Question

I have to finish my homework but I'm having difficulties with it.

We are studying the perpetual inventory system and the periodic inventory system. Some questions: what is the difference between the two systems? What is involved with using each system? Which do you think is more common and why? How does FIFO, LIFO and Weighted Average differ?

How are they alike?

Why don't companies use specific identification more often? Why is this method rare?

Answer 1

The periodic and perpetual/ continuous inventory systems are two different methods used to track and value the inventory in a business. However perpetual Inventory system is more sophisticated for larger businesses. But for small businesses, Periodic Inventory will be much cost effective.

1. Periodic Inventory System: The periodic inventory system is occasional physical count of the inventory to arrive at the closing inventory balance and the COGS. Only purchases are recorded in the books and the COGS at the end will be arrived using below formula.

Cost of Goods Sold= Opening balance of Inventory + Cost of Purchases-Closing balance of Inventory

2. Perpetual Inventory System: Maintaining and tracking Inventory in perpetual inventory system is much easier and helps the management to have more control on the Inventory cycle. Perpetual Inventory system is also known as Continuous Inventory system. As the name suggests Inventory is tracked at each and every step. Balance as per the records should match with the physical Inventory at any given point of time unless there is physical loss of goods due to pilferage or theft.

In this system, Value of Inventory can be obtained at any point of time.

3. Difference between the two systems:

1. Recording of transactions: In periodic system, only purchases are recorded in the books of accounts. COGS is arrived at the end of the period by Physical count. In perpetual system, all the transactions relating to the Inventory are recorded including issue to production, scrap, etc. COGS account is maintained in the books and is debited at the end of every process.
2. Scale of Business: Periodic Inventory system is suitable for small businesses where inventory is not huge and there is less chance to lose control on Inventory. Perpetual system will be more convenient and reliable where the business is huge and it has huge inventories to handle (especially retail businesses)
3. Cost Involved: Periodic Inventory system is less costly and hence affordable by small businesses whereas Perpetual system is more sophisticated and costlier. However it is to be noted that for large volume of Inventories it is almost impossible to follow periodic system of Inventory.
4. Special software to be used and relied upon for perpetual system where the inventory is very huge whereas few personnel is enough to handle periodic Inventory for a small business.

Taking the above points into consideration, one has to select appropriate Inventory system depending on the scale and affordability of their business.

4. Among the two Perpetual is most common and widely used across the globe for its various benefits like reliability, anytime available numbers, no need to halt production for the sake of inventory count and more control on Inventory process.
5. LIFO- FIFO-Weighted average differ:

LIFO- Last in First Out: In this method the Raw materials issued for production are valued at the latest price (because in this method it is assumed that the last bought in is issued first)

FIFO- First in First Out: In this method the Raw materials issued for production are valued at the oldest price (because in this method it is assumed that the first bought in is issued first)

Weighted Average: In this method, the weighted average of the purchase cost of Raw materials is considered while issuing the Raw materials.

The above analysis holds good for arriving at COGS also while recording sales.

6. Specific identification inventory valuation method is a method where cost of each Individual item is maintained separately. There will not be grouping of Inventory. For regular manufacturing firms it is impractical and impossible to track the costs individually and hence this system Inventory valuation is not often used.

This system will be useful when the Inventory is identifiable and large piece like a customized furniture or vehicle or building etc.

In this method all the costs associated with one single piece of item are tracked and maintained separately. This system is not widely used because of its complexity in implementing.