Perpetual Inventory System: How It Works, Pros and Cons
A perpetual inventory system can transform the way you manage your inventory. Improved visibility, inventory accuracy, and better customer experience are a few of the many benefits of such a system.
If you’re curious about implementing it to improve inventory management, you’ve come to the right place. Keep reading to learn everything about the perpetual inventory system and find out whether it is suitable for your business.
What Is a Perpetual Inventory System?
A perpetual inventory system involves continuously recording inventory changes. It is done in real-time and gives managers a highly detailed, accurate, and current view of which items are in stock.
It is done using inventory management software along with scanners, point-of-sale (POS) systems, barcodes, and other tools. All data is automatically uploaded into the inventory management software when employees scan products during product check-in and/or check-out.
The perpetual inventory system is quite an advanced and complex counting solution, which is why most businesses have been slow to adapt it. Most companies still use the periodic inventory system to keep track of their stocked items.
Differences Between Periodic and Perpetual Inventory Systems
These inventory accounting methods are very different in execution and results. Here are some ways to differentiate perpetual inventory from periodic inventory.
The periodic inventory system involves counting items at regular intervals. In contrast, the perpetual setup is just that—continuous counting throughout the business’s regular operations.
Because perpetual inventory goes on constantly, it results in fewer errors, and all data is recorded in real-time. Periodic inventory can result in more inconsistencies because of the span of time between two counts.
In a perpetual inventory system, sales are recorded as they happen. Whereas in periodic systems, they’re only recorded at the end of the set timeline, which may be once a week or once a quarter.
The time between two scheduled periodic counts can leave a business unable to gain complete control of its inventory. This may cause substantial losses and make it difficult to implement management strategies for improved monitoring.
Perpetual inventory, in contrast, enables complete visibility over all items, simplifying processes like asset tracking and financial reporting.
Perpetual Inventory System: Pros and Cons
- Minimal costs
- Lower risk of stockouts and overstocking
- Customer satisfaction
- Inventory visibility and accuracy
- Better demand predictions and forecasting
- Higher sales margins
- Real-time inventory management
- Operational efficiency
- Timely loss prevention
- Fraud detection
- Supply chain management on another level
- High setup costs
- Employees require training
- Fixing errors can take time
Why Should You Use a Perpetual Inventory System?
When using a perpetual inventory system, the company can simply use its existing resources to gather information on the items in stock as they move through storage or retail spaces.
Perpetual inventory is ideal for large businesses with high volume sales that result in a constantly changing physical inventory. Companies planning to scale in the future might want to consider doing it now. And organizations with multiple locations can also benefit from using a perpetual inventory system.
Overall, this is the best solution for any business that wants to minimize effort and time spent tracking assets.
Note that periodic inventory may still be needed. Combining it with the perpetual system will optimize the benefits and minimize the costs and effort involved.
Perpetual Inventory System: How Does It Work?
The process behind running a perpetual inventory system is quite complex. Below, we list all the points during which inventory items will be counted in a perpetual inventory system.
1. Scanning Products at Point-Of-Sale
Each time a product is sold, it is scanned by a POS system. In a perpetual inventory system, the data of the scanned product and its status is automatically uploaded to an integrated inventory management system.
From there, the details of the sale are logged at various points in the system, such as inventory count, accounting journal, income statement, etc.
2. Adjusting Reorder Points
As each sale is recorded, the system also readjusts the reorder points if needed.
Businesses often face changes in demand for certain products at different times of the year. An inventory management system automatically accounts for these shifts in customer behavior and adjusts the reorder level for particular items based on this data.
This step is crucial in a perpetual inventory system—businesses can maintain optimum stock levels and avoid running out of high-demand items.
3. Generating Purchase Orders
Once the system adjusts the reorder points, it generates purchase orders when the inventory reaches the reorder point and sends them to your supplier.
All of this happens automatically. Reorder activity is also immediately recorded on your balance sheet.
4. Entering Inventory Into Warehouse
Another point at which inventory counting takes place in a perpetual inventory system is when products enter the warehouse or storage area for the first time.
Every time new inventory arrives, products are scanned into the system and then stored. Sometimes, employees need to add new information about the items in the system. All of this data is automatically updated across the inventory dashboard and on all distribution channels.
5. Updating Cost of Goods Sold (COGS)
Depending on your method of costing, data for COGS is automatically calculated and updated in the inventory system when the products enter your warehouse and when they’re sold.
Updated COGS information affects your accounting data in multiple areas: income statement, balance sheet, and inventory credits.
Perpetual Inventory System Methods and Formulas
Perpetual inventory is the best method for visibility and accuracy. To achieve accuracy, a business must first calculate all reorder points, optimum stock levels, reordering lead time, etc.
The following formulas and inventory management methods will streamline the process:
Cost of Goods Sold (COGS)
The COGS formula helps you calculate the direct costs involved in producing goods a company sells. These direct costs comprise materials, labor, etc., and not indirect expenses like those spent for distribution or sales.
The formula for COGS is:
COGS = BI + P – EI
BI = Beginning inventory (all items available at the start of the inventory period)
P = Purchases during the period
EI = Ending inventory
COGS is a crucial formula as it factors into other calculations.
Economic Order Quantity (EOQ)
Here’s the EOQ formula:
EOQ = √ 2DS / H
D = Consumer demand for units per year
S = Order cost for every purchase
H = Holding cost for a single unit of inventory per year
Calculating gross profit will help you understand how much you’re spending on manufacturing and the profit you generate.
The formula for gross profit is:
Gross Profit = Revenue – COGS
This formula calculates the cost of inventory ready to be sold. It is useful for sellers to set pricing for their products while ensuring all costs are covered, and healthy profits are generated.
Here is the formula for determining the value of your finished goods:
Beginning finished goods inventory + COGM – COGS = Ending finished goods inventory
COGM = Cost of goods manufactured
Weighted Average Cost (WAC)
WAC is one of the three cost flow assumptions used to evaluate the value of inventory.
Calculating weighted average cost will give you a rough estimate of the cost of each unit sold and each unit in your inventory.
The formula is:
Weighted average cost = total cost of goods purchased / number of units available for sale
FIFO is another type of cost flow assumption businesses use to value their inventory. It assumes the items that enter the system first are also sold first. Under the FIFO method, the cost of goods purchased first is used to calculate the COGS.
The formula to calculate FIFO:
FIFO = Cost of oldest inventory * amount of inventory sold
The LIFO method is the third type of cost flow assumption. It assumes that the last items entering the inventory are sold first. In this method, the cost of goods purchased most recently is used to calculate the COGS.
The formula to calculate LIFO:
LIFO = Cost of most recent inventory * amount of inventory sold
Set up Intelligent Inventory Management Solutions
There’s no doubt that the perpetual inventory system is set to become the most adopted management solution of the future. We hope this guide has helped clear your doubts about setting it up for your business.
But first, you need a robust intelligent inventory management system. This will help your team streamline processes for data entry and organization, planning, analysis, and logistics. Whether you’ve got dozens of complex product categories or a long list of vendors and OEMs to manage, intelligent solutions like Nest Egg can take care of it all.
You can test our world-class support right away by getting in touch for more information on implementing a perpetual inventory system.
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