Business owners use inventory systems to track and update inventory. This lesson defines the periodic inventory system, outlines its advantages and disadvantages, and demonstrates its use with an example.
Periodic Inventory System
For any business that carries inventory, or products stored for future sale, it is necessary to keep track of what is currently on hand. Some businesses keep track of inventory using a periodic inventory system. A periodic inventory system is an inventory system that updates inventory at the end of a specified period of time. This may mean that they update their inventory records at the end of each month, quarter, or year.
Whenever the period ends, it generally coincides with the end of a reporting period, or a timeframe for which a report is drawn on all financial activities that occurred during that time. Common reporting periods conclude on a quarterly or annual basis.Since a periodic inventory system only keeps track of inventory periodically throughout the year and not as inventory is purchased or sold, a physical count of the inventory must be conducted. A physical count is a complete and exact count of each item in the inventory done by hand. Some businesses carry hundreds or thousands of products, so physical counts can be extremely time-consuming. Even for businesses that carry few products, physical counts can be tedious and may take a lot of time to complete if problems, such as missing parts or wrong counts, arise.
Inventory Management Between Counts
Inventory purchases made between physical counts are recorded in a purchases account, a ledger used to record all inventory purchases and their cost.
We’ll try to break it down as simply as possible.The purchases account begins with the beginning balance of inventory, a complete and thorough record of the cost of all of the items the company has acquired that will be resold. Throughout the recording period, additional inventory purchases are logged into the same ledger. These entries track only inventory goods, items that will be resold. Entries include the number of each item purchased, how much these items cost, and other pertinent information, such as from which vendor and the date.At the end of the recording period, the purchases account will be balanced and the numbers it generates will be compared to the physical count. Adding the inventory’s beginning balance, the amount of money spent on inventory items at the start of the recording period, to the total amount of money spent on additional inventory shipments throughout the same recording period will result in the cost of goods for sale.
At this point, the physical count will be conducted. This physical count will tell how much inventory is in stock. Based on records, businesses can then calculate how much the inventory is worth, or the ending balance.
By subtracting the ending balance, the worth of the inventory on hand at the end of a reporting period, from the cost of goods for sale, the company can determine how much inventory was sold during the period and for how much money. This final number is called the cost of goods sold, or COGS.The formula for this process is Beginning Balance of Inventory + Cost of Inventory Purchases = Cost of Goods for Sale Cost of Goods for Sale – Cost of Ending Inventory = Cost of Goods Sold (COGS).
Let’s take a look at an example to help clear this up. Just to keep it simple, we’ll stick with a retail store that sells exactly one thing – envelopes.The Envelope Store uses the periodic inventory system. Its reporting periods are quarterly, running January through March, April through June, July through September, and October through December.
On January 1, the store records in the purchases account the beginning balance of inventory as $15,520. From January 1 through March 31, the store orders three shipments of additional envelopes, each at a cost of $2,250.At the end of the quarter, the Envelope Store conducts a physical count of all the inventory on hand.
They find after counting the envelopes and totaling their cost that the ending inventory for the quarter is $8,450 worth of envelopes. The question is how much was the Envelope Store’s COGS for the first quarter of the year?Well, let’s use our formula! The beginning balance of inventory plus the cost of inventory purchases will give us the cost of goods for sale. So, $15,520 + 3 ($2,250) = $15,520 + $6,750 = $22,270. Okay, the cost of goods for sale was $22,270. This cost of goods for sale minus the cost of the ending inventory will give us the COGS.
$22,270 – $8,450 = $13,820So, the cost of goods sold during the first quarter was $13,820! That wasn’t too awful, was it?
Advantages ; Disadvantages
It should be noted that the periodic inventory system was much more widely used before computers made inventory management in real time very easy. However, some businesses still do use a periodic system for a few different reasons.Cost effectiveness, for instance, is one reason to use the periodic system. Computer-based perpetual inventory systems can be very expensive. In contrast, little to no cash is needed to implement the periodic inventory system; in fact, very small companies may be able to track inventory using only pen and paper accounting books! A periodic inventory system is also useful for businesses that sell large quantities of inexpensive products, start-ups, or businesses that do not need to keep track of inventory in real time.
Though there are a few advantages to the system, there are also drawbacks. One of the most notable is the fact that when the system is used alone, no records are kept to account for loss and other issues. Often, the periodic inventory system is used in conjunction with another inventory system to assist business owners in accounting for loss, theft, breakage, scanning errors, or inventory movement that is not tracked.
A periodic inventory system is an inventory system that updates inventory at the end of a specific period of time. This may mean that they update their inventory records at the end of each month, quarter, or year.
Whenever the period ends, it generally coincides with the end of a reporting period, or a timeframe for which a report is drawn on all financial activities that occurred during that time.Inventory is only updated when a physical count, or a complete and exact count of each item in inventory done by hand, is conducted. Throughout the reporting period, inventory shipments are tracked in a purchases account log. At the end of the period, the physical count is done and calculations are made that determine the COGS, or the cost of goods sold, during the period.The formula used to figure out the COGS is Beginning Balance of Inventory + Cost of Inventory Purchases = Cost of Goods for Sale Cost of Goods for Sale – Cost of Ending Inventory = Cost of Goods Sold (COGS).
The periodic inventory system is more likely to be used by businesses that sell large quantities of inexpensive items, do not need to keep a daily total of inventory, have small budgets for accounting practices, small businesses, or start-ups. It’s often used in conjunction with other inventory systems to make adjustments to inventory totals due to breakage, theft, scanning errors, or inventory movement that is not tracked.