As a child, one of my favorite days of the year was when I would go to work with my dad on a Saturday to count inventory. He managed a box plant, and the massive rolls of paper that would later become boxes needed to be counted for that period’s inventory accounting.
About 10 of us would walk through the warehouse and scan the barcode on each roll. My favorite part, not surprisingly, was when a roll was too high up, and we called over the forklift driver to bring it down to be scanned.
The scanner communicated with a computer in the office, where the accountants reconciled the count with their spreadsheets and worked on the balance sheet for the quarter.
This method, known as the periodic inventory system, is not as prominent as it once was due to technological advances in accounting software. However, it could still be the best method for your business. Read on to learn about periodic inventory and its younger brother, the perpetual inventory system.
What is periodic inventory?
Companies that use periodic accounting do all necessary journal entries and bookkeeping at the end of each accounting period. As part of their period-ending work, they count inventory and then use that number on the balance sheet and to calculate cost of goods sold.
Let’s take a look at how periodic inventory accounting would work:
Imagine at the end of the first quarter, inventory is $50,000. This figure becomes the beginning inventory for the second quarter. Purchases during the quarter amounted to $18,000, and at the end of the quarter, inventory was counted at $42,000. We can calculate the cost of goods sold using this information.
Start with the total cost of inventory, which is the beginning inventory plus purchases ($50,000 + $18,000 = $68,000). Subtract out the inventory remaining, and you’re left with the cost of inventory that was sold, or cost of goods sold ($68,000 - $42,000 = $26,000).
One advantage of the periodic inventory system is that counting inventory allows you to identify shrinkage (inventory that is lost, stolen, or damaged). Inventory that is only managed on the cloud can more easily disappear and end up being sold out of the back of a truck somewhere.
Keep a budget of expected gross margin each period to compare with the actual margin. Shrinkage will automatically be included in the cost of goods sold, so if the numbers vary by a large amount, it’s time to investigate.
What is perpetual inventory?
Some companies don’t wait until the end of an accounting period to track inventory. Instead, they use the perpetual inventory method. This approach involves an integrated point-of-sale system. Inventory is tracked instantaneously when purchased or when sales are made.
Under the perpetual inventory system, new units are added directly to the inventory account instead of a purchases account, and the cost of goods sold is calculated based on the inventory accounting method used, usually LIFO or FIFO.
Let’s work through an example purchase with this inventory history:
Using proper internal controls, for each purchase, an employee will enter a purchase order into the accounting software that is then approved by a manager. When the inventory is received, along with the invoice from the vendor, payment is approved, and the cash and inventory accounts are updated accordingly.
At the time of sale, two journal entries would be made: one to recognize the sale, and one to move the inventory to cost of goods sold:
Cash and revenue both increase to recognize the sale. Cost of goods sold is calculated using the FIFO method, and inventory is decreased by that amount. The 10 units from June 1 and four of the June 5 units are included ((10 x $10) + (4 x $10.12)).
Periodic inventory vs. perpetual inventory: What's the difference?
The key difference between periodic and perpetual accounting is timing. Periodic inventory is done at the end of a period to create financial statements. Perpetual inventory is done as sales and inventory purchases happen.
Look back at the examples above. In the periodic section, we used a separate purchases account to track new inventory coming during the period, and then we used that account in a formula to calculate cost of goods sold.
The purchases account is closed at the end of the period with a closing journal entry that moves the balance into inventory.
With perpetual assets, there is no purchases account. When new inventory is purchased, it goes directly into the inventory account, and there is no closing entry. Cost of goods sold is increased, and inventory is decreased the instant that inventory is sold.
Using perpetual inventory, you’re able to track and manage inventory as transactions happen, buying more inventory when necessary and zeroing in on the best prices.
Perpetual vs. periodic: How to select the right method for your business
It’s easy to see why periodic inventory would be cumbersome for big businesses. It would not be cost effective for Amazon.com to count every Kindle, James Patterson book, or even jumbo pack of toilet paper in its warehouses once a month to calculate inventory.
It also wouldn’t make sense for small businesses that sell their inventory as a side project to use perpetual inventory. An appliance repair company selling two or three used refrigerators per month has no need to invest in an expensive point-of-sale system.
Most businesses are somewhere between these two extremes. If inventory is a key component of your business, and you need to manage it daily or weekly to make new orders and keep up with demand, use perpetual inventory accounting.
If you don’t need that sort of timeliness and can take the time each month to count inventory, go with periodic.
The decision is not black and white. Businesses that account for inventory periodically likely use the FIFO method to sell older units first. Retailers that use the perpetual system often make it a practice to count inventory (or at least a sample of inventory) to make adjustments for shrinkage.
At my father's box plant, inventory was counted twice a year. When I worked at a restaurant in high school, key items were counted every single night.
Measure what matters
Management pioneer Andy Grove made Intel into one of the leading tech companies for decades with a philosophy based on objectives and key results, or OKRs. You must have clear goals with results that are measurable.
Objectives are big-picture goals, such as "create a diverse and sustainable product line."
Key results are the tangible indicators that the objective has been achieved, such as: three or more product lines with over $10,000 in sales, average growth of more than 5% per product line, and at least two new product lines introduced.
If inventory is central to your business, it must be managed, and to do that it, must be measured. This can only be done with the perpetual inventory method.
If you have a service business that sells a few items on the side, use the periodic method so you can focus on measuring what matters.