4.2 Merchandising Operations & Perpetual/Periodic Inventory

Merchandising Operations & Perpetual/Periodic Inventory

Unlike service enterprises that generate revenue solely by performing professional activities, merchandising enterprises purchase tangible products from wholesalers or manufacturers and resell them to consumers or retail clients at an elevated price. This operational model introduces specialized inventory tracking, contra-revenue accounts, trade credit terms, freight logistics, and the single largest expense category for retailers: Cost of Goods Sold (COGS).

---

1. The Merchandising Income Statement

A merchandising firm utilizes a multi-step Income Statement format to distinguish between primary gross merchandising margins and overall operating profitability:

+-----------------------------------------------------------------------------+
|                   MULTI-STEP MERCHANDISING INCOME STATEMENT                 |
|                                                                             |
|   Gross Sales                                                               |
|   Less: Sales Returns and Allowances ............... ($XX,XXX)              |
|   Less: Sales Discounts ............................ ($XX,XXX)              |
|   -----------------------------------------------------------------------   |
|   = NET SALES                                                 $XXX,XXX      |
|   Less: Cost of Goods Sold (COGS) ........................... (XXX,XXX)     |
|   -----------------------------------------------------------------------   |
|   = GROSS PROFIT (GROSS MARGIN)                               $XXX,XXX      |
|   Less: Operating Expenses (Selling & Administrative) ....... (XXX,XXX)     |
|   -----------------------------------------------------------------------   |
|   = OPERATING INCOME (INCOME FROM OPERATIONS)                 $ XX,XXX      |
+-----------------------------------------------------------------------------+

Net Sales Calculation

Gross Sales represents the total unadjusted invoice price of all merchandise sold during the period. To reach Net Sales, two contra-revenue accounts are subtracted:

$\text{Net Sales} = \text{Gross Sales} - \text{Sales Returns \& Allowances} - \text{Sales Discounts}$

• Sales Returns: Physical return of unsatisfactory merchandise by the customer for full refund or credit.
• Sales Allowances: Price reduction granted to a customer who agrees to keep damaged or defective goods.
• Sales Discounts: Cash discounts taken by customers for paying credit invoices within an early discount window (e.g., $2/10, n/30$).
• Both accounts carry normal debit balances and directly offset Gross Sales.

---

2. Cost of Goods Sold & Inventory Formulas

Cost of Goods Sold represents the direct acquisition cost of the merchandise sold to generate Net Sales during the period.

The Periodic COGS Formula

Under a periodic inventory system, COGS is not tracked continuously during daily operations. Instead, it is computed at the end of the accounting period after a physical inventory count determines Ending Inventory:

$\text{Cost of Goods Available for Sale (COGAS)} = \text{Beginning Inventory} + \text{Net Purchases} + \text{Freight-In}$

$\text{Cost of Goods Sold (COGS)} = \text{COGAS} - \text{Ending Inventory}$

$\text{Net Purchases} = \text{Gross Purchases} - \text{Purchase Returns \& Allowances} - \text{Purchase Discounts}$

+-----------------------------------------------------------------------------+
|                        PERIODIC COGS CALCULATION FLOW                       |
|                                                                             |
|   Beginning Inventory ........................................  $ 40,000    |
|   [+] Gross Purchases ............................  $120,000                |
|   [-] Purchase Returns & Allowances ..............   ( 5,000)               |
|   [-] Purchase Discounts .........................   ( 2,400)               |
|   ------------------------------------------------            ------    |
|   = Net Purchases ................................  $112,600                |
|   [+] Freight-In (Transportation-In) .............     4,400                |
|   ----------------------------------------------------------            |
|   = Cost of Goods Available for Sale (COGAS) .................  $157,000    |
|   [-] Ending Inventory (Physical Count on Dec 31) ............   (37,000)   |
|   -----------------------------------------------------------------------   |
|   = COST OF GOODS SOLD (COGS) ................................  $120,000    |
+-----------------------------------------------------------------------------+

---

3. Perpetual vs. Periodic Inventory Systems

Businesses account for merchandise using one of two primary systems:

Side-by-Side Journal Entry Comparison

Scenario A: Purchase of Merchandise on Credit

Firm buys $$10{,}000$ of merchandise on account, terms $2/10, n/30$.

PERPETUAL SYSTEM                               PERIODIC SYSTEM
Merchandise Inventory ..... $10,000             Purchases ................. $10,000
    Accounts Payable ......         $10,000         Accounts Payable ......         $10,000

Scenario B: Sale of Merchandise on Credit

Firm sells merchandise for $$16{,}000$ on account (Cost of merchandise sold is $$9{,}500$).

