Riding herd on your inventory is one of the most challenging things about operating a business. From the operational side of things, you'll always want to know how much product is available to sell, and when to get more. Your accountants will need accurate inventories as well, so they can keep your books in order and give you the information you need to make business decisions. In most, but not all, cases, you'll probably want to do that through a perpetual inventory system.
Periodic Inventory System
There are two ways to handle your inventory control. One is through what's called a periodic inventory system, which means that at the end of a given period – a month, a quarter, a year or whatever works in your situation – you close your doors, and physically count whatever inventory you have on hand. For accounting purposes, you'll call this the closing inventory for your period. Your previous inventory count was the starting inventory for this period. You'll add all your purchases to the starting inventory, subtract all the sales and in an ideal world, the result will look very much like your closing inventory. Of course, we don't live in an ideal world, and in practice, the longer you go between inventories, the more discrepancies will creep in. Under the periodic inventory system, the amount of inventory is only accurate right after it's counted, which is a major inconvenience.
Perpetual Inventory System
The perpetual inventory system requires a lot more setup, but once it's in place, it's much easier to operate. Every piece of inventory you own is entered into your computer system as it's purchased. When it comes out of inventory, when it's sold or used up, it's automatically deducted from the on-hand inventory in your computer system. If your business model revolves around knowing what you have and when you'll need to order more, which applies to just about every business, using the perpetual inventory method offers a lot of advantages.
Periodic Versus Perpetual Inventory
Which approach you'll take to managing your inventory depends on your situation. If you're content to operate on a "mom and pop" basis, keeping your business small and your inventory low, a periodic inventory system might be all you need. Setup is minimal, and you can count your inventory as often as you think is necessary. If your plans for your company involve plenty of growth, you'll want to implement the perpetual inventory method at the earliest opportunity, ideally from day one.
The downside is that the perpetual inventory method is complicated to set up, and requires a significant investment in computers, software and expertise. If you're running on a tight budget, which is often the case with startups, that initial investment might be more than you can comfortably manage. Sometimes, you'll need to settle for an inventory and accounting system that provides basic perpetual inventory management in the short-term, but can be upgraded to a more fully featured offering as your business and revenues grow.
It's Not Perfect
The whole point of a perpetual inventory system is that you'll always have an accurate, up-to-date count of what items are on hand. That's broadly true, but in the real world, there's always a gap between theory and practice. You'll lose product to breakage and theft; suppliers will invoice you incorrectly, you'll receive orders that are over or short by a few pieces, sales staff will ring in sales or refunds incorrectly and so on. Good training, security and inventory-handling practices can help keep that to a minimum, but you'll still need to do a real count every so often to verify the numbers you're working with.
You might opt to do a full physical inventory at least once a year, or you might opt for ongoing "cycle counts." That just means you'll choose certain portions of your inventory to count regularly in search of discrepancies. You can focus on just the highest-value or highest-volume items, because they're the most likely to give you problems, or you can count your whole inventory a bit at a time through the year and adjust your inventory when you find errors.
Perpetual Inventory in Retail/Wholesale Environments
The best case for perpetual inventory systems is in retail. When your customer brings a product up to the counter, you'll ring it in with some form of a scanner, or perhaps by manually entering a part number. Scanning is better, whenever possible because it reduces the opportunity for mistakes. Once the sale is completed, your system will reduce the available inventory on hand to allow for what's walking out the door in your customer's hand.
If one of your other salespeople looks up that product from a computer in another department, the newly revised total is what will show on the screen. Your system can also prompt you to order more when your supplies get low or even place the order automatically. The best systems keep track of your suppliers' discounts and order minimums as well, so you can set them not to order 950 pieces if there's a discount at 1,000. Wholesalers work the same way, except they buy from manufacturers and distributors and sell to the retailers.
Perpetual Inventory in Manufacturing/Production Environments
If you're in the business of making products, rather than just selling them, you'll use a perpetual inventory system a bit differently. In this case, the items in your inventory are raw materials or sub-assemblies, and ultimately they'll become finished goods. You'll also need to keep track of your raw materials while they're on their journey to becoming finished goods, which can take as little as a second or two or as long as several years depending on the product. At that state, they're counted as work-in-process. With an efficient perpetual inventory system, you should never run out of raw materials, and you'll know how many finished goods you have available for sale. More importantly, you'll also know what your manufacturing costs were, even if your materials fluctuate in cost.
LIFO and FIFO Accounting
Your physical inventory management should always make sure that the oldest product on your shelves gets sold first, even if it's not especially perishable. Packaging fades over time, boxes get damaged and even steel nails will eventually rust. For perpetual accounting purposes, though, you get to decide whether you consider each piece of inventory as being the oldest one currently on hand or the newest one on hand. These systems are called first-in-first-out and last-in-first-out, or FIFO and LIFO for short. If prices are rising, the oldest product will always be the cheapest and the newest product will always be the costliest. If prices are falling, the opposite is true. That has some important implications for how you account for your costs.
LIFO, FIFO and COGS
Suppose, for demonstration purposes, that the oldest item in your inventory was purchased at $85, the newest cost you $95, and you sell at $110. If you work on a FIFO basis, your profit is $110 minus the $85 cost or $25. If you work on a LIFO basis, you'll only count $15 profit on the same sale. If your goal is to report the highest possible profits, perhaps to impress or influence potential investors, you might find it advantageous to use the FIFO method. If you want to keep your recorded profits in check to minimize your tax bill, the LIFO method might – in this hypothetical instance – make more sense. You can use either method, as long as you're consistent. As for keeping track of your actual cost of goods sold in retail, or cost of production in manufacturing, you might opt for a weighted-average method that keeps track of your actual costs as they go up and down.