Businesses that deal with products need some sort of system in place for managing stock. But if you’re on a tight budget, or you only deal with a handful of SKUs, the modern perpetual inventory method may be a little heavy for your basic needs.
Learn about an alternative – the periodic inventory system – as we break down how it works, who it’s best for, and some important considerations for choosing the right inventory management method.
What is a periodic inventory system?
A periodic inventory system is a method of accounting for inventory in which stock updates are made periodically. Periodic inventory systems require you to physically count inventory to determine your on-hand stock levels and the cost of goods sold (COGS).
Physical counts are conducted at the end of the accounting period, usually quarterly or yearly, to establish the value of your inventory and update your accounting records. The balance of the previous accounting period is then applied to the beginning of the new accounting period.
Periodic inventory systems are generally used by smaller businesses and those with lower inventory turnover levels, such as art dealers or recreational marine craft distributors. The often-low inventory levels of these high-ticket items make it easy for inventory stock to be counted by hand.
Periodic inventory vs perpetual
In a periodic inventory system, inventory records are updated only after a physical count of your inventory stock. In contrast, a perpetual inventory system continuously records the movement of your inventory stock.
Key differences between the perpetual vs periodic inventory systems:
- A periodic inventory system periodically counts and tracks your inventory movements at set times. A perpetual system records your inventory movements in real time, as inventory is received, relocated, or sold.
- A periodic inventory system determines inventory information and COGS at the end of the accounting period. Conversely, a perpetual system delivers inventory information and cost of sales in real time.
- The periodic inventory system requires a physical verification of your inventory while perpetual inventory is automated and based on book records.
- In a periodic inventory system, your inventory records are updated at set intervals. A perpetual system records and updates inventory transactions continuously.
- With a periodic inventory system, any loss is included in your COGS, whereas the perpetual inventory system accounts for the loss of goods in your closing inventory.
- Physical counting is necessary for the periodic inventory system, meaning you may have to stop or interrupt regular business operations to undertake an inventory stocktake. A perpetual inventory system provides real-time inventory counts without interfering with the regular workflow of your business.
The accounting practices differ under these two systems. To calculate inventory valuations at the end of the year under the periodic inventory system, you must perform a physical count of your inventory stock.
Most businesses will use periodic estimates, and mid-year markers, such as monthly and quarterly reports. In the perpetual system, inventory balances are tracked continuously and automatically updated each time an item is bought or sold.
Periodic inventory system: Advantages and disadvantages
Like any other inventory valuation method, a periodic inventory system has its advantages and disadvantages.
A periodic inventory system relies on a physical count of your on-hand inventory to calculate current inventory and COGS at the end of your accounting period. While this physical inventory count can be a time-consuming manual task, it does have the advantage of enabling you to identify damaged, missing, or excess inventory.
Let’s look at a few of the key advantages of a periodic inventory system.
1. Simple & cheap to implement
A periodic inventory system is both simple and cost-effective to implement. You don’t need to invest in inventory software because inventory counts are done manually once or only a few times a year.
2. Ease of record keeping
With a periodic inventory system, you can easily manage your records using either a physical or computer-based spreadsheet.
The three basic parameters of periodic inventory are the current quantity of items in stock, the number of items purchased, and the number of items sold. Recording these three items on your spreadsheet makes it easy to analyse the data and make any necessary adjustments.
3. Ideal for smaller businesses
A periodic inventory system can be used by businesses of any size. However, it is ideal for small businesses with specific inventory types or low inventory levels where sales and costs are easier to control.
For larger organisations, inventory tends to become more complicated as they deal with higher inventory transactions and thousands of orders per inventory period.
4. No disruption to normal operations
Your physical inventory counts can be scheduled at any time meaning they can be conducted outside of normal business hours and at very minimal cost to the business.
However, physical inventory counts can also be outsourced to a third party that offers full stocktaking services for businesses of any type or size.
Next, let’s talk about some of the disadvantages of a periodic inventory system.
1. Increased risk of human error
A periodic inventory system has the potential to be highly inaccurate. This is because your accounting records are only modified at the end of your year, or the end of a preestablished accounting period, to reflect your physical inventory count.
While it’s possible to ensure a reasonable degree of accuracy, you’ll never be completely sure of your inventory accuracy between physical inventory counts.
Manual counts are also susceptible to human error.
Common errors made during physical inventory counts include inaccurate counting, incorrect calculations, and inventory misrepresentation or the data entered incorrectly into your spreadsheets.
2. Labour intensive
The periodic inventory system is challenging if you have limited inventory, with low levels of transactions throughout the year.
It’s easy to update inventory data in a manual system. However, a periodic inventory system can prove to become highly challenging as your business grows.
Physical inventory counts are more labour-intensive the bigger your business becomes, particularly if you have large amounts of inventory transactions.
