Merchandising Organizations

A merchandising firm is one of the most common types of businesses. A merchandising firm is a business that purchases finished products and resells them to consumers. Consider your local grocery store or retail clothing store. Both of these are merchandising firms. Often, merchandising firms are referred to as resellers or retailers since they are in the business of reselling a product to the consumer at a profit.

Think about purchasing toothpaste from your local drug store. The drug store purchases tens of thousands of tubes of toothpaste from a wholesale distributor or manufacturer in order to get a better per-tube cost. Then, they add their mark-up (or profit margin) to the toothpaste and offer it for sale to you. The drug store did not manufacture the toothpaste; instead, they are reselling a toothpaste that they purchased. Virtually all of your daily purchases are made from merchandising firms such as Walmart, Target, Macy’s, Walgreens, and AutoZone.

Merchandising firms account for their costs in a different way from other types of business organizations. To understand merchandising costs, Figure 2.2 shows a simplified income statement for a merchandising firm:

Figure 2.2 Simplified Income Statement for a Merchandising Firm. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

This simplified income statement demonstrates how merchandising firms account for their sales cycle or process. Sales revenue is the income generated from the sale of finished goods to consumers rather than from the manufacture of goods or provision of services. Since a merchandising firm has to purchase goods for resale, they account for this cost as cost of goods sold—what it cost them to acquire the goods that are then sold to the customer. The difference between what the drug store paid for the toothpaste and the revenue generated by selling the toothpaste to consumers is their gross profit. However, in order to generate sales revenue, merchandising firms incur expenses related to the process of operating their business and selling the merchandise. These costs are called operating expenses, and the business must deduct them from the gross profit to determine the operating profit. (Note that while the terms “operating profit” and “operating income” are often used interchangeably, in real-world interactions you should confirm exactly what the user means in using those terms.) Operating expenses incurred by a merchandising firm include insurance, marketing, administrative salaries, and rent.

Figure 2.3 Shopping Mall. Merchandising firms must identify and manage their costs to remain competitive and attract customers to their business. (credit: “stairs shopping mall” by “jarmoluk”/Pixabay, CC0)

Concepts In Practice

Balancing Revenue and Expenses

Plum Crazy is a small boutique selling the latest in fashion trends. They purchase clothing and fashion accessories from several distributors and manufacturers for resale. In 2017, they reported these revenue and expenses:

Before examining the income statement, let’s look at Cost of Goods Sold in more detail. Merchandising companies have to account for inventory, a topic covered in Inventory. As you recall, merchandising companies carry inventory from one period to another. When they prepare their income statement, a crucial step is identifying the actual cost of goods that were sold for the period. For Plum Crazy, their Cost of Goods Sold was calculated as shown in Figure 2.4.

Figure 2.4 Plum Crazy’s Cost of Goods Sold Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Once the calculation of the Cost of Goods Sold has been completed, Plum Crazy can now construct their income statement, which would appear as shown in Figure 2.5.

Figure 2.5 Plum Crazy’s Income Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Since merchandising firms must pass the cost of goods on to the consumer to earn a profit, they are extremely cost sensitive. Large merchandising businesses like Walmart, Target, and Best Buy manage costs by buying in bulk and negotiating with manufacturers and suppliers to drive the per-unit cost.

Manufacturing Organizations

A manufacturing organization is a business that uses parts, components, or raw materials to produce finished goods (Figure 2.6). These finished goods are sold either directly to the consumer or to other manufacturing firms that use them as a component part to produce a finished product. For example, Diehard manufactures automobile batteries that are sold directly to consumers by retail outlets such as AutoZone, Costco, and Advance Auto. However, these batteries are also sold to automobile manufacturers such as Ford, Chevrolet, or Toyota to be installed in cars during the manufacturing process. Regardless of who the final consumer of the final product is, Diehard must control its costs so that the sale of batteries generates revenue sufficient to keep the organization profitable.

