So you’ve recently been considering which inventory-tracking system would suit your business and its operations best? You have come to the right place! After having just evaluated the inner-workings of the perpetual inventory system in our previous article, we are now shining a spotlight on the periodic inventory system. Follow along for a comprehensive guide on all things periodic inventory!
What is a Periodic Inventory System?
A periodic inventory system is both an inventory valuation and tracking system involving a physical count of stock, periodically, at the beginning and end of a specific accounting period – such as a month, or year. It is also a method used by companies to calculate the cost of goods sold (COGS) during a specific allotment of time. This is determined by calculating the difference between the balances of beginning and ending inventory, with adjustments being made for any inventory-related transactions, purchases and sales that occurred during the accounting period.
Briefly explained in our previous article on perpetual inventory are the differences between the two inventory tracking methods. Let us recap. The perpetual inventory system involves continuous, computerised updates of any inventory-related purchases and sales through the use of point-of-sales machines and barcoding systems. The periodic inventory system, however, greatly differs in that it involves physical counts of stock only at specific periods of time, rather than a continuous tracking as seen in the perpetual inventory system. Transactions, in a periodic inventory system, are also not recorded as part of the system, but rather separately until a physical count is conducted at the end of the accounting period.
When is a Periodic Inventory System Used?
A question we will not blame you for pondering is, ‘Why would businesses opt for a periodic inventory system when there are machines and computers that do this work for you, such as the perpetual inventory system?’ However, businesses often choose to use the periodic inventory system for specific situations that align with their needs and resources. Several factors influence this decision:
Low transaction volume: Small businesses or those with relatively low inventory turnover may find it more practical, manageable, and cost-effective to perform periodic physical counts rather than investing in real-time tracking systems.
Cost considerations: Not far-off from the previous point, periodic inventory systems are generally less expensive to maintain than perpetual inventory systems as they do not make use of any specific software or technology. This is, obviously, a big plus to companies with budget constraints.
Limited resources: Implementing a perpetual inventory system requires a certain level of technological infrastructure and training. A periodic approach may be more feasible for businesses that lack resources, software, manpower, or expertise to maintain and thoroughly execute the above.
Minimal inventory variability: Periodic inventory systems are best suited for companies who have minimal environmental changes affecting the consumer market. Businesses with stable and predictable inventory patterns, such as small, neighbourhood grocery stores, may find periodic inventory sufficient to manage their stock levels effectively.
Industry: A factor that plays a crucial role in many business decisions is the type of industry it finds itself in. Certain service-based companies where the inventory component is not a primary focus are greatly suited to the periodic inventory system, as this can imply low transactional volumes, limited resources, and minimal inventory variability.
Cost of Sales in Periodic Inventory?
In a perpetual inventory system, the cost of goods sold is updated with each inventory movement. This is a crucial calculation in determining one’s company’s net profits, and ultimately, how it has performed during the accounting period. However, the periodic inventory system calls for the manual calculation of COGS using beginning inventory, net purchases, and ending inventory. This process usually involves several steps – let us assess:
COGS = (Beginning Inventory + Purchases) - Ending Inventory
- Beginning inventory: At the start of the accounting period, the company takes note of the value of the inventory on hand from the previous period’s ending inventory. Read through our opening inventory article for a more comprehensive explanation of the uses and functions of beginning inventory.
- Purchases: As mentioned above, any inventory purchases made throughout the accounting period are recorded separately. This is inclusive of the cost of acquiring raw materials and/or finished goods from suppliers, as well as any additional costs related to inventory, such as transportation and holding fees.
- Ending inventory: As the accounting period ends, a physical count of the remaining stock is conducted. This count represents the ending inventory period (and another Intuendi article we recommend!)
- Calculate net purchases: Any inventory related purchases made during the accounting period are added together to calculate the total purchases. It is important to subtract any returns, allowances, or discounts made during this period.
- Calculate COGS: Using the formula above, the COGS can be calculated.
- Impact on financial statements: The COGS figure is a crucial component in determining a company’s gross profit. It is reported on the income statement and is deducted from total revenue to arrive at gross profit. This is ultimately used to evaluate the company’s net income.
Benefits and Challenges of Periodic Inventory
The larger benefits of implementing a periodic inventory system are its 3 main characteristics: low cost, low maintenance, and low manpower. Without having to spend money on advanced equipment, technology, or software, businesses are able to save money on performing the tasks of computers manually. Additionally, there is no specific manual labour or expertise needed as there is no software to take care of and maintain. It is the easiest and most straight-forward solution.
It’s important to note that while the periodic inventory system can be practical in many senses, it may also have limitations. For instance, it may not provide real-time visibility into inventory levels, leading to potential stock-outs or overstocking situations. This additionally means that the COGS figure may not be as precise as in a perpetual inventory system which constantly updates inventory levels. As a result, the periodic inventory system may require additional internal controls to minimise errors and discrepancies during the physical counting process. Each business should carefully evaluate its needs and requirements to determine the most suitable inventory management approach.
Examples of Periodic Inventory Transactions
- Beginning inventory: A small store starts its accounting period with a beginning inventory of 100 units of a product that costs $10 per unit.
- Purchases: During the accounting period, the store makes the following purchases:
- Purchase 1: 200 units at $12 per unit
- Purchase 2: 150 units at $11 per unit
- Sales: Throughout the accounting period, the store makes sales of the product as follows:
- Sale 1: 50 units at $20 per unit
- 120 units at $22 per unit
- 100 units at $21 per unit
- Ending inventory: A physical count takes place at the end of the accounting period of the remaining inventory revealing that there are 180 units of the product on hand.
- COGS calculation:
- Net purchases: (200 x $12) + (150 x $11) = $4050
- COGS: (100 x $10) + $4050 – (180 x $11) = $3070
Who Would Use a Periodic Inventory System?
Suitable for businesses with lower transaction volumes, limited resources, and minimal inventory variability, a periodic inventory system updates inventory records periodically through physical counts, rather than in real-time with the help of software. When implementing a periodic inventory system, businesses should carefully consider factors like inventory turnover, cost, and the need for real-time inventory visibility, as choosing the right inventory management approach directly impacts financial statements, profitability, and overall operational efficiency. Careful evaluation of business needs and resources is essential to make an informed decision on the most appropriate inventory management system.
