What is a Periodic Inventory System?

Periodic Inventory System

A periodic inventory system is an inventory accounting method in which updates to the inventory accounts are made periodically, typically at the end of a reporting period like a month, quarter, or year, rather than on a continual or perpetual basis.

In this system, the Cost of Goods Sold (COGS) and ending inventory balance are updated using physical inventory counts. A company will determine the number of units of each product it has on hand, typically through a physical count, and then uses this information to update its Inventory and Cost of Goods Sold accounts.

Here’s a brief overview of the steps typically involved in a periodic inventory system:

1. The company starts the period with a known beginning inventory.
2. Purchases during the period are recorded in a Purchases account, not directly in the Inventory account.
3. At the end of the period, the company physically counts its ending inventory.
4. The Cost of Goods Sold for the period is calculated as:Beginning Inventory + Purchases – Ending Inventory = COGS
5. The Inventory account is updated to match the physical count (ending inventory), and the difference between the calculated COGS and the beginning inventory plus purchases is recorded in the COGS account.

The periodic inventory system is simpler and less expensive to operate than the perpetual inventory system, which updates inventory accounts continuously. However, it provides less timely information, and discrepancies between physical inventory and the inventory account won’t be discovered until the end of the period.

Example of a Periodic Inventory System

Let’s consider a simple example of how a periodic inventory system works using a small t-shirt retailer:

• Beginning Inventory: At the start of the year, the retailer has 100 t-shirts in stock, which cost $10 each, so their inventory is worth $1,000.
• Purchases: Over the course of the year, the retailer purchases an additional 400 t-shirts at a cost of $12 each, or $4,800 total. These purchases are recorded in a separate purchases account.
• Sales: During the year, the retailer sells 450 t-shirts for $20 each, or $9,000 total. These sales are recorded in the sales revenue account. However, the cost of the t-shirts sold isn’t recorded at the time of sale in a periodic inventory system.
• End of Year Count: At the end of the year, the retailer does a physical count of inventory and finds that there are 50 t-shirts remaining in stock.
• Calculating COGS and Updating Inventory : At this point, the retailer can calculate the cost of goods sold (COGS) and update the inventory account:
  • The total cost of goods available for sale is the beginning inventory plus purchases, or $1,000 + $4,800 = $5,800.
  • The cost of the ending inventory is 50 t-shirts * $12 (the cost of the most recently purchased t-shirts) = $600.
  • Therefore, the COGS for the year is $5,800 (cost of goods available) – $600 (ending inventory) = $5,200.
• Accounting Entries: Finally, the retailer will make the following journal entries:
  • Debit (increase) COGS by $5,200.
  • Credit (decrease) Purchases by $4,800 (moving this amount to the inventory account).
  • Credit (decrease) Inventory by $400 (the difference between the beginning inventory of $1,000 and the physical count of $600).

In this way, the retailer has updated its Inventory and Cost of Goods Sold accounts using a periodic inventory system.