The periodic inventory system is an important method of inventory management, where the management takes the physical count of every inventory present with them. This is done weekly, monthly, or quarterly.
Alternatively, a perpetual inventory system provides real-time information on the inventory level. Both these aspects are integral for a business. In this blog, we are going to unfold the details of periodic inventory systems and various key aspects associated with them, such as periodic vs perpetual inventory systems, examples, benefits, challenges, and more.
What Is Periodic Inventory?
Periodic inventory is an inventory valuation method that conducts the physical counting of inventory at a fixed interval. This can be done monthly, weekly, or quarterly. With this, a company can accurately measure the inventory level and make the right decision accordingly. This is done when the company needs to order more products, sell their products, and restock again.
To determine the cost of goods sold, periodic inventory requires a business to track the total purchases of inventory during the accounting period and subtract the ending inventory value from the total cost. This method is commonly used by small businesses or those with low inventory volumes as it requires less administrative work and may not require specialized software or equipment.
While this method is easy to implement but it comes with certain limitations. For example, manually keeping a check on the inventory level can lead to errors. This can also lead to inaccuracies in the inventory report which can eventually impact the profitability of the organization.
The choice of inventory management method depends on the size of the business, the resources available, and the funds available with them. Carefully evaluating these factors can help the business choose the right method of inventory management.
What Is a Periodic Inventory System?
Inventory management is a key component of any business that deals in manufacturing goods. Companies keep track of their inventory to ensure that there is always sufficient stock available. It eventually helps them make the right decision when it comes to restocking the inventory or placing the order, or selling the product. To ensure that every process takes place seamlessly, a periodic inventory system can be beneficial.
It is also known as a physical inventory system where the inventory team takes the regular physical count of the inventory to determine if the quantity available with them is apt to meet the demand or not. An alternate method to this is perpetual inventory management, wherein the company uses technologies and software to track the real-time update on inventory.
Let's understand how the periodic inventory management system work. As mentioned, this method is basically based on the physical counting of the products or start. The physical count is used to determine the cost of such goods sold and the value of the remaining inventory. This is calculated by subtracting it from the total cost of purchased goods during the period.
When Is a Periodic Inventory System Used?
It is used when a business wants to do a manual check of the inventory level available to them. This method is particularly useful for small businesses or companies with a limited product range.
Here are some situations when a periodic inventory system might be used:
Small businesses
A periodic inventory management system is useful for small businesses that don't have the requirement or the budget to accommodate complex inventory tracking methods. Also, when scaling the business is not on the cards anytime soon, this system to record inventory is apt.
Limited product range
If a company is dealing with a limited product range, it can adopt the periodic inventory management system. Conversely, if there is a company that has a wide range of product lines, periodic inventory management and manually counting the stock can be a challenging task.
Low sales volume
A business that has a low sales volume or that deals with products that have longer shelf life may not need real-time tracking of the inventory. In this case, they can adopt the periodic inventory system.
Simple inventory system
If a business has a simple inventory system with minimal fluctuations in inventory levels, a periodic inventory system can be used to manage inventory effectively.
Simple training
Manual counting does not involve any complexities, so getting workers to do manual inventory counting is easy. Even if workers are churning frequently, this training can be done in a matter of hours.
While a periodic inventory system has its advantages, it also has its limitations. For example, it can be more time-consuming and less accurate than a perpetual inventory system. Businesses need to evaluate their inventory management needs and capabilities to determine which inventory system is best suited for their needs.
Benefits of Periodic Inventory System
The periodic inventory system is a manual method of inventory management where businesses do physical counts of their inventory at regular intervals. While it may not be as advanced as a perpetual inventory system, it still offers several benefits for businesses. Here are five benefits of using a periodic inventory system:
Cost-effective
One of the major advantages of implementing a periodic inventory system is that it doesn't require extra resources in the form of tools, software, and training the staff. Hence, when compared to the cost parameter, the periodic inventory system takes the lead. Moreover, it is a beneficial choice for companies dealing in smaller product lines.
