TYPES OF BUSINESS

ACCORDING TO
ACTIVITIES

PREPARED BY : PROF. JONAH C. PARDILLO

 LEARNING OBJECTIVES

After reading this chapter, you should be able to:

 Compare and Contrast the types of business according to activities;

 Identify the advantages, and disadvantages, and business requirements of each

type.
 Service Business
 This type of business provides various forms of services, not tangible products, to its customers or
clients. Some examples of entities that render services are: professional, repair shops, banks,
brokers, consultants, schools, hotels, insurance companies, utility enterprises, and service
contractors. A service enterprise recognizes income in the form of fees, rents, interests, realties,
retainers, or commissions.
 Service Business
 The typical financial transactions recorded for a service company include collecting a deposit from
the customer, providing the service and receiving payment. These activities may occur in the same
accounting cycle or in several cycles.

Receive Cash
Cash

Accounts
Receivable
 Merchandising Business

 This type of business entity is in the “buy and sell” business. A “trading” or merchandising
enterprise buys ready-to-use products, such as appliances, vehicles, households items, toys,
clothing apparels, supplies, ready-to-eat food. A business enterprise that purchases ready-to-use
materials from wholesalers or manufacturers, and then sells the same to other processors or
manufacturers, without changing the form of the materials bought and sold, is also classified as a
merchandising enterprise.
 Merchandising Business

 Wholesaler buys large quantities of finished goods directly from the manufacturers or importers,
and then resells the same to the different merchandisers.

 Retailers or traders sell the goods directly to the end-customers. Examples: (SM, Mercury Drugs,
Uniwide, Rustan’s and supermarkets.
 Merchandising Operating Cycle

 The primary sources of revenues is referred to as sales revenue or sales.

 The operating cycle of a merchandising company ordinarily is longer than that of a
service company
 Income Measurement of Merchandising Business
Not used in a service
business
Sales less
Revenue
Equals
Cost of Gross
Good sold Profit
less

Cost of goods sold is the total cost Operating Equals Net Income
Of Merchandise sold during the period. Expenses (Loss)
 Inventory systems
 Perpetual System

Features:

1. Purchases increase Merchandise Inventory.

2. Freight costs, Purchase Returns and Allowances and Purchase discounts are included in
Merchandise Inventory.

3. Costs of Goods Sold is increased and Merchandise Inventory is decreases for each sale.

4. Physical count done to verify Merchandise Inventory balance.

The perpetual inventory system provides a continuous record of Merchandise Inventory and Cost of
Goods Sold.
 Inventory systems
 Periodic system

Features:

1. Purchases of merchandise increase purchases.

2. Ending inventory determined by physical count.

3. Calculation of Cost of Goods Sold:

Beginning inventory

Add: Purchases, net

Goods available for sale

 Recording Purchases of Merchandise

 Made using cash or credit (on account)

 Normally recorded when goods are received.

 Purchase invoice should support each credit purchase.

 Recording Purchases of Merchandise
 Freight Costs

Terms
 FOB shipping point – seller places goods Free on Board the carrier, and buyer pays freight costs.

 FOB destination – seller places the goods Free on Board to the buyer’s place of business, and seller
pays freight costs.

Freight costs incurred by the seller on outgoing merchandise are an operating expense to the
seller (Freight-out or Delivery Expense).
 Recording Purchases of Merchandise
 Purchase Returns and Allowances
 Purchaser may be dissatisfied because goods are damaged or defective, of inferior quality, or do not meet
specifications.

 Purchase Return
 Return goods for credit if the sale was made on credit, or for a cash refund if the purchase was for cash.

 Purchase Allowance
 May choose to keep the merchandise if the seller will grant an allowance (deduction) from the purchase
price.
 Recording Purchases of Merchandise
 Purchase Discounts
 Purchase terms may permit buyer to claim a cash discount for prompt payment.

 Advantages:
 Purchaser saves money.

 Seller shortens the operating cycle.

 Example:
 Credit terms of 2/10, n/30, is read “two-ten, net thirty”. 2% cash discount if payment is made within 10
days.
 Recording Purchases of Merchandise
 Purchase Discounts Terms

Credit term: 2/10, n/30

 2% discount of paid within 10 days, otherwise net amount due within 30 days.