PERPETUAL SYSTEM (Two Entries)                 PERIODIC SYSTEM (One Entry)
1. Accounts Receivable ... $16,000             1. Accounts Receivable ... $16,000
       Sales Revenue .....         $16,000            Sales Revenue .....         $16,000
2. Cost of Goods Sold ....  $9,500             (No second entry at time of sale)
       Merchandise Inv. ..          $9,500

Scenario C: Customer Returns Merchandise

Customer returns goods sold for $$2{,}000$ on account (Cost of goods returned was $$1{,}200$).

PERPETUAL SYSTEM (Two Entries)                 PERIODIC SYSTEM (One Entry)
1. Sales Returns & Allow. .  $2,000            1. Sales Returns & Allow. .  $2,000
       Accounts Receivable          $2,000            Accounts Receivable          $2,000
2. Merchandise Inventory ..  $1,200            (No second entry at time of return)
       Cost of Goods Sold .         $1,200

---

4. Credit Terms & Cash Discounts

In business-to-business transactions, sales are commonly made on credit with standardized credit terms designed to encourage early settlement.

+-----------------------------------------------------------------------------+
|                        DECODING CREDIT TERMS: 2/10, n/30                    |
|                                                                             |
|       2      /      10       ,            n         /         30        |
|       |              |                    |                    |            |
|   Discount %     Discount Period      Net Amount Due     Full Due Date      |
|   (2% discount   (if paid within      (No discount       (Total invoice     |
|   allowed)       10 days)             applied)           due in 30 days)    |
+-----------------------------------------------------------------------------+

Other Common Credit Terms:

• $1/15, n/30$: $1%$ discount if paid within 15 days; full invoice balance due in 30 days.
• $n/EOM$: Full net amount due by the End of the Month.
• $2/10, n/EOM$: $2%$ discount if paid within 10 days of invoice; balance due by end of month.

Worked Example: Purchase Discount Calculation

• Invoice Date: June 1
• Purchase Amount: $$8{,}000$, terms $2/10, n/30$, FOB Destination.
• Return on June 4: $$1{,}000$ of defective merchandise returned before payment.
• Adjusted Invoice Balance: $$8{,}000 - $1{,}000 = $7{,}000$.
• Payment on June 9 (Within 10-day window): $\text{Cash Discount} = \$7{,}000 \times 2\% = \$140$ $\text{Cash Paid} = \$7{,}000 - \$140 = \$6{,}860$

GENERAL JOURNAL (PERPETUAL SYSTEM - PAYMENT WITHIN DISCOUNT PERIOD)
Date        Account Titles and Explanation                Debit       Credit
June 9      Accounts Payable .........................   $7,000
                Merchandise Inventory (Discount) .....                  $140
                Cash .................................                $6,860
            (To record payment of invoice within 2% discount window)

(Note: Under the perpetual system, purchase discounts reduce the capitalized cost of Merchandise Inventory directly. Under the periodic system, the credit goes to Purchase Discounts).

---

5. Transportation Terms: FOB Shipping Point vs. FOB Destination

Freight terms define two critical legal parameters: (1) who pays shipping costs, and (2) where legal title passes from seller to buyer.

+-----------------------------------------------------------------------------+
|                   FOB SHIPPING POINT VS. FOB DESTINATION                    |
|                                                                             |
|   FEATURE                    FOB SHIPPING POINT        FOB DESTINATION      |
|   -----------------------------------------------------------------------   |
|   Title Passes               At SELLER'S Shipping Dock At BUYER'S Location  |
|   Goods in Transit Owned By  BUYER                     SELLER               |
|   Who Pays Freight           BUYER                     SELLER               |
|   Accounting Account         FREIGHT-IN                FREIGHT-OUT          |
|   Account Classification     Added to Inventory Cost   Operating Expense    |
|                              (Capitalized / COGS)      (Selling Expense)    |
+-----------------------------------------------------------------------------+

[!IMPORTANT] Freight-In vs. Freight-Out Distinction:

• Freight-In (Transportation-In): Cost incurred by the buyer on incoming goods. Under GAAP, it is a necessary cost of acquiring inventory and is capitalized into Merchandise Inventory (or added to Net Purchases under periodic).
• Freight-Out (Delivery Expense): Cost incurred by the seller to deliver goods to customers. It is never added to inventory; it is classified as an Operating Selling Expense on the Income Statement.