Perpetual Inventory: How a Perpetual Inventory System Works

Discover how a perpetual inventory system could help replenish stock, save you time, and increase your business cash flow.

Counting inventory is one of the most time-consuming–and essential–tasks for a retailer.

There are two ways to do it: a physical inventory count, usually performed once a month, or a perpetual inventory count, which uses a perpetual inventory system to reorder stock automatically. That way, you always have the right amount of stock available and customers can get what they want. 

Ahead, learn the basics of perpetual inventory, discover the pros and cons, and ultimately decide whether a perpetual inventory system should be part of your inventory management plan.

What is perpetual inventory?

Perpetual inventory is a system of inventory which allows you to keep track of stock in real time. It helps prevent stockouts, detect theft and shrinkage immediately, and increase cash flow.

A perpetual inventory system continuously updates inventory levels as you buy and sell goods. It saves all product data into a single system, both for online and physical retail stores, making it easy for you to keep sufficient stock on hand. You never run out of inventory, because the system constantly reorders products as counts diminish. 

Since this inventory accounting method tracks stock changes in real time, you can identify when items are running low and immediately restock them.

 

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The perpetual inventory method also helps uncover your customers' buying habits. Because inventory is updated regularly, you can discover if demand surges during certain times of the day or how the weather impacts demand for a specific item.

The internet has made perpetual inventory systems easy to manage. Using barcodes, radio frequency identification scanners (RFID), and point of sale, you can support this system by quickly updating inventory information as goods are sold. Problems like broken inventory and missing stock are mitigated because all discrepancies are tracked and recorded through the system.

“Accurate data on available stock is the biggest benefit of using a perpetual inventory system,” says George Pitchkhadze, CMO, Keyzar Jewelry. “We always know what we have enough of and what we’re about to run out of. There is zero risk of us running out of a specific diamond or setting because we reorder or remake what we’re missing as stocks dwindle.” 

Accurate data on available stock is the biggest benefit of using a perpetual inventory system.

George Pitchkhadze, CMO, Keyzar Jewelry

Inventory levels are always accurate under the perpetual inventory system, and the inventory turnover ratio can always be calculated correctly. This ratio informs a business owner if sales are slowing down or if specific products are no longer selling quickly online.

Perpetual vs periodic inventory methods

Perpetual inventory is often compared with periodic inventory to show which is more effective and gets a better return. 

As noted, perpetual inventory offers real-time tracking and reordering of inventory. In a periodic inventory system, you record stock levels at the end of an accounting period—be it monthly, quarterly, or yearly. 

Under a perpetual system, two journal entries are recorded when a product is sold:

1. The sale amount is debited to Accounts Receivable or Cash and is credited to Sales
2. The cost of merchandise sold is debited to the cost of goods sold (COGS) account and credited to inventory

Under the periodic system, the second entry isn’t made. This method takes inventory at the beginning of a period, adds new inventory purchases—including raw materials, Work In Process (WIP), and finished goods—during the period, and subtracts ending inventory to find the COGS. This means a company cannot know its full stock levels or COGS until a physical inventory count is finished. 

The benefits of using a physical inventory reporting method like periodic inventory are:

• Simple setup
• Low cost
• Easy for small businesses

Some disadvantages include:

• Less control over inventory
• Delayed results
• Labor-intensive
• Time-consuming

Patrick Brown, who runs The Personal Shop, feels retailers should leverage both methods.

“Perpetual inventory eliminates the need for us to close our shop regularly to perform physical inventories in our warehouse,” he says. “But a perpetual inventory system still requires an annual inventory to synchronize data with the physical inventory record.”

How does perpetual inventory accounting work?

1. Perpetual inventory formulas
2. POS updates inventory
3. COGS is updated
4. Reorder points are adjusted
5. Purchase orders are created
6. Received inventory is scanned and added to database

Imagine you own a shoe store. It’s the end of October, and you’re holding 125 pairs of shoes at $9 per unit to buy.

In November, you buy another 200 pairs of shoes at the same price, $9 per unit, and sell 250 units at $30. 

Here we are using set numbers, but in the real world, there will be price fluctuations to account for. 

1. Perpetual inventory formulas

• Economic Order Quantity (EOQ)
• Cost of Goods Sold (COGS)
• Finished goods
• FIFO
• LIFO
• Weighted average cost

Economic Order Quantity (EOQ)

Economic order quantity (EOQ) refers to the number of units you should add to inventory with each order. The goal is to help minimize the total costs of inventory, like stockouts and warehousing space.

The EOQ formula is the square root of: [2(demand rate)( setup costs)] / holding costs

Q= √2DS/H

• Q = The number of EOQ units
• D = Annual demand for product
• S = Setup costs, or how much one order costs per purchase
• H = Holding costs, which is the total cost of holding inventory

Cost of Goods Sold (COGS)

COGS is the direct cost of producing or buying products. It includes the cost of labor and materials related to production or manufacturing, but not distribution or sales costs. In a perpetual system, COGS is recalculated after each transaction.

COGS = (BI + P) - EI

• BI = Beginning inventory
• P = Purchases during period 
• EI = Ending inventory

Finished goods

Finished goods are all the products you can actually sell to customers. To calculate your finished goods on hand, subtract your cost of goods manufactured (COGM) from your COGS. Then add your previous cycle’s finished goods inventory. 

FIFO

First-in, first-out (FIFO) is an inventory valuation method that assumes the first products produced or acquired were sold first. To calculate FIFO, you need to determine the cost of your oldest inventory and multiply it by the amount of inventory sold.

