Perpetual inventory systems: what are they and how do they work?
Perpetual inventory systems have become increasingly popular with the development of sophisticated scanning tools at the point of sale and in the warehouse, and with lower software costs and increased software functionality.
Although many small businesses still use more traditional periodic inventory systems, they could also benefit from the accurate real-time updates of a perpetual inventory system.
In this guide, we’ll explore the main perpetual inventory formulas and methods before looking at some of the advantages of using a perpetual inventory system in your business.
What is perpetual inventory?
Perpetual or continuous inventory is an accounting practice that records inventory changes in real-time, without requiring periodic physical stock counts. Whenever goods are sold or received, the inventory level is adjusted accordingly.
Put another way:
Ending inventory = beginning inventory + receipts - shipments
Sometimes accountants and stock controllers may need to adjust inventory levels using a manual journal entry. But, in general, accounting inventory is exactly the same, or almost the same, as the actual inventory.
Keep overstatements, also known as phantom inventory, as well as missing inventory understatements to a minimum with using perpetual inventory.
What are the main perpetual inventory formulas?
There are 2 main perpetual inventory formulas.
The Cost of Goods Sold (COGS) formula considers the direct expenses of producing goods. These expenses include the cost of labour and materials and direct factory overhead costs, but not distribution or sales.
The Economic Order Quantity (EOQ) formula helps you decide when to purchase inventory and considers the cost of the goods against how much it costs to store them. The result dictates the optimal amount of stock to buy or manufacture to minimise expenses.
What are the main perpetual inventory methods?
Businesses use cost flow assumptions to value their inventory.
A cost flow assumption is an inventory accounting method that uses the value of products from the starting inventory of a period plus purchases of new stock during that period to determine the value of the ending inventory and the cost of goods sold.
The 3 cost flow assumptions are FIFO, LIFO, and the Weighted Average Cost (WAC).
1. FIFO perpetual inventory method
The FIFO (first-in, first-out) perpetual inventory method makes a cost flow assumption that the first items received in inventory are the first items sold. So, the inventory remaining at the end of the period is the most recently purchased or produced.
For example, if you purchased the first 5 items for $100 and the following 5 items for $200, FIFO would assign the cost of the first item sold of $100. After you sold 5 items, the cost of the items sold would become $200. So, if you sold 7 items, the cost of the items would equal $900 – 5 at $100 and 2 at $200.
2. LIFO perpetual inventory method
The LIFO (last-in, first-out) perpetual inventory method is the opposite of FIFO and makes a cost flow assumption that the last items received in inventory are the first items sold. So, the inventory remaining at the end of the period is the oldest purchased or produced.
For example, if you purchased the first 5 items for $100 and the following 5 items for $200, LIFO would assign the cost of the first item sold as $200. After you sold 5 items, the cost of the items sold would become $100. So, if you sold 7 items, the cost of the items would equal $1,200 – 5 at $200 and 2 at $100.
3. Weighted Average Cost perpetual inventory method
The Weighted Average Cost (WAC) perpetual inventory method is a cost flow assumption that uses the average cost of goods sold for all the inventory.
Accountants use the weighted average cost method – also called the moving average cost method – differently in a perpetual system than in a periodic system.
The weighted average cost method is the simplest to apply, plus you cannot manipulate income as easily as the other perpetual inventory methods.
What is a perpetual inventory system?
Now that we understand what perpetual inventory is, it’s important to understand the management systems associated with it.
A perpetual inventory system is an inventory management software application that continuously adjusts your inventory based on your transactions rather than a physical inventory count. The system starts with the baseline from a physical count and updates the figure based on purchases received and goods shipped.
Typically, warehouse staff use barcode scanners to register goods in and out, and the software makes the adjustment in real-time. Integrating the system with other business applications will instantly update your accounting and financial records.
Other teams also benefit from a perpetual inventory system. For instance, marketing teams can get a snapshot of what products are selling, and which aren’t, and customer service staff can manage delivery expectations for a better customer experience.
How does a perpetual inventory system work?
A perpetual inventory system works by updating inventory counts continuously as goods are bought and sold. You assign a unique tracking code, such as a barcode or RFID (radio-frequency identification) code, to every product so that you can track its quantity, location and any other relevant details.
Occasionally, you’ll need to perform physical stock counts since inventory counts can become skewed over time due to theft, loss or breakages.
Point-of-sale system updates inventory levels
Whenever a product is sold, the POS (point-of-sale) system immediately debits inventory levels in the integrated inventory and accounting systems. Barcode or RFID scanners make this process quick and easy.
