Merchandisers versus service firms
A merchandiser buys goods and resells them. This adds two things to the income statement: sales revenue and cost of goods sold (COGS), the cost of the goods that were sold.
Gross profit = Net sales − Cost of goods sold
and operating income = gross profit − operating expenses (rent, wages, advertising).
Net sales
Net sales begin with total sales and subtract:
- Sales returns and allowances: refunds or price cuts for goods returned or defective.
- Sales discounts: reductions for early payment.
These are contra-revenue accounts, which carry debit balances that reduce sales.
Credit terms
A common term is 2/10, n/30: the buyer may deduct 2 percent if paying within 10 days; otherwise the full amount is due in 30 days. On a $1,000 invoice paid on day 8, the buyer pays 1,000 − 20 = $980.
Shipping terms
- FOB shipping point: ownership passes to the buyer when the goods leave the seller. The buyer pays the freight and owns goods in transit.
- FOB destination: ownership passes on arrival. The seller pays the freight.
Perpetual versus periodic
- Perpetual system updates the inventory account with every purchase and sale, so the balance is always current. Each sale records two entries: the sale itself, and a debit to COGS with a credit to Inventory.
- Periodic system updates inventory only after a physical count. COGS is then calculated:
Beginning inventory + Purchases (net of returns and discounts, plus freight in) − Ending inventory = COGS
Worked example
A shop reports:
- Sales: $80,000
- Sales returns: $2,000
- Beginning inventory: $10,000
- Purchases: $60,000
- Ending inventory: $18,000
- Net sales = 80,000 − 2,000 = $78,000.
- Goods available for sale = 10,000 + 60,000 = $70,000.
- COGS = 70,000 − 18,000 = $52,000.
- Gross profit = 78,000 − 52,000 = $26,000.
- Gross profit margin = 26,000 / 78,000 ≈ 33.3 percent.
Meaning: about 33 cents of each sales dollar is left to cover operating expenses and profit.
Using the margin
A falling gross margin can signal rising supplier prices or heavy discounting. Comparing the margin with competitors' helps judge pricing strategy.
Common mistakes
- Subtracting operating expenses before gross profit.
- Treating sales returns as an expense instead of a reduction of revenue.
- Forgetting freight-in is added to the cost of purchases.