LIFO

Last-in, first-out (LIFO) is the opposite of FIFO. It’s an accounting method that assumes the most recent items added to your inventory are the first to be sold. 

Weighted average cost

The “average” in a perpetual system means the average cost of the items in inventory as of the sale date. The weighted average cost method (WAC) is the middle point between FIFO and LIFO. 

It gives an average of how much each inventory item is worth by dividing the total cost by the volume of inventory in your stockroom. 

2. POS updates inventory

When you sell a product, your inventory management system immediately debits the main inventory across your sales channels. RFID and barcode scanners make this easy. 

3. COGS is updated

Whenever you sell or receive a product, COGS is recalculated. 

4. Reorder points are adjusted

Your perpetual inventory system automatically updates reorder points based on historical data, keeping a continuous optimal inventory count. 

5. Purchase orders are created

When a SKU number reaches its reorder point, the system creates a new purchase order and automatically sends it to your supplier. 

6. Received inventory is scanned and added to database

After inventory is sent to the warehouse, it’s scanned using warehouse management software. All items will appear in your inventory and be available for purchase throughout all your sales channels. 

Automation is critical for a successful perpetual inventory system. Patrick notes that because the system updates second by second, there are heaps of real-time data involved.

“It’s important that the system you build integrates well with your existing infrastructure. After all, the point of implementing perpetual inventory is to save time and money,” he says.

Ken suggests investing in a system that integrates with all of your sales channels, retail locations, and your warehouse management system, in order to maximize your inventory system’s benefits.

Pros and cons of a perpetual inventory system

Now that you understand how perpetual inventory accounting works, here’s a look at the pros and cons of a perpetual inventory system.

Pros of perpetual inventory

• Saves times, especially during peak or seasonal periods
• Inventory updated in real time
• Reduced physical inventory counts
• Better demand forecasting
• Staying on top of all product sales
• Predictive data helps you identify trends and shifts
• Makes financial statement planning easier
• Saves labor costs
• Prevents stockouts
• Gives a more accurate view of customer preferences
• Centralizes the inventory management system for multiple locations
• Provides greater accuracy, because each item is recorded in a separate ledger
• Makes it easier to identify theft and leakage 

Cons of perpetual inventory 

• Requires complex systems
• Higher startup costs
• Requires more consistent record-keeping
• Subject to errors due to overstatements (phantom inventory)
• Can also be misled by stolen inventory or human error

Who should use a perpetual inventory system?

Retailers in the US and Canada lost $349 billion in 2022 due to stockouts; in some verticals, shoppers experience stockouts as frequently as every third shopping trip.

It’s clear stockouts are on the rise, and a perpetual inventory system can help. But is it the right system for you?

Businesses that tend to excel using a perpetual inventory system include: 

• Businesses with high sales volume and multiple retail locations
• Fast-growing businesses with lots of SKUs
• Small-to-medium retailers that want to scale
• Dropshipping businesses with lots of moving inventory

Patrick says a perpetual inventory system does not work for all types of products and believes the best way to determine if it could work for your business is to consider three factors:

• Offering. “Some products are unitized, have small parts, or consist of multiple separate items. This is particularly true if your business makes products, rather than having a finished goods inventory,” he notes. “It can create more work and take more time to onboard or configure new products which consist of multiple units.” 
• Demand. “For a single store with relatively few products, it is probably not necessary and is a matter of personal preference. However, in large stores with more products, having up-to-date product data and availability allows you to manage cash flow more efficiently and discover seasonal trends within your range.”
• Inventory size. He suggests that stores with a large range of products should use a perpetual inventory system because it’s automatic and tracks every purchase and sale. Businesses with lower-volume inventory may excel with periodic counts. 

“It’s not efficient to manage a large store without having an insight into product availability,” Patrick adds. “You risk missing out on collecting useful data that can reveal popular products as well as those underperforming. It also provides complete data transparency, as every product can be accounted for transactionally.”

Is perpetual inventory right for your business?

As you see, a perpetual inventory system can reduce stockouts and increase cash flow. The best part? It doesn’t have to be complicated. With the right tools and processes in place, you can set up an inventory control system that automatically replenishes stock and lowers the cost of inventory management, with no human intervention or ordering errors. 

Using a point of sale system like Shopify POS, you can easily implement a perpetual inventory system and start seeing the benefits today.

Perpetual inventory FAQ

What is a perpetual inventory example?

Perpetual inventory is a system of tracking inventory purchases and sales on a continual basis. An example of this would be a retail store that keeps track of their inventory in real time as it is purchased and sold. Every time a product is sold, the amount of inventory in the store is updated to reflect the sale. The store also keeps track of incoming shipments of inventory to make sure that the amount in stock is accurate.

Is perpetual inventory FIFO or LIFO?

Perpetual inventory can use either FIFO (First-In, First-Out) or LIFO (Last-In, First-Out) depending on the preferences of the company.

What is the primary difference between perpetual and physical inventory?

The primary difference between perpetual and physical inventory is that perpetual inventory is tracked electronically in real time, while physical inventory is tracked manually through counting physical items in stock. Perpetual inventory systems allow businesses to have an accurate and up-to-date record of their inventory levels at any given time, while physical inventory requires manual counting and is limited to a certain point in time.

How does a perpetual inventory system work?

A perpetual inventory system is a method for tracking inventory that is updated in real-time. Every time an item is sold, the inventory system is updated to reflect the new quantity of the item. This system allows businesses to more accurately track their inventory, as well as identify when they need to order more of a particular item. It also helps prevent overstocking and understocking of items, as well as reduce the amount of time spent manually tracking inventory.