Periodic vs. Perpetual Inventory Systems: Which One is Right for Your Business?

As a business owner, keeping your inventory accurate and up-to-date can feel like an endless battle, with constant guesswork and discrepancies in your stock levels. The key to solving these issues lies in choosing the right inventory management system.

In this article, we'll break down the differences between periodic and perpetual inventory systems using examples and journal entries. We'll also explore the pros and cons of each system, helping you determine which is best suited for your business needs.

Key Takeaways

• The periodic inventory system involves counting and recording inventory at specific intervals, such as weekly, monthly, quarterly, or yearly.
• In contrast, the perpetual inventory system continuously maintains inventory balances, updating them with each transaction.
• Periodic inventory systems are best for small businesses with low stock levels or sales volume.
• Perpetual inventory systems are ideal for large businesses with high stock levels or companies with multiple retail outlets.

Why Is It Important for a Business to Maintain and Record Accurate Inventory Levels?

Before diving into details, it’s crucial to understand why business owners should maintain and accurately record their inventory levels.

Let’s consider a grocery store, for example. If you don't keep a proper record of your inventory, you won't know what you have and don’t have in stock.

Inventory, also known as stock, refers to the physical goods and materials a business owns for selling purposes. In this example, the inventory includes all the grocery items like drinks, snacks, and candies.

Maintaining sufficient stock is essential for smooth business operations. Having too little means you can’t meet customer demand, while having too much can lead to items deteriorating on the shelves, resulting in wasted resources.

Without recording inventory, you also won't be able to tell if your "missing" stock was stolen.

Keep in mind that inventory (or closing stock) is recorded as a current asset in the balance sheet.

In the income statement, inventory is crucial for calculating the cost of goods sold for gross profit, which we'll discuss in more detail below.

Therefore, it’s important to count, maintain, and record your inventory properly to ensure improved cash flow, informed purchasing decisions, robust financial position and performance, and satisfied customers.

What is the Cost of Goods Sold?

Cost of Goods Sold (COGS) is a key figure recorded in the income statement or statement of profit or loss. This statement shows whether a business made a profit or loss over a period.

So, what exactly is the cost of goods sold?

COGS includes all costs directly related to the production of goods sold by a company, such as direct materials, direct labor, and direct expenses.

For example, in a furniture manufacturing business, the direct material cost can be the cost of purchasing wood. The direct labor cost is the wages paid to carpenters, and direct expenses include the cost of renting machines to produce the furniture.

You can also calculate COGS using a simple formula:

Cost of Goods Sold = Opening Inventory + Purchases - Closing Inventory

Example of Calculating COGS

Imagine a shopkeeper who records inventory using the calendar year. He notes the opening inventory at the start of the year (January 1) and the closing inventory at the end of the year (December 31).

The closing inventory from the previous year becomes the opening inventory for the current year. Let's say the inventory valued at $3500 was carried forward to this year. This $3500 is the opening inventory.

This year, the shopkeeper purchased additional inventory valued at $1200. His closing inventory at the end of the year was $1000.

Here's how to calculate COGS:

COGS = Opening Inventory + Purchases - Closing Inventory

COGS = $3500 + $1200 - $1000

COGS = $3700

This shows that his business’s cost of goods sold is $3700.

Now, you might wonder how this COGS figure is used in the income statement. Here's how:

Sales - Cost of Goods Sold = Gross Profit

Let’s say this shopkeeper made $6000 in sales for the year. So, his gross profit will be:

$6000 - $3700 = $2300

Calculating gross profit is crucial for businesses. It helps them determine if their sales are higher than their costs, indicating a profit or loss, which can guide their business strategies.

Looking at the example above, this shopkeeper has generated a gross profit of $2300 as the sales are more than the cost of goods sold. Whereas, he could also calculate gross margin with the given figures, which would indicate his business's financial health and efficiency.

What Is the Periodic Inventory Method?