Flexibility
The periodic inventory system depends on physically counting the inventory and is therefore not dependent on any external tools or applications. It provides inventory teams to independently and flexibly to do the inventory counts as and when required since there is no automated system here.
Inventory control
Ensuring timely counting of inventory helps the business handle its inventory level internally with better control. It also helps them adjust the inventory level as required based on internal requirements.
Improved management of funds
With this system, businesses have free capital as they have the leverage to adjust the inventory level and reorder the product on their own. Thus freeing up the capital for other purposes.
Although the periodic inventory system may not be as advanced as the perpetual inventory system or other automated systems, for several businesses the periodic inventory system may still prove to be beneficial. It is a cost-effective option and also gives leverage to the business to adjust the inventory level with their manual actions.
Challenges of Periodic Inventory
Here are some of the common challenges that businesses may face when using a periodic inventory system:
Inaccurate inventory levels
You may not get accurate results every time with this approach. If you have a business with a small product line, then there are fair chances of the periodic inventory system working well. However, in a scenario where a company has acquired a diverse product line, having an accurate measure of the inventory can be difficult. Moreover, it is prone to errors.
Time-consuming
Another key challenge of periodic inventory is that it is a time-consuming process. Since one has to depend on manual counting of the inventory, it consumes excessive resources and time to complete the check. This is particularly difficult for companies that are dealing with large volumes of products, making this approach non-scalable.
Lack of real-time data
While periodic inventory is a fair option, however, in a scenario where a company needs to keep a tab on the real-time inventory and its status; a periodic inventory system fails to give the desired result. Hence, it makes it challenging for businesses to manage inventory levels and respond to the dynamism of the market.
Limited visibility
A periodic inventory system may not be able to provide a complete overview of every inventory movement. Hence, it makes it difficult for a business to keep track of the status of the products in real time.
Disruption to business operations
Conducting a physical inventory count may interrupt business operations. Businesses may need to shut down operations temporarily or work after hours to conduct the inventory count. This can impact productivity and increase labor costs.
What Is a Perpetual Inventory System?
A perpetual inventory system is an inventory management method that automatically updates inventory levels based on recorded inventory movements, providing businesses with real-time information about their inventory levels. It is an automated system that can generate reports with valuable information about inventory levels, such as stock levels, reorder points, and sales trends.
It helps to keep track of the movement of goods in real-time. Within this approach, businesses deploy software and tools to manage their inventory and keep a record of the sale. It provides them with accurate information about the levels of inventory, every purchase and sale transaction, and even inventory size and where it is stored.
In the best perpetual inventory system, barcode scanning or Radio-Frequency IDentification (RFID) technology is used to track inventory movements as they occur. Every time a product is received, sold, or moved; it is auto-recorded in the system.
The perpetual inventory system provides several benefits for businesses. Providing real-time information about inventory levels helps businesses make informed decisions about their inventory management. It also helps businesses reduce the risk of stockouts or overstocking, ensuring that they always have enough products on hand to meet customer demand.
However, implementing a perpetual inventory system requires businesses to invest in modern technology and software. Businesses also need to ensure that their employees are trained to use the system effectively to avoid errors in inventory records.
A perpetual inventory system is an intuitive inventory management approach. It provides businesses with real-time information about inventory levels. Although this method can be costly and consumes more resources as compared to the periodic inventory management system, when it comes to the results and outcomes, the perpetual inventory system takes the lead.
Periodic vs. Perpetual Inventory System
A company deploys different inventory management systems to keep a check on the movement of stock and to figure out if there are any missing items. The two most commonly used inventory management systems include a periodic inventory system and a perpetual inventory system.
