Knowing how much you have spent on inventory is one of the most important aspects of running a business. Monitoring inventory after a predetermined period is important for estimating future product demand. Once that is known, business leaders can then work to eliminate any excess inventory to save on both space and costs.
The periodic inventory system is a type of inventory valuation method that makes it incredibly easy to track inventory costs. In fact, periodic systems are often used by small business owners and startup companies because of its simplicity. Think of inventory monitoring practices as a financial responsibility that allows companies to gather basic data on how to manage product output.
This article will explore how the periodic inventory system works, as well as the differences between this method and its counterpart the perpetual inventory method. By the end, you'll be able to make an educated decision on which method will be best for your own company.
What is a Periodic Inventory System?
A periodic inventory system is a form of inventory management where the cost of goods sold is the primary concern. To use this method, businesses must manually count stored products at a given point in time to maintain their general ledgers. Most organizations that choose to participate in a periodic inventory system opt to measure inventory levels in monthly, quarterly, or annual periods, depending on their products and accounting needs.
Instead of updating the inventory system regularly with real-time sales transactions like what happens within a perpetual inventory system, businesses utilizing a periodic inventory system instead begin by measuring current inventory levels. Combined with the data involving inventory purchases throughout this period, they can then calculate what they’ve spent.
Periodically calculating a business' inventory is helpful if the facility doesn’t have the resources to accurately estimate inventory daily. In short, it helps small businesses keep their costs low.
Deriving the Cost of Goods Sold (COGS)
The cost of goods sold is the driver behind the periodic inventory system. Functioning as an income statement, calculating the COGS can only be determined after the existing inventory has been counted.
The COGS Formula is as follows:
(Beginning inventory + Purchases made during the period) – Ending inventory = COGS
Let’s do an example. The company begins its quarter with $300,000 in products. They purchase $200,000 more as time passes within the quarter. Right before the first quarter ends and the second quarter begins, they then manually count the product they have left and determine that there is about $150,000 left in ending inventory. The formula would appear as the following:
($300,000 + $200,000) – $150,000
$500,000 – $150,000 = $350,000 COGS
The company sold $350,000 worth of products.
As can be seen here, utilizing a periodic inventory system is incredibly easy and the calculations are simple.
Performing a Physical Inventory Count
There are four different ways to take inventory to maintain a periodic system. They are as follows:
- Manual Completion – This method utilizes paper count cards to record inventory. This is often incredibly time-consuming as well as has a higher risk of error.
- Electronic Counting – Get out the mobile scanning devices, barcodes, and RFID scanners for electronic-centered inventory management. Not only is this method fast, but it is also accurate.
- Full Inventory – Instead of allocating only a few workers to complete an inventory check, the entire staff is recruited to help. While this is faster than the first option, it does often require the plant to shut down during the process.
Performing s physical count on merchandise is often the hardest part about utilizing the periodic inventory method. Workers find it tedious and depending on the method used, inventory counts can also be rife with human error.
No matter what, manual inventory counts are essential for the periodic inventory method to work.
Periodic Systems Vs. Perpetual Inventory Systems
There are several major differences between both the periodic inventory system and the perpetual system. So much so, in fact, that there is usually only one right choice when factoring in how the business operates and how efficient the company wants to be. Let’s compare the two.
Financial Accounting Differences
- The perpetual inventory system is centered around updating the inventory ledger or general ledger every time something either leaves the facility or is brought in.
- The periodic inventory system is obligated to perform an inventory count at the end of an accounting period to determine the cost of goods sold.
Software or the Lack Thereof
- The perpetual inventory system is used in environments where the quantity of products is so large that it makes it impossible to manually keep track of items. With the help of computer software, the company can keep track of thousands of transactions throughout the determined accounting period, whether that be quarterly or annually.
- The periodic inventory system is so simple, and ideally, on a small scale, that inventory can be manually accounted for with a trusty pen and paper, or barcodes if the facility wants to become more streamlined.