The periodic inventory method involves physically counting and recording inventory at regular intervals, such as weekly, monthly, quarterly, or yearly.

This method works well for small businesses because they typically have lower inventory levels and fewer sales. Even service-based businesses might find it beneficial since they don’t have a lot of products to track.

However, since inventory is only counted at set intervals, businesses won’t know the exact stock levels between counts. This means they won't know precisely how many units are left or when to reorder until the next count.

Periodic Inventory System Example

A furniture store might use a periodic inventory system because furniture is a high-ticket item that isn't sold frequently. For such a store, it makes sense to implement this system.

This means the furniture store will physically count and update its inventory only at the end of each month or on whatever schedule it has set.

Another example might be a small clothing store that makes most of its sales in summer and winter. This way, inventory only needs to be counted and updated at the end of each season.

Journal Entries in Periodic Inventory Accounting

Journal entries are used to record all business transactions in one place. Let's see what journal entries look like in a periodic inventory system.

For example, consider a shopkeeper who sells chocolates and updates his inventory in his journal only at the end of each month.

He purchases 200 chocolates on January 5 for $2 each. Then, he sells 150 chocolates on January 15 for $5 each.

Journal Entry for 5th January:

NOTE: Since this shopkeeper is using a periodic inventory system, he will not open an inventory account here. Instead, he will call it a “purchases” account.

Journal Entry for 15th January:

Journal Entry for 31st January:

This shopkeeper will now open his inventory account and close his “purchases” account as he is updating the inventory at the end of the month.

He will first calculate COGS and adjust inventory.

COGS = Opening Inventory + Purchases - Closing Inventory

COGS = $0 + $400 - $100*

COGS = $300

*Closing Inventory: (200 - 150) = 50 units @ $2 each

Now this shopkeeper will record COGS and inventory, and close the purchases account by crediting it.

What Is the Perpetual Inventory Method?

The perpetual inventory system updates inventory with every transaction. This means stock levels are always current as you make a sale or purchase.

With this system, you always know how much inventory is in stock and when you need to order more.

You don't have to count the inventory yourself because it's all handled via barcodes and inventory accounting software.

As you scan an item’s barcode, it automatically updates your accounting and inventory systems.

This method is ideal for businesses with large sales volumes. They need to track many units and can't afford to count and record them at intervals.

Perpetual Inventory System Example

Amazon uses the perpetual inventory method because they handle a large number of sales and inventory items. They have invested in tools and software to automatically update inventory with every transaction.

Every time a sale is made, the stock unit is reduced from the inventory. Similarly, with purchases, the stocks are added to the total inventory.

Other examples could be grocery stores or pharmacies.

Journal Entries in Perpetual Inventory Accounting

Let's use the above example of the shopkeeper selling chocolates to see how the journal entries will look in a perpetual inventory system.

Journal Entry for 5th January

NOTE: Unlike the periodic inventory method, which uses a purchases account instead of an inventory account, the perpetual inventory method records inventory in real-time, directly updating the inventory account.

Journal Entry for 15th January:

NOTE: The entry above is the same as for periodic inventory since it’s a general sales entry. However, another entry (the one below) will be recorded simultaneously to calculate the cost of goods sold and update the inventory according to the sales made.

Differences in the Journal Entries Using Periodic System and Perpetual System

Let’s help you better understand the difference between the journal entries using both the inventory management systems below.

Recording Purchases

In the periodic inventory system, purchases are recorded in the "purchases" account because the inventory account is only updated at the end of the period.

In contrast, the perpetual inventory system records purchases directly in the inventory account, ensuring an up-to-date inventory balance.

Recording Sales

In the periodic inventory method, only the revenue from the sale is recorded. The Cost of Goods Sold is not immediately recognized, and the inventory account is not updated.

In perpetual inventory, both the revenue from the sale and the cost of the inventory sold are recorded immediately. The entry updates both the sales and the COGS, reflecting the decrease in inventory.

