How Do I Track Inventory in My Business?

Inventory Systems

There are two inventory systems, the perpetual inventory system and the periodic inventory system. With the perpetual system, a (computer) system is in place which keeps track of inventory. It is therefore possible to compare the actual inventory with the inventory according to the system. However, such a system comes at a cost. With the periodic system, inventory is not kept up to date. To find out the units that have been sold, a physical count is necessary. Choosing between the two systems involves a complex cost-benefit tradeoff. Benefits of a computerized system include having up-to-date information (and potentially better decision making) and less theft by employees. However, automated systems are not for free. Software needs to be purchased or programmed. Also, separation of duties between employees is required for making somebody accountable for missing units.

In this section, I take a firm’s choice for either system as a given and focus on the accounting implications of the differences between perpetual and periodic inventory systems.

When the perpetual inventory system is used, the inventory T-account is updated with every purchase and every sale. When new inventory is purchased, the asset inventory is increased. When sold, the inventory is reduced and expensed as cost of goods sold. This system is therefore in line with the matching principle.

With the periodic inventory system however, no up-to-date system is in place. When inventory is purchased, it is expensed. When sold, no entry is made (as it has already been expensed when purchased). At the end of the period, a correction needs to be made, because in the income statement the cost of goods sold needs to be expensed. Purchases are generally not equal to cost of goods sold. Since beginning inventory + purchases = ending inventory + cost of goods sold, the correction that needs to be made is beginning inventory – ending inventory. This correction is added to inventory on the balance sheet, and also added to purchases, so that the income statement is expensed with cost of goods sold.

Cost Flow Assumptions

To determine the cost of a product that is sold, a firm can either determine the original cost of that specific unit, or, when goods are similar, make an assumption about the ‘flow’ of goods for costing purposes. When goods are not similar in nature – for example a gallery selling paintings of the masters of the 1700’s – it makes sense to tag products or in some other way keep track of the products’ original cost. This way, when a product is sold, the original cost can be matched as the cost of goods sold.

When products are (very) similar or identical, it makes less sense to keep track of the original cost. Consider for example an oil trader. The main interest of an oil trader is today’s oil price, and when a barrel is sold, there is not much to gain to retrieve the cost of that specific barrel. He might as well have sold another (physically essentially the same) barrel that could have had another cost. In situations like this, it makes sense to assume a ‘cost flow’. I consider three cost flow assumptions: First In, First Out (FIFO), Last In, First Out (LIFO) and average cost.

With FIFO it is assumed that when a product is sold, it was the oldest product in inventory (‘First In’). As a result, the ending inventory is assumed to exist of the most recent purchases.

With LIFO it is assumed that to most recent purchase is sold. Thus, the ending inventory is assumed to exist of ‘old’ units (which physically need not be the case, as it is an assumption). With increasing prices (and non-decreasing inventory), net income using LIFO is lower than under FIFO.

Note that when a firm chooses between FIFO and LIFO it basically makes a decision of where it wants recent prices to go: if it prefers recent prices to be the basis for the valuation of ending inventory, the firm chooses FIFO. If it wants the cost of goods sold to be based on recent prices, it chooses LIFO. In this context it is relevant to know that under IFRS, LIFO is not allowed. Apparently, the IASB (International Accounting Standard Board; the standard setting body) believes the balance sheet to be more important than the income statement.

Finally, the average cost assumption assumes that all units have the same (weighted) average cost. The resulting cost of goods sold and ending inventory valuation are therefore between the numbers based on FIFO and LIFO.

When the firm uses the perpetual inventory system, the firm will need to assign a cost to the products at the time of sale, as the inventory T-account needs to be up-to-date at all times. In the situation that the periodic inventory system is used, the company can (and usually will) wait till the end of the period to determine the cost of goods sold. This affects the cost of goods sold (and ending inventory valuation) for the LIFO and average cost.

For example, if the firm uses the periodic system with LIFO and after the last sale but in the same period another purchase is made, it is assumed that this later purchase is sold first! Physically it is not possible to sell (and deliver) a product that has not been purchased by the firm. Accounting-wise it is nonetheless possible, since the calculations for the periodic inventory system are made at the end of the period when all the period’s transactions are know.