explain the difference between a trading business and a service business

Resources | Subject Notes | Accounting

5.1 Sole Traders: Trading vs. Service Businesses

A sole trader is a business owned and run by one person. Understanding the difference between a trading business and a service business is crucial for accounting purposes. This section will explain these distinctions.

Trading Business

A trading business involves buying goods and selling them on to customers. The profit is made from the difference between the selling price and the cost price of the goods.

Key characteristics of a trading business include:

  • Purchasing inventory (goods)
  • Selling those goods to customers
  • Profit is calculated as: Profit = Revenue - Cost of Goods Sold
  • Examples: Retail shops, wholesalers, online stores selling physical products.

Service Business

A service business provides intangible services to customers. Customers pay for expertise, skills, or effort rendered.

Key characteristics of a service business include:

  • No physical goods are bought and sold.
  • Revenue is earned from providing a service.
  • Profit is calculated as: Profit = Revenue - Cost of Services
  • Examples: Hairdressers, accountants, lawyers, consultants, plumbers.

Key Differences Summarized

The following table summarizes the key differences between trading and service businesses:

Feature Trading Business Service Business
Main Activity Buying and selling goods Providing services
Inventory Holds stock of goods No stock held
Revenue Source Sale of goods Provision of services
Cost of Goods Sold Direct cost of the goods sold Cost of providing the service (e.g., wages, materials)
Examples Retail shop, Wholesaler Hairdresser, Accountant

Understanding whether a sole trader operates a trading or service business is important for determining the appropriate accounting methods and the types of expenses that can be claimed as allowable costs.

Suggested diagram: A simple diagram showing a trading business (goods flowing from supplier to customer) and a service business (a person providing a service to a customer). Label the key elements in each diagram.