Figure 2.6 Manufacturing firms apply direct labor to raw materials in order to produce the finished goods purchased from retailers. (credit: “work manufactures” by “dodaning0”/Pixabay, CC0)

Manufacturing firms are more complex organizations than merchandising firms and therefore have a larger variety of costs to control. For example, a merchandising firm may purchase furniture to sell to consumers, whereas a manufacturing firm must acquire raw materials such as lumber, paint, hardware, glue, and varnish that they transform into furniture. The manufacturer incurs additional costs, such as direct labor, to convert the raw materials into furniture. Operating a physical plant where the production process takes place also generates costs. Some of these costs are tied directly to production, while others are general expenses necessary to operate the business. Because the manufacturing process can be highly complex, manufacturing firms constantly evaluate their production processes to determine where cost savings are possible.

Manufacturing organizations account for costs in a way that is similar to that of merchandising firms. However, as you will learn, there is a significant difference in the calculation of cost of goods sold. Figure 2.7 shows a simplification of the income statement for a manufacturing firm:

Figure 2.7 Simplified Income Statement for a Manufacturing Firm. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

At first it appears that there is no difference between the income statements of the merchandising firm and the manufacturing firm. However, the difference is in how these two types of firms account for the cost of goods sold. Merchandising firms determine their cost of goods sold by accounting for both existing inventory and new purchases, as shown in the Plum Crazy example. It is typically easy for merchandising firms to calculate their costs because they know exactly what they paid for their merchandise.

Unlike merchandising firms, manufacturing firms must calculate their cost of goods sold based on how much they manufacture and how much it costs them to manufacture those goods. This requires manufacturing firms to prepare an additional statement before they can prepare their income statement. This additional statement is the Cost of Goods Manufactured statement. Once the cost of goods manufactured is calculated, the cost is then incorporated into the manufacturing firm’s income statement to calculate its cost of goods sold.

One thing manufacturing firms must consider in their cost of goods manufactured is that, at any given time, they have products at varying levels of production: some are finished and others are still process. The cost of goods manufactured statement measures the cost of the goods actually finished during the period, whether or not they were started during that period.

Before examining the typical manufacturing firm’s process to track cost of goods manufactured, you need basic definitions of three terms in the schedule of Costs of Goods Manufactured: direct materials, direct labor, and manufacturing overhead. Direct materials are the components used in the production process whose costs can be identified on a per item-produced basis. For example, if you are producing cars, the engine would be a direct material item. The direct material cost would be the cost of one engine. Direct labor represents production labor costs that can be identified on a per item-produced basis. Referring to the car production example, assume that the engines are placed in the car by individuals rather than by an automated process. The direct labor cost would be the amount of labor in hours multiplied by the hourly labor cost. Manufacturing overhead generally includes those costs incurred in the production process that are not economically feasible to measure as direct material or direct labor costs. Examples include the department manager’s salary, the production factory’s utilities, or glue used to attach rubber molding in the auto production process. Since there are so many possible costs that can be classified as manufacturing overhead, they tend to be grouped and then allocated in a predetermined manner to the production process.

Figure 2.8 is an example of the calculation of the Cost of Goods Manufactured for Koeller Manufacturing. It demonstrates the relationship between cost of goods manufactured and cost of goods in progress and includes the three main types of manufacturing costs.

Figure 2.8 Koeller Manufacturing’s Cost of Goods Manufactured. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

As you can see, the manufacturing firm takes into account its work-in-process (WIP) inventory as well as the costs incurred during the current period to finish not only the units that were in the beginning WIP inventory, but also a portion of any production that was started but not finished during the month. Notice that the current manufacturing costs, or the additional costs incurred during the month, include direct materials, direct labor, and manufacturing overhead. Direct materials are calculated as

All of these costs are carefully tracked and classified because the cost of manufacturing is a vital component of the schedule of cost of goods sold. To continue with the example, Koeller Manufacturing calculated that the cost of goods sold was $95,000, which is carried through to the Schedule of Cost of Goods Sold (Figure 2.9).

Figure 2.9 Koeller Manufacturing’s Cost of Goods Sold. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Now when Koeller Manufacturing prepares its income statement, the simplified statement will appear as shown in Figure 2.10.

