What Is Perpetual Inventory?
Perpetual inventory is a continuous accounting practice that records inventory changes inreal-time, without the need for physical inventory, so the book inventory accurately showsthe real stock. Warehouses register perpetual inventory using input devices such as point ofsale (POS) systems and scanners.
Perpetual inventory methods are increasingly being used in warehouses and the retailindustry. With perpetual inventory, overstatements, also called phantom inventory, andmissing inventory understatements can be kept to a minimum. Perpetual inventory is also arequirement for companies that use a material requirement planning (MRP)system for production.
Perpetual inventory has its own formula companies can use to calculate the endinginventory:
Ending Inventory = Beginning inventory +Receipts - Shipments
What Is a Perpetual Inventory System?
A perpetual inventory system is a program that continuously estimates your inventory based onyour electronic records, not a physical inventory. This system starts with the baseline froma physical count and updates based on purchases made in and shipments made out.
Max Muller, president at Max Muller &Associates LLC and Author of “Essentials of Inventory Management”, says,“Perpetualinventory management systems keep track in real-time. It uses software to follow the rules,keep the system up-to-date, and it works great. I recommend doing 3D-counting, where youcount cross-sections often enough to account for the whole over time. You could considerthis perpetual, but it would need to be software-driven and follow the rules or do avariation.”
Inventory management software and processes allow for real-time updating of the inventorycount. Often, this means employees use barcode scanners to record sales, purchases orreturns at the moment they happen. Employees feed this information into a continuallyadjusted database that tracks each change. The automatic, or perpetual, updating of theinventory is what gives the system its name and differentiates it from the periodicapproach.
In recent years, advances in inventory management software and the ability to integrate itwith other business systems have made perpetual inventory a more practical and powerfuloption for many businesses. Additionally, cloud-based inventory management systems are oftenreal-time, a key element of a perpetual inventory system.
The real value of perpetual inventory software comes from its ability to integrate with otherbusiness systems. For instance, real-time inventory information is vital for the financialand accounting teams. Inventory can make up a large part of your stated assets, sointegrating inventory management with financial systems helps ensure accurate tax andregulatory reporting.
With access to real-time data, salespeople can provide accurate shipping information, manageexpectations and provide a better customer experience that directly impacts your reputation.Integrating the inventory software with marketing systems provides that team with a currentsnapshot of what is selling and what is not. Marketers can set current information in thecontext of historical trends to understand customer behavior and position the company tomeet anticipated customer demand.
What Is the Periodic Inventory System?
The periodic inventorysystem, also called the noncontinuous system, is a method companies use to accountfor their products. Based on a specified accounting period, periodic inventory does not keepa continuous tally of goods, purchases, sales and their associated costs.
This system works by the company accountant recording all purchases into a purchase account.The company then makes a count of the physical inventory and the accountant shifts anybalance in the purchases into the inventory account. Next, the accountant adjusts theinventory account to match the cost of the ending inventory. A hallmark of a periodic systemis the physical count of goods. This number is critical since the company does not trackunique transactions. Whether the company performs it weekly, monthly, quarterly or annually,this inventory kicks off the records reconciliation.
In a periodic system, companies calculate Cost of Goods Sold (COGS) directly after a physicalinventory, as they do not keep it on a rolling basis, nor do they update it continuouslyafter each transaction. They do not keep an inventory account in a periodic system sincethey debit all purchases to a purchase account. Once the period is complete, the companyadds the purchase account totals to the inventory’s beginning balance. Then, thecompany can also compute the cost of goods available for sale for the new period.
Perpetual vs. Periodic Inventory Systems
Perpetual and periodic systems require different tools and procedures around how employeesdocument inventory, although they can be complementary. In a perpetual system, employeestrack the products all the time. In a periodic system, employees record products only atspecified intervals.
