Perpetual Inventory System

What Is a Perpetual Inventory System?

A perpetual inventory system is a computerized system that continuously records inventory changes in real time, thereby reducing or eliminating the need for physical inventory checks. Relying on data provided by electronic point-of-sale technology, it provides a highly detailed view of changes in inventory and immediate reporting on the amount of inventory in stock. Perpetual inventory systems differ from periodic inventory systems, in which a company must instead depend on regularly scheduled physical counts.

Understanding Perpetual Inventory Systems

Perpetual inventory systems may be preferable to older periodic inventory systems because they allow for immediate tracking of sales and inventory levels for individual items, which helps to prevent running out of stock. A perpetual inventory does not need to be adjusted manually by the company's accountants, except to the extent that it deviates from the physical inventory count due to loss, breakage, or theft.

System software provides real-time updates to inventory through the use of barcode scanners or other computerized records of product acquisition, sales, and returns as they occur. This information is fed into a continually adjusted perpetual database.

The system allows for integration with other areas, including finance and accounting teams. This helps ensure adherence to tax and other regulations. Employees can use perpetual inventory data to provide more accurate customer service regarding availability of products, replacement parts, and other physical components.

Perpetual vs. Periodic Inventory Systems

The differences between perpetual and periodic inventory systems go beyond how the two systems function, although that is the main point of distinction.

Perpetual inventory systems track sales constantly and immediately with computerized point-of-sale technology. Periodic inventory systems only track sales when a physical count is ordered and require a point-in-time count.

Large companies or those with complex inventories are well suited to a perpetual system. Smaller companies with limited inventory can often survive with a periodic system. The same applies to margin for error, which is lower with a perpetual system, although a limited, uncomplicated inventory may not suffer much with a periodic system.

The cost of goods sold (COGS) is an important accounting metric derived by adding the beginning balance of inventory to the cost of inventory purchases and subtracting the cost of the ending inventory. With a perpetual inventory system, COGS is updated constantly instead of periodically with the alternative physical inventory.

Overall, once a perpetual inventory system is in place, it takes less effort than a physical system. However, the startup costs for a perpetual inventory system are greater.

Pros and Cons of Perpetual Inventory Systems

Proponents of perpetual inventory systems don't always go out of their way to point out the downsides of these systems, the chief of which is the lack of accounting for loss, breakage, or theft. On the other hand, detractors don't necessarily note that reported stockouts without corresponding sales can signal theft or loss and trigger a physical inventory check faster than with a periodic system. When deciding how to maintain control over physical inventory, it's prudent to carefully weigh both the pros and cons of any system under consideration.

Pros

• Real-time updates. A perpetual system, as the name implies, provides ongoing updates regarding purchases and sales. Managers and employees alike can monitor these data and use them as needed in real time.
• More informed forecasting. The ability to track customer buying patterns and seasonal fluctuations, and the opportunities that this information provides, are important advantages of a perpetual inventory system. Knowing and updating customer buying patterns allows for a stocking plan that minimizes either excess or inadequate stock, which can result in losses.
• Multiple-location management. One of the major challenges of inventory management is the monitoring of inventory at multiple locations. A connected perpetual inventory system creates a number of fulfillment opportunities, including moving stock from one location to another and managing inventory levels for all locations internally.
• Preparation of financial statements. This system makes it easier to prepare financial reports. One of the components of financial statements is inventory value; having the amount and value of the available stock recorded directly in the system can speed up the preparation of financial reports and avoid the errors of manual calculations.
• Reduction of down time or store closures. Businesses that rely solely on periodic physical inventories have difficult decisions to make. Do they tie up employees' time, even close stores on a frequent basis, to conduct inventories and gain accuracy, or do they opt for less frequent stock counts and sacrifice up-to-date data? A perpetual inventory system eliminates those problems.

Cons

• Loss of stock. This can occur due to damage, spoilage, and theft, among other reasons. When the estimated perpetual inventory does not match up to a subsequent physical inventory, that discrepancy equates to a loss.
• Improper inventory tracking. Scanning errors, misplacement of product, software malfunction, or operator (employee) errors can degrade the efficiency of a perpetual inventory system. When this happens, tracking the company's goods and inventory in the warehouse or store will hamper business operations.
• Hacking. Computer systems, despite their speed and efficiency, are susceptible to malfeasance in the form of hacking. Hacking threatens the security and accuracy of all data and information and forces the implementation of cybersecurity measures that can be expensive.
• Cost. Perpetual inventory systems are expensive, especially on the front end, due to the cost of equipment, software, and training. Updates to all of the above are part of the ongoing cost of maintaining a perpetual system. For a small company with limited inventory and small margins, a perpetual system may not be affordable or even necessary. (However, larger companies or those with multiple locations may see a cost savings.)
• Need for physical inventory. Due to the eventual need to “count stuff,” a physical inventory, at least on an annual basis, is prudent if not absolutely necessary. Although physical inventories can't be eliminated, their number can be reduced under optimal circumstances.

