What Is Periodic Inventory System? How It Works and Benefits

What Is Periodic Inventory?

The term periodic inventory system refers to a method of inventory valuation for financial reporting purposes in which a physical count of the inventory is performed at specific intervals. As an accounting method, periodic inventory takes inventory at the beginning of a period, adds new inventory purchases during the period, and deducts ending inventory to derive the cost of goods sold (COGS). It is both easier to implement and cost-effective by companies that use it, which are usually small businesses.

Key Takeaways

  • Periodic inventory is an accounting method that requires a physical inventory count at specific intervals.
  • Periodic inventory counts may be executed monthly, quarterly, or annually, rather than regularly or after each sale.
  • Small businesses with few employees and companies that sell low volumes often use the periodic inventory system.
  • This method of accounting is often easier and more cost-effective to implement.
  • Larger, more established companies use the perpetual inventory system, which updates their inventory lists on a regular basis—even after goods are sold.

How Periodic Inventory Works

The term inventory refers to the raw materials or finished goods that companies have on hand and available for sale. Inventory is commonly held by a business during the normal course of business. It is among the most valuable assets that a company has because it is one of the primary sources of revenue.

There are several ways that companies can account for their inventory. One of these is the periodic inventory system. This accounting method requires a physical count of inventory at specific times, such as at the end of the quarter or fiscal year. This means that a company using this system tracks the inventory on hand at the beginning and end of that specific accounting period. The inventory isn't tracked on a regular basis or when sales are executed. The periodic inventory system also allows companies to determine the cost of goods sold.

Periodic inventory is normally used by small companies that don't necessarily have the manpower to conduct regular inventory counts. These companies often don't need accounting software to do the counts, which means inventory is counted by hand. As such, the system is commonly used by companies that sell small quantities of inventory, including art and auto dealers.

One of the main benefits of using periodic inventory as a method of accounting is that is it easy and cheap to implement. That's because it doesn't have to occur on a regular basis. It doesn't require fancy software or even extra hands, especially for businesses that sell a very low volume of goods. But there are drawbacks as well, which include:

  • The possibility of human error
  • Problems detecting defects and/or theft
  • The potential need to shut down operations to do a count

A company's COGS vary dramatically with inventory levels, as it is often cheaper to buy in bulk, especially if it has the storage space to accommodate the stock.

Periodic Inventory vs. Perpetual Inventory

Under the periodic inventory system, a company doesn't know its unit inventory levels nor its COGS until the physical count process is complete. This system may, in fact, be acceptable for a business with a low number of stock-keeping units (SKUs) in a slow-moving market.

For others, the perpetual inventory system is considered superior for the following main reasons:

  1. The perpetual system continuously updates the inventory asset ledger in a company's database system. This gives management an instant view of inventory. The periodic system is, therefore, time-consuming and can produce stale numbers that are less useful to management.
  2. The perpetual system keeps updated COGS as movements of inventory occur compared to the periodic system, which cannot give accurate COGS figures between counting periods.
  3. The perpetual system tracks individual inventory items. This means that if there are any defective items, the source of the problem can quickly be identified. Contrast this with the periodic system, which most likely would not allow for prompt resolution.
  4. The perpetual system is tech-based and data can be backed up, organized, and manipulated to generate informative reports. On the other hand, the periodic system is manual and more prone to human error, and data can be misplaced or lost.

Many companies may start off with a periodic system because they don't have enough employees to do regular inventory counts. But this can change as companies grow, which means they may end up using the perpetual inventory system when their labor pool expands.

Example of Periodic Inventory

The cost of goods sold is a fundamental income statement account. But a company using a periodic inventory system will not know the amount for its accounting records until the physical count is completed.

Let's suppose the value of a company's inventory is $500,000 on January 1. The company purchases $250,000 worth of inventory during a three-month period. After a physical inventory count, the company determines the value of its inventory is $400,000 on March 31. This becomes the beginning inventory amount for the next quarter. COGS for the first quarter of the year is $350,000 ($500,000 beginning + $250,000 purchases - $400,000 ending).

Due to the time discrepancies, it becomes the onus of the manager or business owner responsible for monitoring the period inventory if it makes sense to the bottom line to allocate hours to count inventory daily, weekly, monthly, or yearly.

What Are the Advantages of a Periodic Inventory System?

The periodic inventory system is commonly used by businesses that sell a small quantity of goods during an accounting period. These companies often find it beneficial to use this system because it is easy to implement and because it is cost-effective, as it doesn't require any fancy software.

Can You Determine Shrinkage in the Periodic Inventory System?

Inventory shrinkage happens when there is a discrepancy between the actual stock and the inventory list. As such, the actual stock is lower than what's recorded on the list. Shrinkage isn't necessarily evident in the periodic inventory system. That's because it takes the inventory at the beginning of the reporting period and at the end unlike the perpetual system, which takes regular inventory counts. So if there is any theft, damage, or unknown causes of loss, it isn't automatically evident.

When Would You Use a Periodic Inventory System?

Companies would normally use a periodic inventory system if they sell a small quantity of goods and/or if they don't have enough employees to conduct a perpetual inventory count. Small businesses, art dealers, and car dealers are several examples of the types of companies that would use this accounting method.