Chapter 5 Accounting for Merchandise Operations 233In the examples of inventory misstatements, we assumed that an error occurred in
the physical inventory count. This could occur because the quantities of inventory were
miscounted or summarized (added) incorrectly. Other types of errors that could mis-
state the inventory could include using incorrect costs or including items not owned by
the business. For example, merchandise businesses often carry items on consignment
from other retailers. Items on consignmentare owned by another retailer, called a con-
signor. The retailer carrying the item is a consignee. The consignee normally earns a
commission or fee when the consigned goods are sold. Since consigned merchandise is
normally displayed along with the consignee’s own merchandise, consigned merchan-
dise on hand at the end of the year may be incorrectly included in the consignee’s phys-
ical inventory. This would overstate the ending physical inventory and misstate the
financial statements. Likewise, merchandise out on consignment might be overlooked
in counting the consignor’s inventory, and thus understate the consignor’s physical
inventory.
Inventory misstatements may also arise for merchandise in transit at year-end. For
example, merchandise may be ordered FOB shipping point near the end of the year.
In such cases, it is likely that the merchandise is in transit at year-end. In determining
the ending physical inventory it would be easy to overlook this merchandise in tran-
sit, since it is not on hand. The result would be that the physical inventory is under-
stated. Similarly, merchandise sold FOB destination could be in transit at year-end.
Even though the merchandise is not on hand, it is still owned by the seller and should
be included in the seller’s ending physical inventory.GROSS PROFIT AND OPERATING
PROFIT ANALYSISGross profit and operating income are two important profitability measures analysts
use in assessing the efficiency and effectiveness of a merchandiser’s operations. In this
section, we use these measures to assess JCPenney’s operating performance for the
past several years against Saks Incorporated, which operates several major depart-
ment stores.
Like many financial statement measures, sometimes referred to as performance
metrics, gross profit and operating income are normally compared to competitors and
analyzed over time as a percent rather than as dollar amounts.
Gross profit and operating profit as a percent of net sales for JCPenney are shown
in Exhibit 13. The data (in millions), shown for three recent years, are taken from the
Securities and Exchange Commission annual filings (Form 10-K). In addition, similar
data (in millions) are shown for Saks for comparison in 2004.
As you can see in Exhibit 13, the gross profit as a percent of sales for JCPenney has
gradually improved over the three-year period, to reach its peak in fiscal year 2004.
Likewise, the operating income to sales has also improved in the three-year period. The
operating income to sales ratio in 2004 is more than twice the ratio in 2002. In addition,
JCPenney appears to have outperformed Saks Incorporated in 2004. JCPenney’s gross
profit and operating profit as a percent of sales in 2004 exceed the equivalent ratios for
Saks, with the operating income to sales ratio a significant 2.5 percentage points above
Saks (5.5%3%). Obviously, JCPenney made significant improvements from 2002 to- Management credits the improvement to compelling products, a more appealing
and attractive shopping environment, and improved information technology that sup-
ports store operations.
Describe and illustrate the
use of gross profit and
operating income in
analyzing a company’s
operations.