Clearly, a perpetual system is more complex than periodic systems, as there are more recordsfor the software and employees to maintain. Muller suggests, “When considering thesystemthat you want to use, the fundamentals are the same — regardless of your approach.Even withthe most advanced software, if there is a disconnect within the fundamental system, you arejust speeding up your mistakes. You would make decisions about the system based on thenature of your products, their perishability and their physical handling: whether they werelarge or small and how much space they consume. The nature of the product also depends onhow your company receives and stocks it. Some goods are unitized: They have small parts andare broken up into individual bins”.
Muller shares an example: “Years ago, I worked with a company that had no experiencewithfrozen chicken. They would unload the chicken on the hot dock when they were checking it in.As a result, and even though it was still edible and safe, it became very unsightly aftercooking. They learned to bring the stock into the freezer and then perform the check-in totheir stock. They had to adjust their procedures and systems based on their product’sneeds”.
Additional differences between the perpetual and periodic systems:
Updating Your Accounts:
In a perpetual system, updates to the general ledger and inventory ledger arecontinuous with every transaction. In a periodic system, updates to the generalledger only occur when there is a physical count, not based upon transaction.
Calculating Cost of Goods Sold (COGS):
Under a perpetual system, the software system maintains a running tally oftransactions, so it is always able to provide COGS. A periodic inventory systemcalculates COGS after conducting a physical inventory, in a lump sum at the end ofan accounting period. It is not possible to calculate a precise COGS before the endof the accounting period.
Record Transactions:
In a perpetual system, it is not possible to maintain records manually, because therecould be thousands of transactions to track; a perpetual inventory system requiressoftware. A periodic system, however, does not require software. You could manuallytrack your inventory in a periodic inventory system.
Cycle Counting:
Cycle counting is when businesses count portions of their inventory with the intentof completing a full inventory over a time cycle. They do not count their entireinventory at once, but they do make small adjustments based on what they count. Alsocalled sampling, businesses only use cycle counting in a perpetual system. They donot use cycle counting under a periodic inventory system because they are not ableto set a baseline.
Recording Purchases:
In a perpetual system, you record purchases in the raw materials inventory account orthe merchandise account. In a periodic system, you log purchases into the purchasesasset account, without adding any unit-count information.
Performing Investigations:
In a perpetual system, transactions are available at a very detailed level. As such,you can conduct investigations into inventory-related errors easily. In a periodicsystem, these investigations are more complicated, because the system aggregatesdata at a high level. It is difficult to use this data to pinpoint errors in theprocess.
Even though GAAP standards say that either perpetual or periodic systems are appropriate forany business, each is more suited to different-sized organizations. Overall, perpetualsystems are more suited to companies that have high sales volume or multiple retaillocations because it is a timelier system. Periodic systems could hinder decision-making forthese types of organizations. Periodic systems are more suitable for businesses not affectedby slow inventory updates. These include emerging businesses, ones that offer services orcompanies that have low sales volume and easy-to-track inventory. Companies whose staffstruggle with a perpetual system, for instance those with seasonal help, would also benefitfrom maintaining a periodic system. As their business grows, they can always instituteperpetual inventory.
Not everyone agrees it’s wise to use periodic systems when you do not have a lot ofproducts. Muller echoes the sentiment: “Periodic inventory systems are terrible.During theannual inventory, you go out and do a count. The chances are excellent that the paper lifeof the item is not going to match its real life (shelf count). So, you have a disconnect. Ifyou only take inventory once a year, you do not know when the disconnect happened. There areso many issues between the beginning and end of a product’s life, there is no way tofind the errors in a periodic system. We should be able to go back and find items shortlyafter problems happen to help improve inventory. Companies correct records and fiximbalances and move on — it is a snapshot in time. The problems will then reassertthemselves almost immediately. For accounting purposes, though, it is important to performthis exercise, unless you have a mature cycle count program. Auditors will take a maturecycle count program as an annual physical count.”