Credit term: 1/10 EOM

 1% discount if paid within first 10 days of next month.

Credit term: n/10 EOM

 Net amount due within the first 10 days of the next month.
Computation of the Profit of service vs. merchandising business

Service Business
Revenue from services rendered P xx
Less: Operating expenses xx
Profit of the period P xx

Merchandise Business
Revenue from goods sold P xx
Less: Cost of goods sold xx
Gross profit on sales P xx
Less: other operating expenses xx
Profit of the period P xx
 Gross Profit on sale equation

Derived Equation:

Sales – Cost of goods sold = Gross profit on sales

Sales – Gross profit on sales = Cost of goods sold

Sales – Cost of goods sold + Gross profit on sales

Gross profit on sales – other operating expenses = Profit

Gross profit on sales – Profit = Other operating expenses

Gross profit on sales = Other operating expenses + Profit

 Sample Computation of gross profit on sale

Compute for the missing amounts.

Case 1 Case 2 Case 3 Case 4

Sales Revenue 1,244,325 2,468,540 1,425,360 ?

Cost of goods sold 825,450 1,727,970 ? 875,890

Gross margin ? ? ? ?
Other operating expenses 245,330 ? 301,320 275,280
Profit during the period ? 210,335 132,550 125,200
 Check your Answers

Compute for the missing amounts.

Case 1 Case 2 Case 3 Case 4

Sales Revenue 1,244,325 2,468,540 1,425,360 1,276,370

Cost of goods sold 825,450 1,727,970 991,490 875,890

Gross margin 418,875 740,570 433,870 400,480
Other operating expenses 245,330 530,235 301,320 275,280
Profit during the period 173,545 210,335 132,550 125,200
 Cost of goods sold Equation
Cost of goods sold formula on periodic Inventory system:

Inventory that is
Inventory at the Net purchases
+ = - = available for sale
beginning of the during the
during the reporting period
reporting period reporting period

Inventory that is Unsold portion, which is Sold portion, which

available for sale
during the reporting
period
becomes,
Ending merchandise cost of goods sold,
inventory, reported reported in the income
statement
in the balance sheet
 Sample Computation on cost of goods sold

Compute for the missing amounts.

Case 1 Case 2 Case 3 Case 4

Inventory, beginning 125,750 87,985 55,780 ?

Purchases 775,350 822,500 ? 695,220

Inventory available for sale ? ? ? ?
Inventory, ending 85,755 ? 45,230 91,245
Cost of goods sold ? 750,335 615,750 855,455
 Check your Answers

Compute for the missing amounts.

Case 1 Case 2 Case 3 Case 4

Inventory, beginning 125,750 87,985 55,780 251,480

Purchases 775,350 822,500 605,200 695,220

Inventory available for sale 901,100 910,485 660,980 946,700
Inventory, ending 85,755 160,150 45,230 91,245
Cost of goods sold 815,345 750,335 615,750 855,455
 Manufacturing Business
 Manufacturer also called fabricator, producer or processor

 Is in the normal business of producing the goods that he sells. He has factory facilities where
the finished goods are produced out of materials and supplies by applying labor and other
manufacturing costs.

 Manufacturing firms will purchase raw materials from suppliers and convert them into
finished products, such as Apple iPods, Levi Stauss jeans, and Ford trucks and cars.
 Manufacturing Business
Manufacturer

Wholesaler
Selling Goods and
Services to Customers
Retailer

Consumer

Service Company
 Manufacturing Business
 Manufacturing Costs
 Represents all the costs associated with producing or manufacturing a physical product.

 Direct materials: includes the major material inputs that can be directly and conveniently traced to each unit of
product(the cost object).

 Direct labor costs: refers to the “hands on” labor that can be directly conveniently traced to the product, such as
the wages of employees on the production of the product (pizza) production line and in the packaging
department.

 Manufacturing overhead: includes all manufacturing costs other than direct materials and direct labor incurred
to produce a physical product. It includes all of the indirect costs that are incurred inside the manufacturing
facility or factory that cannot be traced to each unit of product, such as indirect materials, indirect labor, factory
rent, factory insurance, and factory utilities.
 Manufacturing Business
 Manufacturing Costs
 Represents all the costs associated with producing or manufacturing a physical product.

