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Whether you are an e-commerce merchant or run a brick-and-mortar store, inventory is a valuable asset on your company’s balance sheet. The cost of inventory is one of the biggest expenses a business can face; therefore, inventory valuation is critical for financial reporting.
The periodic inventory system is one such inventory valuation method. It helps businesses figure out the value and cost of inventory while keeping a tab on the beginning and ending inventory during an accounting period.
This guide explores everything you need to understand and use the periodic inventory method for your business. Between deliveries, there is minimal to no storage.
What Is A Periodic Inventory System?
The periodic inventory system serves a financial purpose by taking inventory valuation into account. Under a periodic inventory system, physical valuation, recording, and counting of inventory occur at specified intervals. So, instead of updating the inventory and cost of goods sold (COGS) after every inventory purchase/sale, the business updates the accounting records after a specific accounting period has passed.
The periodic inventory system helps businesses determine the COGS and trace the inventory purchase and sales throughout an accounting period. Since inventory updating is done towards the end of an accounting period, the method helps businesses track the beginning and ending stock. In addition, the periodic inventory system allows companies to maintain separate accounts for inventory and delivery costs while keeping track of ongoing inventory account expenses.
Understanding Periodic Inventory: How Does it Work?
A business does not keep a continuous record of each sale or purchase in a periodic inventory system. Instead, it physically counts inventory at the end of a specified period, which could be a month, a quarter, or a year, to determine the cost of goods sold and the inventory on hand. In other words, the COGS and final inventory balance are updated at the end of an accounting period through a physical inventory count.
Rather than updating their records with the cost levels and current inventory on an ongoing basis, businesses taking the periodic inventory approach to calculate costs consider the beginning and ending inventory levels and purchases made during the accounting period.
A periodic inventory system works best for businesses that physically keep items in stock but do not need to know the current inventory levels regularly. It is handy for small business retailers and enterprises looking to keep expenses low and having limited SKUs to update at the end of each accounting period. Periodic inventory is unnecessary for larger and growing businesses that typically require more elaborate inventory tracking.
Periodic Inventory Accounting: Calculating The Cost Of Goods Sold Using The Periodic Inventory System
What is the cost of goods sold (COGS)?
The cost of goods sold (COGS) or the cost of sales is the direct cost a business incurs to sell goods, including the labor cost and the cost of raw materials to manufacture a product. It excludes indirect expenses such as sales force and distribution costs. In other words, COGS includes the expenses directly tied to the production of goods. For instance, the COGS for a bicycle manufacturer would include the costs of materials that go into making the parts of a cycle plus the labor costs required to put the cycle together. The cost of sending the finished products to dealerships or the labor involved in selling the bicycles are not part of the COGS. However, the cost of goods sold will vary depending on the level of inventory and the accounting parameters used during calculation. In addition, if you are calculating the gross profit and margin, you need to subtract COGS from the sales revenue. The higher the COGS, the lower the margin.
Formula For COGS
COGS includes only those costs directly related to the production of goods intended for sale. Here’s a simple formula for calculating the cost of goods sold:
COGS = (Inventory at the start of the accounting period) + (Purchases during the accounting period) – (Inventory at the end of the accounting period)
In the above formula, cost of goods available = (Inventory at the start of the accounting period) + (Purchases during the accounting period)
Therefore, COGS = Cost of goods available - Inventory at the end of the accounting period
The beginning inventory for a year or the inventory at the start of the accounting period is the inventory remaining from the previous year. In the formula, any additional purchases or productions are added to the beginning inventory. At the end of the accounting period, the ending inventory or the unsold products are deducted from the sum of the beginning inventory along with extra purchases. Hence, we get the value of the cost of goods sold for the accounting period.
A company’s balance sheet has a current assets account which includes an item called inventory. Since the balance sheet represents a company’s financial health at the end of an accounting period, the inventory value included in the current assets is the ending inventory.
Accounting Methods To Calculate The COGS
The value of COGS will depend on the inventory costing method you use. There are broadly four accounting methods you can use when calculating the level of inventory sold during an accounting period: the first-in, first-out (FIFO) method, the last-in, first-out (LIFO) method, the average cost method, and the special identification method.
First-In, First-Out, Or FIFO Inventory Method
First-in, first-out implies that the earliest manufactured or purchased goods are sold first. FIFO is a reliable indicator of the ending inventory value since the older items get used up first while the most recently purchased/manufactured items reflect current market prices. Moreover, since prices typically increase with time, a company taking the FIFO approach to inventory accounting will sell its least expensive goods first, resulting in a lower COGS. Therefore, net income tends to increase over time.
