What Is a Periodic Inventory System?
Inventory is defined as items, goods, merchandise, and materials stocked by a business to sell for profit. According to the Generally Accepted Accounting Principles (GAAP), all properties intended for sale can be considered inventory items. This means raw materials for use in the production of goods and services, work-in-process (WIP) inventory (goods on which work has begun but not yet finished), and finished goods ready for sale all count as inventory. The daily activities of manufacturing, retail, and even service-based businesses revolve around how well they manage their inventories.
For instance, if a retail company doesn't have the right amount of inventory to meet customer demands, it will lose sales. The same goes for a manufacturing business that's low on materials. Production might have to stop for a few hours or days, and the company will lose money because it still has to pay its employees, rent, and more. This is why effective and efficient inventory management is essential for small businesses and large companies alike.
How Does a Periodic Inventory System Work?
The periodic inventory system is one of the simplest and oldest inventory tracking processes. With the periodic inventory system, businesses update and record changes in the inventory account after manually counting inventory. If you choose to implement the periodic inventory system in your business, you decide whether you want to count and update your inventory daily, weekly, monthly, quarterly, or yearly.
This is in contrast to the perpetual inventory method, another inventory management system that has become popular due to advances in technology. This inventory valuation method is possible through point-of-sale (POS) systems and radio frequency identification tags tied directly to accounting software packages. The perpetual inventory method automatically and continuously records purchases and sales as they happen and updates the inventory account.
Business owners are free to choose between periodic and perpetual inventory systems because the GAAP doesn't have a required inventory system. The GAAP is the set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB) to guide virtually every accounting scenario.
How Do You Calculate Inventory Using a Periodic System?
With the periodic inventory system, you set a predetermined time frame to physically count your inventory. After each count or at the end of the year, you take the ending inventory balance and update your cost of goods sold (COGS).
Calculate the Beginning Inventory
With the periodic inventory method, the ending inventory from your previous physical count becomes the beginning inventory for the next period.
Total the Amount of Purchase
Add up inventory purchases, raw materials, and merchandise that you purchased during the accounting period. Deduct purchase discounts or purchase returns, if any. Purchase returns refer to defective items you returned to the supplier.
Calculate the Closing Inventory
The closing inventory is the total of all products you have on hand. Deduct expired goods or materials, if any.
Determine the Cost of Goods Sold (COGS)
Use the following formulas to calculate for the cost of goods sold (COGS):
| Beginning Inventory |
| + Purchases |
| Cost of Goods Available for Sale |
| Cost of Goods Available for Sale |
| − Closing Inventory |
| COGS |
(Where beginning inventory equals the ending inventory balance from the last physical count)
Example Using the Periodic Inventory Method
To illustrate how to record and calculate for your cost of inventory and the cost of goods sold using the periodic inventory method, let's assume the following figures for a retail shop selling organic beauty products:
- Beginning inventory = $10,000
- Purchases for January = $5,000
- Closing inventory (ending inventory) after end-of-month count = $7,000
- There are no defective or expired items to account for this counting period.
Again, the formula for the cost of goods sold is:
| Cost of Goods Available for Sale |
| − Closing Inventory |
| COGS |
We'll need to find the total cost of goods available during the accounting period and then calculate the cost of goods sold.
| Beginning Inventory |
| + Purchases |
| Cost of Goods Available for Sale |
| $10,000 |
| + $5,000 |
| $15,000 |
| Cost of Goods Available for Sale |
| − Closing Inventory |
| COGS |
| $15,000 |
| − $7,000 |
| $8,000 |
In the periodic inventory system, GAAP standards require a business to maintain a ledger where it can record the cost of inventory during the course of an accounting period in a "purchases account."
The entry in the ledger would look like this if the purchases worth $5,000 were bought on credit:
| Date | Accounts | Debit | Credit |
|---|---|---|---|
| Jan 15 | Purchases | $5,000 | |
| Accounts Payable | $5,000 |
If the inventory were paid for in cash, the entry would look like this:
| Date | Accounts | Debit | Credit |
|---|---|---|---|
| Jan 15 | Purchases | $5,000 | |
| Cash | $5,000 |
At the end of the period, you or your employees would do a physical inventory count to determine the ending inventory balance. You'll calculate the COGS and update your ledger. The entry in the ledger would be:
| Date | Accounts | Debit | Credit |
|---|---|---|---|
| Jan 31 | Inventory | $8,000 | |
| Purchases | $8,000 |
These journal entries are examples of how you'll record purchases and the cost of sales at the end of the accounting period if you're using a periodic inventory system.
Try Skynova's accounting software, and you won't have to spend time learning how to do your own journaling. The double-entry accounting feature records every transaction, ensuring there's a complete accounting record for your business. You can also view real-time records of your earnings and expenses through the general ledger.
Should You Use This Method for Your Inventory Records?
The periodic inventory system is a simple, cost-effective method best suited for:
- A business that maintains minimal inventory
- A business that carries inventory that is easy to count (e.g., furniture)
- A business that carries a small variety of products
- A business that processes a relatively small number of sales per day or week (e.g., art galleries, car dealerships)
Small business owners generally adopt the periodic inventory system while building their company. The important thing is that you have a process to monitor your inventory. You can reassess your needs as your business grows; you may decide to switch to the perpetual method when the benefits outweigh the costs of installing the system.
Read on for a list of the benefits and downsides of the periodic inventory method.
Benefits of Using the Periodic Inventory Method
- Simple system: The periodic system is not time-consuming since it doesn't involve exhaustive monitoring and recording of inventory, and it's all done manually.
- Ideal for small businesses: A small business owner with no employees can easily implement the system.
- Less expensive: The periodic system doesn't require expensive software and the added cost of training employees.
- High probability of discrepancies: Since the periodic system is manual, it's more prone to human error. Mistakes could happen while counting or recording, and the information can be misplaced or lost.
- Inaccurate inventory numbers between counting periods: The periodic system creates a gap in information regarding inventory levels and inventory value between counting periods. For instance, by the time business owners do their physical count and discover that they're low on best-selling merchandise, it might be too late to order, or they've already lost sales.
- Slower response to inventory losses: With the periodic method, defective items and obsolete inventory may not be discovered, returned to suppliers, or recorded as losses until the next counting period.
- Weaker inventory control: Businesses can't accurately account for theft and errors with the periodic method, and forecasting how much and when to order inventory will not be accurate because there's no information available between counting periods.
Challenges of Using the Periodic Inventory Method
- High probability of discrepancies: Since the periodic system is manual, it's more prone to human error. Mistakes could happen while counting or recording, and the information can be misplaced or lost.
- Inaccurate inventory numbers between counting periods: The periodic system creates a gap in information regarding inventory levels and inventory value between counting periods. For instance, by the time business owners do their physical count and discover that they're low on best-selling merchandise, it might be too late to order, or they've already lost sales.
- Slower response to inventory losses: With the periodic method, defective items and obsolete inventory may not be discovered, returned to suppliers, or recorded as losses until the next counting period.
- Weaker inventory control: Businesses cannot accurately account for theft and errors with the periodic method, and forecasting how much and when to order inventory will not be accurate because there is no information available between counting periods.
Let Skynova Help You Manage Your Inventory
Get an accurate view of your company's financial health with Skynova's all-in-one invoicing and accounting software. Check your income and expenses in real time for better-informed business decisions. You can also use the software to generate financial statement reports like income statements, balance sheets, and cash flow statements anytime you need them.
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Notice to the Reader
The content within this article is meant to be used as general guidelines in the periodic inventory system and may not apply to your specific situation. Always consult with a professional accountant to ensure you're using methods best suited to your business needs.