Whether you’re studying to become a CPA or in an introductory accounting class, understanding the perpetual inventory system is essential. However, it’s not a difficult concept once you review the information contained within this article and practice the journal entries. If you need further assistance with this topic after reading the article, please drop a comment with your question at the bottom of this page.
Businesses use systems to track the flow of their inventory better. There are two types of inventory systems commonly used: a periodic system and a perpetual system. The primary difference between a periodic and perpetual inventory system relates to how and when companies track the inventory.
Under a periodic system, companies occasionally perform a physical inventory count to track their current level of inventory. After a company performs a physical inventory count, they compare it to their previously counted inventory. Comparing the two inventory amounts allows them to determine the cost of goods sold for the period.
In contrast, the perpetual inventory system continuously tracks the sale and purchase of inventory through automated entries. A perpetual system provides a company with very detailed records. And clear records allow them to understand precisely how much inventory they have on hand. Additionally, companies using a perpetual system can track their cost of goods sold with little effort.
To monitor changes in inventory levels, companies implement a point-of-sale system. A store’s point-of-sale system is where a customer makes a purchase or remits a payment. By implementing this system, companies are able to track the inflow and outflow of inventory easily.
Periodic inventory systems generally are better for small businesses because they are less expensive to implement. However, perpetual inventory systems are better for large companies with high sales volumes. For example, a locally owned jewelry store specializing in high-end diamonds would likely opt for a periodic inventory system because of their low sales volume. On the other hand, a grocery store chain with 1,000 locations would use a perpetual system due to its higher volume.
Companies can pair periodic and perpetual inventory systems with different inventory flows, such as first-in-first-out (FIFO), last-in-first-out (LIFO), specific identification, and weighted average. The accounting and tracking under each method varies, depending on whether the company utilizes a periodic or perpetual system.
For example, if a company uses the weighted average perpetual inventory system, the units’ cost must be calculated with each sale. However, if the company utilizes FIFO instead, the cost of goods sold would simply align with the cost of the first purchased inventory.
Another notable difference between a periodic and perpetual inventory system is that companies are not required to prepare end of period entries in a perpetual system. Because a perpetual system continually tracks the inflow and outflow of inventory, the companies’ accounts are accurate at all times. In contrast, a periodic system requires end of period entries to ensure accounts are up to date.
In a perpetual inventory system, companies automatically record journal entries to continuously track purchases, sales, and cost of goods sold. Assume that Whole Foods, a nationally recognized grocer, uses a perpetual inventory system. And, in one particular store, an inventory manager realized they were running low on almond milk, so they ordered $4,000 worth of almond milk on account. The perpetual inventory system journal entry to record the purchase of inventory would be:
Accounts Payable $4,000
In addition, Whole Foods may incur freight costs associated with the delivery of their almond milk. Whole Foods will include these shipping costs as a part of the cost of inventory, so the journal entry to record $100 in freight costs would be:
Accounts Payable $100
Then, let’s say that Whole Foods sold 12 cases of almond milk for $1,250, with an associated inventory cost of $700, to a local coffee shop on account. The entries to record the sale would be:
Accounts Receivable $1,250
Sales Revenue $1,250
Cost of Goods Sold $700
As you can see in this example, Whole Foods can easily track the inflow and outflow of inventory. In turn, this prevents shortages in inventory.
Even though perpetual systems continually track the flow of inventory, companies must still perform periodic physical inventory counts to account for the spoilage of inventory. For example, if Whole Foods performed a physical count and determined that 12 cases of their almond milk worth $700 had spoiled, they would need to record a loss. The journal entry to record this loss would be:
Loss on Inventory Write-Down $700
Discounts are often offered by vendors to incentivize payments made before an invoice’s due date. The terms used are generally shown as 2/10, net 30, where the purchasing party will receive a 2% discount if they pay within 10 days. Otherwise, the net amount is due within 30 days. When a company utilizes a perpetual inventory system, discounts are credited to inventory to reduce inventory cost in the accounting records.
For example, suppose Whole Foods was offered terms of 3/10 net 30 on their purchase of $4,000 worth of almond milk. If they remit payment within 10 days, they will reduce the total inventory cost by $120 to reflect the 3% discount. The initial journal entry to record the purchase wouldn’t change. But, when remitting their payment, Whole Foods would record a subsequent journal entry to account for the payment and discount.
Accounts Payable $4,000
In contrast, if Whole Foods used a periodic inventory system, the inventory account wouldn’t be directly reduced. Instead, Whole Foods would debit the payables account and credit a purchase discount account.
Cost of goods sold represents the resources expended by a company to generate revenue. Under a perpetual inventory system, each purchase and sale of goods changes the inventory balance. Through the implementation of this system, both ending inventory and the cost of goods sold will reflect each account’s current position accurately.
The calculation for cost of goods sold under a perpetual inventory system depends on the type of inventory system used.
For example, suppose Whole Foods uses a perpetual inventory system that follows the first-in-first-out (FIFO) cost flow assumption. Whole Foods had no beginning inventory and made two purchases throughout the year. The first purchase was for 100 jars of peanut butter at $1.50 each. The second purchase was for 150 jars of peanut butter at $1.75 each. Whole Foods sold 75 jars of peanut butter for $300 on account immediately after their second purchase to a local bakery.
Therefore, the cost of goods sold would be assigned to the first purchase of inventory so the journal entry would look like:
Accounts Receivable $300
Sales Revenue $300
Cost of Goods Sold $150
To determine the end of period cost of goods sold, Whole Foods would take the sum of all transactions that impacted the COGS account. This is the value that will be reflected on the income statement.
I am the author of How to Pass The CPA Exam (published by Wiley), and I also passed all 4 sections of the CPA Exam on my first try. Additionally, I have led webinars, such as for the Institute of Management Accountants, authored featured articles on websites like Going Concern and AccountingWeb, and I'm also the CFO for the charity New Sight. Finally, I have created other accounting certification websites to help mentor non-CPA candidates. I have already mentored thousands of CPA, CMA, CIA, EA, and CFA candidates, and I can help you too!
FIFO Method — First In, First Out