Last In, First Out, Or LIFO Inventory Method
In the last-in, first-out inventory method, the latest items added to the inventory are sold first. Since the LIFO approach considers the most recent merchandise to value COGS, the remaining stock is either very old or obsolete. Therefore, LIFO does not provide a reliable or accurate inventory value because the valuation is lower than the inventory’s current market prices. Moreover, LIFO is not a practical option because most companies would not prefer using their latest inventory while older stock sits idle. Since goods with higher costs are sold first, the COGS value rises, and net income decreases over time.
Average Cost Method
The average cost method factors the average price of all the items in the stock to calculate the value of goods sold. Using the average cost of goods prevents the extreme cost of one or more purchases from impacting the COGS value.
Special Identification Method
The special identification method is used for unique or high-valued items such as cars, rare and precious jewels, and real estate. In this method, the specific cost of each unit of inventory or merchandise is used to calculate the COGS and ending inventory for a particular accounting period. A business using the special identification method knows which items were sold and their exact cost.
An Example of Periodic Inventory
Now, let’s understand periodic inventory and calculate the cost of goods sold using an example:
Say you run an e-commerce store with an inventory of $10,000 in the starting period. You pay $4,000 for purchases over the accounting period, and after a physical inventory count, your closing inventory is worth $2,000.
Using the formula, the calculation for the cost of goods available is as follows:
Putting the values we get:
Cost of goods available = (Inventory at the start of the accounting period) + (Purchases during the accounting period)
Cost of goods available = $10,000 + $4,000
Cost of goods available = $14,000
Now, COGS = Cost of goods available – Inventory at the end of the accounting period
COGS = $14,000 – $2,000
COGS = $12,000
Using the periodic inventory method, the COGS for the accounting period is $12,000.
Periodic Inventory System Advantages And Disadvantages
The periodic inventory system lets a business track its starting and ending inventory during a given accounting period. To use a periodic inventory system, you only need the starting inventory count and a simple formula.
However, the periodic inventory system has both benefits and drawbacks. Let’s have a look at them:
Advantages Of The Periodic Inventory System
Perks of a periodic inventory system include:
- Easy to implement: One of the most significant benefits of a periodic inventory system is its simplicity. It takes a few minutes to install, implement, and integrate the system with your business. It requires fewer records than other inventory accounting methods and involves simpler calculations.
- Cost-effective: The periodic inventory system is one of the most straightforward and cost-effective approaches to inventory accounting. It does not require expensive software solutions or infrastructure and involves minimum investment. If you are ready to put in the effort, the cost of implementing a periodic inventory system will never go higher.
- Ideal for small businesses: Most importantly, a periodic inventory system is a great option for small businesses that do not stock a large inventory because it is easier to perform a physical inventory count. Also, calculating the cost of goods sold over an accounting period becomes simpler.
Disadvantages of the periodic inventory system
Periodic inventory systems have the following limitations:
- Prone to errors: A periodic inventory system can be unreliable. Since stocks are not updated regularly, it could result in inventory write-offs, inaccurate inventory forecasting, delays in identifying issues, and incomplete information on finished goods inventory. Moreover, a periodic inventory system relies on manual inventory audits, which increases the chances of human errors.
- Time-consuming and laborious: Using a periodic inventory system is not an issue if you handle a small inventory. However, the problem arises if your business expands and you have to deal with a higher number of orders. In such a scenario, physical inventory counting is time-consuming, laborious, and the perfect opportunity for errors to creep into the inventory accounting process. A periodic inventory management system will become increasingly challenging as your business grows.
- Unsuitable for larger businesses: Going down the periodic inventory path is not a wise option for companies with a large SKU count, high inventory turnover rate, and multichannel inventory requirements. Such businesses must adopt a more efficient and automated inventory management approach with real-time data continuously available.
Perpetual Inventory vs. Periodic Inventory
Businesses looking to improve inventory control often face a dilemma in deciding whether to choose a perpetual or periodic inventory system. Although the decision ultimately boils down to what’s best for a business, it is worth looking at the differences between the two.
But first, let’s understand what a perpetual inventory system is.
What is perpetual inventory?
Unlike a periodic inventory system, the perpetual inventory system involves updating records as inventory is purchased or sold. In other words, the perpetual inventory system keeps a continuous tab of inventory balances. It records all the information in real-time using point-of-sale and enterprise asset management technology, making it far more sophisticated than periodic inventory.
A perpetual inventory system protects against theft and misplacement. Any legitimate change to the inventory is accurate, with the COGS account updated with every sale. Human intervention is minimal since the method involves technology. The real-time information that a perpetual inventory system collects goes to central databases.