Although the end objective of both these methods is the same but their functioning and features do vary. This is the tabular representation of the difference between perpetual and periodic inventory systems.
| Parameters | Periodic Inventory System | Perpetual Inventory System |
|---|---|---|
| Inventory Counting Frequency | It is counted at an interval of a week or a month or a quarter. | It gives a real-time update on the moments of inventory. It includes sales or receipts. |
| Mode | The periodic inventory system is usually manual and relies on paperwork. | The perpetual inventory system deploys the use of tools and software for real-time tracking. An example includes RFID technology. |
| Cost | It is a less expensive method | This system is more expensive and requires training of the staff on the technology. |
| Results | The periodic inventory system is useful in the case of small businesses and may give accurate results, but when it comes to big organizations where the company has a large product line, the results may not be accurate. | The perpetual inventory management system is a perfect choice for companies dealing with a wider product line. Since these tools give precise and automated results, it is less prone to errors and flaws. |
| Area of Implementation | The periodic inventory system is suitable for businesses with lower inventory volumes and lesser transactions. | A company that deals in a wide array of products and is loaded with frequent movement of products requires a perpetual inventory system. |
Having understood the pros and cons of the periodic inventory system and the perpetual system, let's see some examples of periodic transaction journal entries.
Examples of Periodic Transactions Journal Entries
In a periodic inventory control system, there is no continuous tracking of the inventory in real-time. The inventory updates are made at month-end or the end of the specific period only.
Even when there is any sale or purchase of inventory it does not record any cost of goods sold (COGS). What is recorded is just sales revenue and accounts receivable. There is no record of the cost of goods sold or inventory level. The physical counting of goods is done at month-end and recorded in the financial statement. The month-end closing journal entry would include the previous month's balance and COGS.
Journal entries are done when:
- The company purchases inventory: On buying inventory, the company needs to record it in the purchase account. For this, the journal entry debits the purchase account and credits accounts payable. So the increase in inventory balance will be reflected in the purchase account that is part of the inventory account. In case of a return of inventory, the company will debit the accounts payable and credit the purchase account.
- **When a company makes sales: **When a sale is made, the periodic inventory system records only the revenue and accounts receivable or cash. The journal entry debits accounts receivable and credits the revenue due to sales. As a result of this transaction, there will be an increase in the income statement and the accounts receivable and cash. In case of returns or discounts, a journal entry will record it by debiting sale discount or sale return and crediting accounts receivable. Since return and sales discount does not fall in the category of sales revenue, it reduces the sale amount from the income statement.
- COGS and ending inventory: In the periodic inventory system, the cost of goods sold is not recorded with the sale done because the COGS calculation is done at month-end. The formula for COGS is = Beginning Inventory + Purchases - Ending Inventory
For ending inventory, the company carries a physical count of goods at month's end. The ending inventory balance and COGS is dependent on the physical count at the end of the month and is recorded in financial statements in the form of journal entries.
The ending inventory and COGS will show on the debit side while the beginning inventory and purchase will show on the credit side of the balance sheet.
Let's now understand the periodic transactions journal entries.
Periodic inventory system journal entries are simple since the inventory balance is updated only once a period. However, it is important to understand the concept of accrual accounting, which is the basis for periodic transactions.
Under accrual accounting, revenue, and expenses are recorded when they are earned or incurred, regardless of when the cash is received or paid out. This means that periodic transactions journal entries are used to adjust the accounts to reflect the revenue and expenses that have been earned or incurred but not yet recorded.
Accrued Interest Expense Journal Entry:
Debit: Interest Expense Account Credit: Interest Payable Account
Suppose a company has taken out a loan, which accrues interest at the end of each month. At the end of the first month, the company will record an entry to accrue the interest expense, even though the payment has not yet been made.
Accrued Salaries Expense Journal Entry: Debit: Salaries Expense Account Credit: Salaries Payable Account
Suppose a company pays its employees at the end of each month for work done during that month. At the end of the month, the company will record an entry to accrue the salaries expense, even though the payment has not yet been made.
Prepaid Rent Deferral Journal Entry: Debit: Prepaid Rent Account Credit: Rent Expense Account
Suppose a company pays its rent for the next three months in advance. At the time of payment, the company will record an entry to defer the rent expense until the following months.
