Understanding the periodic inventory system for small businesses: Benefits and implementation

When every dollar and cent counts in the search for profitability, deploying an effective inventory management system can be a huge benefit.

What is a periodic inventory system?

The periodic inventory system definition is simple: businesses calculate stock levels and the cost of goods sold (COGS) at set intervals, whether monthly, quarterly, or annually. This is in contrast to a perpetual stock counting system, where the balance is continually updated – a process that can be time-consuming and burdensome, especially for businesses that sell lower volumes.

The periodic inventory management system allows organizations to compare inventory sales at the beginning and end of a fixed period, using the results to make appropriate stocking and accounting decisions.

How does periodic inventory work?

Unlike perpetual inventory systems, periodic inventory systems take a more hands-on approach. Here’s a breakdown of what the process entails.

Decide how often inventory should be counted

Sellers have the flexibility to define their own inventory tracking intervals within a periodic system. The optimal choice hinges on several factors specific to your business, including:

• Sales volume and velocity. Businesses with high sales volumes and rapid inventory turnover might require more frequent counts to maintain accurate records and avoid stockouts. Conversely, those with slower-moving inventory might find quarterly or even annual counts sufficient.

• Product types. Perishable goods or items with short shelf lives necessitate more frequent counting to minimize spoilage and waste. Durable goods or products with longer lifespans might allow for less frequent counts.

• Industry standards. Certain industries have established norms or regulatory requirements regarding inventory counting frequency. For example, the food and beverage industry often mandates stricter inventory controls and more frequent counts due to food safety concerns. Similarly, heavily regulated sectors like pharmaceuticals might have specific inventory tracking requirements.

Take a physical count of the inventory

At the end of the set period, employees will spend time taking a physical count of inventory. This encompasses not only readily available products on shelves or in warehouses but also those in transit or temporarily unavailable due to various reasons (e.g., being held for customer pickup, undergoing repairs, etc.).

Accuracy is key here – after all, the physical count forms the foundation for subsequent calculations and financial reporting. Employing standardized counting procedures, such as checklists or inventory management software, and double-checking counts can help minimize errors.

Record the account

Once the physical count is complete, it's time to record the product quantities. This data is typically entered into a digital database or inventory management software, ensuring a centralized and organized repository for your inventory information.

This digital inventory record serves as the foundation for any subsequent calculations and analysis needed for tracking inventory flows, identifying trends, and making informed business decisions.

Calculate the Cost of Goods Sold (COGS)

The periodic inventory system relies on calculating the Cost of Goods Sold (COGS). You can use this simple formula to calculate COGS:

COGS = (beginning inventory + purchases) - ending inventory

• Beginning inventory. The value of your inventory at the start of the accounting period.

• Purchases. The total cost of all goods purchased during the period, including any freight or transportation costs.

• Ending inventory. The value of your inventory at the end of the accounting period as determined through the physical count.

By subtracting the ending inventory value from the combined value of beginning inventory and purchases, you essentially calculate the cost of the goods that were sold during the period – essential information for financial reporting, profitability analysis, and tax purposes.

Learn more about COGS and why this calculation is important.

When is a periodic inventory system used?

When debating between a periodic or perpetual inventory system, consider these factors:

• Intermittent tracking needs. Periodic inventory systems are used in situations where a perpetual system is unnecessary due to low or slow-moving stock levels.

• Limited resources. A manual approach may be more practical if a small business does not have the resources to use automated perpetual count technology, which can be costly and difficult to maintain.

The benefits of a periodic inventory system

Here are some of the key advantages that make periodic inventory systems appealing:

• Simplicity and affordability. By counting manually and periodically, you reduce the technical complexities and associated costs of implementing a perpetual counting system.

• Resource efficiency. Counting stock only when necessary can help reduce staff workloads and free up resources for other business activities.

The challenges of periodic inventory

There are some potential drawbacks associated with periodic inventory systems to be aware of, such as:

• Lack of real-time insights. Information gaps can occur between counting periods, meaning the system may not be as responsive to changes in demand. Businesses with shifting sales levels may need to increase the frequency of their counting periods.

• Inventory discrepancies. An inventory count is only as accurate as the staff conducting it. Discrepancies can occur through human error, creating future accounting issues.

• Inventory carrying costs. Storing unsold goods can be costly. A periodic count may not reveal depreciation and lost opportunities quickly enough.

• Need for write-downs. If inventory becomes obsolete or damaged between counting periods, it may require write-downs, impacting profitability.

Tips for implementing a periodic inventory system

Ready to get started with a periodic inventory system? Keep these tips in mind:

• Set counting intervals. Select a counting period that reflects the speed of sales, seasonal fluctuations, and accounting needs. Adjust the length of intervals as necessary so the system always provides the right data for business decisions.

• Track and document with accuracy. Reliable counting and record-keeping are fundamental to an effective periodic inventory system. This ensures monthly, quarterly, and annual records are reliable and can be used to make meaningful business decisions.

• Collaborate with vendors. Collaboration can align orders and reduce overstocking. This reduces inventory carrying costs and overstocking.

Strategies for making the most of periodic inventory

Beyond the basics, here are some additional strategies to maximize the benefits of a periodic inventory system:

• Forecast demand. Historical insights from inventory data collection can help businesses predict inventory needs between counting periods, reducing the risk of over- and under-stocking.

• Calculate safety stock levels. Periodic counting determines safety stock levels and reduces stockouts during periods of higher demand.

• Conduct regular audits. Identify discrepancies and continually adjust inventory systems for increased profitability. Keep the system under regular review to ensure it's working for your business.

Explore insights that can help you grow, drive sales, and optimize your operations management strategy. Visit the PayPal Resource Center for detailed guides designed for small to medium-sized businesses.