Merchandising Activities & Cost Flows
🎯 Learning Objectives
- Understand the difference between service companies and merchandisers in the accounting equation
- Identify the components of merchandise cost of goods available for sale
- Calculate cost of goods sold and gross profit from inventory data
- Describe the operating cycle of a merchandiser and its impact on financial statements
- Understand how purchases, sales, and inventory relate in the perpetual and periodic systems
- Explain the importance of gross profit margin and its relationship to profitability
📚 Background & Principles
Merchandising is the business of buying goods from suppliers and selling them to customers. Unlike service companies that sell intangible services, merchandisers deal with tangible products that move through the supply chain from purchase to sale. This creates unique accounting challenges, particularly around tracking inventory costs and calculating gross profit.
Service Company vs. Merchandiser
Revenue - Expenses = Net Income
Examples: Accounting firms, consulting agencies, hair salons
No inventory to track
Revenue = Services performed
Gross Profit - Operating Expenses = Net Income
Examples: Walmart, Amazon, local bookstore, clothing retailer
Must track inventory costs
Revenue = Goods sold to customers
Buy goods from suppliers. Cash decreases or Accounts Payable increases. Inventory increases.
Store goods until sold. Inventory is a current asset on the balance sheet.
Record sales revenue. Remove inventory from balance sheet and record Cost of Goods Sold.
Receive payment from customers. Cash or Accounts Receivable increases.
Use cash collected to purchase more inventory. The cycle continues indefinitely.
🔑 Key Concepts
A business that purchases goods from suppliers and sells them to customers. Involves inventory tracking and cost of goods sold calculations.
The cost of inventory sold to customers during the period. Calculated as: Beginning Inventory + Purchases - Ending Inventory.
Net Sales minus Cost of Goods Sold. Represents the profit before operating expenses. Also called "Gross Margin."
Total sales revenue minus sales returns, allowances, and discounts. The top line for merchandising income statements.
Beginning Inventory + Net Purchases. The total cost of all inventory that could have been sold during the period.
The time it takes to turn cash into inventory, then into receivables, and back into cash. Longer cycles require more working capital.
🔍 Deep Dive
Explore merchandising activities at different levels of depth:
🟢 Foundational Level
Understanding the basic merchandising model and profit calculation.
The Retail Relay Race
Analogy: The Retail Relay Race
Merchandisers (like Walmart or Amazon) run a never-ending relay race.
You start with cash and run to buy inventory (The Baton). Cash decreases, Inventory increases.
You hand the baton (Inventory) to a customer, who promises to pay later. Inventory decreases, Accounts Receivable increases.
The customer pays you. Now you have MORE cash than you started with (Profit).
You use that new cash to buy MORE inventory, and the race starts again.
Gross Profit must cover all operating expenses to create Net Income
🟡 Standard Level
Understanding cost flow calculations and the income statement structure.
Cost of Goods Sold Calculation
Let's track inventory costs for a small bookstore called "Chapter One."
Jan 1: 50 books @ $10 each = $500
Inventory carried over from the previous period.
During January: 200 books @ $10 = $2,000
All inventory purchased during the period, net of returns and discounts.
$500 + $2,000 = $2,500
Total cost of all inventory that could have been sold.
Jan 31: 30 books @ $10 = $300
Physical count of unsold inventory at period end.
$2,500 - $300 = $2,200
The cost of the 220 books sold during January.
Merchandising Calculator
Complete Merchandising Income Statement
Using the calculations above, here is Chapter One's income statement structure:
| Sales Revenue | $80,000 |
| Less: Sales Returns & Allowances | (2,000) |
| Less: Sales Discounts | (1,000) |
| Net Sales | $77,000 |
| Cost of Goods Sold | (42,000) |
| Gross Profit | $35,000 |
| Operating Expenses | (20,000) |
| Net Income | $15,000 |
✅ Reality: COGS is a direct cost related to producing or purchasing the goods sold. Operating expenses (rent, salaries, advertising) are indirect costs of running the business. Both reduce income, but they're reported separately.
🔴 Advanced Level
Understanding inventory systems, cost flow assumptions, and analysis techniques.
Perpetual vs. Periodic Inventory Systems
Real-time tracking:
- Inventory updated after every sale
- COGS known at all times
- Uses technology (barcodes, scanners)
- Standard in modern retail
- Cost flow assumptions still apply
Periodic tracking:
- Inventory updated only at period end
- COGS calculated after physical count
- Simpler but less accurate
- Used for low-value items (nails, bolts)
- Ending inventory = physical count
Cost Flow Assumptions (Inventory Valuation)
When inventory costs change over time, we must assume which costs flow to COGS:
Effect during inflation: Lower COGS, Higher Ending Inventory, Higher Net Income.