Figure 2.10 Koeller Manufacturing’s Income Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

So, even though the income statements for the merchandising firm and the manufacturing firm appear very similar at first glance, there are many more costs to be captured by the manufacturing firm. Figure 2.11 compares and contrasts the methods merchandising and manufacturing firms use to calculate the cost of goods sold in their income statement.

Figure 2.11 Merchandising firms consider the cost of goods purchased, and manufacturing firms consider the cost of goods manufactured in order to determine the cost of goods sold. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Concepts In Practice

Calculating Cost of Goods Sold in Manufacturing

Just Desserts is a bakery that produces and sells cakes and pies to grocery stores for resale. Although they are a small manufacturer, they incur many of the costs of a much larger organization. In 2017, they reported these revenue and expenses:

Their income statement is shown in Figure 2.12.

Figure 2.12 Just Desserts’ Income Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

You’ll learn more about the flow of manufacturing costs in Identify and Apply Basic Cost Behavior Patterns. For now, recognize that, unlike a merchandising firm, calculating cost of goods sold in manufacturing firms can be a complex task for management.

Service Organizations

A service organization is a business that earns revenue by providing intangible products, those that have no physical substance. The service industry is a vital sector of the U.S. economy, providing 65% of the U.S. private-sector gross domestic product and more than 79% of U.S. private-sector jobs.³ If tangible products, physical goods that customers can handle and see, are provided by a service organization, they are considered ancillary sources of revenue. Large service organizations such as airlines, insurance companies, and hospitals incur a variety of costs in the provision of their services. Costs such as labor, supplies, equipment, advertising, and facility maintenance can quickly spiral out of control if management is not careful. Therefore, although their cost drivers are sometimes not as complex as those of other types of firms, cost identification and control are every bit as important in the service industry.

For example, consider the services that a law firm provides its clients. What clients pay for are services such as representation in legal proceedings, contract negotiations, and preparation of wills. Although the true value of these services is not contained in their physical form, they are of value to the client and the source of revenue to the firm. The managing partners in the firm must be as cost conscious as their counterparts in merchandising and manufacturing firms. Accounting for costs in service firms differs from merchandising and manufacturing firms in that they do not purchase or produce goods. For example, consider a medical practice. Although some services provided are tangible products, such as medications or medical devices, the primary benefits the physicians provide their patients are the intangible services that are comprised of his or her knowledge, experience, and expertise.

Service providers have some costs (or revenue) derived from tangible goods that must be taken into account when pricing their services, but their largest cost categories are more likely to be administrative and personnel costs rather than product costs.

For example, Whichard & Klein, LLP, is a full-service accounting firm with their primary offices in Baltimore, Maryland. With two senior partners and a small staff of accountants and payroll specialists, the majority of the costs they incur are related to personnel. The value of the accounting and payroll services they provide to their clients is intangible in comparison to goods sold by a merchandiser or produced by a manufacturer but has value and is the primary source of revenue for the firm. At the end of 2019, Whichard and Klein reported the following revenue and expenses:

Their Income Statement for the period is shown in Figure 2.13.

Figure 2.13 Whichard & Klein’s Income Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The bulk of the expenses incurred by Whichard & Klein are in personnel and administrative/office costs, which are very common among businesses that have services as their primary source of revenue.

Concepts In Practice

Revenue and Expenses for a Law Office

The revenue and expenses for a law firm illustrate how the income statement for a service firm differs from that of a merchandising or manufacturing firm.

Welch & Graham is a well-established law firm that provides legal services in the areas of criminal law, real estate transactions, and personal injury. The firm employs several attorneys, paralegals, and office support staff. In 2017, they reported the following revenue and expenses:

Their income statement is shown in Figure 2.14.

Figure 2.14 Welch & Graham’s Income Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

As you can see, the majority of the costs incurred by the law firm are personnel related. They may also incur costs from equipment and materials such computer networks, phone and switchboard equipment, rent, insurance, and law library materials necessary to support the practice, but these costs represent a much smaller percentage of total cost than the administrative and personnel costs.