COGS is automatically recalculated
The cost of goods sold (COGS) gets automatically recalculated whenever you sell or purchase a product.
Reorder points are adjusted to maintain optimal inventory levels
Based on historical data, a perpetual inventory system automatically updates reorder points as demand increases or decreases to maintain an optimal inventory level at all times.
Purchase orders are generated and sent to suppliers
Whenever an item or SKU hits its reorder point, the system automatically generates a new purchase order and sends it to your supplier.
Products are scanned into inventory
When you receive inventory at your warehouse, you can scan products using warehouse management software (WMS) so that they appear in your inventory count and are available to sell.
Perpetual inventory system vs. periodic inventory system: what’s the difference?
Perpetual and periodic inventory systems require different tools and workflows to record inventory correctly.
In a perpetual inventory system, the software tracks stock movement continuously.
In a periodic system, employees record physical stock counts at specific intervals, like year-end. Consequently, a perpetual inventory system is more complex as it has more transactions to process.
Here are the main differences between the perpetual and periodic inventory systems:
In a perpetual inventory system, updates to the general ledger and inventory ledger are adjusted continuously with every transaction. In a periodic inventory system, updates to the general ledger only occur when you input a physical stock count.
The software can always provide the COGS in a perpetual inventory system as it maintains a running tally of transactions. In a periodic inventory system, the COGS gets calculated at the end of an accounting period after you’ve completed a physical inventory count.
A perpetual inventory system requires software to continuously track thousands of records in real-time. It’s impossible to maintain records manually. But, you could manually track transactions in a periodic inventory system, as it only needs updating every period.
Cycle counting, also called sampling, is an ongoing process where you count a small subset of your inventory over time instead of counting everything all in one go. It lets you choose when to perform the count, which items to check and how often to repeat the process. You can only use cycle counting in a perpetual inventory system.
In a perpetual inventory system, you record purchases in the raw materials inventory account or the merchandise account. In a periodic system, you record purchases in the purchases asset account without adding any unit count information.
Which businesses should use a perpetual inventory system?
Various organisations can benefit from using a perpetual inventory system, from small to medium-sized businesses that want to scale to large enterprises with huge inventories or a chain of retail outlets.
For instance, an organisation with multiple retail locations, like a grocery or pharmacy chain, could use a perpetual inventory system to inform customers which store has an item in stock in real-time instead of phoning around to locate it.
Other businesses that could benefit from a perpetual inventory system include those specialising in drop-shipping (where the manufacturers ship directly to customers) or trade and distribution.
These businesses have fast-moving inventory and process a high volume of returns and exchanges. A perpetual inventory system would handle the large volume of inventory transactions and provide real-time stock availability updates.
What are the advantages of a perpetual inventory system?
There are several advantages (and no real disadvantages) to using a perpetual inventory system for all kinds of businesses.
It’s a much more advanced and accurate system for tracking and monitoring your stock in real-time, but there are several more benefits:
Records data accurately in real-time
A perpetual inventory system records stock updates and movements in real-time, so you can trust your data to be accurate at all times.
Provides a paper trail to pinpoint bottlenecks
A perpetual inventory system tracks stock movements and interactions throughout your supply chain, so you can pinpoint bottlenecks in your procedures and discover other valuable insights.
Lowers inventory management costs
A periodic inventory system requires staff to physically count the available stock and compare figures with existing data for discrepancies. As you can imagine, this is an enormously time-consuming task, particularly for businesses that deal with large volumes of stock.
Eliminates stock level discrepancies
A perpetual inventory system lets you investigate any stock level discrepancies and make necessary stock adjustments when required. For instance, you can run spot checks to identify theft, damages or errors and quickly adjust figures.
In contrast, you have to adjust the year-end inventory balance to match the physical inventory count results in a periodic system, which means you can’t attribute discrepancies accordingly.
Simplifies demand forecasting
A perpetual inventory system simplifies demand forecasting. It uses historical inventory and sales data to predict future sales trends and cycles and ensure you have the optimal stock at the right time of year, such as the holiday season.
Improve your inventory management with MYOB
A perpetual inventory system is more efficient than a periodic inventory system and is suitable for businesses of all sizes, from small startups to mid-market enterprises.
It provides accurate, up-to-the-minute records of all stock transactions. Plus, it lowers inventory management costs by automatically calculating stock holding costs, replenishing low-stock items and saving labour on manual stock counts.
If that sounds like the inventory system for your business, then check out MYOB’s inventory management software. It accurately keeps track of what’s in stock, highlights your best-selling items and automatically reorders them before they sell out.
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