Core Accounting Components for Distributors

A distributor operates as an intermediary in the commercial supply chain, purchasing products from manufacturers to sell to other businesses, such as retailers. This business model is centered on the buying, holding, and selling of physical goods. The focus on tangible products creates a distinct set of accounting requirements compared to service or manufacturing companies. A distributor’s financial health is directly tied to its management of finished goods, and its accounting revolves around the flow of these products from purchase to sale.

Managing Inventory and Cost of Goods Sold

For a distributor, inventory represents the most significant asset on the balance sheet and the primary driver of profitability. The methods used to value this inventory and track its movement directly determine the Cost of Goods Sold (COGS), an expense that dictates gross profit. Proper management begins with choosing an inventory system, such as a perpetual system for real-time tracking or a periodic system that uses physical counts at the end of an accounting period.

The First-In, First-Out (FIFO) method assumes that the first units purchased are the first ones sold. This means the cost of the oldest inventory is transferred to COGS, while the most recently purchased items remain in ending inventory. In an environment of rising prices, FIFO results in a lower COGS and higher reported profit.

Conversely, the Last-In, First-Out (LIFO) method assumes the most recently acquired items are sold first. Permitted under U.S. Generally Accepted Accounting Principles (GAAP) but prohibited by International Financial Reporting Standards (IFRS), its use is primarily limited to the United States. Under LIFO, the cost of the newest inventory is assigned to COGS, which during inflation leads to a higher COGS and lower reported profit. The use of LIFO for tax purposes requires the same method for financial reporting, a constraint known as the LIFO conformity rule.

A third option is the Weighted-Average Cost method, which smooths out price fluctuations. This approach calculates the average cost of all goods available for sale during a period and applies that average cost to both the units sold and those remaining in inventory. For example, if a distributor buys 10 units at $5 and 10 units at $7, the weighted-average cost is $6 per unit. The choice of method fundamentally alters the financial statements and must be consistently applied.

Revenue Recognition and Accounts Receivable

Revenue is recognized when control over the goods is transferred to the customer. This transfer point is often specified in the sales contract, commonly occurring either when the product is shipped from the distributor’s warehouse (FOB shipping point) or when it arrives at the customer’s location (FOB destination).

Distributors must also account for variables that can reduce the total revenue figure. Sales returns and allowances are common occurrences that require specific accounting entries. When a customer returns goods, the distributor must decrease revenue and accounts receivable while increasing an asset account for returned inventory. An allowance is a price reduction for damaged goods that the customer keeps, which also reduces revenue and the amount owed by the customer.

Flowing directly from sales is accounts receivable (A/R), the money owed to the distributor by its customers for goods sold on credit. A primary tool for managing A/R is the aging report, which categorizes outstanding invoices by the length of time they have been due, such as 30, 60, or 90 days. This report helps identify slow-paying customers and signals potential collection problems.

Because it is unlikely that 100% of credit sales will be collected, distributors must estimate and account for potential bad debt. This is accomplished by creating an “allowance for doubtful accounts,” a contra-asset account that reduces the total value of accounts receivable on the balance sheet. Each period, the company records a bad debt expense based on historical data and the current A/R aging. This practice aligns with the matching principle by recognizing the expense in the same period as the related revenue.

Accounting for Supply Chain Costs

The cost of inventory extends far beyond the price on a supplier’s invoice. To determine the true cost of acquiring goods, distributors must calculate the “landed cost,” which includes all expenses incurred to get the inventory from the supplier to the distributor’s warehouse. These costs are capitalized, meaning they are added to the value of the inventory asset on the balance sheet. Common components of landed cost include:

• The initial product price
• Freight-in
• Customs duties and tariffs
• Import fees
• Insurance during transit

Freight-in refers to the transportation costs to bring inventory to the distributor’s location; these are considered a product cost and are included in the inventory’s value. For example, if a distributor pays $10,000 for goods and $500 for shipping, the inventory is recorded at a cost of $10,500. This cost is later expensed as COGS when the product is sold.

In contrast, freight-out is the cost of shipping goods to a customer and is considered a selling, general, and administrative (SG&A) expense. It is recorded on the income statement in the period it is incurred, separate from COGS. Vendor rebates, often provided for reaching certain purchase volumes, are treated as a reduction in the cost of inventory. Similarly, early payment discounts from suppliers decrease the overall cost of the goods.

Essential Financial Reports and Metrics

A distributor’s accounting activities are presented in its financial statements, primarily the income statement and the balance sheet. The income statement displays revenue at the top, followed by the Cost of Goods Sold, which is subtracted to arrive at the gross profit. The balance sheet provides a snapshot in time, featuring inventory as a current asset and accounts receivable, offset by its allowance.

Beyond the raw numbers on these statements, specific metrics provide deeper insight into a distributor’s operational health. The Gross Margin Percentage, calculated as (Revenue – COGS) / Revenue, reveals the profitability of each dollar of sales before considering operating expenses. A higher percentage indicates more effective pricing strategies or lower product acquisition costs.

Another important metric is the Inventory Turnover Ratio, found by dividing the Cost of Goods Sold by the average inventory value. This ratio measures how many times a company sells and replaces its inventory over a period. A high turnover ratio often suggests efficient inventory management and strong sales, while a low ratio could indicate overstocking or weak demand.

Days Sales Outstanding (DSO) measures the average number of days it takes to collect payment after a sale. Calculated as (Average Accounts Receivable / Total Credit Sales) Number of Days, a lower DSO indicates that a company is collecting its receivables quickly. A rising DSO can be a warning sign of deteriorating customer credit quality or inefficient collection processes.