 Direct materials: includes the major material inputs that can be directly and conveniently traced to each unit of
product(the cost object).

 Direct labor costs: refers to the “hands on” labor that can be directly conveniently traced to the product, such as
the wages of employees on the production of the product (pizza) production line and in the packaging
department.

 Manufacturing overhead: includes all manufacturing costs other than direct materials and direct labor incurred
to produce a physical product. It includes all of the indirect costs that are incurred inside the manufacturing
facility or factory that cannot be traced to each unit of product, such as indirect materials, indirect labor, factory
rent, factory insurance, and factory utilities.
 Manufacturing Business
 Prime costs: taken together, direct materials and direct labor. Direct labor and direct materials are
considered as “primary” costs of manufacturing product.

Formula:

Prime Cost = Direct materials + Direct labor

 Conversion costs: the costs incurred to convert direct materials into a finished product. Direct labor
and manufacturing overhead are referred to collectively as conversion costs.

Formula:

Direct labor + Manufacturing overhead

 Non-Manufacturing Costs
 Non-manufacturing costs: are the costs associated with running the business and selling the
product as opposed to manufacturing the product. They are generally classified into one of two
groups:
 Marketing or selling expenses: are incurred to get the final product to the customer.

 General and administrative expenses: are associated with running the overall business. They include
general management salaries, rent and utilities for corporate headquarters, and corporate service
functions such as the accounting, payroll, and legal departments.
Product and Period Cost Flows
 Manufacturing Cost Concepts

Financial Accounting Managerial Accounting

Cost is a measure of resources Product costs are the costs a
used or given up to achieve a company assigns to units
stated purpose. produced.
 Manufacturing Costs

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

The Product
 Classifications of Costs
Manufacturing costs are often
combined as follows:

Direct
Direct Direct
Direct Manufacturing
Manufacturing
Materials
Materials Labor
Labor Overhead
Overhead

Prime Conversion
Cost Cost
 Nonmanufacturing Costs
Marketing and selling costs . . .
– Costs necessary to get the order and deliver the product.
Administrative costs . . .
– All executive, organizational, and clerical costs.
 Product Costs Versus Period Costs
Product costs include direct Period costs are not included in
materials, direct labor, and product costs. They are expensed
manufacturing overhead. on the income statement.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 Balance Sheet
Merchandiser Manufacturer
Current Assets Current Assets
– Cash  Cash
– Receivables  Receivables
– Prepaid Expenses  Prepaid Expenses
– Merchandise Inventory  Inventories
Raw Materials
Work in Process
Finished Goods
 Balance Sheet
Merchandiser Manufacturer
Current Assets Current Assets
– Cash  Cash
– Receivables  Receivables
Materials waiting to be
– Prepaid Expenses  Prepaid Expenses
processed.
– Merchandise Inventory  Inventories
Partially complete products –
Raw Materials
some material, labor, or overhead
Work in Process
has been added.
Finished Goods

Completed products awaiting

sale.
 The Income Statement
Cost of goods sold for manufacturers differs only slightly from cost of goods
sold for merchandisers.

Merchandising Company Manufacturing Company

Cost of goods sold: Cost of goods sold:
Beg. merchandise Beg. finished
inventory $ 14,200 goods inv. $ 14,200
+ Purchases 234,150 + Cost of goods
Goods available manufactured 234,150
for sale $ 248,350 Goods available
- Ending for sale $248,350
merchandise - Ending
inventory (12,100) finished goods
= Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
sold $236,250
 Manufacturing Cost Flows Income
Balance Sheet Statement
Costs Inventories Expenses
Material Purchases Raw Materials
 Manufacturing Cost Flows Income
Balance Sheet Statement
Costs Inventories Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead
 Manufacturing Cost Flows Income
Balance Sheet Statement
Costs Inventories Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold
 Manufacturing Cost Flows Income
Balance Sheet Statement
Costs Inventories Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
 Inventory Flows
Beginning
Beginning Additions Available
balance
balance + Additions
$$$
$$$
= Available
$$$$$
$$$$$
$$
$$
_
Withdrawals
Withdrawals
$$$
$$$