The Advantages and Disadvantages of Perpetual Inventory
Perpetual inventory allows for more real-time inventory tracking, making it superior to othermethods. However, the system requires consistent record-keeping and monitoring and is moreexpensive to set up than other methods.
Perpetual inventory can save you money in these ways:
- There is no need to close facilities regularly to perform physical inventories,
- Data from scanned barcodes help you forecast stock,
- You can account for all transactions, providing complete accountability of yourproducts.
Even though perpetual inventory is superior, it is not perfect. While there is a constant,automatic product tracking system, there are still ways to lose positive inventory control.
The disadvantages of using perpetual inventory include:
- You must still perform an annual inventory to synchronize your data,
- You must input every transaction, which requires more consistent record-keeping andmonitoring,
- Perpetual inventory systems have higher setup costs than other methods since theyrequire software and training.
Who Uses a Perpetual Inventory System?
Large businesses with enormous quantities of inventory favor perpetual inventory systems.Perpetual inventory systems can also be ideal for emerging and small to medium-sizedbusinesses looking for scalability.
Huge businesses have difficulty performing the cycle counts that are necessary for a periodicsystem. Further, an organization with several retail locations may find it is easier tocontrol inventory when there’s a regularly updated database of products. Take, forexample, a tool retailer that has a customer looking for a specific type of wrench, one thatis rarely requested and sold. It has six locations in the local area. Using a perpetualsystem, it has real-time information about which site may have one in stock so the customercan go get his wrench quickly instead of driving from store to store looking for it.
Other businesses that need perpetual inventory include those that specialize in dropshipping, where the manufacturers ship directly to customers or those who specialize intrade and distribution. In these businesses, the inventory is always on the move. Also,there are constant returns and exchanges. Understanding which stock is available at a giventime requires constant updates or a perpetual system.
When Would You Use a Perpetual Inventory System?
Perpetual inventory systems are helpful for those who always need to understand margins andprofitability. A large business with many products or a company that wants the ability toscale an emerging business over time would use a perpetual inventory system.
Experts think perpetual inventory systems are the future, especially for product companies,as they are getting cheaper and more accessible for even small businesses to acquire anduse. Muller explains, “The future of this industry is leaning towards more real-timeidentification of products and improving on everything having to do with transmitters in andon products. Really, these are automatic forms of identification. It doesn’t matterwhere you store it, you can find it”.
In a perpetual inventory system, software records changes into a sales revenue account eachtime the company makes a sale or purchases new inventory. This process of recording salesensures that the accounting records reflect accurate balances in the accounts affected. Thesoftware also records the price charged. To record transactions in a perpetual system, youmust know the selling price, the purchase price and the accounts affected. The selling priceis what the customer pays for the item. The purchase price is the costs associated with theproduct, including the shipping, receiving and storage costs.
A typical journal entry would show which account the software debited and which account thesoftware credited for each transaction.
Cash Sales Journal Entry
| Account | Debit | Credit |
|---|---|---|
| Cash | 300 | |
| Sales Revenue | 300 | 300 |
| Total | 300 | 300 |
How Is Inventory Tracked Under a Perpetual Inventory System?
A perpetual inventory system tracks goods by updating the product database when atransaction, such as a sale or a receipt, happens. Every product is assigned a trackingcode, such as a barcode or RFID code, that distinguishes it, tracks its quantity, locationand any other relevant details.
When new products enter a business, employees scan them (along with their details) into thecomputer system. Without a computerized inventory system, it would be difficult to trackevery transaction in a business manually, especially in companies that sell many products.For example, a retail big box store has thousands of products. Its supply chain providesdeliveries daily of additional goods that the employees then scan into their database. Ifthe product is new, the employee must add the details of the product when they initiallyscan it. That additional information includes a description, the product code or SKU andwhere customers will find it in the store. If the store already carries the product, thisscan updates the quantity already in stock. When a customer buys one of these products, thedatabase lists one less product in its count. At any time, the store manager can review thedatabase to learn how much of that product is currently in stock and whether they need toorder more.
