Perpetual inventory system
/What is a Perpetual Inventory System?
Under the perpetual inventory system, an entity continually updates its inventory records in real time. To do this, it constantly updates an inventory database to account for received inventory items, goods sold from stock, items moved from one location to another, items picked from inventory for use in the production process, and items scrapped.
Perpetual inventory is by far the preferred method for tracking inventory, since it can yield reasonably accurate results on an ongoing basis, if properly managed. The system works best when coupled with a computer database of inventory quantities and bin locations, which is updated in real time by the warehouse staff using wireless bar code scanners, or by sales clerks using point of sale terminals. It is least effective when changes are recorded on inventory cards, since there is a significant chance that entries will not be made, will be made incorrectly, or will not be made in a timely manner.
The perpetual inventory system is a requirement for any organization planning to install a material requirements planning system.
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Advantages of a Perpetual Inventory System
There are multiple advantages associated with operating a perpetual inventory system, which give a company the ability to operate more effectively. We describe these advantages below:
Avoid ongoing physical inventory counts. With a perpetual inventory system, it is no longer necessary to continually conduct physical inventory counts. This is a major advantage, since any physical count requires a business to shut down its warehousing operations for the duration of the count. In addition, this means that the outside auditors do not have to observe an inventory count; instead, they are handed an inventory report containing inventory locations and unit quantities, which they can verify against the actual inventory.
Trustworthy inventory records. Because a perpetual system ensures that all inventory transactions are recorded in real time, the resulting inventory records can be relied upon to be highly accurate (especially when bolstered with an ongoing cycle counting program). With a high degree of record accuracy, inventory reordering can be conducted with confidence. Also, it means that a business can reliably promise firm delivery dates to its customers, which enhances customer satisfaction and may even increase sales.
Detailed paper trail. A perpetual inventory system includes records for every transaction that involves inventory. This makes it easier to track down record keeping errors anywhere in the company. Not only is this a good control, but it also means that transaction investigations can be used to improve procedures and training, which in turn increases inventory record accuracy over time. This control is especially useful when a user ID is associated with each transaction recorded in the system, so that you can identify who is making incorrect entries.
Reduced inventory investment. Since a perpetual system increases inventory record accuracy, the materials management staff can rely on the resulting on-hand balance information. This means that a business does not have to invest in excess inventory, as would have been the case if management did not trust the inventory numbers, and so wanted to keep excess inventory reserves on hand. Instead, inventory levels can be pared down, resulting in a smaller inventory investment.
Integration with other systems. A crucial advantage of having a perpetual inventory system is the record accuracy that it brings to other systems. For example, the customer service staff can now tell customers exactly how many units are available for shipment. Also, the materials management staff can rely on the inventory records to plan for how many additional units need to be produced or ordered from suppliers. In addition, the accounting department can now rely on the inventory records to devise the ending inventory balance for month-end reporting.
Disadvantages of a Perpetual Inventory System
The calculated inventory levels derived by a perpetual inventory system may gradually diverge from actual inventory levels, due to unrecorded transactions or theft. Therefore, you should periodically compare book balances to actual on-hand quantities (typically using cycle counting) and adjust the book balances as necessary. Cycle counting involves having the warehouse staff count a small portion of the inventory every day, and compare the results to the inventory records; they should investigate and correct any variances as soon as possible, resulting in more accurate inventory records.
When to Use a Perpetual Inventory System
A business should use a perpetual inventory system when it needs to have a detailed knowledge of exactly how many units are in stock at all times. It is especially important when the inventory investment is large and when there are many product types in stock. Without a perpetual system, a business would not be able to accurately tell its customers exactly when it can fulfill their orders. It is also a useful system for businesses that are growing rapidly, since these organizations need to maintain tight control over their working capital investments. In addition, any business that has committed to the rapid fulfillment of customer orders needs to have a detailed knowledge of its inventory balances, which only a perpetual system can provide.
There are also a few cases in which a perpetual inventory system is not needed. One such case is when the cost per unit of inventory is quite low, which allows a business to maintain large buffer stocks with a minimal investment. Also, when products are mostly made to order, only raw materials are kept on hand, so monitoring inventory with a perpetual system is not as necessary.
How to Track Inventory Under a Perpetual Inventory System
The proper maintenance of a perpetual inventory system requires that a large number of transactions be recorded in real time. To do so with minimal errors, each inventory item should be tagged with a bar code or an RFID tag. These tags are used as the basis for a transaction every time an unit is received from a customer, moved within the company, or sold. Any manual entry greatly increases the risk of data entry errors, which reduces the accuracy of the inventory records. For example, a retail store may sell thousands of items per day, each of which must be recorded as a reduction in the on-hand quantity. Without bar code labels or RFID tags, it is quite likely that these sales would be charged to the wrong units, or in the wrong quantities, or not recorded at all.
It is also essential to maintain a system of proper inventory controls. This includes a policy of recording all transactions in the system without delay, as well as recording any units that are damaged or lost, so that they are removed from the system. In addition, cycle counting should be conducted, where a small number of items are counted every day and compared to the inventory record to see if there are any differences. An effective cycle counting program should be used to track down recurring error types, and to alter the associated procedures to ensure that these errors do not occur again.
Perpetual Inventory Journal Entries
The following example contains several journal entries used to account for transactions in a perpetual inventory system:
1. To record a purchase of $1,500 of widgets that are stored in inventory:
| Debit | Credit | |
| Inventory | 1,500 | |
| Accounts payable | 1,500 |
2. To record $300 of inbound freight cost associated with the delivery of inventory:
| Debit | Credit | |
| Inventory | 300 | |
| Accounts payable | 300 |
3. To record a sale of widgets from inventory for $3,000, for which the associated inventory cost is $1,800:
| Debit | Credit | |
| Accounts receivable | 3,000 | |
| Revenue | 3,000 | |
| Cost of goods sold | 1,800 | |
| Inventory | 1,800 |
4. To record a downward inventory adjustment of $800, caused by inventory theft, and detected during an inventory count:
| Debit | Credit | |
| Inventory shrinkage expense | 800 | |
| Inventory | 800 |
Perpetual vs. Periodic Inventory Systems
As just noted, a perpetual inventory system maintains inventory balance information in real time. A periodic inventory system does not maintain such an accurate set of inventory records. Instead, a periodic system relies on an occasional physical inventory count, perhaps on a quarterly or annual basis. At all other times, the inventory records under a periodic inventory system will not reflect the amount of inventory that is actually on hand. Despite their inherent inaccuracy, periodic inventory systems can be useful in situations where the inventory value is low and a company does not have much of it. In these situations, a simple manual scan of the inventory may be sufficient to verify whether there is any inventory on hand. Clearly, periodic inventory systems are used by quite small businesses that operate with relatively primitive paper-based systems. Organizations with larger inventory counts or more valuable inventory, and especially those with sophisticated materials management systems, will need to use a perpetual inventory system.
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