Revenues for a service business are referred to as fees earned. Revenues for a merchandiser are called sales. Merchandisers also have contra revenue accounts that are subtracted from sales to get net sales. The contra revenue accounts include sales discounts, sales returns, and allowances. Public company income statements show only the net sales amount. We also have a new expense item: cost of goods sold. Cost of goods sold is the amount we paid for the merchandise sold during the period. Cost of goods sold is subtracted from net sales to get gross profit.
All right, we're moving from the service business into the merchandising business. The service business was relatively simple. We provided a service for our customer. We had fees earned, and we subtracted out our operating expenses, and that gave us our net income. Merchandising gets a little bit more complicated.
We now have an additional expense account that we have to account for, and that is the cost of the merchandise sold, or cost of the goods sold. I tend to use COGs more readily than cost of merchandise sold. So, please excuse me, but they are the same.
So we start with our merchandising business and we have sales. Sales is how we earned our revenue. From that, we subtract the cost of goods that we sold. Now what does that include? That includes all of the costs that pertain to our inventory that we have available for sale. Let's look at this a little bit.
What if you purchase a t-shirt online, and the t-shirt costs $8, but you have to pay $1 shipping. What did the t-shirt really cost you? The answer would be $9 of course, because you had to pay that shipping expense. Well if you're a merchant, and you are paying for the freight of your merchandise inventory to come into your store, then that becomes a cost of the merchandise that you're selling.
So we have sales minus this new expense called COGs, which gives us gross profit. Gross profit is, very simply, what we have left to pay the expenses of being a business. So from our gross profit, we are now going to subtract out our operating expenses, and that's going to tell us whether we made a profit or we had a loss.
Gross profit is very, very important, because gross profit will tell us what we need to do as far as our pricing, as far as our volume of sales, as far as cutting our operating expenses in order to break even or make a profit. So, once again, we're looking at sales minus the cost of the items that we've sold, giving us a gross profit from which we pay all of the expenses of operating our business, and that gives us net income.
So hopefully this explains a little bit more of how we've gone from a simple industry into a little bit more complex one. Remember that a merchant has two roles. They buy, and they sell, and it's very important that we know at all times which role is pertinent to the transaction.