This system depends on proper inventory control procedures. For example, the system needs toensure that employees scan in any new inventory promptly. Physical counts to reconcile thedatabase are rare, but necessary, since the true inventory count can become skewed over timewith theft, loss or breakage.
Formulas in Perpetual Inventory
Inventory management formulas can tell you when to order more inventory, how much to order,the lead time needed before placing an order and how much stock you require to keep insafety.
Economic Order Quantity (EOQ) Formula
Economic Order Quantity (EOQ) considers how much it costs to store the goods alongside theactual cost of the goods. The results dictate the optimal amount of inventory to buy or maketo minimize expenses.
EOQ Formula
| EOQ | = | √2DS/H, where, |
| D | = | Demand in units per year |
| S | = | Order cost per purchase |
| H | = | Holding cost per unit, per year |
The Cost of Goods Sold (COGS)
When you sell products in a perpetual inventory system, the expense account increases andgrows the costs of sales. Also called the cost of goods sold (COGS), the costs of sales arethe direct expenses from the production of goods during a period. These costs include thelabor and materials costs but leave off any distribution or sales costs.
COGS Formula
| COGS | = | BI + P - EI, where |
| BI | = | Beginning inventory |
| P | = | Purchases for the period |
| EI | = | Ending inventory |
Calculate the beginning inventory as whatever stock remains from the previous period if youdo not have a true beginning inventory. The accounting period can be in months, quarters ora calendar year. The COGS in a perpetual system is rolling and recalculated after eachtransaction, but you can use the COGS formula to calculate it for a period.
Let’s say Ava, a product manager, wants to know if she is pricing generic Acetaminophenhigh enough to leave a healthy profit margin. COGS is an effective formula for settingprices on manufactured goods. If she calculates the COGS as $10 per 100-capsule bottle, shewill need to price each bottle higher than $10 so her company can comfortably turn a profit.
Ava’s business uses the calendar year (starting on Jan. 1 and ending Dec. 31) forrecording inventory. The company accountant valued the Jan. 1 beginning inventory of genericAcetaminophen at $49,000, or 4,900 bottles. During the year, generic Acetaminophen costs thecompany $40,000 for materials and labor. On Dec. 31, the company accountants valued theending inventory at $30,000.
COGS Formula
| BI | = | $49,000 |
| P | = | $40,000 |
| EI | = | $30,000 |
| COGS | = | $49,000 + $40,000 - $30,000 |
| = | $59,000 |
Gross Profit
Ava can use the figure she calculated for COGS to make decisions about the product. Forexample, she can use COGS to calculate the gross profit her company made from genericAcetaminophen. Gross profit is simply the product revenue minus COGS, or
Gross Profit
| Gross Profit | = | Revenue - COGS |
| If the revenue for generic Acetaminophen was $113,000 lastyear, the gross income from it was: | ||
| GrossProfit | = | $113,000 - $59,000 |
| = | $54,000 | |
If Ava needs to raise the product cost to make more profit or lower the cost to make it morecompetitive in the marketplace, she now knows how it will affect her company’s bottomline.
Gross Profit Method
In a perpetual system, you will sometimes need to estimate the amount of ending inventory fora period when preparing financial statements or if stock was destroyed. To calculate thisestimate, start with the beginning inventory and cost of purchases during the period.
Let’s say that you need to estimate the ending inventory from the current month. Thevalues you need to know to calculate this are the gross profit as a percentage of sales, thetotal sales for the period, the beginning inventory for the period and purchases for theperiod. As shown below in the ledger, estimate the relative percentages of both COGS andgross profit for your total sales. From there, solve for the cost of goods sold, and thenfill in the known values minus the COGS figure. The result should provide an endinginventory estimate and how much to claim as the bottom-line figure for this period.
