Merchandising vs. Service Companies Income Statements: An Overview
Even though merchandising companies and service companies conform to generally accepted accounting principles [GAAP], there are differences in the ways each prepares its financial statements, especially income statements, where most differences center around the existence of inventory.
Key Takeaways
- A merchandising company engages in the purchase and resale of tangible goods.
- Service companies primarily sell services rather than tangible goods.
- Income statements for each type of firm vary in several ways, such as the types of gains and losses experienced, cost of goods sold, and net revenue.
Merchandising Company
A merchandising company buys tangible goods and resells them to consumers. These businesses incur costs, such as labor and materials, to present and sell products. Retail and wholesale companies are the two types of merchandising companies. Retail companies sell products directly to consumers, and wholesale companies sell products directly to retailers or other wholesalers. The operating cycle of a merchandising company is the time between the purchase of the product and the sale of that product.
Service Company
Service companies do not sell tangible goods to produce income; rather, they provide services to customers or clients according to a specific expertise or specialty. Service companies sell their services, often charging base fees and hourly rates. Examples of service companies include consultants, accountants, financial planners, and insurance providers.
Key Differences in the Income Statements
The income statement shows financial performance from operations first and then separately discloses gains and losses that fall outside the regular scope of operations.
The differences in income statements can be further understood by examining the balance sheets of both types of companies. For instance, inventory is a large percentage of the assets category for a merchandising company. As such, they tend to have less cash on hand than service businesses since their capital is tied up in illiquid assets. By contrast, service businesses' assets tend to be weighted toward accounts receivable. For a service business, the absence of inventory means receivables are a greater proportion of total assets.
Both service and merchandising companies may experience gains or losses from non-operational sources. However, sources of the gains or losses differ between the two business types. For instance, a merchandiser might decide to redecorate a retail store and sell off fixtures for a profit. A service company might have a one-time gain from the sale of a patent. Lawsuits may also be a factor for both types of businesses. For merchandisers, lawsuits are often related to defective goods. Meanwhile, a service provider might be more likely sued for breach of contract.
Both merchandising companies and service companies prepare income statements to help investors, analysts, and regulators understand their internal financial operations. Merchandising companies hold and account for product inventory, which makes their income statements inherently more complicated. Much of the inventory calculation is manifested through the line-item cost of goods sold, which is an expense account describing the cost of purchasing inventory and delivering it to customers. If you look at an income statement for a service company, you will not see a line item for the cost of goods sold.
The nature of increases or decreases in net revenue for each type of company is also different. Service companies do not typically have enormous expense accounts, meaning that fluctuations in net revenue are almost entirely a function of generating sales. Manufacturing companies are less certain since a decrease in net revenue could be an increase in expenses or a decrease in revenues.
Operating cycle definition
The operating cycle is the time required for a company's cash to be put into its operations and then return to the company's cash account.
Operating cycle example
A manufacturer's operating cycle is amount of time required for the manufacturer's cash to be used to:
- pay for the raw materials needed in its products
- pay for the labor and overhead costs needed to convert the raw materials into products
- hold the finished products in inventory until they are sold
- wait for the customers' cash payments to be collected
The operating cycle is the sum of the following:
- the days' sales in inventory [365 days/inventory turnover ratio], plus
- the average collection period [365 days/accounts receivable turnover ratio]
The operating cycle has importance in classifying current assets and current liabilities. While most manufacturers have operating cycles of several months, a few industries require very long processing times. This could result in an operating cycle that is longer than one year. To accommodate those industries, the accountants' definitions of current assets and current liabilities include the following phrase: ...within one year or within the operating cycle, whichever is longer.
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You can also read our Explanation of Financial Ratios.