Perpetual Inventory: The Good, The Bad and The Ugly
Well, here we go…
The big daddy of inventory keeping battles.
Perpetual inventory method on the one side, and Periodic inventory method on the other; staring across at each other in the stock room with pure determination.
It’s a war as old as the 70’s, and yet it still goes on to this day.
These are the two methods that companies have been using to keep track of their inventory in modern times. Each certainly has their uses, and to understand which one suits your business’ needs we need to first understand what they bring to the table.
But before we get stuck in, let’s consider the harsh truths of taking stock.
We all know that as a business steadily grows, and those orders start streaming in, it can get difficult to keep track of everything you have — especially if you make what you sell.
You have to account for all of those polished final products, as well as all the pesky little bits that go into making them to maintain inventory control.
If you started out making a specific wooden notebook cover then you might only need a limited number of materials. At that point everything is okay.
But what about when you start selling in larger numbers? And then you add new products to the roster; phone cases, pen holders, wallets...
Well, now you not only need to keep track of the new products, but also of all the new materials you need, in order to make them.
It can get messy!
And this is only one of the many issues that can come up as a result of poor inventory management.
There are actually quite a few problems that might arise (don’t worry, things get better by the end).
But here’s a few just to give you an idea of the potentials:
- Missing stock — which can lead to late orders and unhappy customers;
- Excess stock — this means tied up cash, and unnecessary use of precious space;
- Poor replenishment — the stress of not knowing when to restock; and
- Running out of cash — nothing worse than tying up your cash in dormant goods (aka carrying costs).
These are issues that can have drastic effects on running your business.
So, what’s the solution?
Well, there’s some great software out there that can help, but we’ll get to that later.
For now, let’s start with getting to know the two main approaches of dealing with inventory — Perpetual Inventory and Periodic Inventory.
What is Periodic Inventory?
As the name suggests, this method is simply about updating the inventory at fixed time intervals. You basically just get in the stock room and physically count everything in one go.
The time period can be set by the business, but generally businesses don’t do it very often because its super tedious and gets in the way of day to day activities.
It’s probably what you imagine when you first think of stock taking (if you’re anything like me).
Someone walking around with a great dusty record book under their arm. They check each and every item on the shelf, ticking them off and making sure it’s all accounted for.
It sounds boring, but kind of romantic too, I guess.
So you got the basic idea, but what about the important stuff?
“When do I calculate the cost of goods sold?” I hear you say.
Well, your balances get updated each time you take stock.
The cost of goods sold is calculated from the difference in inventory from the previous stock take plus the value of purchases.
Here’s a simplified example:
Last month I had twenty tables in the back room. I bought another two. Now I have twelve.
Therefore, I sold ten tables.
Voila... the cost of these ten tables is now added to my cost of goods sold.
Sounds simple enough, and to be fair it is a tried method that has mostly stood the test of time. It’s certainly the older brother of perpetual inventory, having been around for as long as there’s been paper and shops.
But it is a crude method, and it certainly has its shortfalls.
If, for example, some items get lost, stolen or missing between inventory takes, then they may falsely be included in the cost of goods sold.
That doesn’t sound great, and it isn’t.
And what if demand increases between stock takes and you can’t make enough of your product in time?
What if some stock has gone missing and the customer orders are being delivered late?
Well, these are very real scenarios which occur daily for businesses that don’t take their inventory seriously enough.
It makes sense though.
I mean let’s imagine a scenario from the customer’s perspective...
Our customer’s name is Fred.
He’s just found an awesome leather backpack online in your Shopify store after searching online for weeks. He goes to order it, but its out of stock...
Oh well, he’ll try again later.
So he tries again later... only to find it’s still out of stock!
What does he do?
Well more than likely Fred’s going to just find something elsewhere, and he might never come back to your store again.
People don’t like waiting, and this scenario can be super damaging to any online business.
So despite the attractiveness of the simple Periodic system, there are definitely shortfalls that you need to take into account.
