What Is Perpetual Inventory System - How Does It Work?

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Date: 25 Jan 2023


Perpetual inventory systems: What are they and how do they work

 

Perpetual inventory systems have gained popularity due to the introduction of advanced scanning equipment at the point of sales and in the warehouse, decreased software costs, and improved software capabilities.

Although many small businesses continue to rely on more traditional periodic inventory systems, they could benefit from the accurate real-time updates a perpetual inventory system provides. Accounting software like Busy can come in very handy for inventory management. 

In this guide, we'll look at the main perpetual inventory formulas and methods before delving into some of the benefits of implementing a perpetual inventory system in your company.

 

What is perpetual inventory?

Main formulas for perpetual inventory

COGS Formula

EOQ Formula

Main perpetual inventory methods

FIFO Perpetual Inventory Method

LIFO Perpetual Inventory Method

Weighted Average Cost

What is a perpetual inventory system?

How does it work?

Perpetual inventory system vs periodic inventory system: what's the difference?

Account updates

COGS calculations

Transaction records

Cycle counting

Recording purchases

Who should use the perpetual inventory system?

Advantages of Perpetual inventory system

Data is accurately recorded in real-time

It leaves a paper trail to help identify bottlenecks

Reduces the cost of inventory management

Removes inconsistencies in stock levels

It makes demand forecasting easier

 

What is perpetual inventory?

Continuous inventory, sometimes known as perpetual inventory, is a method of accounting that tracks inventory changes immediately without the need for routine physical stock counts. The inventory level is adjusted whenever goods are sold or received.

 

To put it another way:

Beginning inventory + receipts - shipments = ending inventory

Occasionally, accountants and stock controllers may need to adjust inventory levels manually. However, accounting inventory generally is the same as, or nearly so, actual inventory.

With perpetual inventory, you can keep overstatements, phantom inventory, and missing inventory understatements to a minimum.

Main formulas for perpetual inventory 

  • COGS Formula 

The formula considers the direct costs of producing goods. While distribution and sales are not included in these prices, they cover the expense of labor and supplies and direct factory overhead.

  • EOQ Formula 

The Economic Order Quantity (EOQ) formula assists you in determining when to purchase inventory by weighing the cost of the goods against the cost of storage. The result establishes the ideal quantity of stock to buy or produce to reduce costs.

Main perpetual inventory methods 

Businesses value their inventory using cost flow assumptions.

An inventory accounting technique known as a cost flow assumption uses the value of goods from the beginning inventory of a period, along with purchases of new stock made during that period, to calculate the value of the ending goods and the cost of goods sold.

FIFO, LIFO, and Weighted Average Cost are the three cost flow assumptions (WAC).

  • FIFO Perpetual Inventory Method 

According to the cost flow assumption, the FIFO (first-in, first-out) perpetual inventory technique posits that the first items received in inventory are also the first items sold. As a result, the stock still presents after the period is the most current to be bought or produced.

For example, if you paid Rs. 100 for the first five items and Rs. 200 for the next five, as per FIFO, the first item sold would cost Rs. 100. The cost of the items sold would be Rs. 200 after you sold five items. So, if you sold seven items, the total cost would be Rs. 900 - five at Rs. 100 and two at Rs. 200.

  • LIFO Perpetual Inventory Method 

The LIFO method measures how much inventory is currently on hand and determines the cost of all purchases. The company's historical records calculate the amount of stock that should have been received during a specific period. This amount is then subtracted from the current period's net sales, bringing down the cost of goods sold. If a company had purchased 10 lakh rupees worth of merchandise in February 2020, for example, and sold 12 lakh rupees worth this year, its net income would be 2 lakh (Rs. 12- Rs. 10) because it used the LIFO formula.

  • Weighted Average Cost 

As a perpetual inventory method, the WAC method tends to be more straightforward than other methods and does not require special adjusting procedures. All your records must be up-to-date, and you need more flexibility regarding what can change as inventory changes.

What is a perpetual inventory system?

A perpetual inventory system is a piece of inventory management software that adjusts your inventory based on transactions rather than a physical count. The programme starts with a physical count as a baseline and then adjusts the amount based on payments received and deliveries made. Typically, warehouse teams use barcode scanners to register goods coming out of place, and the software adjusts in real-time. A perpetual system also benefits other teams within your company by providing a snapshot of the sales, not products.

