What is a Perpetual Inventory System?

One of the biggest nightmares for companies large and small is to realize they’re out of stock on a popular product.

Another common issue? Placing an order for additional goods when you didn’t realize you had hundreds of that same item still in stock.

The solution: a perpetual inventory system. But what, exactly, is perpetual inventory, and will it work for your business? We’ll go into all that and more–so let’s get started.

What is a Perpetual Inventory System?

A perpetual inventory system tracks inventory automatically. It uses barcode scanners and computer software to record sales in your inventory count as soon as they happen. It also records when you receive any inventory items.

This system lets you know when you’ve reached your reordering point, which is when your inventory count gets low enough to reorder the product. It then prompts you to place that order.

Why is a Perpetual Inventory System a Good Thing to Have?

A perpetual inventory system can benefit business owners in a few important ways:

1. Shows Costs of Goods Sold in Real-Time

Since a perpetual inventory system accounts for each product sold at the time of the sale, it always gives you an accurate, real-time picture of your cost of goods sold (COGS).

COGS is essentially how much you’re spending on making your actual products (but it doesn’t include other costs like overhead and insurance).

Once you sell an item, it gets removed from your inventory and counted toward your COGS. So, the faster that whole process happens, the faster you’ll know your costs. Why is that important, you ask?

Knowing your COGS can help you:

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• Figure out if you’re charging too much or too little for your items
• Overpaying for products or materials
• Find your taxable income
• Determine your profitability

In short, a perpetual inventory system helps you figure out your COGS (and those key business metrics) whenever you want—rather than waiting until you’ve had time to do a manual inventory count.

2. Helps You Avoid Stocking Issues

Stocking issues and constant backorders can drive your customers to your competitors. Imagine having a blowout sale only to run out of inventory because someone had entered amounts incorrectly. Your customers might look elsewhere for that coveted item.

But too much inventory can be just as bad since it’s unlikely to be sold, resulting in a lower profit margin and a bunch of products you can’t sell taking up valuable space in your warehouse.  But with a perpetual inventory system, you’ll always know how much you have and when you need to reorder stock. Your inventory levels won’t be a mystery.

3. Helps with Demand Forecasting

Since your inventory information is constantly updated, you can use that current (and historical) data to spot sales cycles and prepare for times when orders go way up—potentially around holidays or other relevant seasons for your company.

You can make sure your supply chain can meet that demand and alert vendors that you may have a big order coming in. That can help improve your relationship with those vendors and potentially help you get bulk discounts on raw materials. Not to mention, if your vendors can’t meet that demand—you’ll have ample lead time to look elsewhere.

4. Improves Accuracy of your Financial Statements

Using a perpetual inventory system gives you more accurate financial statements. Since your COGS is updated in real-time, your income and profit and loss statement will accurately reflect your current costs.

These statements are often scrutinized by lenders when applying for loans. They’ll use them to gauge your profit margin and how risky it is to lend you funds. So, they’re always good to have on hand.

What Is an Example of the Perpetual Inventory Method in Business?

So you know what a perpetual inventory system is in theory, but how does it work in the real world?

Let’s start from the beginning. You decide to open a t-shirt shop. To stock your store, you need to order thousands of t-shirts in all colors and sizes. If you’re using a perpetual inventory system, you can use a barcode scanner, which uses RFID or radiofrequency identification, to scan and read the information found in the barcodes on the t-shirt boxes.

When you scan the barcode, the information, such as quantity, size, and color scan into the inventory. They will be automatically entered into your inventory system, eliminating the need to enter information about each item manually. You can rest assured knowing your inventory quantities have been quickly and accurately recorded.

With your inventory set up, you’re ready to open your doors. Your first customer purchases three t-shirts. When you process the sale, the perpetual system automatically reduces the number of t-shirts in stock by three.

Weeks later, you receive a notice that one of your best-selling t-shirts is almost sold out. You immediately order more, scan the barcode on the box when the new shipment is received, and your inventory totals are automatically updated to reflect the new stock levels.

Even with your perpetual inventory system, you can still do spot checks on inventory items to ensure that products have not been damaged or theft hasn’t occurred. But the need to spend hours and hours counting products and cross-checking inventory records has been virtually eliminated.

