What is Physical Inventory?

Physical inventory is an actual count of the goods in stock. This can involve counting, weighing, and otherwise measuring items, as well as asking third parties for counts of inventory items that have been consigned to them. If a business is maintaining inventory records for each item in stock, then these counts are compared to the recorded balances; the recorded amounts are then changed to match the physical counts.

Physical Inventory for a Periodic Inventory System

If a business is maintaining a periodic inventory system, a physical inventory is used to derive the ending inventory balance. This information is then used to calculate the cost of goods sold since the last physical count, using the following formula:

Beginning inventory + Purchases - Ending inventory = Cost of goods sold

In a periodic inventory system, the inventory valuation is only correct on the day when a physical inventory is taken. From that point on, there is a divergence between the value of the on-hand inventory and the value of the inventory as of the day of the physical count.

Physical Inventory for a Perpetual Inventory System

In a perpetual inventory system, there is no immediate need for a physical inventory. Under this system, additions to inventory are added to the inventory records as they occur, while removals from inventory are deducted from the accounting records as they occur. Theoretically, this should mean that there is never a need for a physical inventory. In reality, theft and spoilage will result in an on-hand inventory that is lower than the amount indicated in the inventory records. Therefore, to improve the accuracy of the inventory records, it is customary for an organization using a perpetual inventory system to still conduct a physical inventory count - usually at the end of its fiscal year, and sometimes more frequently.