Perpetual Inventory Counting vs Annual Physical Inventory

January 05, 2011

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If your business maintains inventory there are a few accounting and business practices you should be aware of. Generally Accepted Accounting Principles ( GAAP ) as well as IRS rules require you to either count your complete inventory on an annual basis or implement a perpetual counting system. With good computerized inventory systems, the perpetual counting system (often called “cycle counting”) can save money, increase accuracy of the count, and reduce disruption in your operation during the count. The reasons most often cited in favor of cycle counting is that the complexity of doing an annual physical inventory is much greater and therefore there is more chance for error.

When Does Annual Physical Inventory Make Sense?

In addition to improving the accuracy of your inventory records, cycle counting allows an annual review of each line or segment of products once a year when inventory is divided into 12 segments. By reviewing whether a product should be continued to be stocked, or by analyzing missed sales buyers can constantly be determining what products should be stocked and what shouldn’t. Creating better inventory management processes improves inventory turnover and results in more efficient use of the working capital supporting inventory.

Businesses that have inventory have a number of considerations to make when it comes to keeping track of their actual verses book inventory.

The average business should be able to produce an accurate balance sheet, income statement, accounts receivable and payable aging very shortly after each month has ended. QuickBooks and other modern accounting software systems certainly allow for this to be possible. The key is keeping the inventory accurate, entering accounts payable into the system as soon as the payable has been accrued, and making sure credits and customer payments are posted in a timely manner.

In terms of inventory, the IRS requires a business to state its inventory value to be declared on its annual tax return. There is an expectation that inventory will be physically counted and the number of units will be multiplied by the cost of goods. The IRS only requires that the inventory count be a done in a manner that produces an accurate result.

For small businesses that maintain a small inventory, a single annual physical inventory count makes sense. However, if your business maintains a large number of items in inventory, it may be more accurate to use a cycle counting method rather than one single large inventory.

Getting the Most Out of Perpetual Inventory Counting

To get the most advantage out of the cycle counting process, include the following steps in your annual line review and count:

  • Using your inventory control system ranking feature calculate the popularity of a particular item once a year.
  • Determine which inventory should have the stocking quantity set to 0 based on the last year’s historical sales. If your vendor will take it back and exchange it for faster moving inventory, pull the inventory you want to send back and set the quantities on hand to 0.
  • Count the inventory by vendor or product line, depending on what makes since for your business. Divide the entire inventory into 12 logical segments and determine which month you plan on counting a particular segment.
  • After your count is done, look at your history of lost sales during the year. If you determine that an item’s popularity has increased during the year, consider raising the stocking quantity value so you will stock more of the most popular items.

When receiving inventory, there are several important considerations to remember. When you are receiving inventory into QuickBooks or a similar system, separate freight and other non inventory charges from the inventory, otherwise the value of your inventory will be inflated. This is especially important if you use a separate point of sale or inventory control system.

In the past 12 months cost of goods sold has significantly increased for many industries. Make sure your current cost is always accurate in your system. When possible, recalculate the selling price to achieve your company’s target gross margin for that item.

Businesses that use this approach find they have more accurate inventory book value, lose fewer sales, and have a higher gross margin than those that don’t.

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Topics: Operations, Featured, Business Best Practices, Articles

Ed Lette

Business Bank of Texas

Ed Lette is a Founder of Business Bank of Texas. Serving as a licensed CPA since 1983, Ed’s extensive experience in the banking industry has led him to become the founding president of four national bank charters including Business Bank of Texas, N.A., and the chief financial officer of five national banks during his 45 year career. Ed serves as director of the Texas Bankers Association District 4, chairman of the Executive Advisory Council to the School of Business at Texas Lutheran University, and is a life member of the Texas Association of Business.
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