- The perpetual inventory system requires several different categories for products. These include an account for raw materials and one for finished merchandise. However, there is also another account that keeps track of each inventory item. While this is an extremely accurate way of keeping track of inventory, it is also complicated.
- The periodic inventory system only has one purchasing account called the purchase asset account. Additionally, there are no inventory records for either raw materials or finished products. It all goes into one big list.
The Ability to Perform a Transaction Investigation
- The perpetual inventory system set up for keeping track of purchases makes it incredibly easy to sift through purchasing records for mistakes since everything is so detailed.
- The periodic inventory system makes it impossible to perform any sort of inventory investigation since, again, there is little data on purchases.
The differences between these two processes are significant. However, each has the attributes that make it worthwhile to choose one or the other for either simplicity or efficiency.
Examples of Periodic Systems
Believe it or not, there are several different routes a company can take to establish a periodic inventory system. It starts with what is called the cost flow assumption. This is an inventory price measurement method for periodic systems used by businesses for COGS and inventory estimates. It also must be remembered that the costs that a company has within inventory can flow differently than the physical product.
The initial inventory and the acquisition of new products are the inputs used for accounting calculations for the prices of products available on the market. The facility then must apply the cost flow assumption to any of the costs that it chooses. The following are the different methods one can use to accomplish this goal:
- Periodic LIFO – Referred to as the “last-in, first-out cost layering system,” assumes that the last item that has been added to the existing inventory is the first to leave. Grocery stores are a great example of this. Consumers take items from the front of the shelf, which happened to be the last items that the worker put in place. In a periodic inventory situation for LIFO, the company will see either a high cost of goods against the lowest net income or a low cost of goods to a high net income. This is because they put out the most recently purchased product. So, if they bought 5$ material before, bought more 7$ material, then that higher cost is going out first.
- Periodic FIFO – The “first-in, first-out” method runs off the idea that the first units bought are going to be sold first. A chronological view on calculating COGS. Again, the company must first manually count inventory if they are using a periodic inventory system.
- Periodic Weighted Average Cost (WAC) – The value of inventory is calculated by taking the average cost of all the units. The formula for this is (Beginning Inventory + Purchased Inventory) / Units for Sale = WAC. This then can be used to determine the COGS.
Who uses the Periodic System?
Think of it this way, large businesses have significantly more inventory as well as inventory expenditures than small businesses. This is to the point that a large business would face too many errors, too much time spent, and too much data to comfortably deal with if they counted inventory by hand as the periodic inventory system does. Automation for them with the perpetual inventory system makes sense.
That said, the periodic inventory system is built to cater to small businesses without very much inventory. Low inventory means less time spent performing physical inventory counts, which means it’s cheaper to implement. A factor that many startups need to choose to get established for more growth in the future.
The Benefits of Periodic Inventory
One of the major benefits that periodic inventory offers to its users is that it does not require the company to make separate categories for raw material, WIP, and finished goods. Putting all of these in one basket allows for much simpler calculations.
Periodic inventory, as already mentioned, is incredibly easy to implement. It does not require any fancy software or computer systems to track real-time expenditures. That said, easy to implement also goes hand in hand with cost. The periodic method costs practically nothing other than paying those hired to take inventory occasionally.
There are certainly perks to choosing to utilize this method, but it does not come without challenges.
The Challenges of a Periodic System
Despite the periodic inventory system’s alluring benefit of simplicity, the periodic inventory system has been determined to be risky because the stock level may not always be updated. This can cause delays, an incorrect inventory balance, write-offs, and potentially major problems with stock forecasts due to a lack of accurate data.
Additionally, periodic inventory may be more prone to human error, as it mainly requires physical inventory audits which can be labor-intensive. Upon completion of physical counting, inventory reconciliations may be necessary to resolve stock discrepancies.
Lastly, periodic inventory systems make it incredibly hard to gauge the frequency of theft. Without data, what has been lost and how much it was is impossible to know.
All in all, it is up to you to make the best decision for your facility’s inventory tracking journey, choose wisely.
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