Best for: Perishable goods (food, medicine) where oldest items are sold first.
Effect during inflation: Higher COGS, Lower Ending Inventory, Lower Net Income, Lower Taxes.
Best for: Non-perishable goods (oil, metals) where costs are rising.
Effect: Smooths out price fluctuations. COGS and Inventory fall between FIFO and LIFO.
Best for: Homogeneous goods (grain, oil) where individual items are identical.
- FIFO: Reports higher profits (more taxes), higher inventory values (stronger balance sheet)
- LIFO: Reports lower profits (tax savings), lower inventory values
- Many companies choose LIFO specifically for the tax advantage during inflationary periods
✅ Reality: FIFO and LIFO are cost flow assumptions, not physical flow descriptions. A company can physically sell newer items first (LIFO physical flow) but use older costs for accounting (FIFO cost flow). The assumptions are about which costs are matched to sales, not which physical items are sold.
🎨 Interactive: Merchandising Cycle Simulator
Watch how inventory flows through the accounting system and affects financial statements.
- Sales ($60,000) - COGS ($35,000) = Gross Profit ($25,000)
- Beginning Inventory + Purchases = Goods Available ($50,000)
- Goods Available - Ending Inventory = COGS ($35,000)
- Ending Inventory ($15,000) = Goods Available - COGS
Interactive Cost Flow
🚫 Common Misconceptions & Professional Tips
✅ Reality: Gross profit is sales minus cost of goods sold. Net income is gross profit minus ALL operating expenses (rent, salaries, utilities, etc.). A company can have gross profit but still report net loss if expenses exceed gross profit.
✅ Reality: Ending inventory directly affects COGS on the income statement. Higher ending inventory = lower COGS = higher gross profit. This is why accurate inventory counts are crucial for income statement accuracy.
✅ Reality: Purchases are the cost of inventory bought during the period. COGS is the cost of inventory actually sold. The difference is ending inventory (goods purchased but not sold) and beginning inventory (goods sold but not purchased this period).
✅ Reality: The perpetual system provides real-time data but requires technology and can have errors (theft, damage, recording mistakes). Physical counts are still needed periodically to verify accuracy. Both systems can be accurate when properly maintained.
🧠 Memory Aids & Quick Reference
BPE = Beginning + Purchases - Ended
Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold
SNAC = Sales - Net - Allowances - Cash discounts
Net Sales - COGS = Gross Profit
Net Sales = Gross Sales - Returns - Discounts
COGS = Beginning Inventory + Purchases - Ending Inventory
Gross Profit = Net Sales - COGS
Gross Margin % = Gross Profit ÷ Net Sales
Perpetual: Real-time updates, continuous tracking, COGS known immediately
Periodic: Count-based, updated at period end, COGS calculated retrospectively
FIFO: Oldest costs → COGS (lowers COGS when prices rise)
LIFO: Newest costs → COGS (raises COGS when prices rise)
Weighted Avg: Average cost → COGS (smooths price changes)
Gross Margin % = Gross Profit ÷ Net Sales
Inventory Turnover = COGS ÷ Average Inventory
Days Inventory = 365 ÷ Inventory Turnover
📖 Glossary
A business that purchases goods from suppliers and sells them to customers, tracking inventory costs and calculating gross profit.
The cost of inventory sold to customers during the period. Calculated as: Beginning Inventory + Net Purchases - Ending Inventory.
Net Sales minus Cost of Goods Sold. Represents the profit before operating expenses. Also called "Gross Margin."
Total sales revenue minus sales returns, allowances, and sales discounts. The revenue figure used for gross profit calculation.
Beginning Inventory plus Net Purchases. Represents the total cost of all inventory that could have been sold during the period.
The time from purchasing inventory to collecting cash from customers. Affects working capital needs and financing requirements.
An inventory system that updates inventory records continuously after each sale, providing real-time COGS information.
An inventory system that updates inventory records only at period end based on physical count. COGS is calculated retrospectively.
A cost flow assumption where the oldest inventory costs are assigned to COGS and newer costs remain in ending inventory.
A cost flow assumption where the newest inventory costs are assigned to COGS and older costs remain in ending inventory.
🎯 Final Knowledge Check
Test your understanding of Merchandising Activities:
Question 1: What is the primary difference between a service company and a merchandiser?
Question 2: If Beginning Inventory = $10,000, Purchases = $40,000, and Ending Inventory = $8,000, what is COGS?
Question 3: Gross profit is calculated as:
Question 4: Which is NOT a component of Cost of Goods Available for Sale?
Question 5: What does the operating cycle of a merchandiser measure?