When to Use a Perpetual Inventory System

Large companies with a high volume of constantly rotating physical inventory to manage should consider implementing a perpetual inventory system. The same applies to businesses with multiple locations. Companies that don't meet those criteria now but anticipate growth in the future may want to consider such a system, as well.

Other factors that can affect the need for a perpetual inventory system include:

• The size of the company's margins and its ability to afford implementation and ongoing operating costs
• The size of the inventory to be managed
• The ability of vendors to respond to different types of inventory management methods
  

How to Use a Perpetual Inventory System

To calculate inventory, companies need to set up a system where every piece of inventory is entered into the system and deducted from the system as it's sold. This requires the use of point-of-sale terminals, barcode scanners, and perpetual inventory software to update estimated inventory with every product purchase and sale.

Since a perpetual inventory system estimates stock on hand, it does not replace a periodic physical inventory. At some point, a physical inventory should take place. Businesses that use a perpetual inventory system typically employ cycle counting or the process of physically counting a portion of inventory to use as a baseline to check the accuracy of the perpetual system. The intent is to complete a full physical inventory over time.

Inventory Management

Inventory management refers to the processes involved in ordering raw materials, storing and using them to create products, and ultimately selling products to an end user. There are four main inventory management methods:

• Just-in-time (JIT) management
• Material requirements planning (MRP)
• Economic order quantity (EOQ)
• Days sales of inventory (DSI)

Each of these methods has its pros and cons when it comes to use within a perpetual inventory system.

The use of a perpetual inventory system makes it particularly easy for a company to use the economic order quantity (EOQ) method to purchase inventory. EOQ is a formula that managers use to decide when to purchase inventory based on the cost to hold inventory as well as the firm's cost to order inventory.

Cost of Goods Sold (COGS)

When a company sells products in a perpetual inventory system, the expense account increases and grows the cost of goods sold (COGS). COGS represents production costs and expenses during a specific period. This includes the materials and labor costs but not distribution or sales expenses. The formula for COGS appears below.

COGS = BI + P - EI

BI = Beginning inventory

P = Purchases for the period

EI = Ending inventory

A perpetual inventory system maintains a continuous tally of transactions, making the COGS available at any time. By contrast, a periodic inventory system calculates the COGS only after conducting a physical inventory.

The advantage of a perpetual system in providing a rolling estimate of COGS is clear. A company knows, after each transaction, how much it cost to produce products sold at that point. By updating these data on a continuous basis and integrating them with other business systems, the company has actionable information available on a 24/7 basis as a way to respond to increased costs in a timely manner.

Calculating Gross Profit

Gross profit is the result of subtracting COGS from revenue. Recall that COGS includes the cost of labor and materials but not sales or distribution costs. The formula for gross profit is:

Gross Profit = Revenue - COGS

The ability to estimate COGS continuously also provides a company using a perpetual inventory system the ability to estimate gross profit continuously. That’s because every transaction is recorded in real time under a perpetual inventory system.

Examples of Inventory Costing Systems

Companies can choose among several methods to account for the cost of inventory held for sale, but the total inventory cost expensed is the same using any method. The difference between the methods is the timing of when the inventory cost is recognized, and the cost of inventory sold is posted to the cost of sales expense account.

The first in, first out (FIFO) method assumes that the oldest units are sold first, while the last in, first out (LIFO) method records the newest units as those sold first. Businesses can simplify the inventory costing process by using a weighted average cost, or the total inventory cost divided by the number of units in inventory.

The Bottom Line

Businesses increasingly track inventory using a perpetual inventory system vs. the older, physical-count periodic inventory system. Perpetual systems are costly to implement but less expensive and time consuming over the long haul.

Despite the advantages of a continuously updated estimate of stockage and the interconnectivity of accounting systems, a major drawback of perpetual systems is the inability to track lost, damaged, or stolen items. Many companies counter this with periodic partial inventory counts, which provide a baseline for the perpetual system and are designed to provide a full physical inventory by the end of the period.

Small- and medium-sized companies or those with small physical inventories continue to use the periodic inventory system, though many are opting for low-cost perpetual inventory systems. Large companies, companies with multiple locations, and those with large physical inventories have largely converted to perpetual systems since they can absorb the high startup costs and realize savings through the minimal use of labor that comes with a perpetual system.