What is a Perpetual Inventory System and How Does It Work

What is a Perpetual Inventory System and How Does It Work

perpetual inventory system

Inventory management directly influences profitability and is, therefore, one of your business’s most important assets. If you have too little inventory, you risk stock-outs and losing customers.

You may have to deal with exorbitant storage fees, drained business capital, and a negative bottom line if you have too much inventory. As a result, the significance of efficient inventory management cannot be overstated. 

So what steps should you take to accomplish effective inventory management? 

Effective inventory management requires striking a balance between having enough stock to meet client demands on your eCommerce business and having enough excess stock to cushion any unexpected increase in demand. The systems that make this possible are called Inventory Management Systems. 

Broadly speaking, these inventory systems are grouped into two categories: perpetual inventory systems and periodic inventory systems.

Both help you manage inventory-related tasks, including tracking and recording turnover, shipping, and more. 

What is Perpetual Inventory?

Perpetual Inventory is a process of inventory accounting that records changes in inventory records — such as sales, processing, and ingested products — at the moment of occurrence. 

In other words, perpetual inventory is inventory reconciled in real-time. Periodic inventory, on the other hand, requires manual, scheduled counts. 

Perpetual vs. Periodic Inventory Systems

One of the main differences between the perpetual and periodic inventory systems is the method by which inventory is tracked. Let’s take a closer look.

What Is a Perpetual Inventory System?

In simple terms, a perpetual inventory system is a technology-based method of inventory management that is used to track stock as it is sold or received in real-time.

In this case, technology is typically either an enterprise asset management software, a computerized point-of-sale system, or both. 

Regardless of which technology is used, it collects data automatically and displays detailed changes to your stock levels as they occur.

What is a Periodic Inventory System?

A periodic inventory, on the other hand, is the total opposite. It is done physically, which means that stock has to be counted physically by a member of your staff before it can be compared to sales data.

An easy way to remember this is that periodic systems “periodically” record data, while perpetual systems are “perpetually” running in the background, recording all relevant inventory information.

Periodic inventory methods leave a lot of room for error and are not the most inefficient inventory management systems. 

When Should You Use a Perpetual Inventory System for Your eCommerce Business?

If your retail business handles a high volume of sales, as most eCommerce brands do, a perpetual inventory system is the best way forward. However, even small businesses will benefit from this inventory management system to simplify and automate inventory-related tasks.

The Advantages and Disadvantages of a Perpetual Inventory System 

A perpetual inventory system is far superior to a periodic inventory system for your eCommerce business for a variety of reasons. The biggest advantage, bar none, is that it significantly reduces human error. Other advantages include:

No Downtime 

Since everything is dependent on technology, stock levels are instantly updated using the perpetual inventory management system. You can say goodbye to the time-consuming task of performing a physical inventory count, as well as the resulting business downtime and missed sales opportunities.

As a bonus, you get a warehouse organization that is more efficient and saves employees time. You also enjoy lower supply chain costs, improved cash flow, and a boost to your company’s bottom line. 

It Improves Your Forecasting 

Accurate forecasting is a critical component of effective inventory management. Cisco, the networking equipment behemoth, learned the hard way about the consequences of poor stock forecasting in 2001. 

It had to write off about $2.25 billion in equipment components, and raw materials, as a loss.

Your business may not be on that scale yet, but a loss is a loss — it still hurts. With the assistance of a perpetual inventory system, you can avoid a loss to your business. Because you can keep track of all transactions, you can ensure full product accountability on demand.

Records Data in Real-Time

A perpetual inventory system is also more accurate than a periodic inventory system. The reason for this is simple: because key inventory management tasks are automated, sales and inventory data are recorded as soon as they occur, which has positive applications for stock forecasting and audits.

What this means for your eCommerce business is that you’ll have a more accurate inventory account whenever you need it.

As a result, you can take steps to avoid stockouts, as well as product and production shortages.

Reduces Inventory Management Costs

A perpetual inventory system provides a comprehensive data set of all metrics related to your inventory. The best part is that once the costing system formula is correctly set up, analyzing this data is relatively simple (more on this later).

This has a positive knock-on effect in terms of lowering the amount of money you spend on inventory management. With the data, you can more accurately forecast demand and avoid excess raw materials and stock.

You can also scale up or scale down the cost of holding stock based on demand, ensuring that you are not paying for storage that you do not require and vice versa.

Disadvantages of Perpetual Inventory Systems

Before we get into the cons of the perpetual inventory system, it is important to note that while some of the following points are listed as cons, they’re more like minor inconveniences when compared to the alternative (periodic inventory system).

Annual Physical Stock Audit 

Even if you have a perpetual inventory management system in place, you will need to physically count your inventory in order to synchronize your data.

This count is required because recorded inventory may not accurately reflect what is physically in stock over time, let alone accounting for drop shipments or inventory on order, including accounting for breakage, stolen goods, and loss from shrinkage (which are risks associated with stock in your business).

If you’re looking for the most efficient ways to audit your inventory, take a look at our post on cycle counting

Shrinkage occurs for a variety of reasons, including supplier error, employee theft, and paperwork errors. It’s a costly problem for your business that can result in a loss of profit: you cannot recoup your inventory costs, and you cannot sell the inventory to generate revenue.