Let’s look into the benefits and pitfalls of using the periodic inventory approach.
Periodic Inventory System Advantages and Disadvantages
- Simple application to any inventory
- Doesn’t require any software
- Stock levels directly are reliable after each inventory take
- Lack of info on inventory balances between inventory takes can hinder business decisions
- Time consuming to check stock and then do the math
- Higher chance of theft and fraud due to absence of continuous checking
- Lost goods can be overlooked and taken into account as false sales
- Potentially inaccurate accounts can be very costly
What is Perpetual Inventory?
Ever since the introduction of digital computing, people have been keeping track of their wares in data and barcodes rather than on the books with pen and paper. This has allowed the continuous updating of stock as it happens, a live inventory, if you will.
Nowadays you don’t have to keep your records in a dusty old notebook or multiple spreadsheets that require constant manual updating. Instead you can just use Smart Workshop Software to keep track of your inventory.
Simply put – you could say the perpetual inventory definition is the continuous updating of inventory, unlike periodic inventory, which is refreshed at intervals.
And for your accounts the difference comes down to how cost of goods sold is calculated.
In a perpetual inventory system, cost of goods sold is recorded as you go along, unlike the periodic system which does everything at once. This way you always know how much money you’re making at any given time. And (aside from the love of your craft) that’s the bottom line, right?
You don’t have to wait for your next tedious stock take to know what your balance and inventory stands at. This means lightning fast decisions can be made at any critical moment.
Here’s a perpetual inventory system example that might give you more idea:
You’re a knitted sweater designer.
You have a small team that helps you make the sweaters and a stock room of all the bits needed to make them; material, buttons, yarn, patterns etc.
One morning you wake up to a golden sight – twenty orders have come in for “Ugly Christmas Sweaters” over night, when you usually only sell a couple a month.
It looks like the first snow landed last night, and everyone’s excited.
Well the team is all up for it, but wait...what about the stock?
This is the critical moment where perpetual inventory shines. Because now you know exactly how much raw materials you have in the inventory and how much more you need to order from your suppliers. You can order the materials immediately and make sure that the customers can get their sweaters made in time for Christmas.
But now imagine you were using the periodic system.
Unless you’d taken stock very recently, you have to run into the stock room. Count out everything you have, and stress out over getting this order delivered properly.
Of course it’s not always roses, as even with perpetual inventory you still need to do a physical stock check every now and then to make sure that missed discrepancies don’t build up.
Now let’s look at the benefits and pitfalls of perpetual inventory.
Perpetual Inventory System Advantages and Disadvantages
- Know exactly what you do and don’t have at any given time
- Accurate balance sheet with cost of goods sold added continuously
- Achieve optimum inventory levels
- Make fast business decisions with up to date info
- Easy to spot discrepancies and chances of theft/fraud/lost goods.
- If stock is not checked physically at all then there can be discrepancy in the inventory
- Software required
Perpetual vs Periodic Inventory, the winner is...?
So going through the two methods, we come back to the stock room stand off.
Looking between the two, perpetual inventory has so many benefits that it seems almost the obvious choice. You’d have to ask why would you choose periodic inventory at all?
Well if your business is super simple, with few or no manufacturing processes involved it can make sense. Or if you have limited types of stock too, like a car dealership.
Otherwise keeping up to date with a perpetual inventory is nearly always going to be the smarter business decision. Not only does it allow you to keep your customers happy with on time deliveries, but also keeps your stock at optimum levels so there is more space for you to spend time on the more exciting stuff.
The main arguments that have been made against it all, have usually been the complexity and cost of implementing such a system. It was always reserved for those big players who had the resources, out of reach from growing businesses.
Thankfully, Katana MRP has come up with a smart workshop software that makes keeping a live inventory a real possibility for smaller businesses.
With this all in one solution you can keep track of your raw materials as well as final products in a single system in real time.
Checking your physical stock occasionally to keep everything in perfect working order seems a small price to pay for keeping your inventory flow at maximum efficiency.