3.6 Perpetual Inventory Accounting
There are two such counting (“Accounting”) methods for inventory – “perpetual” and “periodic.”A perpetual inventory counting system is usually used where the inventory units are few in number, and high in unit cost. It thus pays for the firm’s management to spend some extra resources in knowing exactly how many yachts, for example, it has in the showroom. A one-unit difference is substantial. Under this system, the firm knows – at all times– the dollar value of its inventory. There are certain methods under which a perpetual system accounts for its inventory, including “specific identification,” whereby each physical inventory unit is associated with its own specific cost.
In contrast, a periodic inventory system is effective where units are numerous and relatively cheap. Management is not going to be able to justify the extra effort required to know whether there are ten or eleven blue pens in stock, more or less. It will do, instead, a periodic, probably annually, physical audit of what’s down there in the warehouse. When a physical audit is done, the counting is done in units, rather than in dollars. Thus, the ascription of units to dollars is subject to methodological choice.
When a company uses a periodic system, there are management choices under legitimate accounting rules by which the accountant may record the ending inventory balance and, hence, cost of goods sold figures – in dollars. We will illustrate all this below. Upon the completion of which analysis, the analyst’s relevant interpretive issues should become clear.
The differences in the numbers presented, and the related management strategies as related to the choice of cost method, are potentially markedly different. Let’s read on.