Fundamentals of Accounting Business and Management I

1
Types of Business According to Activities

Types of Business According to Activities

A business or business enterprise exists when a person or group of persons

makes an investment or contributes its resources in order to sell products or
render services to others, for the ultimate purpose of making profit. There
are three major types of business enterprises that may be established for the
purpose of making profit such as service, merchandising and manufacturing
enterprises.
At the end of the module, the learner shall be able to:
1. Compare and contrast the types of business according to activities
2. Identify the advantages, disadvantages, and business requirements of
each type

Service Business
Service business is the simplest type of business which performs service, for
a fee, to a client or customer. 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.

A service provider
sells services CUSTOMER
to a customer

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. For a service business, revenue is earned when service has
been rendered. Figure 5.1, shows the operating cycle of the service business

Course Module
 Cash

Collect cash Service

from the rendered on
customers account

Figure 5.1 Operating cycle of Service Business

Merchandising Business
This type of business entity is in the "buy and sell" business. The company
buys from several vendors and provides a central purchasing point where
customers can purchase everything in one stop. The customer benefits by
making one convenient stop for all her needs. Inventory represents the
primary asset of a merchandising company. The typical financial transactions
of a merchandising company include purchasing inventory, storing the
inventory and selling the inventory to customers. These activities may occur
in one or more accounting cycles. Merchandising enterprises may either be
wholesaler or retailers.
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 Normal Operating Cycle
The normal operating cycle is the average length of time from the spending
of cash to acquire the goods, utilities services and other benefits, until cash or
cash equivalent is realized or received in the ordinary sale of the goods. The
cycle of a merchandiser consists of the following activities:
1. available cash is used to buy the goods, pay for wages, utilities,
services, and other operating expenses.
2. The goods are sold to the customers without changing their forms
3. Cash is collected from the customers. After cash collected, it is used
again to start a new cycle. Figure 5.1 shows the stages found in the
normal operating cycle of a merchandising enterprise.
 Fundamentals of Accounting Business and Management I
3
Types of Business According to Activities

Cash is
available for
use

Collect cash Buy goods

from the pay for wages
customers , utilities, etc.

Sell goods to
the customer

Figure 5.1 Operating cycle of Merchandising Business

Difference between Merchandising & Service Enterprise

Service Company

A service company uses its employees to provide a service for the customer.
These services can include lawn care, carpet cleaning or childcare. Some
service companies purchase expensive equipment to provide the service,
such as a vehicle. Other service companies rely on human labor more than
equipment and only purchase a minimal amount of assets. 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.

Merchandising Company

A merchandising company purchases inventory items to resell to customers.

The company buys from several vendors and provides a central purchasing
point where customers can purchase everything in one stop. The customer
benefits by making one convenient stop for all her needs. Inventory
represents the primary asset of a merchandising company. The typical
financial transactions of a merchandising company include purchasing
inventory, storing the inventory and selling the inventory to customers.
These activities may occur in one or more accounting cycles.

Course Module
 Similarities

The accounting cycle for service companies and merchandising companies

includes similar processes. For example, the accounting cycle for both
companies follows the same basic structure of recording transactions and
reporting financial results. The accountants in both types of companies
review the account balances and identify any necessary adjustments.
Adjustments refer to transactions that occurred during the month but did not
create an entry in the financial records. The adjusting entry records the
entry.

Differences

Several differences exist in the accounting cycle between service companies

and merchandising companies. These include recognition of revenue and the
format of the financial statements. Service companies recognize revenue
when the company performs the service for the customer. In most cases, the
company bills the customer on a future date to request payment.
Merchandising companies generally collect payment from customers when
the customer takes the merchandise from the store. The merchandising
company recognizes revenue on the date of sale. The income statement
formats vary between service companies and merchandising companies. The
income statement for the service company subtracts the operating expenses
from the revenues to arrive at net income. The merchandising company
subtracts the cost of merchandising from the revenue to arrive at gross
profit. It then subtracts all other operating expenses to arrive at net income.
Manufacturing Business
Manufacturers are also called fabricators or producers or processors. The
process of converting raw materials, components, or parts into finished
goods that meet a customer's expectations or specifications. Manufacturing
commonly employs a man-machine setup with division of labor in a large
scale production. Manufacturing firms will purchase raw materials from
suppliers and convert them into finished products, such as: Boeing
manufactured Jet aircraft, General Motors manufactured cars, trucks, vans,
Coca-Cola are beverages.
Manufacturing Cost
Manufacturing costs are the costs incurred during the production of product.
These costs include the costs of direct materials, direct labor, and
manufacturing overhead. The costs are typically presented in the income
statement as separate line items.