Ledger to Calculate Gross Profit
| Estimate | Figures | |
|---|---|---|
| Sales | 100% | $156,000.00 |
| Cost of Goods Sold (COGS) | 55% | $85,800.00 |
| Gross Profit | 45% | $70,200.00 |
| Begin Inventory | $45,000.00 | |
| Purchases | $67,800.00 | |
| Cost of Goods Available for Sale | $112,000.00 | |
| Minus COGS | $85,800.00 | |
| Estimated Ending Inventory | $26,200.00 | |
What Is FIFO Perpetual Inventory Method?
FIFO (first-in, first-out) is a cost flow assumption that businesses use to value their stockwhere the first items placed in inventory are the first items sold. So the inventory left atthe end of the period is the most recently purchased or produced.
A cost flow assumption is an inventory accounting method that uses the original value ofproducts from the beginning inventory of a period and purchases of new inventory during thatperiod to calculate the value of the ending inventory and the cost of goods sold. The threecost flow assumptions that businesses use for this are FIFO, LIFO, and the Weighted AverageCost (WAC).
In a perpetual system, the inventory account changes with every transaction. Companies debittheir inventory account with the cost of the merchandise each time they purchase or produceinventory and when they sell inventory to customers. The perpetual inventory softwareupdates the inventory account with each transaction. With each sale, the software alsoupdates the COGS account with a debit. As an example, see the sample FIFO perpetualinventory card below. The retail sales for this product in this company were $25,000 fromJan. 1, 2019 to Jan. 15, 2019.
Inventory Card
| Purchases | Sales | Balance | ||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| Date | Activity | Units | Unit Cost | Total Cost | Units | Unit Cost | Total Cost | Units | Unit Cost | Total Cost |
| 1/1/2019 | Begin Inventory | 600 | 5.00 | 3,000.00 | ||||||
| 1/3/2019 | Sale | 400 | 5.00 | 2,000.00 | 200 | 5.00 | 1,000.00 | |||
| 1/4/2019 | Purchase | 1,600 | 6.00 | 9,600.00 | 200 1,600 | 5.00 6.00 | 1,000.00 9,600.00 10,600.00 | |||
| 1/7/2019 | Sale | 200 800 | 5.00 6.00 | 1,000.00 4,800.00 5,800.00 | 800 | 6.00 | 4,800.00 | |||
| 1/10/2019 | Purchase | 1,000 | 6.00 | 6,500.00 | 800 1,100 | 6.00 5.50 | 4,800.00 6,500.00 11,300.00 | |||
| 1/15/2019 | Sale | 600 | 6.00 | 3,600.00 | 200 1,000 | 6.00 6.50 | 1,200.00 6,500.00 7,700.00 | |||
This card shows the starting inventory, sales, purchases, prices and balances. Under aperpetual system, inventory records for this product are continually changing. When thecompany sells merchandise, the perpetual software records two transactions. First, thesoftware credits the sales account and debits the accounts receivable or cash. Second, thesoftware debits the COGS for the merchandise and credits the inventory account. In aperiodic system, accounting does not perform this second step.
From the perpetual FIFO inventory card above, you can calculate the cost of ending inventoryas the total cost balance from the last row, or $7,700. Calculate COGS by adding the totalcost column in the sales category, or $2,000 + 5,800 + $3,600 = $11,400. Finally, you cancalculate the gross profit as the total retail sales minus the costs of goods sold, or$25,000 - $11,400 = $13,600.
A company may prefer using a FIFO system when it’s trying to show its largest possibleprofit on its financial statements for investors, lenders and stakeholders. A FIFO systemshows a lower COGS expense and a higher net income.
What Is LIFO Perpetual Inventory Method?
