Merchandise businesses can record their inventory with either a periodic inventory system or a perpetual inventory system.
A periodic inventory system records merchandise transactions periodically, usually at the end of the year. Whereas with a perpetual inventory system, all transactions, along with inventory costs and sales of merchandise get recorded immediately as they occur.
In the past, both systems were widely spread.
Nowadays, however, with the growing use of automated and digitized software, the perpetual inventory system has become incredibly easy and cost-effective to implement.
Hence, most businesses, even smaller ones, tend to go for a perpetual inventory system as it ensures more accurate bookkeeping.
In this guide, we will be explaining what a perpetual inventory system is, its advantages, and whether or not it is the right inventory management practice for your small business accounting.
Read along to learn about:
- What Is a Perpetual Inventory System?
- Periodic vs Perpetual Inventory System
- How Does the Perpetual Inventory System Work?
- Inventory Valuation Methods
- Advantages of Perpetual Inventory System
- Journal Entries for Perpetual Inventory
- Perpetual Inventory System with Deskera
What Is a Perpetual Inventory System?
A perpetual inventory system is an inventory management method that records each sale or purchase of inventory in real-time, through automated software.
With a perpetual inventory system, each sale or purchase of merchandise is updated on a real-time basis automatically, thus providing you with a full financial picture of your inventory levels.
The system lets you access inventory reports at any time, updates stock levels, and almost completely reduces human errors through automation.
With that being said, there are a few factors that may require manual input in the system, such as theft, damage, or loss of inventory. Make sure to occasionally check your actual physical inventory and compare the total displayed by the perpetual inventory system.
If you want to learn more about inventory accounting, and how to properly streamline your inventory management process, head over to our complete guide on inventory management.
Who Uses a Perpetual Inventory System?
When business owners or management need up-to-date information about inventory levels, then using a perpetual inventory system is the way to go.
So, for the most part, large businesses with a high number of sales and several retail outlets, such as pharmacies, and grocery stores require a perpetual inventory system.
Small businesses that are looking to expand, or want to take more control over their merchandise, also prefer a perpetual system, as there are plenty of intuitive and low-cost perpetual software options in the market today.
Periodic vs Perpetual Inventory System
While we did explain above the main difference between periodic and perpetual inventory systems, we did not cover all the core features that differentiate the two.
With a perpetual inventory, all transactions involving costs of merchandise get recorded immediately as they occur. For instance, take grocery stores - each time a product is bought and scanned, the system updates inventory levels in the database.
In a periodic inventory system, on the other hand, reports of inventory and cost of goods sold aren’t kept daily, but periodically, usually at the end of each fiscal year, or at the end of each month. This type of inventory management involves physically counting all your stock (at regular intervals) and cross-referencing that data with the sales data to find any discrepancies.
As you might have guessed already, this process is extremely tedious, time-consuming, and prone to a lot of errors.
That’s why most businesses nowadays, use perpetual inventory systems to manage their inventory.
Being able to check inventory levels and the cost of goods sold, in real-time, can save your employees and your business a considerable amount of time and money.
If you want to learn more about the details and uses of periodic inventory, head over to our guide on the periodic inventory system.
How Does the Perpetual Inventory System Work?
Every time merchandise is bought or sold, the perpetual inventory system will continuously update inventory levels automatically. This constant updating allows businesses to always be aware of their best-selling goods and services, as well as, what inventory is running low on supply.
Here is the step-by-step process of how the automation of the perpetual inventory system works.
Step #1: Point-of-Sale System
A point-of-sale or POS system is the hardware that enables businesses to make sales at a physical store. Through a barcode scanner, the POS system calculates the price of the item and updates the inventory count to show that the item is sold.
After the customer pays, through a credit card or cash, the POS system processes the payment, and a digital receipt is created.
Step #2: Update Cost of Goods Sold
Whenever a sale happens, the perpetual inventory system automatically recalculates and updates the corresponding cost of goods sold.
Step #3: Reorder Point Automation
The sale also triggers an automatic update on inventory levels.
Businesses dealing with inventory have minimum required stock levels they need to maintain for every type of good. Whenever a stock amount falls below this minimum, the system sends out a notification suggesting you to order more stock.
This is known as a reorder point.
A perpetual inventory system uses the historical data of the business to automatically update these reorder points and keep inventory levels optimal at all times.
Step #4: Purchase Order Automation
The system not only updates reorder points but also generates the purchase orders necessary for restocking, with zero human interference.
In other words, it can be set up to automatically issue purchase orders, whenever stock levels fall below the required threshold.
Step #5: Warehouse Management Software
A perpetual inventory system comes with a warehouse management system (WMS), which is software designed to support and optimize distribution management.
So, whenever inventory is sent to a warehouse, employees can use the WMS to easily scan the product. The product will then automatically appear in the inventory management dashboard, available for sale on all sales channels.