Raw materials - materials that is to be processed into a finished product.

Materials can be either direct materials, indirect materials.
o Direct materials (the materials that actually become part of the
product—material, screws, metal) or
 Fundamentals of Accounting Business and Management I
5
Types of Business According to Activities

o Indirect materials (materials or supplies that are used in the

manufacturing process but don’t become part of the product—
steel wool, cleaning fluid).
o Some businesses treat insignificant direct materials, such as glue,
as indirect materials as well.
o Indirect material is treated as manufacturing overhead.
Direct Labor - wages of those person whose efforts directly affect the quality
or other characteristics of the products manufactured. Direct labor costs
wages of those person whose efforts directly affect the quality of other
characteristics of the products manufactured such as (salaries of workers
who assembled the final products). Indirect labor costs are the costs of
personnel who support productions but do not directly work with the
product to put it together such as supervisors, repair and maintenance,
janitorial staff. Indirect labor is treated as manufacturing overhead.
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.
Difference between Manufacturing & Service Enterprise
There are five main differences between service and manufacturing
organizations: the tangibility of their output; production on demand or for
inventory; customer-specific production; labor-intensive or automated
operations; and the need for a physical production location. However, in
practice, service and manufacturing organizations share many
characteristics. Many manufacturers offer their own service operations and
both require skilled people to create a profitable business.
Goods
The key difference between service firms and manufacturers is the
tangibility of their output. The output of a service firm, such as consultancy,
training or maintenance, for example, is intangible. Manufacturers produce
physical goods that customers can see and touch.
Inventory
Service firms, unlike manufacturers, do not hold inventory; they create a
service when a client requires it. Manufacturers produce goods for stock,
with inventory levels aligned to forecasts of market demand. Some
manufacturers maintain minimum stock levels, relying on the accuracy of
demand forecasts and their production capacity to meet demand on a just-in-
time basis. Inventory also represents a cost for a manufacturing organization.
Customers

Course Module
 Service firms do not produce a service unless a customer requires it,
although they design and develop the scope and content of services in
advance of any orders. Service firms generally produce a service tailored to
customers' needs, such as 12 hours of consultancy, plus 14 hours of design
and 10 hours of installation. Manufacturers can produce goods without a
customer order or forecast of customer demand. However, producing goods
that do not meet market needs is a poor strategy.
Labor

A service firm recruits people with specific knowledge and skills in the
service disciplines that it offers. Service delivery is labor intensive and
cannot be easily automated, although knowledge management systems
enable a degree of knowledge capture and sharing. Manufacturers can
automate many of their production processes to reduce their labor
requirements, although some manufacturing organizations are labor
intensive, particularly in countries where labor costs are low.

Location

Service firms do not require a physical production site. The people creating
and delivering the service can be located anywhere. Manufacturers must
have a physical location for their production and stock holding operations.
Production does not necessarily take place on the manufacturer's own site; it
can take place at any point in the supply chain.

Differences between a Merchandiser Income Statement and Manufacturing

Companies Income site
The basic difference between a merchandising company and a manufacturing
company is that a manufacturer creates products and a merchandiser sells
them. Merchandisers include both wholesalers and retailers. Consider, for
example a factory that produces widgets and sells them in bulk to
distributors, who in turn sell the widgets in smaller lots to stores around the
country. In this example, the factory is the manufacturer and the distributors
and stores are merchandisers.
An income statement reflects your small-business earnings and shows all the
expenses incurred in generating that income. If your small business is a
manufacturing company, you will show different categories of expenses than
you would for a merchandising company. Learn how to show your cost of
goods sold on an income statement for both types of companies.
Relationships
Merchandising companies that conduct business as wholesalers generally
sell in bulk quantities and may sell only to retailers, not to the average
consumer. Retailers, on the other hand, deal directly with the consumer.
Stores are retailers' places of business. Manufacturers may sell directly to
consumers. However, large manufacturing firms usually sell only to
distributors, a type of merchandiser.
 Fundamentals of Accounting Business and Management I
7
Types of Business According to Activities

