Accounting in Merchandising Companies (Lecture 5)
In this free online accounting lesson we define inventory and merchandise inventory. We then discuss product costs and period costs and talk about selling and administrative expenses as an example of period costs. After that we move on to definitions of cost of goods available for sale, cost of goods sold (COGS), gross margin and operating income. Following that we talk about perpetual and periodic inventory systems. We also discuss how transportation-in and transportation-out are recorded in the accounting records. Finally, we get familiar with multistep and single-step income statement formats. Accounting examples are provided for most learning objectives.
5.1 Definition of inventory
So far, we have talked about businesses that provide services. However, there are other types of businesses one of which is a merchandising company. Merchandising companies create a supply of goods that are delivered to customers. This supply is called inventory.
Inventory is a current asset on a company's balance sheet. Inventory includes goods for resale, raw materials, spare parts, etc.
Inventory usually includes goods that are being made (in the process of being produced) and goods that are finished and ready for sale.
Merchandise inventory is goods that are held for resale by a merchandising company.
Inventory for resale is accounted for in the Merchandise Inventory account. This is an asset account shown in the assets section of the balance sheet.
5.2 Inventory costs. Product and period costs
All costs related to acquiring goods and making them ready for sale are accumulated in the Merchandise Inventory account. Such costs are associated with products and often called product costs.
Product costs are costs required to produce inventory and make it ready for sale. Such costs are directly associated with inventory production.
Product costs are expensed in the period of inventory sale regardless of when the goods were purchased or produced by the company.
There are a few types of expenditures that cannot be directly traced to a specific product. Such costs include (but not limited to) advertising, administrative salaries, insurance, etc. Such costs are called selling and administrative expenses.
Selling and administrative expenses are expenses of selling and administrative nature that are not directly traceable to a specific product. Examples are advertising, administrative salaries and insurance, among others.
Because selling and administrative expenditures are expensed in the period in which they are incurred, they are labeled period costs.
Period costs are costs associated with a specific period and not a specific product. Period costs include selling and administrative expenses.
5.3 Cost of goods available for sale and cost of goods sold
Total inventory cost for a given accounting period is calculated by adding the beginning inventory account balance to the amount of inventory acquired during the period. The result of adding these two numbers is called cost of goods available for sale.
Cost of goods available for sale is the cost of goods acquired during a period plus the cost of goods on hand at the beginning of the period. This cost represents all inventories available for sale during the period.
The cost of goods available for sale is allocated between the Merchandise Inventory account and an expense account called Cost of Goods Sold. At a period end, inventory that has not been sold during the period is shown as an asset on the balance sheet (Merchandise Inventory) and inventory that has been sold is shown as an expense on the income statement (Cost of Goods Sold).
Cost of goods sold (COGS) is the difference between the cost of goods available for sale and the cost of goods on hand at period end. This cost represents the cost of goods sold by the company during the period.
Gross margin is the difference between the sales revenue (i.e., revenue generated from sales) and the cost of goods sold. Gross margin shows what profit the company made after cost of goods sold, but before any other expenses (selling and administrative, etc.).
Operating income is the difference between the gross margin and selling and administrative expenses.
Sales |
Less: Cost of Goods Sold |
Gross Margin |
Less: Selling and Administrative Expenses |
Operating Income |
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