=
Ending
Ending
balance
balance
$$
$$
 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw
materials inventory

Beginning
Beginninginventory
inventoryisisthe
the
inventory
inventorycarried
carriedover
overfrom
fromthe
the
prior
priorperiod.
period.
 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used As
Asitems
itemsare
areremoved
removedfrom
fromraw
rawmaterials
materialsinventory
inventoryand
and
in production placed
placedinto
intothe
theproduction
productionprocess,
process,they
theyare
are
called
calleddirect
directmaterials.
materials.
 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process
Conversion
Conversioncosts
costsare
are
Beginning raw Direct materials
materials inventory + Direct labor
costs
costsincurred
incurredto
toconvert
convert
+ Raw materials + Mfg. overhead the
thedirect
directmaterial
materialinto
intoaa
purchased = Total manufacturing finished
= Raw materials costs
finishedproduct.
product.
available for use
in production
– Ending raw materials
inventory
= Raw materials used
in production
 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory All
Allmanufacturing
manufacturingcosts
costsincurred
incurredduring
duringthe
theperiod
process periodare
are
inventory
= Raw materials used added
addedto
tothe
thebeginning
beginningbalance of
ofwork
= Cost
balance in
inprocess.
of goods
work process.
in production manufactured.
 Product Costs - A Closer Look
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
Costs inventorywith the goods that are completed during
associated process inventory
Costs associated with the goods that are completed during
= Raw materials used = Cost of goods
the
theperiod
period
in
are
aretransferred
transferredto
production tofinished
finishedgoods
goodsinventory.
inventory. manufactured.
 Product Costs - A Closer Look
Work
In Process Finished Goods

Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold
Cost Classifications for Predicting Cost Behavior

How
Howaacost
costwill
willreact
reactto
tochanges
changesin in
the
thelevel
levelof
ofbusiness
businessactivity.
activity.
–– Total
Totalvariable
variablecosts
costschange
changewhen
when
activity
activitychanges.
changes.
–– Total
Totalfixed
fixedcosts
costsremain
remainunchanged
unchanged
when
whenactivity
activitychanges.
changes.
 Total Variable Cost
Your total long distance telephone bill is based on how many
minutes you talk.
Total Long Distance
Telephone Bill

Minutes Talked
 Variable Cost Per Unit
The cost per long distance minute talked is constant. For example,
10 cents per minute.

Telephone Charge
Per Minute
Minutes Talked
 Total Fixed Cost
Your monthly basic telephone bill probably does not change
when you make more local calls.
Monthly Basic
Telephone Bill

Number of Local Calls

 Fixed Cost Per Unit
The average cost per local call decreases as more local calls are
made.

Monthly Basic Telephone Bill

per Local Call
Number of Local Calls
Cost Classifications for Predicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
 Direct Costs and Indirect Costs
Direct costs Indirect costs
• Costs that can be • Costs cannot be easily and
easily and conveniently traced to a conveniently traced to a unit of
unit of product or other cost product or other cost object.
objective. • Example: manufacturing overhead
• Examples: direct material and direct
labor
 Differential Costs and Revenues
Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your hometown. You have a
job offer in a neighboring city that pays $2,000 per month. The commuting cost to
the city is $300 per month.

Differential revenue is:

$2,000 – $1,500 = $500
 Differential Costs and Revenues
Costs and revenues that differ among alternatives.

Example: You have a job paying $1,500 per month in your hometown. You have a
job offer in a neighboring city that pays $2,000 per month. The commuting cost to
the city is $300 per month.

Differential revenue is:

$2,000 – $1,500 = $500
Differential cost is:
$300
 Opportunity Costs
The potential benefit that is given up
when one alternative is selected over
another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for one year is
$15,000.
 Sunk Costs
Sunk costs cannot be changed by any decision. They are not differential
costs and should be ignored when making decisions.
Example: You bought an automobile that cost $10,000 two years ago.
The $10,000 cost is sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $10,000 cost.
 THE END
References:

Kimwell, M.B., “Fundamentals of Accounting”

Manuel, Z.C “Accounting Process, Basic Concepts and Procedures, Int’l Ed.”
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