Inventory
Manufacturers have three classifications of inventory: raw materials, work in
process and finished goods. Contrastingly, merchandisers do not maintain
but one of these three, that is finished goods. Although, merchandisers may
classify inventory into dozens of categories, each product on hand is ready
for sale to consumers.
Profit
Manufacturers make profits by converting raw materials into a finished
product that sells at a price that exceeds total production costs. These costs
are categorized as direct materials, direct labor and manufacturing overhead.
Wholesale merchandisers make profits on the markup, which is the amount
added to the purchase price paid to the manufacturer before the product is
sold to retailers. Retailers in turn make profits from an additional markup
before products are sold to consumers at the retail price. A merchandiser's
net profit is obtained by subtracting the cost of operating expenses from
gross profit. Gross profit equals sales minus the cost of goods sold.

Glossary
Direct cost a cost that can be traced to a cost object. For example, the flour
used in baking bread is a direct cost of a bakery's bread.
Direct materials raw materials that are a traceable component of a
manufactured product. For example, the direct material of a baseball bat is
the wood.
Direct material cost is the cost of the raw materials and components used
to create a product.
Cost of Goods sold the direct expense related to producing the goods by a
company. This may include cost of the raw materials (parts) and amount of
employee labor used in production.
Indirect cost a cost or expense that is not directly traceable to a department,
product, activity, customer, etc. As a result, indirect costs and expenses are
often allocated to the department, product, etc.
Inventory a current asset whose ending balance should report the cost of a
merchandiser's products awaiting to be sold. The inventory of a
manufacturer should report the cost of its raw materials, work-in-process,
and finished goods. The cost of inventory should include all costs necessary
to acquire the items and to get them ready for sale.
Inventoriable cost - cost that is considered to be part of the cost of
merchandise. For a retailer, the inventoriable cost is the cost from the
supplier plus all costs necessary to get the item into inventory and ready for
sale, e.g. freight-in. For a manufacturer the product costs include direct
material, direct labor, and the manufacturing overhead (fixed and variable).

Course Module
 Gross profit refers to what is left after you subtract the cost of goods sold
from the sales. It is also called gross profit margin.
Manufacturing cost direct materials, direct labor and manufacturing
overhead costs. Also referred to as product costs, production costs, and
inventoriable costs.
Manufacturing overhead manufacturing costs other than direct materials
and direct labor.
Sales A revenue account that reports the sales of merchandise. Sales are
reported in the accounting period in which title to the merchandise was
transferred from the seller to the buyer.
Selling expenses are part of the operating expenses (along with
administrative expenses). Selling expenses include sales commissions,
advertising, promotional materials distributed, rent of the sales showroom,
rent of the sales offices, salaries and fringe benefits of sales personnel,
utilities and telephone usage in the sales department, etc.

References
Textbooks:
Kimwell, M.B., (2005), Fundamentals of Accounting. GIC Enterprise & Co.
Inc. 2017 C.M. Recto Avenue, Manila Philippines.
Manuel, Z.V., (2017), "Accounting Process, Basic Concepts and Procedures,
Int’l Edition”. Raintree Trading & Publishing, Inc.
Supplementary materials
Benge, V. (2017) What is the differences between a merchandising company
& a manufacturing company? Small Business. Chron.
http://smallbusiness.chron.com/differences-between-
merchandising-company-manufacturing-company-21423.html (last
accessed: 4/19/2017)
Johnson, K., (2008). Differences a Merchandisers Income Statement and
Manufacturing Companies Income Statement. Chron.
http://smallbusiness.chron.com/differences-between-
merchandisers-income-statement-manufacturing-companies-income-
state-34015.html (last accessed: 4/19/2017).
Unknown, (2005). Merchandising business.
https://www.wyzant.com/resources/lessons/accounting/merchandi
sing
Unknown, (2012). Nature of a Manufacturing Business. WBBB Accounting &
Management http://wbbbb-ams.blogspot.com/2012/07/nature-of-
manufacturing-business.html
Images source citation:
Gash, C. Accounting Clipart. ClipartAll. Nulla, Street Watervliet Oklahoma
70863. http://clipartall.com/clipart/3443-accounting-clipart.html
(last accessed: 4/19/2017)