Lecture: Merchandising Operations
Lecture script · about 15–20 minutes spoken · Week 6
Opening
Picture three places that sell things they did not make. A bicycle shop rolls 10 new bicycles onto its floor. A campus bookstore stacks boxes of textbooks before the term's first rush. A food truck loads its cooler with bread, cheese, and peppers before lunch. Each of them paid for goods first and hopes to sell them for more. Each owner wants the same two answers: what did my goods really cost, and how much is left from each sale after that cost?
Let me remind you where we are. In Week 2 you walked the shop's transactions through the accounting equation. In Week 3 you recorded them with debits and credits. In Week 4 you adjusted the books at the month's end, and in Week 5 you prepared the statements and closed the books. So far the shop has sold one thing, its repair work. In this lecture it starts selling goods, and that adds a new asset to watch and a new expense to record.
Here's the plan. We'll follow the loop a merchandiser repeats. We'll compare two ways of tracking what's on the shelves. Then we'll record the shop's purchase of bicycles, its freight, and its early payment. We'll record the sale, and we'll finish by finding gross profit and placing it on the income statement. Next week, in Inventory Costing, you'll see what happens when the same goods are bought at different costs.
1. The merchandising operating cycle
Start with the food truck. In the morning, the owner buys ingredients. By noon, those ingredients are sandwiches. By two o'clock they've been sold, and the cash in the box pays for tomorrow's ingredients. Money goes out as goods, comes back as sales, and goes out again. That loop is the whole business.
Accountants give the loop a name. The merchandising operating cycle is 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. And inventory is goods a business owns and holds to sell to its customers.
Here's why that matters for the books. Inventory is an asset while the goods sit on the floor, because the goods will bring a future benefit when they sell. The moment a good is sold, its cost leaves the asset side and becomes an expense called Cost of Goods Sold, the expense account for the cost of the goods a business sold during the period. That single move, from asset to expense at the moment of sale, runs through everything in this lecture.
Our bicycle shop is a good example of the change. Since Month 1, it has sold repair work and recorded Service Revenue. Now it orders bicycles to sell. It becomes both a service business and a merchandising business, in one set of books.
Pause and try this. The shop has 10 new bicycles standing on its floor, and none has sold yet. Are those bicycles an asset or an expense right now?
Picture the bicycles by the window, and decide before I go on.
Here's the answer. They're an asset, Inventory. None of them has been sold, so none of their cost has become Cost of Goods Sold yet. Only when a bicycle leaves the floor does its cost become an expense.
So when you see goods on a shelf, think asset. When you see goods walk out the door, think expense.
2. Perpetual and periodic systems
Now, how does a business know what's on its shelves? Think of two shop owners. The first scans every box as it comes in and as it goes out, so a screen always shows what's left. The second doesn't scan anything. At the end of the week, the second owner walks the shelves with a clipboard and counts. Both owners know the truth by the end of the week. They differ in when they know it.
Those two habits have names. 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 the periodic system. Its owner doesn't record the cost of each slice of cheese as a sandwich sells. At the end of the week, the owner counts what's left in the cooler. What the truck started with, plus what it bought, minus what's left, is what it used up.
The bicycle shop tracks each bicycle, so it uses the perpetual system. Each bicycle goes into Inventory with its cost when it arrives, and its cost moves to Cost of Goods Sold when it's sold.
Here's a reassuring fact. For the same goods at the same cost, the two systems land on the same number. The shop had no bicycles before this order, so its beginning inventory was $0. The bicycles it bought cost $4,100 in all, and a count at the end finds 4 bicycles worth $1,640. Take $0, add $4,100, and subtract $1,640, and you get $2,460 of cost of goods sold. That's exactly what the perpetual system records at each sale, as you'll see in a few minutes.
Pause and try this. Which system tells the shop its cost of goods sold at the moment of each sale, and which one waits for a count?
Say the two names to yourself, in order.
Here's the answer. The perpetual system records cost of goods sold at each sale. The periodic system waits for the count at the end of the period. Both reach $2,460 for the shop's bicycles, because they're measuring the same 6 bicycles at the same cost.
3. 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 shorthand.
The first is the credit terms, the supplier's payment terms. The bicycle supplier writes them as 2⁄10, n⁄30, which you read aloud as "two-ten, net 30". That means 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. They 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 buyer's inventory cost. Under FOB destination, the seller owns the goods until they arrive and pays the freight.
Here's how I keep them straight. Ask where ownership changes hands. If it changes at the shipping point, the goods belong to the buyer for the whole trip, so the buyer pays for the trip. If it changes at the destination, the goods belong to the seller until they arrive, so the seller pays.
Now the shop's order. It buys 10 bicycles at $400 each on account, terms 2⁄10, n⁄30, FOB shipping point. That's $4,000 owed to the supplier. Inventory, an asset, goes up, so it's debited $4,000. Accounts Payable, a liability, goes up, so it's credited $4,000. Then the freight arrives on the shop's bill, $180, because the terms are FOB shipping point. Inventory is debited $180, and Cash is credited $180. The bicycles aren't ready to sell until they're on the floor, so the trip there is part of what they cost.
A campus bookstore shows the other side. When it orders textbooks FOB destination, its supplier pays the freight carrier, and no freight enters the bookstore's books at all.
Pause and try this. The shop's order is FOB shipping point. Who pays the $180 freight, and where does that $180 go in the shop's books?
Think about where ownership changed hands.
