Merchandise Inventory

Ch. 8: Merchandise Inventory XXX

Chapter 8

Merchandise Inventory

In this chapter you will learn how merchandise inventory affects businesses, how it is controlled, accounted for, and reported in financial statements.

What Is Merchandise Inventory?

The products merchandising (retailing) companies buy and sell to individuals and/or other companies are called merchandise inventory. Wal-Mart's merchandise inventory includes food, clothing, home appliances, gardening supplies, and toys, to name just a few items. Like other merchandising companies, Wal-Mart buys products (merchandise inventory) from other companies, displays the products in stores and on the internet, and sells them to customers. The key element of merchandise inventory is it is a resource the merchandising company can use. Merchandise inventory is purchased to be sold to customers at a greater price than paid by the merchandising company. Through buying merchandise and selling it to customers at higher prices, merchandising companies increase their resources (assets) over time.

In terms of the accounting equation, merchandise inventory is an asset, as shown below. The numbers in parentheses refer to the chapters in which the items are discussed.

Assets
Current Assets
Cash and cash equivalents (6)
Accounts receivable (7)
Allow. for Uncoll. Accts. (7)
Merchandise inventory (8) / = / Liabilities / + / Stockholders' Equity
Revenues
Sales (7)
Sales Returns & Allow. (7)
Operating Expenses
Uncollect. Accts. Exp. (7)
Bank Service Expense (6)
Other Revenues & Expenses
Interest Revenue (6)
Interest Expense (6)

The amount of merchandise inventory differs from company to company and from year to year within a given company. Exhibit 8-1 presents inventory for three merchandising companies and compares it to the companies' total assets. As the data show, there are many differences among the companies. For example, Target maintained approximately 17% of its total assets in merchandise inventory, while Wal-Mart's inventory was over 22% of total assets.

Exhibit 8-1
Merchandise Inventory ($ millions)
January 31, 2007
Company / Inventory / Total Assets / Percent
Federated Department Stores / $5,317 / $29,559 / 18.0
Target / $6,254 / $37,349 / 16.7
Wal-Mart / $33,685 / $151,193 / 22.3

Merchandising: An Overview

The following paragraphs briefly describe how merchandise inventory affects merchandising companies by discussing one part of the operations of the Matthew Sporting Goods Company. As you may remember from Chapter 7, the Matthew Sporting Goods Company sells sporting equipment and supplies to youth organizations. The following paragraphs are restricted to only that part of the company's operations relating to the sale of customized baseball shirts. Each shirt is imprinted with a team's name and logo. As shown in Exhibit 8-2, there are four steps involved with the company’s merchandise inventory (baseball shirts): (1) the purchase of merchandise from suppliers, (2) the sale of merchandise to customers, (3) the collection of cash from customers, and (4) the payment of cash to suppliers. As will be shown, the Matthew Sporting Goods Company attempts to increase its resources through these four steps.

Exhibit 8-2

Matthew Sporting Goods Company

Merchandising Operations

Step 1: the purchase of merchandise from suppliers In order to sell baseball shirts to customers, the Matthew Sporting Goods Company must purchase the shirts from other companies. These other companies could also be merchandising companies or they could be companies that make the shirts, called manufacturers. Although the Matthew Sporting Goods Company does purchase some products by paying cash, the vast majority of its purchases are on credit. That is, the company buys merchandise by promising to pay for it in the near future, often within 30 days. As a result of buying merchandise on credit, the company's resources (assets) increase, as shown in Exhibit 8-2 by the arrow indicating resources coming into the company (Step 1). Since the source of these resources was creditors, the company's liabilities, called accounts payable, also increase. If the company buys 100 shirts at a cost of $24 per shirt, the effects of step 1, the purchase of merchandise from suppliers, can be summarized as follows.

Step 2: the sale of merchandise to customers When the Matthew Sporting Goods Company sells some of its shirts to customers, two things happen simultaneously: the company’s resources decrease when the shirts go to the customers and the company’s resources increase when the customers either pay for the shirts or promise to pay for the shirts in the near future. Remember, the company’s business is to sell products, not give them away! Because knowledge of each of these two effects is important to managers, the sale of products to customers is separated into its two parts: the decrease in resources when the shirts go to customers and the increase in resources when the customers pay or promise to pay for the shirts.

The flow of merchandise to customers When the Matthew Sporting Goods Company’s shirts go to its customers, the obvious effect is a decrease in the company’s resources, as shown in Exhibit 8-2 by the arrow indicating resources going out of the company (Step 2, part 2A). Consistent with our treatment of resources in previous chapters, this decrease may be viewed as a result of management using up some resources. The resources (shirts) were not sent to creditors, nor were they distributed to owners. The resources were used up by management in the performance of management’s responsibility for operating the company. When management uses up resources in the operation of the company, such uses are reported as expenses. Remember the discussion of the use of supplies in previous chapters. As supplies were used up, the result was reported as a decrease in supplies and an increase in supplies expense. Similarly with merchandise inventory, the “using up” of shirts by them going to customers is reported as a decrease in merchandise inventory and an increase in an expense called the cost of goods sold. Since expenses decrease stockholders’ equity, the ultimate result of shirts going to customers is a decrease in resources (assets) and an equal decrease in stockholders’ equity (through the closing process). If all 100 of the Matthew Sporting Goods Company’s shirts go to its customers, the effects can be summarized as presented as step 2A below. Since each of the shirts cost the company $24, the resources decrease and stockholders’ equity decrease (through the expense increase) are $2,400 (100 x $24).