Here are some features of a perpetual inventory system:
- Items in inventory have barcodes to help keep track of their movement and the time for which they’ve been on the shelf
- Information about COGS, purchases, and remaining stock is kept in separate ledgers
- Computers update the incoming and outgoing inventory in real-time
Benefits of perpetual inventory system
Let’s look at the advantages of a perpetual inventory system:
- Prevents stock issues: A perpetual inventory management system records inventory level changes in real-time and allows accurate monitoring of when inventory is purchased and sold. The system is quick and efficient at identifying merchandise that’s running low, allowing businesses to reorder in time and preventing out-of-stock situations.
- Accurate inventory management: Businesses that deal with large amounts of inventory must monitor their sales and stock closely to prevent a build-up of goods that do not sell or run out of best-sellers. A perpetual inventory system allows for accurate tracking of inventory levels and error-free calculation of inventory turnover ratio. Thus, a company can easily identify items that are no longer selling quickly.
- Uncovers inventory misplacement and theft: A perpetual inventory system compares the year-end count with the inventory balance in the system, allowing businesses to identify any theft, misplacement, or other discrepancies. Thus, companies can amp up security measures and take appropriate steps to determine inconsistencies.
Drawbacks of perpetual inventory system
Despite being the ideal option for large businesses, the perpetual inventory system has its downsides.
- Expensive setup: Perpetual inventory systems are expensive. They involve sophisticated technology such as computers, software, barcode scanners, and the like and add to the company’s budget. Plus, additional costs are involved if a business upgrades its existing system to accommodate technological components. Training employees to handle the technology is also cost-intensive.
- Not feasible for small businesses: Due to the costs involved, perpetual inventory systems are unsuitable for small businesses with low margins. Given the hefty expenses, it only makes sense for expanding or large companies to use a perpetual inventory system that works best for high inventory turnover rates and large SKU counts.
- Overlooks product breakage/spoilage: Since a perpetual inventory system does not involve physical inventory counting, the method does not account for products that break or spoil after purchase or during storage. So, until a deliberate physical counting is done, even spoiled or broken goods will be counted as inventory.
Periodic vs. Perpetual Inventory System: Which is More Effective?
Although a perpetual inventory system seems more appealing, periodic inventory systems have benefits. For instance, a periodic inventory system is a straightforward and economical option for small businesses or startups with low capital and slender resources. It does not involve complex software or technology and has minimal setup requirements. The only costs involved are the labor cost and the time involved in physical counting.
However, periodic inventory systems are often time-consuming and labor-intensive due to the manual tasks involved. While it may not be an issue for small businesses with less inventory, the situation becomes overwhelming and unmanageable as the size and scope of the business increase. If a company deals with a variety of large and complex stocks, a periodic inventory system is not enough.
A perpetual inventory system can be expensive due to the infrastructural costs involved. However, it is more effective and easier to maintain than a periodic inventory system because perpetual inventory gives accurate physical counts and allows for real-time monitoring. With barcodes attached to every item in the stock, businesses are better informed of what moves in and out of their warehouses.
Should My Business Use Perpetual Inventory Or Periodic Inventory?
The periodic inventory management system takes a simple approach to inventory accounting and comes in handy for small enterprises and retailers. Instead of counting inventory regularly, the method relies on updating inventory only after a specific period.
Overall, you can use a periodic inventory management system if –
- You have a simple supply chain management process
- You do not deal with a significant number of stock-keeping units or SKUs
- You run a seasonal business
- You are looking for a simplified and cost-effective approach to inventory management
On the contrary, a perpetual inventory system works best if –
- You have a large/expanding business You deal with a large number of SKUs
- Your inventory turnover ratio is high
- You have the resources and budget to invest in sophisticated infrastructure
Whether you choose a perpetual inventory system for your business or stick to physical counting under a periodic inventory system depends on several factors, such as the size and scope of your business, the resources you are willing to invest, and the inventory quantity you handle.
Inventory management is crucial for any business; even a minor glitch or error can have drastic consequences. This article covered the fundamentals of the periodic inventory system and discussed its benefits and limitations. We have also shed light on the perpetual inventory system, its advantages, and its disadvantages. Ultimately, the inventory management method you choose will depend on your unique business requirements.
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A periodic inventory system is where inventory is physically counted, recorded, and valued at specific intervals known as the accounting period.
Periodic inventory accounting involves calculating the cost of goods sold or COGS. The formula for COGS is:
COGS = (Inventory at the start of the accounting period) + (Purchases during the accounting period) – (Inventory at the end of the accounting period)
One advantage of the periodic inventory system is its minimal and cost-effective setup and implementation.
The features of a periodic inventory system are as follows:
No continuous record of inventory
Involves calculating the cost of goods sold (COGS)
A physical inventory count at the end of the accounting period determines the COGS and ending inventory balance
Simple setup and implementation
A periodic inventory system determines the cost of merchandise or goods sold at the end of an accounting period (a month, a year, or a quarter).