Merchandising Operations and Inventory

TL;DR

Merchandising operations involve buying and selling goods, unlike service businesses. Inventory is the goods a company holds for sale, a significant asset that needs careful tracking. Understanding how inventory flows and is valued is crucial for accurate financial reporting and profit calculation.

1. The Mental Model

Imagine you own a store. You buy items from suppliers and then sell them to customers. "Merchandising operations" is just the fancy term for buying and selling those items, and "inventory" is simply all the stuff you have on your shelves waiting to be sold.

2. The Core Material

Merchandising businesses are distinct from service businesses because they deal with tangible goods. This means they have a new critical asset: inventory.

Merchandising Operations

A merchandiser's primary source of revenue is sales revenue (or sales). The main expense is the cost of goods sold (COGS), which is what the merchandiser paid for the inventory they sold.

The basic income statement for a merchandiser looks like this:
Sales Revenue
- Cost of Goods Sold
= Gross Profit
- Operating Expenses
= Net Income

You'll encounter two main types of inventory systems:
* Perpetual Inventory System: This system continuously updates inventory records for every purchase and sale. It's like having a real-time counter for every item. You always know exactly how much inventory you have on hand and its cost. This system also tracks COGS with each sale.
* Periodic Inventory System: This system doesn't keep a continuous inventory count. Instead, inventory is physically counted at specific intervals (e.g., end of the month, quarter, or year) to determine the cost of goods sold and the ending inventory. It's less precise daily but can be simpler for businesses with low inventory turnover or high volumes of low-value items.

Most modern businesses, especially those using point-of-sale (POS) systems, use a perpetual system due to its accuracy and control.

Inventory Valuation Methods

Photo by Daniel Andraski on Pexels

When you sell inventory, you need to determine the cost of those specific items to calculate COGS. But what if you bought the same item at different prices over time? This is where inventory valuation methods come in. These methods are assumptions about which specific units of inventory were sold.

1. First-In, First-Out (FIFO): This method assumes the first goods purchased are the first ones sold. Think of it like a dairy cooler – you sell the oldest milk first.
   • Effect: In periods of rising prices, FIFO generally results in a higher ending inventory value and a lower COGS, leading to higher gross profit and net income.
2. Last-In, First-Out (LIFO): This method assumes the last goods purchased are the first ones sold. Imagine a pile of sand – you'd take sand off the top (the last added) first. Note: LIFO is generally not permitted under International Financial Reporting Standards (IFRS) but is allowed under U.S. GAAP.
   • Effect: In periods of rising prices, LIFO generally results in a lower ending inventory value and a higher COGS, leading to lower gross profit and net income. This can result in tax savings during inflationary times.
3. Weighted-Average Cost: This method calculates the average cost of all goods available for sale and assigns that average cost to both the inventory sold and the inventory remaining.
   • Effect: This method smooths out price fluctuations, resulting in COGS and ending inventory values that fall between FIFO and LIFO during periods of changing prices.

Here's a diagram illustrating the inventory flow and how these methods impact it:

graph TD
    A["Beginning Inventory"] --> B["Purchases"]
    B --> C["Goods Available for Sale"]
    C --> D{"Inventory Valuation Method?"}
    D -- "FIFO" --> E["Oldest Costs --> COGS"]
    D -- "LIFO" --> F["Newest Costs --> COGS"]
    D -- "Weighted-Average" --> G["Average Cost --> COGS"]
    E --> H["Newest Costs --> Ending Inventory"]
    F --> I["Oldest Costs --> Ending Inventory"]
    G --> J["Average Cost --> Ending Inventory"]
    H --> K["Financial Statements"]
    I --> K
    J --> K
    K --> L["Decision Making"]

3. Worked Example

Let's say a small electronics store, "Gadget Hub," has the following transactions for a specific drone model during October:

• Oct 1: Beginning Inventory: 10 units @ $100 each
• Oct 10: Purchase: 20 units @ $110 each
• Oct 20: Purchase: 15 units @ $120 each
• Oct 25: Sale: 30 units

We need to calculate the Cost of Goods Sold (COGS) and Ending Inventory using FIFO, LIFO, and Weighted-Average methods.

Goods Available for Sale:
* (10 units * $100) = $1,000
* (20 units * $110) = $2,200
* (15 units * $120) = $1,800
* Total Goods Available for Sale: 45 units for a total cost of $5,000

Units Sold: 30 units
Units Remaining (Ending Inventory): 45 - 30 = 15 units

1. FIFO (First-In, First-Out)
* COGS (30 units sold):
* From Oct 1 (beginning inventory): 10 units * $100 = $1,000
* From Oct 10 (first purchase): 20 units * $110 = $2,200
* Total COGS: $1,000 + $2,200 = $3,200
* Ending Inventory (15 units remaining):
* All remaining units come from the last purchase (Oct 20): 15 units * $120 = $1,800

2. LIFO (Last-In, First-Out)
* COGS (30 units sold):
* From Oct 20 (last purchase): 15 units * $120 = $1,800
* From Oct 10 (next-to-last purchase): 15 units * $110 = $1,650 (15 of the 20 units)
* Total COGS: $1,800 + $1,650 = $3,450
* Ending Inventory (15 units remaining):
* From Oct 1 (beginning inventory): 10 units * $100 = $1,000
* From Oct 10 (remaining 5 units): 5 units * $110 = $550
* Total Ending Inventory: $1,000 + $550 = $1,550

3. Weighted-Average Cost
* Average Cost Per Unit: Total Cost of Goods Available / Total Units Available
* $5,000 / 45 units = $111.11 per unit (rounded)
* COGS (30 units sold):
* 30 units * $111.11 = $3,333.30
* Ending Inventory (15 units remaining):
* 15 units * $111.11 = $1,666.65

Summary:
| Method | COGS | Ending Inventory |
| :---------------- | :----------- | :--------------- |
| FIFO | $3,200 | $1,800 |
| LIFO | $3,450 | $1,550 |
| Weighted-Average | $3,333.30 | $1,666.65 |

You can see how the choice of method impacts both COGS (and thus gross profit/net income) and the value of inventory on the balance sheet.

4. Key Takeaways

• Merchandising businesses buy and sell goods, having inventory as a key asset, unlike service businesses.
• The cost of goods sold (COGS) is the primary expense for merchandisers, directly impacting gross profit.
• Perpetual inventory systems continuously track inventory and COGS, offering real-time data.
• Periodic inventory systems rely on physical counts at specific times to determine inventory and COGS.
• FIFO assumes oldest inventory is sold first, generally leading to higher profit during rising prices.
• LIFO assumes newest inventory is sold first, generally leading to lower profit (and taxes) during rising prices.
• The weighted-average method smooths out price fluctuations by using an average cost for all units.

Common Mistakes to Avoid:
- Don't confuse sales revenue with gross profit; remember to subtract COGS.
- Assuming the actual physical flow of goods always matches the inventory costing method used.
- Forgetting that inventory valuation methods can significantly impact net income and taxes.
- Not updating inventory records accurately in a perpetual system or performing regular physical counts in a periodic system.

5. Now Try It

Imagine you own a small t-shirt shop. On June 1, you had 20 t-shirts (beginning inventory) that cost you $8 each. On June 10, you bought 30 more t-shirts for $9 each. On June 25, you sold 40 t-shirts.

Calculate the Cost of Goods Sold and the value of your Ending Inventory for June using both the FIFO and Weighted-Average inventory costing methods. What's the difference in your gross profit if your sales revenue was $600?