6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies

Multi-Step and Simple Income Statements for Merchandising Companies

Income statements for merchandising companies show how revenue flows through costs and expenses to arrive at net income. Unlike service companies, merchandisers have an extra layer of complexity: cost of goods sold (COGS). This makes the income statement format especially important because it determines how much detail you can see about where profits come from.

Two formats exist for presenting this information: the multi-step and the simple (single-step) income statement. The multi-step version separates operating from non-operating activities and highlights gross profit as its own line item. The simple version groups all revenues together and all expenses together, then calculates net income in one step. Both arrive at the same net income, but the multi-step format gives more insight into where profitability is coming from.

Multi-Step Income Statement Preparation

The multi-step income statement earns its name by calculating net income through several intermediate subtotals. Each subtotal tells you something different about the company's performance. Here's how it's structured, from top to bottom:

1. Net Sales

Start with gross sales (total sales before any deductions), then subtract:

• Sales returns and allowances: merchandise returned by customers or price reductions granted after the sale
• Sales discounts: reductions offered to customers for paying early (e.g., 2/10, n/30 terms)

The result is net sales, which represents the actual revenue the company earned from selling merchandise.

2. Cost of Goods Sold (COGS)

This section calculates the cost of the merchandise that was actually sold during the period:

• Start with beginning inventory (merchandise on hand at the start of the period)
• Add gross purchases (total cost of merchandise bought during the period)
• Subtract purchase returns and allowances (merchandise sent back to suppliers or price reductions received)
• Subtract purchase discounts (reductions received for paying suppliers early)
• Add freight-in (shipping costs to get merchandise from suppliers to your warehouse)
• This gives you cost of goods available for sale
• Subtract ending inventory (merchandise still on hand at the end of the period)

The result is COGS, the cost of only the inventory that was sold.

3. Gross Profit

$\text{Gross Profit} = \text{Net Sales} - \text{Cost of Goods Sold}$

Gross profit shows how much the company earned from selling merchandise before paying for operating expenses. This is the first key subtotal that makes the multi-step format valuable.

4. Operating Expenses

These are split into two categories:

• Selling expenses: costs directly tied to selling merchandise (sales salaries, advertising, depreciation of store equipment)
• General and administrative expenses: costs of running the overall business (office salaries, utilities, depreciation of office equipment)

5. Operating Income (Income from Operations)

$\text{Operating Income} = \text{Gross Profit} - \text{Total Operating Expenses}$

This subtotal isolates profit from the company's core business activities, which is why analysts pay close attention to it.

6. Non-Operating Items

• Other revenues and gains: income outside core operations (interest income, gain on sale of assets)
• Other expenses and losses: expenses outside core operations (interest expense, loss on sale of assets)

7. Bottom Line

• Income before income taxes: operating income adjusted for non-operating items
• Income tax expense: taxes owed on taxable income
• Net income: the final profit after everything is accounted for

Simple Income Statement Creation

The simple (single-step) income statement combines everything into one calculation: total revenues minus total expenses equals net income. It contains the same information as the multi-step version but doesn't break out intermediate subtotals like gross profit or operating income.

Here's the structure:

Revenues and Gains

• Net sales (gross sales minus sales returns/allowances and sales discounts)
• Other revenues and gains (interest income, gain on sale of assets)

Expenses and Losses

• Cost of goods sold (calculated the same way as in the multi-step format: beginning inventory + net purchases + freight-in - ending inventory)
• Selling expenses
• General and administrative expenses
• Other expenses and losses (interest expense, loss on sale of assets)
• Income tax expense

$\text{Net Income} = \text{Total Revenues and Gains} - \text{Total Expenses and Losses}$

The simple format is easier to prepare and read, but it doesn't highlight gross profit or operating income separately. That means you lose visibility into how well the company manages its core merchandising operations versus its non-operating activities.

Gross Profit Margin Ratio Analysis

The gross profit margin ratio measures what percentage of each sales dollar remains after covering the cost of goods sold. It's one of the most commonly used metrics for evaluating a merchandiser's pricing and inventory management.

$\text{Gross Profit Margin Ratio} = \frac{\text{Gross Profit}}{\text{Net Sales}} \times 100$

For example, if gross profit is $100,000 and net sales are $500,000:

$\frac{\$100{,}000}{\$500{,}000} \times 100 = 20\%$

This means 20 cents of every sales dollar is left after paying for the merchandise itself.

What a higher ratio signals:

• The company generates more profit per dollar of sales, possibly through higher markups
• Better control over purchasing costs or more efficient inventory management
• Stronger pricing power due to brand strength, unique products, or limited competition

What a lower ratio signals:

• The company may be cutting prices to stay competitive
• Higher costs from suppliers or inefficient inventory management
• Increased competition or pressure from price-sensitive customers

How to use this ratio effectively:

• Trend analysis: Compare the company's ratio across multiple periods. A declining ratio over time could signal rising costs or pricing pressure.
• Benchmarking: Compare against industry averages or direct competitors. A grocery store might have a 25% margin while a jewelry retailer might have 50%, so cross-industry comparisons aren't meaningful.

Factors that influence the ratio:

• Selling price changes: raising prices improves the ratio (assuming sales volume holds); lowering prices reduces it
• Cost of goods sold changes: negotiating lower supplier costs or earning purchase discounts improves the ratio
• Product mix shifts: selling more high-margin products (like luxury goods) lifts the overall ratio, while shifting toward low-margin items drags it down
• Economies of scale: as volume increases, bulk purchasing discounts can lower per-unit costs without a proportional increase in COGS

Inventory Systems and Accounting Methods

Two inventory systems affect how COGS and inventory balances appear on these statements:

• Periodic inventory system: inventory counts happen at set intervals (usually end of period). COGS is calculated after a physical count using the formula: beginning inventory + net purchases + freight-in - ending inventory.
• Perpetual inventory system: inventory records update continuously with each purchase and sale, providing real-time inventory data. COGS is recorded at the time of each sale.

Both systems should produce the same ending figures, but the perpetual system gives you up-to-date information throughout the period.

These statements also rely on accrual basis accounting, meaning revenue is recorded when earned and expenses when incurred, regardless of when cash changes hands. This is what allows the income statement to match revenues with the expenses that generated them within the same period.