End-of-Period Adjustments

In the periodic inventory method, at the end of the period, the “purchases” account is closed, and the COGS and inventory accounts are updated accordingly.

As for perpetual inventory, there are no end-of-period adjustments needed for inventory and COGS, as these are continuously updated with each purchase and sale transaction.

Periodic Inventory System vs. Perpetual Inventory: Pros and Cons

When deciding on an inventory system for your business, it's important to weigh the pros and cons.

First, let’s look at the pros of a periodic inventory system:

• Ideal for smaller businesses - Small businesses, with their lower sales volume, can easily count inventory using just a few employees.
• Simplified record-keeping - With simple calculations and only a few records, managing and implementing this system becomes easier.
• Lower costs - Periodic inventory requires minimal investment in training and technology compared to perpetual inventory.

Here are the cons of periodic inventory:

• Labor-intensive - Physical inventory counts at specific intervals can be tiresome and burdensome for employees.
• Accuracy issues - Manual counting increases the chances of human error and discrepancies in inventory records.
• Lack of real-time data - Without regular updates, you might face stockouts or overstock situations.
• Operational interruptions - Physical counts can disrupt regular business operations and prevent employees from using their time and energy productively.  

On the other hand, here are the benefits of using a perpetual system for a business:

• Real-time inventory tracking - With updates at every transaction, your inventory record stays accurate and up-to-date.
• Accuracy - Using electronic inventory systems eliminates manual errors, leading to more precise records.
• Improved inventory control - Access to accurate, real-time data helps you make better decisions regarding reordering and stock management.
• Efficient operations - Regular and automatic updates reduce the need for frequent manual counts, allowing better focus on business operations.
• Multi-location management - This system centralizes data for businesses with multiple locations, providing real-time access across all sites.

Now let’s look at the disadvantages of implementing a perpetual inventory system in your company:

• Higher start-up costs - Especially for new businesses, investing in technology like POS systems, RFID scanners, inventory software, and employee training can be significant.
• Complexity - Without adequate resources, maintaining and managing your inventory system regularly can be challenging.

Is a Periodic or Perpetual Inventory System Right for Your Business?

To decide if periodic or perpetual inventory is right for your business, you should consider the business size, budget, sales volume, and operational needs. Let’s break down all the factors below:

1. Business Size and Complexity

If your business is small or medium-sized, a periodic inventory system will work well because you have a limited product range and fewer transactions.

However, for a large business with high transaction volumes and extensive product lines, a perpetual inventory system is better. Continuous updates will help manage large inventories effectively.

2. Budget and Resources

For a business with a tight or small budget, a periodic system is more affordable since it doesn’t require sophisticated software or hardware.

However, if budget isn't a concern and you can invest in comprehensive inventory management software and training, a perpetual system will give you more precise control and real-time data.

3. Inventory Turnover and Sales Volume

For businesses with low inventory turnover or fewer transactions, periodic updates may be sufficient with a periodic system.

However, a business with high sales volumes and rapid inventory turnover will benefit from the real-time tracking of a perpetual system to stay updated with stock levels accurately.

4. Operational Needs and Business Goals

For businesses that need up-to-date inventory information to make informed purchasing decisions or manage multiple locations, a perpetual inventory system is ideal.

However, if you prioritize simplified operations and easy maintenance over real-time data, a periodic system is more appropriate.

5. Regulatory and Reporting Requirements

If your business requires detailed and frequent inventory reports for compliance or stakeholder reporting, opt for a perpetual inventory system.

For those where basic periodic reports are sufficient, a periodic system is adequate and less burdensome.

Conclusion

Choosing between a periodic inventory system or a perpetual inventory system depends on your business size, budget, sales volume, and needs.

A periodic inventory system is suitable for small businesses with low transaction volumes, as stock levels are updated periodically and manually.

On the other hand, a perpetual system offers real-time accuracy, ideal for larger businesses since stock levels are automatically updated electronically.

You should evaluate your requirements and resources to pick a system that improves your inventory management efficiency - not the other way around.

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