Learning Consignment Accounting through an example
Tenali is a medium sized town in Andhra Pradesh. M/s Innova Steels manufactures and sells steel utensils in Tenali. There are two big cities located near Tenali, Vijayawada, 30km to its north and Guntur 25 kms to its west. There is also a small town, Ponnur located 25 kms south of it. Innova steels had been consistently making profits for the last few years. It used to make and sell different kinds of steel utensils locally in Tenali only.
Objectives of Business
The basic objective of business is to make profits. Growth is one another objective of business. Even in targeting growth/expansion, their objective is to bring in a growth in overall profits.
Innova Steels is also thinking of growing its business by expanding the market areas to the cities and towns nearby. It identified Vijayawada, Guntur and Ponnur as its potential markets. For this it conducted a preliminary study of the market potential and conditions in the three places.
New places » New business associates
In Vijayawada, Innova Steels identified, M/s Maruthi Steel Traders as the dominant business house dealing in selling steel utensils. So they approached M/s Maruthi traders for a business association to sell the products manufactured by them at Vijayawada.
The ownership of M/s Maruthi Steel Traders, being conservative natured offered to sell their product on the condition that they would not be required to invest anything for the business and moreover they would only stock the goods of Innova Steel, sell them at the price that is decided by Innova Steel on a commission basis. This was agreed upon to be 10% of the sale proceeds. M/s Maruthi Traders are also to be reimbursed any incidental expenses incurred by them. This proposal was agreed to by Innova Steels.
In Guntur, Innova Steels identified M/s Rahim Traders as the dominant business house dealing in selling steel utensils. So they approached M/s Rahim Traders for a business association to sell the products manufactured by them at Guntur. They made an offer similar to the one agreed upon between them and M/s Maruthi Steel Traders at Vijayawada.
The ownership of M/s Rahim Traders was not willing to the proposal. They being people willing to take risk in anticipation of making profits, asked Innova Steels to work out a different plan for them. They told Innova Steels that they could assess the profits made by M/s Innova Steels which they think would be around 40% of the sale proceeds. For that reason they wanted returns based on the profits made by Innova Steels on goods sold by them. However they were also not willing to invest capital. For this reason, Innova Steels worked out a profit sharing deal with M/s Rahim Traders. They decided to account for the transactions separately and share the profits of the business. Stock being the investment of M/s Innova Steels and Sale efforts being the investment of M/s Rahim Traders. Expenses are to be borne by both but are to accounted for in deciding the profits.
In Ponnur, Innova Steels could not identify a proper business house that was dealing in selling steel utensils. There were only a few small shops selling steel utensils. Innova Steels identified that it would be appropriate to set up a trading unit on its own to sell its products. Since it was a small town, it would not cost them much to set up a shop. It would be directly working under them and can be managed with a single employee to look after the shop. This would enable them to retain the total margin.
Different options » Different Business Methodologies
If we go through the deals proposed to be made by Innova Traders at the three places we will notice that there are fundamental differences between the three options/methods for doing business.
At Vijayawada » Consignment
At Guntur » Partnership/Joint Venture.
The method of doing business, where M/s Rahim Traders sell goods for the joint benefit of both Innova Steels as well as themselves is called Partnership and if this relationship is for a short duration we call it a Joint Venture. Both the parties are owners of the business. The profits of the business are shared between them as agreed upon by them at the time of getting into the relationship. We will discuss in detail about the nature of this while learning Accounting for Joint Ventures.
At Ponnur » Branch
The method of doing business, where M/s Innova Steels are setting up a shop on their own is called a "Branch". The person conducting the business is the employee of Innova Steels. All the ownership and risk in the business is with Innova Steels. We will learn more about this while learning "Branch Accounting".
With this understanding in mind we shall now move on to the process of designing the accounting system for consignments. We have to note that M/s Innova Steels as well as M/s Maruthi Traders have an existing business for which they have been preparing their Trading a/c's to decide the basic profit (gross profit) of the business and also a Profit & Loss a/c's to ascertain the net profits made by the organisation.