Here's the answer. The shop pays it, because it owned the bicycles from the moment they shipped. The $180 goes into Inventory, as part of the bicycles' cost, not into an expense and not onto the supplier's books.
4. The purchase discount
You've probably seen a sign that says, in effect, "pay early, save a little." Suppliers make that offer because they'd like their cash sooner. A business with cash on hand can take the offer and lower what its goods cost.
That saving has a name. 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.
The shop pays within the 10 days. Two percent of $4,000 is $80, so the shop pays the supplier $3,920 in cash. Let's walk the entry the way we always do. What happened? The shop settled the full $4,000 it owed. So Accounts Payable is debited the full $4,000. Cash is credited the $3,920 that left the bank. And Inventory is credited the $80, because the bicycles cost $80 less than the invoice said. Check the balance: one debit of $4,000, and credits of $80 and $3,920, which add to $4,000.
Now total what the bicycles cost. Start with the $4,000 price, add the $180 freight, and take off the $80 discount. That's $4,100 for 10 bicycles, or $410 each. I'd like you to hold on to that $410, because it's the figure that leaves Inventory each time a bicycle is sold.
And here's the contrast that shows why the shipping terms matter. Had the terms been FOB destination, the supplier would have paid the freight, and the 10 bicycles would have cost $3,920.
Pause and try this. A friend says the shop "earned" $80 by paying early, so the $80 should be revenue. What would you tell your friend?
Picture what the shop sold to the supplier.
Here's the answer. The shop sold nothing to the supplier, so there's no revenue. It paid less for its bicycles, so the $80 lowers the cost in Inventory. Revenue comes only from the shop's own customers.
5. Recording a sale and its cost
When a store sells you a bicycle, two things happen at the same instant. You agree to pay the price, and the store gives up the bicycle. In a perpetual system, the books record both, so every sale takes two entries.
The shop sells 6 bicycles at $820 each on account. First, the revenue entry. The customers now owe the shop $4,920. Accounts Receivable, an asset, goes up, so it's debited $4,920. Sales Revenue, the revenue account for the selling price of the goods a merchandising business sells, goes up, so it's credited $4,920.
Second, the cost entry. Six bicycles at $410 each left the floor, so $2,460 of cost leaves Inventory. Cost of Goods Sold, an expense, goes up, so it's debited $2,460. Inventory goes down, so it's credited $2,460.
What's left? Four bicycles still stand by the window, at $410 each, which is $1,640. Walk the Inventory account to check: $4,000 in, $180 in, $80 out, $2,460 out, and $1,640 remains. The books match the floor.
Sometimes a customer brings goods back, or keeps them at a lower agreed price because of a scratch. You meet these in words only 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, recorded in a contra revenue account. 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.
Pause and try this. The shop bought 10 bicycles and sold 6. Is its cost of goods sold $4,100 or $2,460?
Count the bicycles that actually left the floor.
Here's the answer. It's $2,460. Cost of goods sold counts only the goods sold, the 6 bicycles that left. The cost of the other 4, $1,640, stays in Inventory as an asset until they sell.
6. Gross profit and the multi-step income statement
Imagine you resell a used bike for more than you paid. You'd say you made something on that bike. But you wouldn't say you made that much for the month, because you also paid for the bus, your phone, and the ad you posted. Accountants keep those two ideas apart, and the first one gets 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.
For the shop, sales of $4,920 minus cost of goods sold of $2,460 gives gross profit of $2,460. Divide $2,460 by $4,920, and the gross margin is 50 percent. In plain words: the shop keeps half of every sales dollar after paying for the bicycles, and that half still has to cover the costs of running the shop.
Now, where does gross profit live? On a multi-step income statement, which shows gross profit, then operating income, then other revenues and expenses, before net income. Read it from the top down. First comes Sales Revenue, $4,920. Less Cost of Goods Sold, $2,460. That gives gross profit, $2,460. Below that come the operating expenses, the costs of running the business, such as wages and rent. Subtracting them gives operating income, gross profit minus operating expenses. Then come other revenues and expenses, such as interest, and last comes net income.
Compare that with the single-step income statement, which groups all revenues together and all expenses together and subtracts one total from the other. Week 5's Month 1 statement had that shape. A merchandiser usually shows the steps, because readers want to see what the goods earned on their own. Dataset C stops at gross profit, because it covers only the bicycle purchase and sale.
Pause and try this. The shop's gross profit on the bicycles is $2,460. Is that the shop's net income for the period?
Think about what hasn't been subtracted yet.
Here's the answer. No. Gross profit is the first total on the statement, not the last. The mechanic's wages, the rent, and every other operating expense still come off before anything is net income.
Closing
Let me pull it together in the order we built it. A merchandiser buys goods, holds them as inventory, sells them, and collects the cash. A perpetual system updates Inventory and Cost of Goods Sold at every sale, and a periodic system finds cost of goods sold from a count; for the shop's bicycles, both reach $2,460. Under FOB shipping point, the buyer pays the freight and adds it to inventory cost. A purchase discount lowers Inventory and is never revenue, so the 10 bicycles cost $4,100, or $410 each. A sale takes two entries, one for the price and one for the cost. And gross profit, $2,460, is a 50 percent gross margin, but it isn't net income.
Next in this module, read the Readings & Resources page, then work the lecture tutorial and the practice set before the quiz, the discussion, and the assignment. Next week, in Inventory Costing, you'll meet FIFO, LIFO, and weighted average, the methods that decide which costs leave Inventory first.
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