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November 27, 2015

Inventory Systems

There are basically 2 methods of recording inventory transactions, Periodic and Perpetual.  Let’s take a look at each method to determine which is more beneficial to the business owner.

To begin, we must understand how bookkeeping handles each method.  For our purposes, to make understanding easier, we will ignore sales tax.

Purchasing Items for Resale

Periodic

Purchases (Expense account) Debit  
Accounts Payable (Liability account)   Credit

 

Perpetual

Inventory (Asset account) Debit  
Accounts Payable (Liability account)   Credit

 

As you can see, in a periodic system, inventory you purchase is expensed immediately as opposed to a perpetual system that correctly records the purchase in an asset account.

Selling Items

Periodic

Cash (Asset account) Debit  
Sales (Revenue account)   Credit

 

Perpetual

Cash (Asset account) Debit  
Sales (Revenue account)   Credit
Cost of Sales (Expense account) Debit  
Inventory (Asset account)   Credit

 

When selling items, a periodic system only cares about recording the funds received and the sale.  A perpetual inventory system reduces the inventory asset when the item is sold and the offset is to the expense account Cost of Sales.  In this way, your Gross Profit (Sales minus Cost of Sales) matches the revenue with the expense each time a sale is recorded.

Now let’s take a look at the Income Statement for each method.

Periodic

Sales   10,000
Cost of Sales:    
  Beginning Inventory 2,000  
  Plus Purchases 20,000  
  Less Ending Inventory 16,000  
  Equals Cost of Sales   6,000
Gross Profit   4,000

 

Perpetual

Sales 10,000
Cost of Sales 6,000
Gross Profit 4,000

 

Notice that the cost of sales in a periodic system is a calculation and can’t be determined without an ending inventory value.  This means that if you are using a periodic system, your monthly income statement is of no value unless you counted and valued your inventory at the end of each month.

One other major problem with a periodic inventory system is inventory shrinkage.  Since the calculation uses the ending inventory value for cost of sales, any shrinkage is buried and you, as the owner, will never know the value of the inventory that is walking out the door.  In a perpetual inventory system, since purchases are tracked through the asset account and the cost of sales only reflect the items sold, inventory shrinkage must be recorded in an expense account that you can easily monitor.

If you have any questions, please don’t hesitate to contact me at barry@retailmagicpos.ca

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