Keeping track of inventory is an essential part of maintaining smooth business operations. Technology advances have enabled businesses to track inventory with exceptional detail, including real-time stock counts and forecasts based on artificial intelligence (AI).
However, more advanced inventory management systems can add costs and complexity to your operations. For small businesses and entrepreneurs, it’s important to know when to choose simplicity over the latest tech.
In contrast to highly complex processes, the periodic inventory system is easy to implement and costs significantly less. Here’s how it works.
What is a periodic inventory system?
A periodic inventory system is an inventory valuation where you do a physical inventory count at the end of a defined accounting period. This can be annually, quarterly, or monthly.
This gives you a predefined schedule for physically counting your inventory and calculating accounting metrics like the cost of goods sold (COGS).
The goal of an inventory system is to tell you how much stock you have and to help calculate your cost of goods sold. Cost of goods sold refers to the direct cost of the sold products, such as raw materials and labor. It’s an accounting metric that gets reported on financial statements (like the income statement).
When calculating periodic inventory, you’ll also use a metric called cost of goods available. This is the total cost of all items available for sale during the period. So, if you have 10 shirts available to sell and they cost $5 to produce, your cost of goods available is $50. If you sell seven of those shirts, your cost of goods sold is $35.
Business owners subtract the cost of goods sold from total revenue to get their gross profit, which is a measurement of the business’s profitability.
How a periodic inventory system works
There are a few metrics you will track and use in a periodic inventory method — beginning inventory, purchases, and ending inventory.
A closer look at what each metric includes:
- Beginning inventory: The total monetary value of the inventory that you had at the start of the accounting period.
- Purchases: The total amount of money you spent on new inventory during the accounting period.
- Ending inventory: The total monetary value of the inventory that you have remaining at the end of the accounting period.
Here are the steps involved in using a periodic inventory system:
- Record the beginning inventory value.
- Track inventory purchases throughout the accounting period.
- At the end of the accounting period, add up all the individual purchase amounts to get the total purchases amount.
- Physically count and add up the number of units remaining in the inventory at the end of the accounting period.
- Determine the monetary value of the ending inventory. (See the section below on inventory valuation methods for more detail.)
- Calculate the cost of goods available for sale.
- Calculate the cost of goods sold.
To calculate the cost of goods available for sale, use the following formula:
Cost of Goods Available = Beginning Inventory + Purchases
And to calculate the cost of goods sold, use the formula below:
Cost of Goods Sold (COGS) = Cost of Goods Available – Ending Inventory
Inventory valuation methods
You can use inventory valuation methods to figure out the monetary value of your inventory based on the number of goods you have.
The three most common inventory valuation methods you can use with a periodic inventory accounting system are:
- First in, first out (FIFO): Assumes that your inventory items are sold in the order that they were purchased, which means the oldest items go first. This method uses the most recent purchase prices to calculate the value of the remaining inventory.
- Last in, first out (LIFO): Assumes that the most recently purchased inventory is sold first and uses the cost of the oldest inventory to calculate the value of remaining items. The LIFO method can only be used in the US, which uses Generally Accepted Accounting Principles (GAAP). The International Financial Reporting Standards (IRFS) don’t allow the use of LIFO for inventory valuation.
- Weighted average cost: Uses a weighted average to calculate per-unit cost, which is used in calculating the cost of goods sold and the value of remaining inventory.
Each of these methods can be used to help you calculate the value of your beginning inventory and ending inventory. You just have to be consistent and use the same one each time.
Periodic inventory system example
Say you have a small business that does quarterly inventory, and your inventory ledger has the following information:
- Jan. 1: You have 100 shirts on hand and each shirt costs $5 to produce. Beginning inventory of $500.
- Feb. 1: You buy 30 more shirts for $5 each for a purchase value of $150.
- Mar. 1: You buy 20 more shirts for $5 each for a purchase value of $100.
- Mar. 31: At the end of the period, you have 90 shirts remaining, with a cost per item of $5. This gives you an ending inventory of $450.
Here’s an example for calculating your cost of goods available and cost of goods sold at the end of the quarter.
First, add up all of the transactions in the purchases account to get the total cost of all purchases. In this example, you would get a total purchase amount of $250 ($150 + $100).
Next, calculate your cost of goods available:
Cost of Goods Available = Beginning Inventory + Purchases
Cost of Goods Available = $500 + $250
Cost of Goods Available = $750
Finally, use the cost of goods available and the value of your closing entry to calculate your cost of goods sold:
Cost of Goods Sold = Cost of Goods Available – Ending Inventory
Cost of Goods Sold = $750 - $450
Cost of Goods Sold = $300
Periodic inventory management vs. perpetual inventory management
In a periodic inventory system, you use regularly scheduled physical inventory counts to measure the cost of goods sold and see how much product you have available. The perpetual inventory method uses a computerized system to continuously update inventory records as items move in and out of the business.
If you use a periodic system, you don’t know the exact number of units you have in stock until the end of the accounting period when you do your physical count of inventory. In contrast, the perpetual inventory system gives you real-time inventory counts because it updates each time a unit moves in or out of your inventory.
A perpetual inventory system uses point-of-sale software (POS software) to scan the barcode of each item that the company sells and adjust inventory levels accordingly. So, if you sell one item, the system will reduce your total inventory level by one right after the sale happens.
Advantages of a periodic inventory system
The top benefits of a periodic inventory system are:
- It’s easy to implement.
- It’s more cost-effective than a perpetual system because it doesn’t require special inventory tracking software.
As such, the periodic inventory system is most appropriate for small businesses that have smaller inventory balances, which makes it easier to do physical counts.
By spending less time on inventory tracking, businesses can focus on other growth areas such as sales, marketing, and customer service.
Disadvantages of a periodic inventory system
There are also some downsides to using a periodic inventory system, such as:
- It doesn’t provide insight into real-time inventory levels.
- It doesn’t provide insight into the real-time cost of goods sold.
- It relies on manual counting and data entry, which makes it more prone to human error.
- It requires physical inventory counting, which can be time-consuming for larger businesses.
- It doesn’t track individual inventory items, which makes it difficult to account for inventory shrinkage.
Inventory shrinkage refers to the difference between how many items should be remaining (based on sales) and how many actually are. These discrepancies can happen as a result of employee theft, shoplifting, or vendor mistakes.
When a periodic inventory system is used
A periodic inventory system is most suitable for small businesses that have less inventory, making it easier to physically count the units.
Percy Grunwald, co-founder of finance website CompareBanks, explains, “For example, a small gift shop that only restocks their inventory a few times a year may not need the real-time tracking and monitoring of a perpetual inventory system.”
Some small businesses may also choose the periodic system because of its affordability. Since it’s a manual process, it doesn’t require complex point-of-sale or inventory tracking software to implement.
Ultimately, the question of which inventory system to use comes down to what you need most: simple and cost-effective processes or highly accurate real-time inventory data. If the answer is simplicity and lower costs, then a periodic inventory system may be right for you.
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