A business’s operations are generally classified as one of three types—service, merchandising, or manufacturing—depending on how that business generates income.

• A service business sells expertise, advice, assistance, professional skills, or an experience rather than a physical product.
• A merchandising business purchases finished and packaged products from other companies, marks up the costs of these items and sells them to customers.
• A manufacturing business assembles and packages products for sale to merchandisers or end-users.

Although managerial accounting is relevant to all three types of businesses, we are focusing on manufacturing systems since that type of business involves the most in-depth facets and examples of managerial accounting. We will also discuss managerial accounting for service businesses where appropriate.

Some businesses are a mix of different types. For instance, auto manufacturers often have a subsidiary or a division that offers financing. Auto dealers may sell cars (merchandise) and also offer repairs and maintenance (service). Some companies, like a restaurant, for instance, may be classified as a service even though the employees are taking raw materials and converting those into a finished product. Other companies, like social media platforms, may not precisely fit in the service category even though that company is neither manufacturing nor merchandising. Other merchandisers, like Amazon, for instance, may provide more service (brokering) than actual retailing.

However, for purposes of this course of study, we’ll focus on clear examples of the different types.

Here is a summary and a comparison of the three:

See the alt text for this image here.

Manufacturing companies:

• Purchase raw materials
• Raw materials transfer to work-in-process (WIP)
• Add direct labor and manufacturing overhead to convert WIP to finished goods
• Sell finished goods to wholesalers and other intermediaries—or sometimes to the end-user

Merchandising companies:

• Purchase finished goods from suppliers
• Sell inventory to end-users (consumers)

Service companies:

• Do not carry inventory
• Sell intangibles such as consulting, tax prep, medical

In addition, service companies will not show cost of goods sold on the income statement because they aren’t selling goods. However, some service companies show the cost of services provided much like cost of goods sold. For instance, finance companies, or even finance divisions of a manufacturing or retail company will show revenues from financing offset by cost of financing. For the most part though, where manufacturing and retail companies show Gross Profit, which is the difference between Sales Revenue and the direct cost of the items sold, a service company will simply show gross Service Revenue.

Even so, service companies still use aspects of managerial accounting, such as budgeting, cash forecasting, and capital acquisition analysis. In fact, many service companies use metrics like unit cost for planning, directing, and controlling operations. For instance, a tax firm might want to know how much to charge for each return processed in order to cover expenses and make a profit.

Here is a short video demonstrating how a service company could calculate the cost of a job:

You can view the transcript for “Service Company calculating unit costs” here (opens in new window).

Now it’s time to check your understanding of the differences between service, manufacturing, and merchandising cost flows.