Perpetual Inventory

Most small businesses use the annual inventory system to determine ending inventory value. Any adjustments are to the income statement inside the cost of goods sold formula. This is acceptable if management only wanted accurate financial statements once a year. But this is unrealistic for a small business. Good operations will want interim financial reports to stay abreast of achieving business goals. To increase the accuracy of interim financial statements and provide greater confidence in the balance sheet value for inventory management should implement a perpetual inventory system.

Almost all perpetual inventory systems are a function of the accounting software or a separate accounting software (independent of the main accounting program or as a module to the existing accounting software). So perpetual inventory implementation is a technology issue in accounting.

To fully understand perpetual inventory I will first explain the annual inventory function and its benefits along with the corresponding drawbacks. Then I’ll explain the perpetual inventory system and its benefits. There are a few drawbacks which are explained too.

Annual Inventory

Typically at year end the business conducts an inventory. This process is physical in nature. Once completed the ending dollar value is inserted into the cost of goods sold formula. Here is the formula:

Beginning Inventory                $ZZ,ZZZ
Add Purchases                         ZZZ,ZZZ
Less Ending Inventory             (ZZ,ZZZ)
Total Cost of Goods Sold      $ZZZ,ZZZ

An interesting side note, the ending inventory is the beginning inventory value for the next accounting cycle.

This system adjusts cost of goods sold for several factors simultaneously. It automatically adjusts for lost, stolen, expired and receiving errors. There is no sub system available to account for dollar values of the various factors sighted. The annual inventory system adjusts cost of goods sold in one fell swoop for all of these dollar values.

Think of the annual inventory system as a physical count whereby each item group is multiplied by the purchase price for an aggregated value per item. Unlike a once a year system perpetual inventory is ongoing and allows for more accurate interim financial statements.

Perpetual Inventory System

This system utilizes several different methods or combinations of methods to accurately state the value of the inventory on the balance sheet. At the same time perpetual inventory will properly state the correct value for cost of goods sold.

The system relies on an initially accurate inventory count and loading of this count into the database. As inventory is received each particular item is increased in numerical count and associated dollar value in the database. If a particular item is sold, the system reduces the particular item by units sold. At the end of each accounting period a report is printed identifying the respective number of units and their corresponding cost value.

On paper this would appear much more advantageous than the annual physical count system. Advantages include:
* Very accurate interim and annual financial statements
* Ability for staff to look up availability for a particular item
* Provide accurate numerical and dollar value for any item in stock
* Identifies receiving and sold dates

There are customarily two methods used with perpetual inventory. The first method groups items together by common components such as brand and item. For example a perpetual inventory system works well for a business selling cards for occasions (think Hallmark Stores). The system may have several brands and each brand has cards for birthdays, holidays, get well, sympathy and so on. A common characteristic for item groups is the low cost for each respective item, in this case the individual cards. Thus there is no need to track each card individually.

The second method is called the specific identification method. Unlike low price items, this method tracks each individual item separately. Typically the dollar value for each item exceeds $100 therefore justifying the costs to implement. The costs to track expensive items are less than the benefits derived making this method worthwhile. Think of dealers in equipment or appliance sales. This method increases control over these expensive items.

Perpetual inventory is significantly more advantageous than the annual inventory system, but it still has its share of drawbacks.

Drawbacks With Perpetual Inventory

The most significant and expensive drawback to a perpetual inventory system is the cost to keep it updated and maintained. Even a small retail store can expect to invest five to eight hours a week of labor to input deliveries and conduct random physical counts. More advanced businesses with thousand of items, several locations and even a warehouse warrant the cost to implement and update the perpetual inventory system. The benefits of such a system will outperform the associated costs.

Other drawbacks include:
* Constant inputting of information, specifically deliveries of products
* Requirement to use a purchase order system
* Additional training is required for all employees that utilize the system
* Price changes for recently received products create issues in correctly valuing the inventory

For any business that has an inventory value exceeding $250,000 the advantages of the perpetual inventory system will easily cover the associated costs and drawbacks.

Advantages of Perpetual Inventory

The number one advantage perpetual inventory provides is increased internal control over inventory. As businesses grow and prosper losses with inventory mount. I’m not even referring to theft; but simple losses such as:

* Expiration of shelf life – this is of the utmost importance in the food service industry
* Termination of Manufacturer’s Warranty or Incentives – a good perpetual inventory program alerts management that certain brands or product lines have expiring coupons for certain items in the inventory
* Misplaced Items – often requires emergency orders to fulfill contracts because staff can’t locate the item
* Physical Control Over More Expensive Items – a perpetual inventory assigns an employee to maintain physical control over more expensive items thus management has a responsible party to question for any lost item

The real value of internal controls for inventory is the greater certainty that the dollar value of the inventory is accurate. If inventory is a major asset in a business – think of dealerships, heavy equipment retailers, gun shops, jewelers, furniture stores and sporting goods; then the perpetual inventory gives the auditor a higher level of confidence that the dollar value stated on the balance sheet is correct. A sound audit opinion weighs as an overwhelming positive for lenders and other creditors.

The second major advantage of a perpetual inventory system is the existence of a clear process to monitor and control inventory. This requires policies and procedures for all employees to follow. Again the benefits (cost savings) will outperform the actual costs to implement and run.

Summary – Perpetual Inventory

In general small businesses with a limited dollar value or minimal item variation for inventory have no pressing need to implement perpetual inventory. Perpetual inventory systems are expensive and require training and time to maintain. However the benefits exceed the costs as the operation increases the value of the inventory. Perpetual inventory allows for greater controls over this important financial asset. It also allows for more accurate interim financial reports.  ACT ON KNOWLEDGE.

Value Investing

Do you want to learn how to get returns like this?

Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.

There are four key principles used with value investing. Each is required. They are:

  1. Risk Reduction – Buy only high quality stocks;
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  3. Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
  4. Patience – Allow time to work for the investor.

If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above. 

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