The good news is that shrinkage can be deducted from your personal or business tax returns when it is discovered. The meticulous records provided by a perpetual inventory system can assist with this.

Constant Record Keeping and Monitoring 

More data means more responsibility. Because perpetual inventory systems are designed to track and record every inventory transaction, you will need to establish an equally robust record-keeping and monitoring system for all data collected.

Why? 

Errors and incorrectly scanned items can have an impact on your inventory records. 

Fortunately, you can deal with this mathematically by using formulas (corrections) that account for the majority of these factors. We’ll get to that in a minute.

Higher Setup Costs 

Perpetual inventory systems may be more expensive to implement the periodic inventory management method as a result of the software, equipment, and training needs.

However, the initial setup costs more than pays for itself in real-time inventory updates and accurate stock on-hand accounting. 

These features help your eCommerce business avoid stockouts and encourage minimal employee contact with the inventory.

 

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How Is Inventory Tracked Under a Perpetual Inventory System?

We’ve already established that a perpetual inventory system works by instantly updating stock counts as it is purchased or sold. Here is a quick rundown of how the system works. 

For the purpose of this guide, the focus is on five metrics — inventory level, COGS (cost of goods sold), reorder points, purchase orders, and received stock. 

Note: the process may differ slightly when integrated into your business and depends on how your supply chain is structured. We recommend scheduling a demo so we can customize SkuVault to suit your specific needs. 

1. Inventory Level 

When a product is sold, an RFID (radio-frequency identification) or barcode scanner is used to notify the inventory management system linked to your point-of-sale system of a debit update. 

This change is then recorded by the system and distributed to all sales channels.

2. COGS (Cost of Goods Sold) 

COGS, like your business inventory level, is updated and recalculated in real-time. That is, whenever an item is added to or removed from your inventory.

3. Reorder Points

Continuous use of the perpetual inventory management system generates historical inventory and sales data, which can then be set up to automatically update reorder points with the flow of your business’s sales volume to ensure that optimal inventory levels are maintained at all times.

4. Purchase Orders

This is done automatically whenever an SKU or item reaches the reorder point you specify, without the need for human intervention. That is, a new transaction order is generated and sent to your supplier automatically.

5. Received Products 

Inventory management systems like SkuVault are designed to work well with warehouse management software. This means that as soon as stock is received and scanned at your warehouse, it is automatically updated on your inventory management dashboard.

A perpetual inventory system, in essence, uses data gathered from each stage of the inventory management process to keep your supply chain running smoothly. These steps are looped indefinitely for as long as the system is turned on.

Formulas in Perpetual Inventory

Businesses use various methods to account for the cost of available inventory. Regardless, the total inventory cost invoiced remains constant.

When using a perpetual inventory system, these inventory costing systems or formulas provide a more efficient way to keep track of inventory counts.

We’ve compiled a list of the most popular methods, as well as how you can apply them to your business, below.

The First In, First Out (FIFO) Approach 

The principle underlying this approach is simple: ensure that stock is purchased in the same order in which it was created or purchased.

This method is useful if you keep perishable goods on hand. It is also advantageous if you stock non-perishable goods because items that have been stored for an extended period of time may become outdated, damaged, or otherwise unsellable.

One of the most effective ways to incorporate FIFO into your perpetual inventory process is to add new products from the back of your stockroom, ensuring older stock is the first off the shelf when an order arrives.

The Last In, First Out (LIFO) Approach 

Unlike the FIFO method, which calculates the cost of goods sold in the order they were received, the LIFO method calculates the COGS (cost of goods sold) using the cost of the most recent stock purchase order.

In simpler terms, inventory is calculated and adjusted based on the total cost of a purchase order and then compared to sales data, in contrast to inventory levels being changed with each sale.

Weighted Average Cost Approach 

The weighted average cost approach is used to determine how much stock has sold and what the current inventory levels are at any given time. 

It is calculated as COGS/total number of stock in inventory. 

Finished Goods Approach 

Businesses use finished goods inventory counting to determine how much stock is available to ship out as soon as an order is placed. It is commonly used by businesses that stock both raw materials and finished goods.

It is also used to forecast inventory costs by calculating the total cost of inventory(raw materials and finished goods).

Formula: Previous Year’s Finished Goods Value + (COGM – COGS)

Economic Order Quantity 

Economic order quantity (EOQ) is defined as the optimal purchase order that your business should make for its inventory to maximize warehousing space and minimize stockouts. 

It is calculated by taking the square root of [2SD] / H = EOQ.

Where H stands for Holding Cost (per unit, per year), 

S is Setup fees (per order including handling and shipping), 

D is the demand rate (average quantity of stock sold annually). 

Final Thoughts

Giving your company better inventory management tools is an integral part of ensuring its overall success. These tools, when combined with a perpetual inventory system, are an excellent way to effectively manage your inventory.

However, selecting a perpetual inventory system is only one part of the equation; you will also need the right software, integrations, and partners to optimize your logistics efforts. SkuVault can be your one-stop shop for everything inventory.

SkuVault empowers you to spend less time on inventory management tasks while maintaining complete insight into your supply chain. Schedule a demo today and we’ll show you how we can help you work on your business and not in it. 

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