Depreciation Expense Deferral Journal Entry: Debit: Depreciation Expense Account Credit: Accumulated Depreciation Account
Let's assume an example where a company purchases a piece of equipment at Rs. 10,000. This equipment has a useful life of five years. Now there will be a monthly depreciation expense on the machinery which is calculated as:
Rs. 10,000 divided by 60 months = Rs. 167
At the end of every month, the company will record an entry to defer the depreciation expense until the following months.
Example of Periodic System
As defined above, under the periodic system the company makes a count of the inventory to determine the ending inventory balance at the end of each month.
Let's take an example here, a company name XYZ Solution has an inventory balance of Rs. 50,000, and during the month, it purchased Rs. 30,000 worth of inventory. Also, the company had sales of Rs. 40,000 during the month.
At the end of the month, the physical count reveals that the ending inventory balance is Rs. 25,000.
To calculate the cost of goods sold for the month, the company must first determine the cost of goods available for sale. This is calculated as follows:
Beginning inventory balance: Rs. 50,000 Purchases during the month: Rs. 30,000 Therefore, the cost of goods available for sale is Rs. 80,000
Next, the cost of goods sold can be calculated as follows:
Cost of goods available for sale: Rs. 80,000
Ending inventory balance: Rs. 25,000 Therefore, the cost of goods sold is Rs. 55,000
Finally, the company can calculate its gross profit for the month:
Sales: Rs. 40,000 Cost of goods sold: Rs. 55,000 Therefore, the gross profit is Rs. 15,000
This example illustrates how a periodic inventory system can be used to manage inventory and calculate the cost of goods sold and gross profit.
Let's assume that the current period beginning inventory account was Rs. 1,000. And the end of the period, Rs. 100 was added to the account. Hence the inventory account will now be Rs. 1,100. So this becomes the cost of goods available for sale.
Cost of Goods available for Sale = 1000+100 =Rs. 1100
Although the "Cost of Goods Available for Sale" value is available, the company doesn't have the amount of inventory sold in the period. By the end of the period, the company will check the inventory. And let's assume that by the end, the inventor count is 1,050 units.
Since each unit costs around Rs. 1, the physically checked ending inventory is worth Rs. 1,050. After reconciling the physical inventory count with the inventory accounts in the books, we need to move Rs. 50 from the inventory account to the cost of goods sold.
Automate Inventory Management With TranZact
Managing the inventory and supply chain is integral for any manufacturing business. It not only helps in keeping a tab on the movement of goods but also helps the organization meet the growing demands in the market.
There are several inventory management software programs out there, and picking the right one is crucial. TranZact is a trusted and feature-packed software that simplifies inventory management, accounting, sales and purchase management, and many other business functions. It facilitates smooth inventory functions by providing real-time insights and tools to record inventory movements and stock reconciliations for enhanced stock management.
FAQs on Periodic Invntory System
1. What is periodic inventory taking?
It is a method of inventory management where the physical count of inventory is done at a predetermined time frame. This can be annual, biannual, weekly, monthly, or quarterly. This method updates the inventory records periodically, usually at the end of the period to reflect any changes in inventory levels.
2. Who would use a periodic inventory system?
Small businesses, especially those with low inventory turnover, may use a periodic inventory system. Businesses that have a large variety of low-cost items, may find this method more cost-effective.
3. When would you use a periodic inventory system?
A periodic inventory system may be used when a business has low reordering requirements or a limited variety of products, making it easier to track inventory levels manually. It may also be used when a business does not want to invest in modern and slightly expensive software like the perpetual inventory system.
4. Which is better, a perpetual or periodic inventory system?
The choice between a perpetual and periodic inventory system depends on the specific needs of the business. Perpetual inventory systems provide real-time inventory tracking, which can help businesses make informed decisions and prevent stockouts. However, they require more resources and investment in software and training. On the other hand, periodic inventory systems are simpler and less expensive but may not provide accurate and up-to-date information about inventory levels.
