Inventory valuation methods such as LIFO and FIFO are used to account for inventory movement immediately. Periodic inventory systems are designed to update inventory totals only after a physical inventory has been completed.
Rather than the perpetual inventory system that is typically used in accounting software applications, periodic inventory systems are frequently used by smaller businesses that are able to easily do a physical inventory.
While this is a possibility for a business that has a limited amount of inventory in stock at any given time, the task would be difficult — if not impossible — for larger businesses with multiple warehouses.
Overview: What is the periodic inventory system?
A periodic inventory system is an inventory accounting system where you record inventory adjustments only after a physical inventory has been taken.
Between inventory accounts, any inventory purchases are recorded in a purchases account, where the balance remains until a physical inventory has been taken.
For instance, if you do a physical inventory on January 15, all subsequent inventory purchases are recorded in a separate purchases account that will be adjusted the next time a physical inventory is conducted.
There are some major differences between a periodic inventory system and a standard inventory system. For instance, when you purchase inventory, instead of posting to an inventory account, you would post the transaction as follows:
If your purchases were bought on account, you would post the transaction like this:
Either way, the purchases go into a separate purchases account rather than directly into your inventory account. These transactions would be posted each time you make an inventory purchase and remain there throughout the period.
At the end of each period, you’ll need to record a journal entry that will reduce the purchases account to zero while increasing your inventory amount by the purchase totals. For example, if you’ve made $2,000 in purchases throughout the period, the journal entry would show:
Another way periodic inventory systems differ from standard inventory is the way a sales transaction is recorded. In other inventory systems, a sales transaction immediately affects your inventory totals.
However, when you use a periodic inventory system, you're not directly impacting your inventory totals, so you’ll need to record the sales transactions a little differently:
Because you're recording inventory movement periodically, a sale will not reduce inventory totals as it would using another inventory system, thus there's no direct impact on inventory value or availability when a sale is made.
Benefits of the periodic inventory system
Larger businesses or those managing multiple inventory items would suffer when using the periodic inventory system, which can include inaccurate inventory counts and an overestimated or underestimated cost of goods sold.
Businesses with large quantities of inventory would also struggle to keep up with the necessary product counts.
But for smaller businesses, or businesses with limited inventory, there are benefits to using the periodic inventory system.
1. Easy to use
A periodic inventory system requires no training, so smaller businesses can start using it from day one. Those using the periodic inventory system can also devise a workable timeframe for completing a physical inventory count, which can be monthly, quarterly, or yearly, depending on the company.
It’s also easy to get started by completing an inventory count for your beginning inventory total and then tracking any purchases along the way.
Small businesses can save a little bit of money since a periodic inventory system does not require any special software or point-of-sale system in order to track inventory movement.
3. Period flexibility
Unlike other inventory systems, a periodic inventory system allows you to pick the period of time you wish to use when accounting for inventory.
For instance, if you sell inventory frequently, a monthly period may be useful, while a quarterly or even yearly period would likely suffice if you seldom sell products.
How to calculate COGS under the periodic inventory system
Unlike the perpetual inventory method, which keeps track of the cost of goods sold (COGS) at all times, you’ll have to estimate the cost of goods sold between physical inventories. When you’re ready to calculate COGS, use the following periodic inventory formula for calculating COGS:
Beginning Inventory + Purchases - Closing Inventory = COGS
For example, in January 2020, your beginning inventory totals $50,000. You decide you’ll do periodic inventory every quarter. During the first quarter of 2020, your purchases total $62,000. After completing your inventory count at the end of the first quarter, your ending inventory total is $44,000.
Your COGS calculation would be:
$50,000 + $62,000 - $44,000 = $68,000
Is the periodic inventory system right for your business?
If you’re a small business with limited inventory to sell, the periodic inventory system may be your best choice for managing inventory. You can track inventory for a given period and estimate COGS if necessary.
However, larger businesses need to track inventory movement in real time, account for COGS, and have access to current inventory balances, something the periodic inventory system cannot do.
When choosing to use the periodic inventory method, keep in mind that your bookkeeper or accountant will be responsible for the periodic accounting necessary.
Inventory management is an important task for any small business, so it’s important to choose the inventory method that's best for your business.