped and pays the freight, which becomes part of its inventory cost. (first used: 3. Record a purchase: credit terms and freight)
- FOB destination — Shipping terms under which the seller owns the goods until they arrive and pays the freight. (first used: 3. Record a purchase: credit terms and freight)
- Purchase discount — The reduction a buyer earns by paying a supplier within the discount period; in a perpetual system it lowers Inventory, and it is not revenue. (first used: 4. Record the payment and the purchase discount)
- Sales Revenue — The revenue account for the selling price of the goods a merchandising business sells to its customers. (first used: 5. Record a sale and its cost of goods sold)
- Sales returns and allowances — Reductions of sales revenue when a customer sends goods back or keeps them at a lower agreed price, recorded in a contra revenue account. (first used: 5. Record a sale and its cost of goods sold)
- Gross profit — Sales revenue minus cost of goods sold; it is not net income. (first used: 6. Compute gross profit and build a multi-step income statement)
- Gross margin — Gross profit divided by sales revenue, written as a percentage. (first used: 6. Compute gross profit and build a multi-step income statement)
- Multi-step income statement — An income statement that shows gross profit, then operating income, then other revenues and expenses, before net income. (first used: 6. Compute gross profit and build a multi-step income statement)
- Single-step income statement — An income statement that groups all revenues together and all expenses together and subtracts one total from the other. (first used: 6. Compute gross profit and build a multi-step income statement)
- Operating income — Gross profit minus operating expenses such as wages and rent. (first used: 6. Compute gross profit and build a multi-step income statement)
Summary
- A merchandiser buys goods, holds them as inventory, sells them, and collects the cash.
- Perpetual updates Inventory at every sale; periodic finds cost of goods sold from a count.
- 2⁄10, n⁄30: 2 percent off within 10 days, full amount within 30.
- FOB shipping point: the buyer pays the freight, and it joins inventory cost.
- A purchase discount lowers Inventory; it is not revenue.
- A sale takes two entries: the price to Sales Revenue, the cost to Cost of Goods Sold.
- Gross profit is sales minus cost of goods sold; the shop's is $2,460, a 50 percent margin.
- A multi-step statement runs gross profit, operating income, other items, net income.
Check your understanding
Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.
- A campus bookstore (illustrative) orders $2,500 of textbooks on account, terms 2⁄10, n⁄30, FOB destination, and pays within 10 days. Compute the discount and the cash paid, say who pays the freight, and give the textbooks' cost in Inventory.
- A food truck (illustrative) uses a periodic system. It starts a week with $300 of ingredients, buys $1,150 more, and counts $250 left at the end. Compute the week's cost of goods sold.
- A farmers' market stall (illustrative) uses a perpetual system. It sells 20 jars of honey at $10 each for cash, and each jar cost it $6. Write the two sale entries, then compute gross profit and gross margin.
- A phone-case kiosk (illustrative) reports gross profit of $9,000 for a month and operating expenses of $6,500. A friend says the kiosk earned $9,000. Explain what is wrong with that reading, and compute operating income.
Answers (worked reasoning — read after attempting)
- The discount is 2,500 × 0.02 = $50, so the bookstore pays 2,500 − 50 = $2,450. Under FOB destination, the supplier pays the freight, so no freight enters the bookstore's books. The textbooks cost $2,450 in Inventory. In words: paying early lowered the cost, and the shipping terms kept the freight on the supplier's side.
- Cost of goods sold is 300 + 1,150 − 250 = $1,200. In words: the truck started with $300 of ingredients and bought $1,150 more, so $1,450 was available, and since $250 is still in the cooler, $1,200 was used up in the meals it sold.
- The revenue entry: debit Cash 200; credit Sales Revenue 200, because 20 × 10 = $200. The cost entry: debit Cost of Goods Sold 120; credit Inventory 120, because 20 × 6 = $120. Gross profit is 200 − 120 = $80, and gross margin is 80 ÷ 200 = 0.40, or 40 percent. In words: the stall keeps 40 cents of each sales dollar after the cost of the honey.
- Gross profit is not net income. The kiosk still had to pay $6,500 of operating expenses, so operating income is 9,000 − 6,500 = $2,500, and other revenues and expenses could still move net income. This is the gross-profit-as-net-income trap: the first total on a multi-step statement is not the last one.
Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment; next week each inventory costing method, FIFO, LIFO, or weighted average, decides which costs leave Inventory first.
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