The traditional way to track inventory is to count how much you have every time you make a sale (or, if you sell stuff too rarely to count all at once, estimate how much you had at the last count). The counting cost is high–in fact, since it’s done infrequently, it’s an opportunity cost of your time–so we want to do it as seldom as we can get away with.
The problem with this method is that we’re likely to forget some of the things we sold. If you’re like me and my friends, when you get home from a trip or a party or an extended lunch break or whatever, someone is going to ask “Did I bring my keys?” and you will spend five minutes searching for them before realizing they were in your hand the whole time.
We don’t want this kind of thing happening when we sell something. If we forget to count something on the way into the storeroom, we also want to forget about it on the way out.
The solution is a periodic inventory system: if you count everything every day and write down what you counted and signed by whom and dated and put in a safe place for future reference, then there’s no need ever to worry about forgetting anything again.
A periodic inventory system means that you regularly count what’s on hand. It is an alternative to counting everything when it is put away, which is called a perpetual inventory system.
These two systems can be used in combination or separately. You might, for example, do a periodic inventory of the most valuable items on your shelves, while using a perpetual inventory system to track everything else. And you might use some other method–like analyzing your sales figures–to double-check your periodic inventory.
The benefits of doing a periodic inventory are that you can get better control over what you sell and that you can make sure your costs are accurate. The cost of doing an accurate periodic inventory is that it takes time–it’s more work than just running an occasional report.
But if you’re working with limited shelf space, there is another reason why you might want to use a periodic inventory system: because of the way it works, it can help prevent shortages.
There’s a common misconception that a periodic inventory system is a good way to avoid being screwed by unscrupulous employees. In fact it’s a very bad way to do that. A periodic inventory system is a good way to avoid being screwed by yourself.
A perpetual inventory system requires you to keep track of everything in your store all the time. It’s not just my store; it’s every store in the world. In the real world, no one does it perfectly, and I’m sure my employees would love to rip me off if they could get away with it. So why don’t I use a periodic inventory system? Because even though my employees are honest, they’re human beings, which means they’re unreliable and dumb and forgetful and sometimes just plain incompetent. We all know it’s easier for a camel to pass through the eye of a needle than for an honest person to pass through a revolving door or remember where he left his keys or pee without making a mess on the floor or keep from spilling coffee on his crotch when he walks across the room. In addition to all their other limitations, humans are notoriously unreliable at doing things exactly right every single time.
There is a fundamental difference between physical inventory and financial inventory. Physical inventory is something you want to know, and physical inventory systems are designed accordingly. Financial inventory is something you don’t want to know, and financial inventory systems are designed accordingly.
A periodic inventory system, like the one Walmart uses, does not tell you how much stuff you have; it tells you what your accountant thinks he knows about how much stuff you have. The problem is that your accountant doesn’t know how much stuff you have either. But he can make an educated guess. He has sales figures and expenses and a prediction of future sales and expenses (always optimistic) and a few other numbers he can play around with to produce a single number for net worth. And if that’s what you want — a single number for net worth — then that’s what a periodic inventory system will give you.
A periodic inventory system is best for a business that has unpredictable sales levels. For example, if your business is building houses, you can’t be sure when people will want to buy houses. If you run out of houses, you lose sales; but if you have too many houses sitting around, you don’t make any money on them until you sell them. Also, the more houses you have in stock, the more interest you pay on the money tied up in inventory.
Unlike a lot of businesses, house builders’ revenues are not proportional to their costs. If they cut back on staff and materials to save money, they will lose sales. But if they hire and spend freely on materials and labor, they will get more houses out the door and increase their market share and profits.
Housing starts today are running at about 1.3 million per year; last year it was about 1.4 million. That’s a pretty big change from the recession years of 2008 and 2009 when starts were less than 700,000 per year. Housing starts would be even higher if there weren’t regulatory barriers to having more construction workers available. The housing industry can add thousands of new employees every month.
For most kinds of inventory, it makes sense to find out what you’ve got and then re-check periodically. With rare exceptions, inventory systems should be periodic.
Periodic systems are simple and make intuitive sense: when you get in something, you count it; when you use something up, you count it again. It’s only when we get into the details that we realize there are a lot of ways things can go wrong.
The simplest inventory systems–those used by most garage-and-basement operations–are perpetual inventory systems. You never stop counting; every item is tracked from the time it arrives until the time it’s sold or thrown away. In theory this sounds great, but in practice perpetual inventory is a lot of work, and–as anyone who has seen a warehouse full of forklifts knows–it is also expensive to maintain large quantities of inventory.
In a perpetual system, if an item disappears from inventory for any reason–because you broke it, because a customer returned it, whatever–you have to track down where it went before you can sell anything else. This is called an out-of-stock situation. It may seem harmless enough in cases where the missing items are just pencils or paper clips or whatever that
I was talking to an accountant the other day, and he described the system his firm uses for inventory. I told him it sounded like a terrible system, but he explained why it’s actually better than the alternative.
One reason this system is better is because of what economists would call “opportunity costs.” If you know how much inventory you have, you can’t also know how much demand there will be. So if you try to estimate demand, that’s time you’re not spending on repairing or replacing inventory.
Another reason is that keeping track of inventory is expensive. You need to hire someone to count things, and if they make mistakes, you need to hire someone else to correct their mistakes. And so on.
But the main reason this system is optimal is that it’s the only way to maintain an optimal quantity of inventory. The alternative is to try to keep track of all your inventory, which requires infinite knowledge of both demand and supply (or at least more knowledge than any human can possess).
Emil is a contributor at Accountant Log. We are committed to providing well-researched, accurate, and valuable content to our readers.