3. No real-time visibility
Businesses need to know what’s selling, and what isn’t.
Without real-time inventory information or gross profit data it is difficult to optimise operations for greater business success.
And without significant inventory data, you’re at risk of costly stockouts or, conversely, expensive inventory holding costs.
4. Tough to maintain control
It’s difficult to maintain control of inventory or identify losses using the periodic inventory system. Since your inventory is only being counted at specific times, it’s impossible to navigate instances of theft, especially if inventory counts are only done once a year.
Periodic inventory method
A periodic inventory system doesn’t continuously update your inventory records to reflect individual sales. These need to be manually edited and updated at the end of your specified accounting period.
This means you need to keep business accounts for your beginning inventory, any purchases within the period, and your current on-hand inventory.
How the periodic inventory method works:
- First, determine your beginning inventory costs for the period.
- Next, add the cost of inventory purchases during that timeframe.
- Next, measure your ending inventory count.
- Finally, subtract the cost of your remaining inventory to arrive at your COGS.
You should also maintain a record of your sales.
This won’t impact your inventory account directly because these figures aren’t adjusted until you have calculated your ending counts.
Alternatives to a periodic inventory system
Four alternatives to a periodic inventory system include:
Below we break down each of these periodic inventory system alternatives in greater depth.
Just-in-time inventory (JIT)
The just-in-time inventory method enables you to save money and reduce the risk of inventory waste. It does this by only keeping the inventory you need to produce and sell products.
JIT inventory reduces your storage and insurance costs and the expense of holding, liquidating, or discarding excess inventory.
However, a JIT inventory system can be risky.
If you have unexpected spikes in demand, it may be difficult to source more inventory stock quickly to meet the increased demand.
Given the current consumer expectations of fast delivery, even the shortest delay in replenishing stock can be an issue. Any delay can damage your reputation with customers and drive them to your competitors.
Materials requirement planning (MRP)
Materials requirement planning is an inventory method based on sales forecasts. This means that you must have precise sales records to allow you to accurately monitor your inventory needs and to promptly communicate these with your materials suppliers.
For example, if you’re a coffee roaster using an MRP inventory system you need to ensure that your quantity of coffee beans is in stock based on your forecasted orders.
Getting this wrong can lead to supply chain delays that make it difficult for you to fulfil orders.
Economic order quantity (EOQ)
The economic order quantity system of inventory management is used to calculate the number of units your business should add to your inventory.
Each batch order should reduce the total costs of your inventory while assuming consumer demand will remain constant. In the economic order quantity model, the costs of your inventory will also include holding and setup costs.
The EOQ inventory system aims to guarantee that the correct amount of inventory is ordered per batch. This is to ensure you don’t need to place frequent orders, but still avoid an excess of inventory on hand. The method assumes a trade-off between inventory holding and inventory setup costs, minimising both.
Days sales of inventory (DSI)
The days of sales inventory ratio indicates the average time in days that your company takes to turn over your inventory. DSI includes the goods that are a work in progress, that result in sales.
The DSI method is also known as the average age of inventory. It can be interpreted in many ways. DSI shows the liquidity of your inventory, representing how many days your business’s current inventory stock will last.
Generally, a lower DSI is favoured because it demonstrates a shorter timeframe to clear inventory. However, the average DSI will vary between industries.
Periodic inventory system formula
The periodic inventory system formula is an inventory valuation method used for financial reporting purposes. It relies on a physical inventory count performed at set times within a financial year.
Periodic inventory starts with the beginning inventory for the period, adds any new inventory purchases during the period, and then subtracts ending inventory to determine the COGS.
Here’s a formula for establishing a periodic inventory system:
- Establish your beginning inventory. Undertake an inventory count to establish your beginning inventory assets. Check for broken or damaged stock to ensure your on-hand inventory is 100% saleable.
- Determine new purchases. All new inventory purchases for the period should be entered into your purchases account. Ensure you know how much inventory you purchase and the amount you paid for those purchases.
- Sell your inventory. Whether you’re an SME, large manufacturer, or eCommerce business, you need to calculate the revenue generated from your total sales once your inventory has been sold.
- Establish your closing inventory. Conduct a physical inventory check. This could be monthly, quarterly, or yearly and will often depend on the quantities of inventory held. Simplify inventory counts using barcodes, QR codes, and scanners. These tools help to make the counting process more efficient to arrive at your closing inventory.
- Determine COGS. The COGS is the direct costs of inventory you have sold during an accounting period. It is deducted from sales revenue to determine your gross margins.
The formula for calculating COGS is:
(Beginning Inventory + Inventory Purchases) – End Inventory = Cost of Goods Sold
The COGS calculation doesn’t include lost, broken, or damaged goods. Any missing or unsaleable inventory should be reported as you encounter it.