How does it work?

The system continuously updates inventory counts as goods are bought and sold. A unique tracking identifier, such as a barcode or RFID (radio-frequency identification) code, is assigned to each product so you can keep track of its amount, location, and other pertinent details.

Periodically, physical stock counts are needed because inventory counts can fluctuate over time due to theft, loss, or breakages.

The following things are part of the process of working on a perpetual inventory system:

  • The point-of-sale system updates inventory levels.

  • COGS is recalculated automatically.

  • To maintain optimal inventory levels, reorder points are adjusted.

  • Purchase orders are created and distributed to suppliers.

  • Products are scanned into inventory.

What distinguishes a perpetual inventory system from a periodic inventory system?

Perpetual inventory systems track the total turnover of products through the system. A perpetual inventory system tracks physical stock counts at each check-in rather than requiring employees to record these manually.

Some of the significant differences between the periodic inventory system and the perpetual inventory system are listed below:

  1. Account updates

A perpetual inventory system's transactions update the general ledger and inventory ledger. While in a periodic inventory system, updates to the general ledger occur only when a physical stock count is entered.

  1. COGS calculations 

The software can always offer the COGS in a perpetual inventory system since it maintains a total of transactions. A periodic inventory system calculates COGS at the end of an accounting period after completing a physical inventory count.

3) Transaction records 

A perpetual inventory system necessitates real-time software that can track thousands of records. It is impossible to keep records manually. However, you could manually track transactions in a periodic inventory system because it only needs to be updated every period.

4) Cycle counting 

Cycle counting, often called sampling, is an ongoing procedure where you count a tiny portion of your inventory over time instead of doing it all at once. It allows you to specify when the count should be performed, which items to check, and how frequently the process should be repeated. Cycle counting can only be used in a perpetual inventory system.

5) Recording purchases 

A perpetual inventory system maintains the records of all materials purchases and uses those records to record the use of the purchased goods.

In a periodic system, purchases are recorded in the purchased asset account without any unit count information being added.

Who should use the perpetual inventory system?

A perpetual inventory system can be used by many organizations, including small businesses that wish to expand their operations and larger enterprises with thousands or even millions of items in their inventories.

For instance, a grocery or pharmacy chain could use a perpetual inventory system to let customers know which location has a particular item in stock. Businesses specializing in drop-shipping (where manufacturers ship directly to customers) or trade and distribution could also benefit from a perpetual inventory system.

These companies deal with a high volume of returns and exchanges and have fast-moving inventory. A perpetual inventory system can handle high inventory transactions while providing real-time stock availability updates.

Advantages of Perpetual inventory system 

A perpetual inventory system has several advantages (and no real disadvantages) for all businesses.

It's a far more advanced and accurate system for tracking and monitoring your inventory in real time, but there are a few other advantages:

  • Data is accurately recorded in real time.

No worries about your data not being updated regularly because the information is updated in real time if an organization uses the perpetual inventory system. 

  • It leaves a paper trail to help identify bottlenecks.

A perpetual inventory system monitors stock movements and interactions throughout your supply chain, allowing you to identify bottlenecks in your processes and gain valuable insights.

  • Reduces the cost of inventory management

A perpetual inventory system, once implemented, automatically calculates stock holding costs, replenishes low stock items and saves labor on the manual stock count. 

A periodic inventory system necessitates staff physically counting available stock and comparing figures to existing data to identify discrepancies. As you might expect, this is time-consuming, especially for businesses that deal with large volumes of stock.

  • Removes inconsistencies in stock levels

A perpetual inventory system allows you to investigate stock level discrepancies and make stock adjustments as needed. You can, for example, run spot checks to detect theft, damage, or errors and quickly adjust figures.

In a periodic system, you must adjust the year-end inventory balance to match the physical inventory count results, which means you cannot attribute discrepancies accordingly.

  • It makes demand forecasting easier.

A continuous inventory system streamlines demand forecasting. It forecasts future market patterns and cycles using previous stock levels and sales data to ensure you have the products during a specific time of year, such as the holiday season.