Resources / Accounting for Inventory: Periodic Inventory Management vs Perpetual Inventory Management

Chapter 2

Accounting for Inventory: Periodic Inventory Management vs Perpetual Inventory Management

Accounting for your inventory is as important as accounting for your sales. Every product you have on the shelf has a cost value, and in order to grow your business effectively, you need to understand how to manage this cost properly.

There are two different ways to do this within retail:

  • Periodic Inventory Management
  • Perpetual Inventory Management

In this article, you’ll discover the key differences between both of these inventory accounting methods and which is best for your unique retail business.

Periodic Inventory Management

If you’re only updating your inventory and associated accounts after a specific period of time (i.e. quarterly or annually), then you’ll be using what is known as periodic inventory management.

This is more commonly used by smaller retailers that have minimal quantities of inventory at any one time, however, costs of goods sold accounting has to be done manually. It’s also impossible to adjust for obsolete or scrap losses in between each inventory update, which could result in large accounting adjustments that may not have been foreseen in financial planning decisions.

Using the periodic method, inventory accounting doesn’t occur when a sale happens. A sale stores the revenue and tax transactions, and shows as 100% profit on your Income Statement. At month (or year) end, an inventory update is run, a value is assigned, and this is then compared to the previous month’s inventory value.

The “Opening inventory value” and “Closing inventory value” are logged in your accounts, which, factoring any purchases you may have made during the period, gives you a cost of sale. This is subtracted from your revenue to give you your gross profit.

Let’s look at an example of this in action:

Inventory at start of month: $100

Purchases made during month: $50

Inventory at end of month: $25

Even though you’ve bought $50 of inventory, at the end of the month you are $75 down on the previous month (opening balance $100 – closing balance $25). This means the total spend on products contributing to sales in the month is:

$125 ($50 purchases + $75 inventory shipped)

$75 inventory shipped = opening balance $100 – closing balance $25

Total spend on products contributing to sales: $125 = $50 purchases + $75 inventory shipped

Total_spend_on_products_contributing_to_sales

With periodic accounting, the purchase value is added directly to the Profit and Loss (P&L) report or Income Statement when you buy the inventory, and the inventory adjustment is added at the end of the month. You can only get an accurate profit report once a month, after all of the calculations are made.

An inventory valuation should follow a full cycle count (i.e. stocktake) to take into account any gift sales, free samples, damage, or theft. Any loss of inventory due to damage or theft won’t be discovered until the count is done, and by that time, it won’t be easy to determine where and when it happened.

However, because you don’t have to account for the cost of inventory for each and every sale, the periodic accounting method is simpler and easier to work with if you’re running separate software systems for accounting and inventory management.

Perpetual Inventory Management

Your other option is perpetual inventory management, which is when inventory updates and their associated accounting transactions are made continually.

With every sale, purchase and manual inventory change, your inventory reports are updated in real time (including those all important accounting transactions related to inventory updates). This method significantly speeds up the inventory process, saving valuable time and money.

With the perpetual inventory accounting method, an entry is made on your Income Statement or Profit and Loss report for every single sale that contains inventory. Your asset value on the Balance Sheet is decreased, and your Cost of Sale on the P&L is increased, based on the actual value of the items that have been shipped. When you buy more inventory, the purchase value is added into your assets (found on the Balance Sheet), not into the P&L, as it would be with periodic inventory accounting.

Let’s see an example of this in action:

  • Opening inventory value: $100
  • Purchases made: $50 (no change to P&L)
  • Sale #1: $40
  • Cost of Sale #1: $25
  • Gross profit for the sale made: $40 – $25 = $15.

If we continue to make 5 similar sales in the month, we have a sales revenue of $200 and a cost of sale of $125, giving the same gross profit as the periodic accounting method, but without the need for inventory valuation.

Sales revenue: $200 = $40 * 5

Total cost of sale: $125 = $25 * 5

Gross profit: $75 = $15 * 5

Total_spend_on_products_contributing_to_sales_–_1

We can also see the profitability in real time.

But what about the closing inventory value?

In this example, we open with $100, add $50 directly into the assets with the purchase order, and then subtract $25 for each of the 5 sales made, leaving $25 at the end of the period.

In this example, we open with $100, add $50 directly into the assets with the purchase order, and then subtract $25 for each of the 5 sales made, leaving $25 at the end of the period.

Inventory at start of month: $100

Inventory purchased: $50

Inventory sold: $125

Cost of Sale #1: $25

Total_spend_on_products_contributing_to_sales

When you receive goods into the warehouse, it’s essential that you enter the most accurate cost value available. Your software should account for any slight discrepancies if the actual value is given on the purchase invoice.

Receiving inventory later is different. To benefit from perpetual inventory accounting, purchasing, inventory and accounting processes need to be tightly integrated, and ideally all operate within the same software platform. Through a single configuration, accurate data can be accessed in real time, since transactions are automated and opportunities for error are reduced.

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