What is a perpetual inventory system?
Any business owner will tell you that effective inventory management is the lifeline of any business. A company has to find an optimal balance between too much inventory that accumulates storage costs and too little inventory that does not meet customer demand.
For this reason, businesses must find an inventory tracking system that works for them, such as the perpetual inventory system. The perpetual inventory system is lauded for its reliability.
This article explores how it works, why you should consider it for your business, and how to value your inventory when using it.
Perpetual Inventory System Defined
The perpetual inventory method is defined as a method of tracking inventory that records any inventory transactions in real-time by applying technology such as point-of-sale systems and asset management software.
This system reflects any inventory changes immediately they occur, and one can tell the level of inventory at any point in time.
How Does It Work?
As indicated earlier, the perpetual inventory system, also known as a continuous inventory system, works by updating the inventory values as products are purchased or sold. In this section, we provide a detailed step-by-step outline of exactly how the system operates.
Step 1: Point-of-Sale
At the point of sale or purchase of an item, the system installed in the POS (point-of-sale) system applies a credit or debit to the inventory. This is achieved through the use of Radio-Frequency Identification (RFID) and barcode scanners.
Step 2: Recalculation of Cost of Goods Sold
Each time an item is purchased or sold, the cost of goods sold is automatically recalculated by the system.
Step 3: Adjustment of Reorder Points
To ensure an optimal inventory level is maintained continuously, a perpetual system manipulates historical data to automatically update a company’s reorder points.
Step 4: Generation of Purchase Order
The perpetual system can automatically identify when an SKU has hit its reorder point and consequently generate and send a purchase order to the requisite supplier accordingly.
Step 5: Updating of Received Products
To update new inventory, an employee needs to scan the new products using warehouse management software. They automatically reflect on your inventory management dashboard and sales channels.
When To Use The Perpetual System
This system is ideal for a large business with a high SKU level. This is because such companies need to continually track their inventory to make critical purchasing and sale decisions quickly to ensure consumer demand is always met in time.
For example, let’s assume that Company A sells dresses and pants, and its inventory is distributed across five warehouses. During summer, the Company receives an order for several woolen pants that have rarely been ordered before.
Suppose Company A does not use a continuous online inventory tracking system. In that case, the warehouse managers in the five warehouses will probably have to physically go through numerous sheets of paper to identify if the woolen pants are available and how many they have in stock.
On the other hand, if Company A uses the perpetual inventory system, the specific warehouse with the woolen pants stocked will automatically get notified of the system’s order.
When Not To Use The Perpetual System
For startup companies or companies that don’t have sufficient resources to invest in an enhanced accounting system, the recommended inventory tracking system would be the periodic inventory system. Despite its speed and reliability, the perpetual inventory system tends to be rather expensive to implement and maintain.
Formulas Used In The Perpetual Inventory System
To make good purchasing, stocking, and marketing decisions, mathematical formulas come in handy. Below are several procedures applied in the use of the perpetual system:
Cost of Goods Sold (COGS)
In this method, the cost of goods sold is recalculated automatically after every sale or purchase. This is unlike in the periodic inventory method. The cost of goods sold can only be determined at the end of a particular audit period once the physical inventory count has been done. The COGS formula, however, remains standard as follows;
Cost of Goods Sold (COGS) = Beginning Inventory + Purchases – Closing Inventory
Economic Order Quantity (EOQ)
Companies use this formula to calculate what amount of inventory needs to be purchased to meet customer demand and reduce costs associated with inventory. Because the perpetual system tracks inventory continuously, calculating EOQ becomes relatively more straightforward.
The formula for calculating EOQ is…
EOQ = √ (2SD/H), where d = total annual demands for a product, s= cost of order per purchase and h= total annual associated (holding) costs per product
Perpetual Inventory System v Periodic Inventory System
This section discusses whether most business owners want to be answered, which is better, the perpetual or periodic inventory method? Before we get into the nitty-gritty of what differentiates the two systems, we must point out that both systems are accepted under the General Accepted Accounting Principles (GAAP).
It’s no secret that the perpetual inventory system has gained massive popularity over the years, especially with technological advancement. However, at the same time, many business owners have chosen to continue using the more manual periodic inventory system.
So what is the periodic inventory system? The periodic inventory system is an inventory tracking system where a physical count of available inventory is conducted on a regular/scheduled basis.
Differences Between The Two Systems:
- Cost of Goods Sold
Because the tracking of inventory under the perpetual system is continuous, the cost of goods sold is automatically recalculated after every sale or purchase. In the periodic system, however, the cost of goods sold can only conclusively be determined at the end of the accounting period when the physical inventory count is conducted.
