If your business sells merchandise or manufactures products, you must accurately track your inventory to figure your profits, manage production and purchasing, and help prevent shrinkage. Because of the increased use of automated tracking technology and inventory management systems, many businesses adopt the perpetual inventory system and seldom take a count of inventory. Nonetheless, errors can creep in over time unless you occasionally take a physical inventory.

Perpetual Inventory Method

Under the perpetual inventory method, you track all purchases, production, sales and movements of inventory items in real time. In theory, you can use this method to keep accurate tabs on your entire inventory without spending a lot of time and money on physical counts. The technology that enables perpetual inventory includes devices that automatically record the comings and goings of inventory items, such as bar code readers, radio frequency identification tags and point-of-sale cash registers. These devices hook into computer systems that can integrate with your other accounting functions.

Benefits of Perpetual Inventory

Companies that rely only on physical counts to track inventory must spend time and money on taking those counts. This means that you must periodically -- usually monthly -- interrupt your normal operations and divert employees to inventory counting. Alternatively, you can pay for a service to take your counts for you. In either case, the practice increases costs and disrupts operations. A perpetual system reduces or eliminates these costs.

In addition, a perpetual system connected to an inventory management system can give you up-to-the-minute reports concerning inventory value and cost of goods sold. You can also use this information to automatically reorder merchandise as needed.

Risks

It is important to adjust your inventory for discrepancies that can accumulate over time. Unless you take a physical count, you might be unaware of damaged, missing or spoiled inventory. Even worse, it is easier for dishonest managers to commit inventory fraud if there is no physical audit of item counts. The Internal Revenue Service insists that you take a physical inventory at “reasonable intervals” to re-establish you actual inventory. The IRS taxes you on your net income, which largely depends on your gross profits: net sales minus cost of goods sold. A physical count accurately establishes your ending inventory and thus your COGS, enabling you and the IRS to correctly figure your taxable income.

Considerations

If you maintain relatively small amounts of inventory, the periodic method may be more cost-effective and easier to administer. Companies with perpetual inventory systems can perform cycle counting to help keep accurate item counts. Cycle counting involves the daily count of a portion of your inventory until you cycle through the entire lot. It is a never-ending process that allows you to spot check the numbers you get from your perpetual inventory system.

Investors rely on accurate financial reporting to gauge how well your company operates. They need you to accurately state your inventory value and gross profits so that they can evaluate the soundness of investing in your business. By taking a periodic count, you help assure investors of the accuracy of your financial reporting as well as your ability to detect inventory fraud.