Perpetual Inventory System Journal Entries

When you use perpetual inventory management software, your journal entries will be done automatically each time an inventory transaction is processed. These are a few of the typical journal entries that will be made:

When you purchase $5,000 worth of inventory on credit:

When you sell $1,500 worth of inventory to your customers on credit:

When $700 worth of merchandise is returned by your customers:

When there’s a shortage of $600 in inventory that needs to be adjusted:

What is the Difference Between Perpetual and Periodic Inventory Systems?

There are two systems that are used to track inventory—a periodic inventory system and a perpetual inventory system. While both can keep track of stock, they are actually very different approaches to inventory management.

Periodic Inventory

• ‍Requires manual counting and data entry: Companies using a periodic system have to count all their products by hand. Then they adjust their inventory totals on the books to reflect that physical inventory count and check for any discrepancies. This can be very time-consuming and lead to errors in your accounting records.‍
• Used by businesses with lower sales volume: If there isn’t a ton of inventory to manage or count, it might be more affordable to do so manually rather than purchasing a whole new inventory management system and training team members on how to use it.‍
• COGS is updated only when you do inventory counts: Your cost of goods sold balance remains the same until you update your records, usually at the end of the year. Even for smaller businesses, calculating your COGS once or twice a year may not be enough, particularly if you sell a lot of products. Not knowing how much it costs your company to sell a product might cause you to price them way too high or low, pay too much for your goods and even cut into your profit margin.

Perpetual Inventory

• ‍Automatically records all inventory movement: Perpetual inventory updates your inventory count and COGS each time a purchase is made or a product is received. It automates that manual calculation, so you’re free to focus on other important things.
• ‍Eliminates the need to perform inventory counts: Because inventory is updated automatically, you no longer have to schedule frequent inventory counts to verify totals. This saves a lot of time, which you can then allocate elsewhere.‍
• Real-time access to cost of goods sold: You don’t have to wait until the end of an accounting period to know if you’re turning a profit or not. This also means more accurate financial statements, making you, your CFO, your accounting manager, and your lending institution happy.

How Do I Calculate Perpetual Inventory?

When you set up your inventory for the first time, the first thing you’ll want to do is choose an inventory accounting method. Inventory accounting, also known as inventory valuation or inventory costing, is designed to keep track of your expenses so you’ll know how much you’re spending on your products and materials. 

The most common ways to find the cost of inventory are:

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• ‍FIFO (first in, first out): Assumes the oldest inventory in stock is sold before more recent purchases. FIFO is probably the most common inventory costing method since most companies sell older items first.‍
• LIFO (last in, first out): Assumes the most recent inventory purchased is sold before older products. Companies looking to save on taxes will often use LIFO since it can show a lower profit (and taxable income).‍
• Weighted Average Cost: Assigns an average cost to each product that you sell rather than assigning individual pricing for each product. Let’s say you sold pens with $5, $10, and $15 costs. If you sold ten pens for $100 total, your average cost per pen sold would be $10.

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After you choose your costing method, you’ll enter that into your perpetual inventory system. Then it will perform the calculations necessary to keep your inventory values accurate and up to date.

Are There Any Downsides to Using Perpetual Inventory?

Despite its many advantages, there are some downsides to using a perpetual inventory system, starting with cost.

It can be expensive to make the switch to a perpetual inventory system since it usually involves purchasing things like a new point-of-sale system (POS) or peripherals like barcode scanners.

Training team members can also prove to be expensive since there will be multiple systems they’ll need to learn. For some small businesses that don’t sell a lot of products or don’t have a large amount of inventory to manage, it may be difficult to justify the cost.

Perpetual Inventory Can Make Your Life A Lot Easier

Designed to do most of the heavy lifting for you, a perpetual inventory system records all sales transactions immediately.

Not only that, but any products you order can be scanned into the system and accounted for in real-time.

This real-time inventory approach is key to avoiding stockouts or overstocking—in essence, it keeps your inventory balances stable. It also makes sure your record-keeping is super accurate, so you can track how much you’re making off selling your products.

With perpetual inventory systems becoming more affordable every day, there’s no better time than now to make the switch from periodic inventory to a perpetual system. You won’t regret it!