Merchandising operations and sales taxes

So far Birchwood Bikes has earned all its revenue from repairs, a service. In June it starts selling new bicycles and accessories, which makes it a merchandiser as well: a business that buys goods and resells them without changing their form. Merchandising adds a large new expense, the cost of the goods sold, and a new asset, merchandise inventory. It also brings sales taxes into the records. This lesson explains the operating cycle of a merchandiser, the perpetual and periodic inventory systems, how purchases, returns, discounts and freight are recorded, how gross profit and the multiple-step income statement are built, and how sales taxes are accounted for. Lesson 9 covers how inventory costs are assigned when prices change.

The operating cycle of a merchandiser

A merchandiser's operating cycle runs from cash, to inventory bought from suppliers, to sales to customers (often on credit), to receivables, and back to cash. For a grocery store the cycle may be a couple of weeks; for a bicycle shop that buys its spring stock in winter, it can be many months. The length of the cycle affects how much cash the business must tie up in inventory and receivables, a theme lesson 12 returns to with turnover ratios.

Gross profit is what is left from sales after paying for the goods; it must cover all the other operating expenses, such as wages, rent and advertising, before there is any net income. Gross profit divided by net sales is the gross margin, a key measure for retailers.

Perpetual and periodic inventory systems

Under a perpetual inventory system, the inventory account and the cost of goods sold account are updated with every purchase and every sale. Each sale is recorded with two entries: one for the revenue at selling price and one transferring the cost of the item from inventory to cost of goods sold. Barcode scanners and point-of-sale software make the perpetual system the norm for most retailers today. It shows the inventory that should be on hand at any time, so shrinkage from theft, damage or error can be measured by comparing the records with a physical count.

Under a periodic inventory system, purchases are recorded in a Purchases account, and inventory and cost of goods sold are not updated during the period. At the end of the period, a physical count establishes ending inventory, and cost of goods sold is calculated as beginning inventory plus net purchases minus ending inventory. The periodic system is simpler to run but gives no running inventory figure and cannot separate shrinkage from goods sold. Some small businesses still use it.

Purchases: returns, discounts and freight

Purchase returns and allowances reduce the cost of inventory: if goods are returned to the supplier or the supplier gives a price reduction for damage, the perpetual entry debits Accounts payable (or Cash) and credits Inventory. Purchase discounts are reductions for paying early. Terms of 2/10, n/30 mean the buyer may deduct 2 percent if it pays within 10 days, and otherwise the full amount is due in 30 days. Under the gross method, the purchase is recorded at the full price and the discount, if taken, reduces inventory when payment is made. Taking such a discount is usually a very good deal: giving up 2 percent to pay 20 days later is equivalent to an annual interest rate of about 37 percent.

Freight costs depend on the shipping terms. FOB shipping point means ownership passes to the buyer when the goods leave the seller, and the buyer pays the freight; the freight is part of the cost of the inventory. FOB destination means ownership passes when the goods arrive, and the seller pays the freight as a selling expense (often called freight-out or delivery expense). The terms also decide which business owns goods that are in transit on the balance sheet date, which matters for the year-end count. International contracts often use Incoterms such as EXW, FCA or DDP, which set the same kinds of rules in more detail.

Sales: returns, discounts and cost of goods sold

On the selling side, a perpetual system records two entries for each sale: revenue at selling price, and the transfer of cost from inventory to cost of goods sold. If a customer returns goods, the seller reverses part of the revenue through a contra revenue account, Sales returns and allowances, and, if the goods can be resold, returns their cost to inventory. Sales discounts for early payment are also recorded in a contra revenue account. Net sales equals gross sales less returns, allowances and discounts. Under current revenue standards, a business that expects customers to return goods or take discounts estimates them when it records the sale; ACCT-211 covers that refinement.

Sales taxes

In the United States there is no federal sales tax. Forty-five states and the District of Columbia impose a state sales tax, and many cities and counties add local taxes, so combined rates vary by location; this lesson uses an illustrative combined rate of 7.5 percent for Birchwood's location. Sales tax is levied on the final consumer. A retailer collects it from customers at the point of sale and records it as a liability, Sales tax payable, because it is collected on behalf of the state; it remits the tax monthly or quarterly. The tax is not revenue. A retailer does not pay sales tax on goods bought for resale, because it gives the supplier a resale or exemption certificate. Sales tax it pays on items for its own use, such as supplies or equipment, becomes part of the cost of those items. Since the 2018 Supreme Court decision in South Dakota v. Wayfair, states can require out-of-state sellers to collect tax once their sales into the state pass an economic nexus threshold, commonly $100,000; rules differ by state.

# Gross profit and sales tax for a month of merchandise sales (illustrative)
units_sold, price, unit_cost = 42, 650.00, 404.63
returns_units = 2
tax_rate = 0.13          # HST in Ontario; change to 0.075 for the US example

gross_sales = units_sold * price
returns = returns_units * price
net_sales = gross_sales - returns
cogs = (units_sold - returns_units) * unit_cost
gross_profit = net_sales - cogs
tax_collected = net_sales * tax_rate

print(f"Gross sales      {gross_sales:>10,.2f}")
print(f"Less returns     {returns:>10,.2f}")
print(f"Net sales        {net_sales:>10,.2f}")
print(f"Cost of goods    {cogs:>10,.2f}")
print(f"Gross profit     {gross_profit:>10,.2f}")
print(f"Gross margin     {gross_profit / net_sales:>10.1%}")
print(f"Sales tax collected (a liability, not revenue): {tax_collected:,.2f}")

Gross sales       27,300.00
Less returns       1,300.00
Net sales         26,000.00
Cost of goods     16,185.20
Gross profit       9,814.80
Gross margin          37.7%
Sales tax collected (a liability, not revenue): 3,380.00

The multiple-step income statement

A merchandiser usually presents a multiple-step income statement, which shows subtotals that help users understand performance: net sales, cost of goods sold, gross profit, operating expenses (often split into selling and administrative), operating income, other income and expenses (such as interest), income before tax, income tax, and net income. The single-step format, used in lesson 7, lists all revenues and all expenses with one subtraction; both give the same net income.

For a business that sells both goods and services, gross profit is sometimes reported only for merchandise, with service revenue shown separately. Accountants choose the layout that best informs users and apply it consistently.

Inventory shrinkage and the year-end count

Even with a perpetual system, businesses count their inventory at least once a year. The count checks the records against reality and measures shrinkage. If the records show $48,200 of inventory and the count finds $47,350, the $850 shortfall is recorded by debiting Cost of goods sold (or a separate Inventory shrinkage expense) and crediting Inventory. Cut-off procedures make sure goods received or shipped around the count date are recorded in the right period, which is where the FOB terms matter. Shrinkage is a significant cost for retailers; industry surveys often put it at between 1 and 2 percent of sales.