LIFO (last-in, first-out) is a cost flow assumption that businesses use to value their stockwhere the last items placed in inventory are the first items sold. So the remaininginventory at the end of the period is the oldest purchased or produced. In a perpetual LIFOsystem, the last costs available at the time of the sale are the first that software movesfrom the inventory account and debits from the COGS account. See the example LIFO perpetualinventory card below to get an idea of how it works. The retail sales for this product inthis company were $25,000 from Jan. 1, 2019 to Jan. 15, 2019.
From the perpetual LIFO inventory card above, you can calculate the cost of ending inventoryas the total cost balance from the last row, or $7,200. You can calculate COGS by adding thetotal cost column in the sales category, or $2,000 + 6,000 + $3,900 = $11,900. Finally, youcan calculate the gross profit as the total retail sales minus the costs of goods sold, or$25,000 - $11,900 = $13,100.
During periods of inflation, a LIFO system may be more appropriate for companies that do notwish to pay as much in taxes, because it will show a higher COGS expense and a lower netincome. Therefore, your company has a lower tax liability in a LIFO system, becausebusinesses get taxed on profit. The Internal Revenue Service allows companies to use LIFO intheir tax accounting, even when they use FIFO in their financial statements.
What Is the Weighted Average Cost Perpetual Inventory Method?
The Weighted Average Cost (WAC) is the cost flow assumption businesses use to value theirinventory. WAC is the average cost of goods sold for all the inventory. Also called themoving average cost method, accountants perform this differently in a perpetual system ascompared to a periodic system.
The goal of using the WAC is to give every inventory item a standard average price when youmake a sale or purchase. In a perpetual system, you would not calculate the WAC using aformula for a specific period. You can use WAC to calculate an average unit cost, COGS for aperiod and ending inventory for a period. For example, Ava wants to figure out the averagecost to assign for Acetone repackaged in her company’s warehouse. She will use thisinformation to calculate the ending inventory and COGS for the period. Her company uses aperpetual system. See the ledger below for transactions for Acetone in Jan. using a weightedaverage. This ledger mimics that of a software ledger in a perpetual system.
January Perpetual Ledger of Sales and Purchases for Acetone
| Number of Units | Actual Unit Cost | Total Actual Cost | |
|---|---|---|---|
| Beginning Inventory | 300 | $10.00 | $3,000 |
| Purchase | 200 | $15.00 | $3,000 |
| 500 | $12.00 | $6,000 | |
| Sale | 300 | $12.00 | $3,600 (COGS) |
| 200 | $12.00 | $2,400 | |
| Purchase | 100 | $17.00 | $1,700 |
| 300 | $13.67 | $4,100 | |
| Sale | 250 | $13.67 | $3,418 (COGS) |
| 50 | $13.67 | $648 | |
| Purchase | 300 | $20.00 | $6,000 |
| Ending Inventory | 350 | $6,684 |
Notice the ledger above calculates the actual unit costs (in red) as a dividend of the numberof units and total actual cost. The ledger adds the beginning inventory to the purchasedinventory (500 units). The ledger then adds the beginning inventory cost to the purchasedinventory cost ($6,000) to come up with a new unit cost of $12.00 for future sales. The nextentry shows a sale made with this calculated unit cost. This sale enables you to calculatethe COGS for this transaction. The ending inventory is just an arbitrary stopping pointbased on the period you are reviewing. For this ledger’s period, you can alsocalculate the total COGS as $3,600 + $3,418 = $7,018.
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NetSuite Can Help Provide Visibility Into Your Inventory
Properly managing inventory can make or break a business, and having insight into your stockthrough the perpetual inventory method is crucial to success. Regardless of the type ofinventory control process you choose, decision-makers know they need the right tools inplace so they can manage their inventory effectively. NetSuite offers a suite of nativetools for tracking inventory in multiple locations, determining reorder points and managingsafety stock and cycle counts. Find the right balance between demand and supply across yourentire organization with the demand planning and distribution requirements planningfeatures.
Learn more about how you can manage inventoryautomatically, reduce handling costs and increase cash flow with NetSuite.
