Business Accountants: Periodic Inventory System: Usage and Benefits
To ensure efficient business operations, inventory management is crucial. With advancements in technology, businesses now have the capability to track inventory in great detail, including real-time stock counts and AI-based forecasts.
However, for small businesses and entrepreneurs, it’s important to strike a balance between advanced inventory management systems and simplicity. This is where the periodic inventory system comes into play, offering an easy-to-implement and cost-effective alternative. Let’s explore what it is and how and when to use it.
What is a Periodic Inventory System?
A periodic inventory system involves conducting a physical inventory count at the end of a specific accounting period, typically yearly, quarterly, or monthly. This approach provides a predetermined schedule for physically counting inventory and calculating important accounting metrics, such as the cost of goods sold (COGS).
The primary goal of an inventory system is to determine the quantity of stock on hand and facilitate the calculation of the cost of goods sold. The cost of goods sold represents the direct expenses associated with the sold products, including raw materials and labor. This metric is essential for financial reporting purposes, particularly on the income statement.
How the Periodic Inventory System Works
When using a periodic inventory system, several metrics are tracked and utilized: beginning inventory, purchases, and ending inventory. Here’s a closer look at each:
1. Beginning Inventory: The total monetary value of inventory at the start of the accounting period.
2. Purchases: The amount spent on acquiring new inventory during the accounting period.
3. Ending Inventory: The monetary value of inventory remaining at the end of the accounting period.
The following steps outline the process of using a periodic inventory system:
1. Record the value of beginning inventory.
2. Keep track of inventory purchases throughout the accounting period.
3. Sum up all individual purchase amounts to calculate the total purchases.
4. Physically count and tally the number of units remaining in inventory at the end of the accounting period.
5. Determine the monetary value of the ending inventory (refer to inventory valuation methods for more details).
6. Calculate the cost of goods available for sale.
7. Calculate the cost of goods sold.
To calculate the cost of goods available for sale, use the formula:
Cost of Goods Available = Beginning Inventory + Purchases
And to calculate the cost of goods sold, apply the following formula:
Cost of Goods Sold (COGS) = Cost of Goods Available – Ending Inventory
Inventory Valuation Methods
Inventory valuation methods help determine the monetary value of inventory based on the number of goods in stock. The three common methods applicable to a periodic inventory accounting system are:
1. First in, First out (FIFO): Assumes that inventory items are sold in the order of their purchase, with older items sold first. This method uses the most recent purchase prices to calculate the remaining inventory’s value.
2. Last in, First out (LIFO): Assumes that the most recently purchased inventory is sold first and calculates the value of remaining items using the cost of the oldest inventory. The International Financial Reporting Standards (IFRS) do not permit the use of LIFO for inventory valuation.
3. Weighted Average Cost: Utilizes a weighted average to calculate the per-unit cost, which is used for calculating the cost of goods sold and the value of remaining inventory.
Consistency in the chosen valuation method is crucial for accurate calculation of both beginning and ending inventory values.
Advantages of a Periodic Inventory System
Implementing a periodic inventory system offers several benefits, including:
1. Ease of Implementation: The periodic system is simple to set up and use.
2. Cost-Effectiveness: As it does not require specialized inventory tracking software, a periodic system is more affordable than a perpetual system.
3. Suitable for Small Businesses: The periodic system is particularly well-suited for small businesses with smaller inventory balances, making physical counts more manageable.
4. Focus on Core Areas: By minimizing time spent on inventory tracking, businesses can dedicate more attention to sales, marketing, and customer service.
Disadvantages of a Periodic Inventory System
Despite its advantages, the periodic inventory system has some limitations, including:
1. Lack of Real-Time Inventory Insights: The periodic system does not provide immediate information about inventory levels.
2. Absence of Real-Time COGS Insights: Similarly, real-time cost of goods sold information is not available with this system.
3. Potential for Human Error: Manual counting and data entry increase the risk of human errors.
4. Time-Consuming: For larger businesses, physical inventory counting can be time-consuming.
5. Limited Tracking of Individual Items: It becomes challenging to account for inventory shrinkage, which refers to the discrepancies between expected and actual inventory levels due to factors such as theft, shoplifting, or vendor errors.
When to Use a Periodic Inventory System
A periodic inventory system is most suitable for small businesses with smaller inventory volumes, enabling easier physical counts. A small gift shop that restocks inventory a few times a year may not require the real-time tracking capabilities of a perpetual inventory system.
Additionally, small businesses often opt for the periodic system due to its affordability, as it does not necessitate complex point-of-sale or inventory tracking software.
Ultimately, the choice between inventory systems depends on the specific needs of your business. If simplicity and cost-effectiveness are prioritized over real-time inventory data accuracy, the periodic inventory system can be the right choice for you.
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