The flow of promises (accounts receivable) from customers At the same time the Matthew Sporting Goods Company’s customers receive the shirts, they must give something in return to the company. Usually customers give either cash or promises of cash. Thus, the company receives either cash or accounts receivable. In either case, the obvious effect is an increase in the company’s resources, as shown in Exhibit 8-2 by the arrow indicating resources coming into the company (Step 2, part 2B). Consistent with our treatment of resources in previous chapters, this increase may be viewed as a result of management generating resources. The resources (cash or accounts receivable) were not borrowed from creditors nor invested by owners. The resources were generated by management in the performance of management’s responsibility for operating the company. When management generates resources in the operation of the company, such generations are reported as revenues. Remember the discussion of providing services to customers in previous chapters. As customers were serviced, the result was reported as an increase in cash or accounts receivable and an increase in fees revenue. Similarly with the sale of products to customers, the receipt of cash or accounts receivable from customers is reported as an increase in cash or accounts receivable and an increase in a revenue called sales. Since revenues increase stockholders’ equity, the ultimate result of the receipt of cash or accounts receivable from customers is an increase in resources (assets) and an equal increase in stockholders’ equity (through the closing process). If the 100 shirts of the Matthew Sporting Goods Company were sold to its customers on credit, at a price of $37 each, the effects can be summarized as presented as step 2B below. The resource increase and the stockholders’ equity increase (through the revenue increase) are $3,700 (100 x $37).

Total Resources / = / Sources of Borrowed Resources / + / Sources of
Owner Invested Resources / + / Sources of Management Generated
Resources
Assets / = / Liabilities / + / Stockholders' Equity
Step 1: purchase
of merchandise on credit / + $2,400 / = / + $2,400
Step 2A: flow of merchandise to customers (expense) / - $2,400 / = / - $2,400
Step 2B: flow of accounts receivable from customers (revenue) / + $3,700 / = / + $3,700
Totals / + $3,700 / = / + $2,400 / + / + $1,300

Step 3: the collection of cash from customers Within a very short time, often 30 days or less, the Matthew Sporting Goods Company collects cash from customers to whom it sold shirts on credit. As a result, as cash increases and accounts receivable decrease, the company’s resources increase and decrease by the same dollar amount, as shown in Exhibit 8-2 by the arrows at Step 3. If the Matthew Sporting Goods Company collects all of its accounts receivable from its customers ($3,700), the effects can be summarized as presented in step 3 below.

Step 4: paying cash to suppliers for purchases made on credit Similar to collecting cash from its credit customers, the Matthew Sporting Goods Company pays cash to its suppliers from whom it purchased the shirts on credit. The obvious effect of the flow of cash out of the company is the company’s resources decrease, as shown in Exhibit 8-2 by the arrow indicating resources going out of the company (Step 4). Inasmuch as the cash is paid to creditors, the other effect is to reduce liabilities (accounts payable). If the Matthew Sporting Goods Company pays all its accounts payable ($2,400), the effects can be summarized as presented in step 4 below.

Result of four merchandising steps As shown above, the result of the four merchandising steps is the Matthew Sporting Goods Company increased its resources and sources of resources by $1,300. This increase in resources came about because the company was able to charge its customers $13 ($37 - $24) more per shirt than it cost the company to buy each shirt from its suppliers. Since the company sold 100 shirts, the company’s resources increased by $1,300 (100 x $13). Stockholders’ equity increased by $1,300 because management generated the $1,300. This process of increasing resources by charging customers more for products than it cost the company to buy the products is the basis of merchandising. This process is the foundation of merchandising companies and is repeated by them hundreds or thousands of times. Furthermore, this increase in resources through the operation of the company is the key function of management. Management’s primary responsibility is to take resources they have been entrusted with and use them to generate additional resources. The additional resources generated can then be used by the company for many purposes. For example, the additional resources can be used to generate more resources, they may be distributed to owners as dividends, they may be given to employees as additional salaries or wages, or they can be contributed to various charitable organizations.

Management’s ability to generate additional resources by charging customers more than it cost the company to buy the products from its suppliers is reported on the income statement as gross profit or gross margin. As shown in the Matthew Sporting Goods Company’s August income statement in Exhibit 8-3, gross profit is the difference between sales (the dollar amount customers are charged) and the cost of goods sold (the dollar amount charged by suppliers). You should also note in Exhibit 8-3, while the cost of goods sold is the largest expense for the company, there are other expenses, specifically operating expenses and income taxes expense. As you would probably expect, operating expenses include such costs as employees’ salaries and wages, advertising, rent, and insurance.