What Is a Periodic Inventory System and How Does It Work?
The Periodic Inventory System is an inventory management tool where a physical count of available inventory is conducted on a periodic/scheduled basis. It allows businesses to account for their beginning and ending inventory for a specific period of time.
How Does It Work?
It’s no secret that for most business owners, physically taking count of the goods in stock is both tedious and time-consuming. This is why most businesses prefer to conduct the count in determined intervals, perhaps once every quarter or even annually.
Under the periodic inventory system, any new purchases or transactions that occur in the middle of the accounting period are recorded in the company’s purchase account. This purchase account basically tracks inventory movement by deducting it from the cost of goods sold. Unfortunately, the purchases account does record returned, damaged, or lost goods.
This means that to accurately determine the number of goods in stock, a physical count is necessary.
Once the periodic inventory count is conducted, the records in the purchase account are amended to accurately reflect the monetary value of the number of goods actually present.
When To Use The Periodic Inventory System
Generally, the companies that apply the periodic inventory system cannot know the cost of goods sold or the exact number of goods in inventory until a physical count is conducted. For this reason, the system is recommended for businesses with a low number of SKUs in a relatively slow market.
The system is also recommended for companies that either lack resources or do not want to spend too much money to implement a more detailed inventory accounting system. It could be the best solution for start-up companies, particularly those with huge inventories consisting of relatively low-cost items.
When Not To Use The Periodic Inventory System
Due to the large volume of inventory transactions, this system may not be ideal for large businesses. This is because, for large businesses, there is a need to constantly track the number of goods in your inventory to be able to make key purchasing decisions.
Calculating The Cost Of Goods Sold Using The Periodic Inventory System:
The calculation of the cost of goods sold using this system is fairly simple.
First, the aggregate of the purchases account is added to the beginning inventory to get the cost of goods available for sale.
Thereafter, the ending inventory is determined through the physical count of each item in the inventory. The cost of the ending inventory may be computed through methods such as weighted average cost, First in First Out or Last In First Out.
The ending inventory is then subtracted from the cost of goods available for sale to determine the cost of goods sold.
The formula for calculating the cost of goods sold under the periodic inventory system is therefore as follows:
Cost of Goods Sold (COGS) = Beginning Inventory + Purchases – Closing Inventory
The values indicated below belong to Company A for its first quarter:
- Beginning Inventory-$200,000
- New Purchases -$100,000
- Closing Inventory after physical count-$100,000
Using the formula indicated above, let’s calculate the cost of goods sold.
We first need to identify the cost of goods available as follows-
Cost of Goods Available= Beginning Inventory + New Purchases
Company A’s Cost of Goods Available = $200,000+$100,000=$300,000
Now, to calculate Company A’s Cost of Goods Sold, we will subtract the ending inventory from the Cost of Goods Available.
Cost of Goods Sold= Cost of Goods Available-Ending Inventory
Company A’s Cost of Goods Sold=$300,000-$100,000=$200,000
See? Extremely simple!
What Inventory Valuation Method is Recommended For The Periodic Inventory System?
Because costs are not tracked on a real-time basis, it becomes rather difficult for one to value their inventory when using the periodic inventory method. The preferred inventory valuation method for most businesses that use this system is Last In, First Out (LIFO). LIFO operates on the assumption that the recently bought stock items are the first to be sold or used. This means that the ending inventory value is derived from the cost of the oldest items in stock.
Perpetual Inventory System vs Periodic Inventory System?
In this section, we discuss a question that is commonly debated, which is better, the perpetual or periodic inventory method? It is important to point out that both methods are accepted under the General Accepted Accounting Principles (GAAP).
In this section, we will discuss what differentiates the two systems from each other, and which system is best suited for your company, based on your business model.
Over the years, the perpetual inventory system has gained popularity due to the advancement of technology and the invention of things such as barcode scanning and inventory management software. All the same, the periodic inventory system seems to have a soft spot for most small business owners.
Before we explore their differences, it is important that you understand exactly what a perpetual inventory system is.
The perpetual inventory system tracks inventory by recording any inventory adjustments in real-time through point-of-sale inventory systems. This allows for continuous stock-taking as the systems keep a running account, updating every sale or return.
Differences Between The Two Systems:
- The most significant difference between the two systems is that the perpetual inventory system allows for continuous counting of inventory while under the periodic system inventory is counted at the end of a particular accounting period.
- The perpetual system is often used in organizations where the items being sold are not too many. Smaller organizations with a large stock generally gravitate towards the periodic system due to its simplicity.
- The perpetual system, due to its partial reliance on technology such as bar code scanners may be expensive. Since the periodic system only requires you to perform a physical count of your ending inventory, you will not incur any extra costs.
