Periodic Inventory Systems: What Businesses Should Use It and How?
Inventory management is the complex process of tracking a company’s assets from manufacturing to retail stores. This practice helps ensure that operations run smoothly and that all products reach the right customers at the right time, ultimately maximizing the company’s resources.
A study has shown that around 43% of small businesses do not monitor their inventory, leading to shrinkage. Maintaining a robust, accurate inventory system is essential to minimize losses and ensure a stable income.
In this article, we will dive deep into periodic inventory systems, how they work, and how businesses can benefit from such a setup.
What Is a Periodic Inventory System?
A periodic inventory system involves physically counting and accounting for items after a specific timeframe or season (periodically). This inventory management method will show you what is in stock and what needs replenishment to meet customer demand.
The period of accounting differs from one company to another. Small businesses schedule their inventory counts quarterly, every six months, or annually. Those with more extensive stocks will need to do it more often.
How Does a Periodic Inventory System Work?
Physically counting every single item in an inventory of thousands is incredibly time-consuming and challenging. This is why many businesses resort to a periodic inventory system.
With this method, a team manually counts all items in stock in set intervals without using automated accounting software. After the manual count, the numbers are reconciled for a new period.
When using a periodic inventory system, companies must understand that it doesn’t account for products sold—just the last physical count. The only way to determine the number of products sold is to set it against the numbers of the previous count.
Example of a Periodic Inventory System
To help you understand this method, let’s take an example of a fictional small business selling cosmetics called KiKi.
KiKi uses the periodic inventory system every quarter, so it cannot check the accuracy of its accounting records until the physical count is completed at the end of the quarter.
Let’s say the value of KiKi’s inventory is $5,000 on January 1st. The business adds stock worth another $5,000 in the weeks after. After physically counting all items, it determines that the current inventory is worth $9,000.
Let’s also assume the counting of items was completed on March 31st. With $9,000 as the amount that has been accounted for (until the next inventory period), it means that the Cost of Goods Sold (COGS) for the quarter is $1,000.
Because of the time gap and lack of active inventory monitoring for three full months, the discrepancies, if any, between sales records and end-of-quarter physical count, may be difficult to account for.
Features of a Periodic Inventory System
Here are some key features of a period inventory system that make it stand out:
In this system, it is important to count the raw materials, products being processed physically, and finished goods. Each item is accounted for and recorded in the most efficient method available. These numbers can then be imported into software for analysis.
No Real-Time Counting
Because there is no real-time inventory tracking between periods of physical counting, businesses do not have access to accurate information about their items on hand. This may lead to issues like inaccurate accounting and lack of information to meet customer demand.
A Challenging Method
Physically counting each item on the shelves and stored in the warehouse can be incredibly challenging. The bigger the inventory, the larger the risk of errors, as everything is done manually.
Good for Small Businesses
Not all businesses will benefit from a periodic inventory system. It’s best suited for micro or small companies with limited inventory to ensure accuracy.
Advantages of Using a Periodic Inventory System
Easy to Implement
Implementing a periodic inventory system doesn’t take a lot of work or resources if you have a small business. One or two employees can count everything up every few months to determine the value of the items on hand and calculate COGS.
Doesn’t Interfere With Regular Operations
The store doesn’t need to be shut down for periodic counting. One or two employees can get everything done as the retail store continues smooth operations around them.
This system is quite cost-effective because you don’t have to pay for software or assign a dedicated team of inventory handlers. Your accounting team should be able to complete all the calculations needed after the physical count.
Disadvantages of Using a Periodic Inventory System
Cannot Determine Shrinkage
Shrinkage is determined by counting the actual stock and comparing it with the inventory list. So, if the actual items on hand is lower than the hypothetical inventory, it indicates shrinkage.
It’s hard to account for shrinkage in a periodic inventory system, as the counting is done several months apart. This means theft, damage, or any other loss may not be unaccounted for. The chances of fraud are also quite high.
Doesn’t Provide COGS in the Interim
Because of the nature of the system, actual COGS is not calculated until the end of the counting period. This makes accurate accounting a challenge in the months between counts.