Inventory Valuation Methods
In a perpetual inventory system, there are three main methods you can choose from to account for inventory: FIFO, LIFO, and the average method.
FIFO stands for First-In-First-Out, and it’s based on the assumption that the first merchandise bought is the first one sold.
To better visualize this method, you can think of FIFO as a queue. The first person that’s queued, is also the first person to go out.
The LIFO method, or Last-In-First-Out method, assumes that the most recently purchased merchandise is sold first.
A better way to visualize LIFO is by imagining a stack of plates. The first plate (the one you placed at the bottom), will be the last one to go out because you’ll first have to remove all the plates that were placed on top of it.
3. Weighted Average Method
The weighted average method, also known as the average-cost method, calculates the cost of merchandise based on the average cost of all units.
The average cost is computed by dividing the total cost of inventory available by the number of units.
Keep in mind that whichever inventory method a business decides to go with, it does not affect performance. These methods only have an effect on the way income taxes are reported.
For instance, depending on price fluctuations, a company that wants to appear less profitable in an accounting period in order to pay fewer taxes, can decide to opt in for LIFO instead of FIFO.
If you want to learn more about how to use these inventory methods, check out our guide on the different inventory valuation methods, with business examples.
Principle of Consistency
The principle of consistency states that, once a business has adopted one of the three inventory methods mentioned, they should follow that method consistently.
That doesn’t prohibit a business from ever switching their inventory valuation method, though. A change can be made, but the reasons for the change have to be explained, and the business’ net income must also be fully disclosed.
Advantages of Perpetual Inventory System
A perpetual inventory system recognizes changes in inventory levels, as soon as a sale or purchase takes place.
This constant inventory tracking provides businesses with the advantage of always knowing which goods may be running low so that they can respond on time and avoid stock-outs or shortages.
And if you’re managing a big business that operates in several locations and uses several warehouses, a perpetual inventory system allows you to manage everything with ease, through one central automated system.
Planning and Forecasting
The perpetual inventory system helps businesses improve their demand forecasts by analyzing the data trends from historical transactions.
Businesses can get a better understanding of their customer’s buying patterns, along with insight on best-selling products and growing segments.
Save Time and Minimize Error
There’s nothing better than automating tedious, repetitive, and time-consuming tasks for you and your employees!
A perpetual inventory system saves your business time, money, and prevents a handful of human accounting errors that can occur along the way.
Journal Entries for Perpetual Inventory
When dealing with inventory accounting, you’ll likely find yourself journalizing transactions. Below you’ll find some of the most common journal entries you’ll need, to do accounting for your inventory.
1. Purchase of Merchandise at Cost
To record the purchase of merchandise at cost, inventory is debited and accounts payable credited, as shown below:
2. Payment of AP
The journal entry for making an invoice payment would look like this:
3. Credit Terms
Typically, manufacturers and wholesalers will sell goods on credit. These credit terms are written down in the seller’s bill or invoice.
For the sake of our example, let’s assume that on April 1st, the company purchases another $2,000 worth of merchandise, on credit, with payment terms 2/10 net 30.
A 2/10 net 30 payment term means that the buyer has 30 days to pay back its vendor, but can get a 2% discount if they pay within 10 days.
Now, Company XYZ records their purchases at net cost, which is the invoice price of $2,000 minus the 2% available discount, which amounts to $40.
Therefore, the company will record this purchase as follows:
If the company fails to pay within 30 days, and losses the discount, the following journal entry will be made to record the loss:
4. Sale of Merchandise
When a business sells merchandise, two journal entries need to be created: one to recognize the sale, and another to record the costs of goods sold.
5. Collection of AR
Cash collection of accounts receivable is recorded as shown below:
Want to learn more about the different types of accounts and how to properly journalize them? Head over to our guide on journalizing transactions, with definitions and examples for business.
Perpetual Inventory System with Deskera
By now you’re probably convinced of the benefits and advantages that a perpetual inventory system can bring to your business.
So, you might be wondering, how do I choose the best inventory management software for my small business?
Well, the right perpetual inventory system will help you automate almost every part of your inventory management.
The Deskera inventory management software is an intuitive, online software that helps you to manage and track your inventory, prevent stock shortages, issue credit notes for returns, operate multiple stores/warehouses, and ensure accurate record-keeping. All in one place!
And that’s not even the best part!
Sign up for Deskera and start your free trial now! No credit card details necessary.
A perpetual inventory system will give your business an accurate view of inventory and stock levels anytime, anywhere, without the trouble of manually processing every transaction by hand.
At the same time, the system prevents error, helps you prevent any imprecision, and allows you to manage multiple locations from one centralized place.
With the Deskera inventory management software, you can obtain all of these benefits and so much more, with as little as $149 per year, per user.