Key Distinctions in the Income Statements of Merchandising and Service Organizations

There are various forms of business enterprises key among them being service and merchandising organizations. The manner in which each company presents its income statements is different due to the differing nature of the businesses where the former offers service at a fee while the latter purchases products and sell them for a profit. This paper identifies the key distinctions in the income statements of merchandising and service organizations. The paper will also highlight the valuation methods of determining the value of goods on hand and indicate how the cost of goods is determined. Lastly, it will highlight the importance of gross margin to management and the industries with high and low gross margin percentages.

Differences between Income Statement of Merchandising and Service Company

Firstly since merchandising companies buy products for sale, they incur purchase and shipment costs. Therefore, their income statement presents the cost of goods sold. On the contrary service companies do not show this account since they offer services which do not carry inventory. The format of presentation of the income statements also differ. In determining the net income of a service company, operating expenses are subtracted from the revenue. However, for a merchandising company, the net income computation is through several steps where the gross margin, income from operations and net income are determined. Another fundamental difference between the two income statements is the cause of fluctuations in their net revenues. Service companies have fewer expense accounts implying that any change in the net revenue is determined by the level of sales generated. On the contrary, for merchandising companies, net income fluctuation could emanate from either an increase in expenses or decrease in revenue.

Computation of the Gross Margin

This margin is the net of cost of goods sold and revenue. To arrive at the net sales one subtracts the sales returns and the sales discounts from the total sales. While determining the cost of goods sold, the beginning inventory figure is added to any purchase of stock made to give the goods available for sale then a subtraction is made for the closing inventory.

Methods Used To Determine Merchandise Inventory

While determining the value of goods on hand, the two methods used by accountants are the perpetual inventory method and periodic inventory method (Gilbertson, Gentene, Lehman, 2014, p. 249). The perpetual inventory method provides a continuous track of the amount of merchandise in hand by maintaining daily records. The method maintains real-time inventory balance through constant updating of transactions that increase or decrease the inventory balances. This method is applicable where a company has multiple locations of business but wishes to centralize its inventory management. Also, the method is applicable where the administration of a company wants to employ less staff since there are no physical inventory counts. The method is also effective where management of a company wishes to ensure there are no stock outs thus meeting customer expectations. Large businesses such as supermarket chains typically use the perpetual inventory systems.

The periodic inventory method determines stock values by conducting physical counts monthly, quarterly or annually (Gilbertson, Gentene, Lehman, 2014, p. 249). Any additions or sale of inventory is not updated instead purchases are recorded on the purchases account while a single journal entry is made for each sale. The method can be applied where a company does not have sufficient funds to buy the real time systems or for businesses. Companies dealing with minimal stocks of inexpensive products also use the periodic inventory method.

Computation of the Cost of Goods Sold

The cost of goods sold is given by the sum of the beginning stock balance and the net purchases then the closing stock is deducted. The net purchases figure consists of a sum of acquisitions and freight in costs less any returns on purchases.

Classified and Unclassified Income Statement

The unclassified income statement only presents only two components which are the revenues and expenses the net of which gives the net income. Conversely, the classified income statement makes a separation for revenues and expenses by indicating the revenues that relate to operations and the non- operating ones. The classified income statement also classifies expenses into two categories those that relate to core operations of the business and those that do not relate to the operations (Shim & Siegel, 2008, p.24). The classified income statement is elaborate and self-explanatory for users.

Companies opt to present their income statement using the classified income statement since it has more useful information and is easy to understand as it indicates all components of the net income. Also, the statement makes it possible to analyze the operations of the company and identify how it generates its income. A classified income statement has three major sections. The first one presents the computation of the gross margin by deducting the cost of goods sold from the net revenue. The second part provides a summary of the operating expenses which are deducted from the gross margin to give the income or loss from operations. This segment is significant since it shows the ability of the company to make profits from its critical activities. The third section presents the non-operating incomes and expenses. Other expenses, losses, and taxes are deducted from the sum of income from operations, gains, and other revenues to give the net income.

Net sales= Gross sales-(sales discount + sales returns and allowances)

Cost of goods sold=Beginning inventory + net cost of purchases-closing inventory

Gross margin=Net sales cost of goods sold

Income from operations=Gross margin Operating expenses

Net income=Income from operations + other revenues and gains - other expenses and loss

Gross Margin and Its Computation

The gross margin depicts the much that a company generates after making payments for the cost of goods sold. Therefore the gross margin is the net of revenue and the cost of goods sold. An expression of the gross margin as a percentage is given by dividing it by sales and multiplying by a hundred. Management is keen on the gross margin figure since it indicates the ability of a company to deal with the initial production costs efficiently. Therefore the entity will be able to generate profit after taking into consideration of the other operating and non-operating expenses. Observing the trends in the gross margins of a company over time also informs the management if the company's activities are leaning towards better or less efficiency in production activity. Management can use the gross margin while comparing a company's performance with others in the same industry which indicates if its operations are efficient compared to others.

Industries with Low and High Gross Margin Percentage

The gross margin reported by capital intensive industries is very low due to the high costs of goods sold. Examples of industries with low margins include car dealers, building, and construction, engineering, food, and beverages. Conversely, industries that report high gross margin include the service sector such as banking, legal services, internet service providers and healthcare.

Conclusion

From the above discussion, it is clear that the significant difference between merchandising and service companies is in the presentation of income statements in which case the former applies the classified income statement while the latter uses the unclassified income statement. The classified income statement presents the net profit in three sections where gross margin, income from operations and net profit are determined. Two methods used in determining the value of the merchandise inventory are the perpetual and periodic inventory. Gross margin is necessary for determining production efficiency, and the industries in the service industries report high gross margin while that of capital intensive industries is low.

References

Gilbertson, C. B., Gentene, D. H., & Lehman, M. W. (2014). Century 21 accounting. Multicolumn Journal, 2(10), 249. Retrieved from https://books.google.co.ke/books?id=UJ90AgAAQBAJ&pg=RA1-PA188&dq=methods+of+determining+the+merchandise+inventory&hl=en&sa=X&redir_esc=y#v=onepage&q=methods%20of%20determining%20the%20merchandise%20inventory&f=false

Shim, J. K., & Siegel, J. G. (2008). Understanding financial statements. In Financial Management (p. 24). New York: Barron's Educational Series Inc.