Not Suitable for All Companies
Physically counting thousands of items is tedious and impractical. That is why a periodic inventory system is not ideal for large businesses; they should use a perpetual inventory system instead.
Key Differences Between a Periodic and Perpetual Inventory System
A periodic inventory system involves manual counting of items to calculate their overall value. In contrast, a perpetual inventory system uses automated software that updates the company’s records in real time.
Periodic inventory systems don’t calculate COGS until after the business has counted all items at the end of a quarter (or the interval of their choice).
Meanwhile, perpetual inventory systems record sales as they occur, reducing the risk of inaccuracies.
Employees need to account for every single product at the start and end of each cycle. The chances of human error are very high, which is not ideal. In fact, a study conducted found that 5.8% of inventory shrinkage was due to human error.
Perpetual inventory systems don’t involve much effort from humans after the automated systems are in place, so the chances for mistakes are quite slim.
What Businesses Should Use Perpetual or Periodic Inventory Systems?
So, owing to the tedious process, which companies would benefit from using this system? Well, the answer is quite simple.
Using a perpetual inventory system makes a lot of sense for large companies with multiple product lines and significant turnover. The ease and accuracy that software provides are unmatched and are needed for fraud prevention. Grocery stores and pharmacies would benefit from a perpetual inventory system.
On the other hand, a small business that deals with limited variations of products at relatively low prices per unit and has good physical security, can establish a simple periodic inventory system. It is great for micro or small retail operations with limited time, money, and manpower. However, if shrinkage because of employee or customer theft, or inadequate security during closed hours is an issue, small businesses should go with a perpetual inventory system to detect losses closer to when it occurs in order to take steps to recoup, reduce and prevent losses.
Newly launched businesses often start with periodic inventory systems, as they have few products and very limited resources. Eventually, they move on to perpetual inventory as their operations expand and their inventory grows.
How Does a Business Determine the Inventory Period?
Days in inventory refers to the average time a company takes to sell its items. Calculating this indicates the average time of turnover.
These five steps will help you calculate days in inventory:
To find the average inventory, add the value of inventory units at the beginning of the period to the value of inventory units at the end of the period and divide that number by two.
Let’s take the same example of the cosmetics company mentioned above. It would need to add $10,000 (the value at the beginning of the period) to $9,000 (the value at the end of the period) and divide it by 2.
10,000 + 9,000 / 2 = 9500
The average inventory amount is $9,500.
To calculate COGS, add the inventory value at the beginning of the period to the cost of goods, including expenses for materials, labor, overheads, etc. Then, subtract the value of inventory at the end of the period.
In the example with the cosmetics company, the calculation is as follows:
($10,000 + $2,000) – $8,000. The cost of goods sold is $2,000.
Choose the period for which you want to find the inventory days. If your business prefers annual counting, usually at the end of the fiscal year, it would be set at 365. Similarly, if a company wants to find quarterly numbers, it would be calculated as 91.
(Average Inventory Cost / COGS) x 91
(9500 / 2000) x 91 = 432.25
This indicates that the business is not selling as many items as it should and should increase its sales to maintain healthy profits.
Alternatively, you can take the value of the average inventory and divide it by the cost of goods sold:
$9,500 / $2,000 = 4.75
Multiply this by the number of days in the period:
4.75 x 91 = 432.25
The inventory period depends on several factors, like the size and complexity of the warehouse and products, the value of the items, and customer demand.
Choose Nest Egg
Nest Egg, an intelligent inventory management system, has proved to be an effective solution for small and big companies. It helps users stay on top of logistics through simplified data entry and effective data organization. Businesses in the retail, healthcare, logistics, and IT industries have benefited from using it.
A periodic inventory system is a practical choice, as it is cost-efficient, does not require much manpower, and is easy to implement. However, this is not ideal for businesses operating with inadequate physical security or with a large inventory of thousands of items in stores and warehouses.
Note that there is a lot of room for human error in this system, and it does not account for shrinkage. Given the gaps between counting periods, businesses cannot access timely data regarding surplus and loss.
This system may be combined with other inventory methods to maintain accurate counts and robust records for accounting.
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