Companies need a way to track the number of products they have available as inventory. In doing so, they can use one of the two commonly used methods: periodic inventory or perpetual inventory.
These systems are polar opposites and offer different benefits for a company.
Periodic inventory refers to the accounting method that lets companies occasionally measure inventory balances. You can intuitively understand the concept from the word “periodic,” which usually related to activities that are only executed once in a while. Typically, this system is a great choice for small firms that have a limited budget.
On the other hand, as evident from its name, the perpetual inventory system demands the company always keep track of their inventory status. Updates should happen after even just one product is sold or returned. It goes without saying that this particular counting method can be much more expensive compared to the periodic inventory. But even so, all major retailers use this system since, in their case, the benefit outweighs the costs.
Understanding Periodic Inventory
Since the periodic inventory system doesn’t immediately take into account inventory changes, any purchase the company made instead is recorded on the purchases account. At the same time, sales are registered under a single journal entry of a sales account. These reports are not directly affecting the inventory account except for when the accounting period has ended. After the set period has reached its end—this can go from after a month to even a year, only then during this time that inventory account is updated.
Knowing the level of inventory also helps businesses determine the value of another important measurement; the cost of goods sold (COGS).
To calculate COGS, here’s the formula:
$$Cost\: of\: Goods\: Sold = Beginning\: Inventory + Inventory\: Purchases - Ending\: Inventory$$
Beginning inventory refers to the inventory left from the previous period. Putting it another way, it can also mean the amount of inventory at the beginning of the period. Inventory purchases are added purchases or productions the company made during the period. Finally, ending inventory is the value of inventory at the end of the period.
COGS represents the direct costs of producing goods ready for sale. This can include material cost, labor cost, and any additional overhead. You might be wondering why the formula above does not calculate the material cost and such but inventory & purchases instead. Well, that is simply another method of determining COGS. Regardless, the value of COGS should be the same either way.
For companies that employ the periodic inventory system, the value of inventory and COGS are not up-to-date most of the time. This situation could be avoided by using perpetual inventory.
However, for small companies, that can be quite difficult and time-consuming. For large corporations, it’s not a big deal since they can afford to do it. But imagine owning a small grocery store. You need to update the inventory level for every candy a child buys — that’s not very practical now, is it?
Understanding Perpetual Inventory
Companies that use the perpetual inventory system have a clear advantage when it comes to accuracy. The balance status of inventory is continuously and automatically updated with every transaction. These transactions may stem from purchases, sales, and even returns. How can they track every transaction? To answer this question, let’s go back to the example of grocery stores.
Grocery stores owned by large retailers can easily update the central balance of inventory thanks to the expensive but sophisticated digital tracking technology that they own. With the technology, every store can send updates to the database in real-time, even for a single candy or gum sale. This happens when products’ barcodes are being scanned by the cashier. The technology is not cheap, and small businesses who wish to do the same would most likely struggle to make it a reality. This is the reason why perpetual inventory is often not the most cost-effective system for them.
With that said, using perpetual inventory, the value of inventory and COGS will always be accurate, assuming that extraordinary factors such as damages and misappropriations are not taken into account.
When a company decides which inventory accounting method to use, truth be told, it’s not simply a matter of business size but also the number of sales. Let’s consider vehicle dealerships as an example. These businesses, although relatively large in size, usually have a low amount in terms of the number of sales.
This makes it easier to keep track of the figure of inventory. In this case, it’s not a bad idea to opt for easy-to-manage and cheaper periodic inventory system.
This, however, doesn’t apply to retailers that would normally sell a large number of items daily. The need to use modern tracking technology can’t be avoided if you want to keep up with the ever-changing inventory balances. This ensures accurate accounting as well as greatly minimizes the probability of errors.
Summary of Perpetual vs. Periodic Inventory Differences
To get an even better understanding of differences between the two terms, below is the list of some key distinctions that we’ve mentioned as well as a few additions.
- Inventory and COGS accounts are updated continuously for perpetual inventory, whereas periodic inventory would only update these accounts at the end of each period—be it monthly, quarterly, or yearly.
- Every company purchases, sales, and returns are directly affecting the value of inventory for the perpetual system.
- On the other hand, these figures are recorded on the purchases and sales account for periodic inventory and would only alter the value of inventory at the end of the period.
- Despite its cheapness, the periodic inventory system may obstruct companies from making better decisions due to the lack of accuracy.
- In a different circumstance, the perpetual system helps companies to get a precise figure in order to make more desirable choices, despite being more expensive. It also contributes to mitigating errors and preventing mismanagement.