- Due to the continuous tracking, the perpetual system allows for quicker resolution of any existing problems since they are identified in real-time. The periodic system would only be able to identify underlying problems at the end of the accounting period, which could be too late.
- Due to the fact that the perpetual system is rather tech-based, it allows for the backing up of data, prompt organization, and even manipulation of the data to provide detail-packed reports. The periodic system on the other hand is manual in nature and may thus be prone to human error where data is misplaced or lost.
- The perpetual inventory system does not interrupt the normal operations of a business. The periodic system is bound to hamper business operations specifically on the day of taking the physical count depending on the volume of goods being counted.
- The perpetual system will be able to provide you with accurate COGS values at any point in time. With the periodic system, however, you can not get the accurate COGS in the middle of an accounting period and would have to wait till the physical count is conducted.
- The perpetual system might require you to either extensively train your employees or employ a bunch of tech-savvy employees who have experience with the system. The periodic system is credited for its simplicity and would therefore not require any extra training on the part of the employees.
Choosing Between The Two
For small business owners, the periodic inventory system would be ideal because their operations are typically limited to the cash register and relatively simple accounting procedures.
For businesses that offer services rather than products, it goes without saying that you would not require an inventory management system. This is, of course, unless you have inventory items that need to be tracked such as food or medicine items, or you are in the hospitality industry e.g operating a restaurant.
As a business expands, however, there may be a need to migrate to a perpetual system as it allows you to access your Cost of Goods Sold at any given time. It also enables you to identify any defects in stock in real-time and make the relevant decisions.
As indicated earlier, most large businesses prefer the perpetual inventory system as opposed to the periodic system due to the large volume of inventory transactions that they handle as well as the computerized nature of their accounting systems.
We hope that you are now able to conclusively tell the difference between the two methods and can now determine which suits your business best.
Advantages and Disadvantages of The Periodic Inventory System
Prior to the introduction of technological accounting solutions, the periodic inventory system was quite popular. There was no denying that it was flawed, but most business owners felt that its benefits generally outweighed its flaws.
Interestingly, the system remains rather popular to date, with several business owners preferring it to the perpetual inventory system. One might be right to conclude that the periodic inventory system has as many haters as it has fans. This is because there are people who strongly feel that it is unwise to subject your business to a management tool that has the potential to provide inaccurate results.
To ensure you are making an informed decision, we have listed the benefits and disadvantages of the periodic inventory system below.
Advantages of The Periodic Inventory System
This is perhaps the biggest benefit of the system, its ease of implementation and use. Since you do not need to acquire bar codes or bar code scanners, you can switch to this system at any point you feel the need to. You can schedule the physical counting of inventory whenever you feel like it. Most businesses prefer to do the physical count of inventory annually.
If you are looking to save on costs, then this is the right method for you. Because you don’t have to buy any software to use this system, it becomes extremely cheap to implement. In fact, the only thing you need to invest in to use this system is the time needed to take the physical inventory. Additionally, you will never incur costs in inventory management for as long as you are willing to create time for the physical count.
- Suitable For Small Businesses
The periodic inventory system is ideal for small businesses that do not necessarily post large volumes of transactions throughout the year.
Disadvantages of The Periodic Inventory System
- Unknown Stock Levels
In between the allocated accounting period, one can’t tell the cost of goods sold when using this system. This is due to the fact that there is no constant tracking of inventory. Ultimately this means that crucial decisions such as planning for changes in demand, optimizing production, or determining the optimum level of inventory are hard to make.
Because accounting records are only modified at the end of the given accounting period, the system is prone to inaccuracies. This is also an unchangeable aspect of the system, implying that it is inherently flawed. While some businesses, particularly small businesses may not view this as a problem, large businesses could be wary. As indicated earlier, it is also prone to human error because the physical count is done manually.
- Labour Intensive
In the long run, the system could become extremely labor-intensive. This is especially so where your business has grown, both in terms of its inventory and also in terms of the number of transactions occurring during the accounting period. This would imply requiring a large number of employees, as well as time, to conduct the tedious physical inventory count.
- Potential revenue losses
Because inventory is not tracked constantly, it becomes difficult to notice shrinkage occurring due to damage, theft, or even misplacement (employee error). Losses arising out of product returns may also go unnoticed. Not tracking your inventory constantly generally leaves room for varying degrees of potential losses that are difficult to spot.
We at Emerge App take care of your inventory management, allowing you to focus on expanding your business and improve customer experience. Inventory management and tracking can be tedious, to avoid the headaches associated with it, partner with Emerge today.