- Error Investigation
Due to the continuous tracking, the perpetual system allows for instant identification of any errors or abnormalities and enables business owners to resolve them much faster. On the other hand, when you use the periodic system, mistakes can only be identified at the end of the accounting period, which often is too late to provide workable solutions. Further, because the system is run and managed by humans, it is highly susceptible to human error where data may be misplaced or even lost.
- Generation of Reports
Because of the perpetual system’s tech-based nature, data can be manipulated to provide management with comprehensive analytical reports that enable them to make informed purchasing and marketing decisions. However, it is rather hard to generate such-like reports when using the periodic system due to its manual nature.
- Computerized systems
Because of the periodic inventory system’s straightforward nature, records are maintained either in physical books or simple excel sheets. On the other hand, the perpetual system’s complexity does not allow for manual record-keeping, mainly because of the huge number of transactions in a given accounting period.
- Installation and maintenance expenses
There are no extra costs incurred if you choose to track your inventory using the systematic method. However, the perpetual process requires you to purchase software, barcode scanners, and several other digital solutions to ensure it runs smoothly, which could be relatively expensive.
- Interruption of business
The periodic system requires you to set aside a day where you will conduct the physical count of inventory at the end of the accounting period, affecting business operations. On the other hand, the perpetual system is continuous and does not need you to halt operations to implement it.
- Record of purchases
Purchases in the perpetual inventory system are recorded either in a merchandise account or raw materials inventory account, depending on their nature. Conversely, purchases in the periodic inventory system are all recorded in a single purchases account.
This list indicates that the perpetual system is superior to the periodic structure in more ways than one. This is not to say that the regular system cannot be applied. It works perfectly for small businesses with a small inventory and operating in a relatively slow market. It may also be a great solution for startup companies as they generate revenue to afford the more reliable perpetual system.
Advantages of the Perpetual Inventory System
Below are some of the advantages that your business will get from using the perpetual inventory system:
- Enhanced inventory control– due to the continuous tracking of inventory, you will have a firm grasp of your inventory details and values.
- Saving on associated costs– again, you will always know the optimum level of inventory that you should stock due to the continuous tracking. This means that you will avoid extra costs associated with excess inventory, such as storage costs.
- Market analysis– the periodic inventory system enables you to analyze consumer behavior because you can track sales in real-time.
- Reduction of inventory shrinkage– inventory shrinkage is described as the difference between the inventory you PRESUME you have in storage and the stock you have in the warehouse. Inventory shrinkage is caused by various factors such as spoilage, loss, or theft. A study conducted by the National Retail Federation revealed that inventory shrinkage in 2017 cost around 1.33% of the total sales made that year. The perpetual inventory system enables you to identify any discrepancies occasioned by shrinkage, allowing you to make informed replenishing decisions.
- Reduced chance of overstocking or understocking– because of the enhanced inventory control, a business that implements the perpetual inventory system is always aware of its inventory status. It can thus make informed decisions on how much or how little it needs at a given time. This means that there are minimized chances of overstocking or understocking as you are always aware of what needs to be restocked.
- Generates useful reports– one can derive loads of helpful information from the perpetual inventory system, such as the impact of discounts on sales, return patterns on particular products, and purchase patterns.
- Increased accuracy– since there is little to no room for error in this system, you can get accurate data and reports in real-time. There is no need to add that precise data is valued way more than money in today’s economy.
Disadvantages of the Perpetual Inventory System
Despite having numerous benefits, the perpetual inventory system has several limitations, such as:
- Hacking– the software used in this system depends on the internet, which poses the risk of your system getting hacked by malicious cybercriminals, who have been able to hack into even government databases from time-to-time. You risk losing all your inventory data.
- Internet shortages– without a stable internet connection, the system may become stiff or even impossible to implement.
- Cost-intensive– the perpetual inventory system will require you to purchase and install inventory management software, bar code scanners, and several other such-kike resources to implement. These resources may prove expensive to acquire and maintain for most small businesses or startup companies.
- Extra training– a company seeking to implement this system will need to conduct training on its employees or even look for tech-savvy or familiar employees with the system. Training may be an additional cost for the company.
For any fast-growing business, a perpetual inventory system would be the solution for inventory tracking. In comparison, we can safely conclude that the periodic inventory system leaves many rooms for error, which is not a risk any business with a large inventory should be willing to take. The perpetual inventory system allows you to optimize your inventory levels and so much more.
EMERGE App provides you with an online inventory management solution that provides you with information such as available inventory, batch expiry dates, and track details such as exchanges and returns.