As your business accelerates, so does the complexity of tracking and managing your stock – a challenge that traditional periodic inventory systems may struggle to handle efficiently. But there’s a modern solution at your fingertips – the Perpetual Inventory System.
In a marketplace where 46% of small-to-medium businesses either don’t track inventory or use a manual method, those leveraging perpetual inventory systems can gain a significant edge over their competitors.
In this blog, we’ll discuss deeply the Perpetual Inventory System, its definition, examples, how it works, and many more things that businesses need to know.
What is a Perpetual Inventory System?
The Perpetual Inventory System, as its name suggests, is a method of warehouse inventory management that continuously updates inventory levels in real time. Unlike traditional methods that only provide snapshots at given intervals, the Perpetual Inventory System keeps an ongoing record of every incoming and outgoing product. This includes all purchases from suppliers, customer returns, and sales made across all your platforms.
The magic lies in its immediacy. The moment a sale occurs, the system adjusts the inventory count accordingly. But it doesn’t stop there. Beyond merely counting items, it also calculates the cost of goods sold (COGS) simultaneously, providing you with essential data to make informed business decisions.
Software solutions are crucial in implementing and maintaining a Perpetual Inventory System. Without them, it would be nearly impossible to manage the sheer volume of data generated by online transactions.
Inventory management software, such as ERPs or specialised eCommerce platforms, makes it feasible to automate and streamline the tracking process. These technologies synchronise data from multiple sales channels, monitor stock movements, and update records in real time, bringing the perpetual inventory concept to life.
Example of Perpetual Inventory System in eCommerce
Let’s consider an online boutique specialising in high-end clothing and accessories. They started their e-commerce business with a traditional periodic inventory system, conducting stock takes at the end of every month. However, as the business grew, they realised this method couldn’t keep up with the pace of their operations. Overstock and stockout situations were common, impacting customer satisfaction and profitability.
They decided to switch to a perpetual inventory system, leveraging advanced inventory management software that integrates with their e-commerce platform. With the new system in place, the inventory levels are instantly updated every time a sale is made. The software also provides real-time visibility into the cost of goods sold and the current inventory value.
The online store noticed significant improvements after implementing the perpetual inventory system.
First, their inventory accuracy skyrocketed. Real-time updates meant they could maintain optimal stock levels, reducing instances of overstock and stockouts. This directly increased customer satisfaction as they could reliably promise and deliver products.
Additionally, the perpetual system provided vital insights into their selling patterns, enabling them to forecast demand better. They also identified slow-moving items quicker, taking timely promotional actions to minimise holding costs.
How Does the Perpetual Inventory System Work?
Update Inventory Levels on the Point-of-Sale System
At the core of the perpetual inventory system lies its real-time nature, which ensures that when a sale is registered on your point-of-sale system, the inventory levels automatically adjust to reflect this transaction.
The point-of-sale system is not just a transaction recording tool in this context; it becomes a central part of your inventory management process. By connecting the point-of-sale system with your inventory management system, all sales and returns are immediately mirrored in your stock level, offering a transparent view of your inventory status.
Update Cost of Goods Sold
Perpetual inventory systems automate the calculation of COGS, incorporating all sales and inventory changes as they occur.
Having an up-to-date COGS allows businesses to make informed pricing, discounts, and profitability decisions. Moreover, it clearly explains how much capital is tied up in inventory, which is critical for cash flow management and financial planning.
Reorder Point Automation
In a perpetual inventory system, reaching the reorder point triggers automatic notifications. The reorder point is a predetermined stock level at which new orders should be placed to replenish inventory before running out. Automated alerts enable businesses to maintain optimal inventory levels without manual monitoring.
Purchase Order Automation
Integrating purchase order automation into the perpetual inventory system further streamlines inventory management. Once the system hits the reorder point, it can automatically generate purchase orders to replenish stock. This reduces administrative workload and speeds up the restocking process.
Warehouse Management Software
Lastly, warehouse management software plays a significant role in the operation of a perpetual inventory system. It allows businesses to track inventory across multiple eCommerce warehouses and locations, ensuring accurate stock levels.
Integrating warehouse management software with other business systems allows for efficient data exchange. This interconnectivity ensures that all parts of your business – from sales and procurement to warehousing and logistics– have a consistent, accurate view of inventory levels.
How to Calculate Perpetual Inventory
In a perpetual inventory system, inventory calculation is a constantly updated and dynamic process. It is not a one-time calculation that needs to be done at set intervals. Instead, it is an ongoing process that is updated as transactions occur in real time. Here’s how it works:
This continuous updating of inventory levels is what gives the perpetual inventory system its name – it is ‘perpetual’ because the calculations are ongoing, not confined to specific points in time.
To simplify, you could say the formula for perpetual inventory management is as follows:
Ending Inventory = Beginning Inventory + Purchased Inventory – Sold Inventory
In this formula:
- Beginning Inventory refers to the amount of inventory at the start of the period.
- Purchased Inventory refers to the items added to your stock during the period.
- Sold Inventory refers to the items sold during the same period.
- Remember, the ‘period’ in this context is not a traditional accounting period like a month or a quarter, but rather the time between inventory updates, which in a perpetual inventory system could be as short as a few seconds or minutes.
Formulas of Perpetual Inventory System
Economic Order Quantity (EOQ)
EOQ calculates the ideal order quantity a company should purchase for its inventory to minimise total inventory costs, including holding costs, shortage costs, and order costs. The formula for EOQ is:
EOQ = √[(2DS)/H]
D = Demand rate (quantity sold per year)
S = Ordering cost per order
H = Holding cost per unit per year
Consider an eCommerce business that sells handmade soaps with an annual demand of 5000 units, an ordering cost of ₹20 per order, and a holding cost of ₹5 per unit per year. Substituting these values into the EOQ formula, we would find the EOQ to be approximately 200 units. This suggests that the company should aim to order 200 soaps at a time to minimise total inventory costs.
Cost of Goods Sold (COGS)
COGS represents the direct cost of producing the goods sold by a company. This includes the material costs used in creating the goods and the direct labour costs used to produce the goods.
COGS = Opening inventory + Purchases during the period – Closing inventory
For instance, if our handmade soap company started with an inventory worth ₹10,000, made additional soap purchases worth ₹5,000 during the period, and ended with $4,000 worth of soaps, the COGS would be ₹10,000 + ₹5,000 – ₹4,000 = ₹11,000.
Gross Profit is a company’s total revenue minus the cost of goods sold. It reflects the efficiency of a company’s management as well as its underlying health.
Gross Profit = Total Revenue – COGS
Let’s say the soap company made a total revenue of $30,000, and we already calculated the COGS as $11,000, and the gross profit would be $30,000 – $11,000 = $19,000.
Inventory Management Methods (FIFO, LIFO)
First-In-First-Out (FIFO) and Last-In-First-Out (LIFO) are crucial methods used in cost accounting to calculate the value of unsold inventory, the cost of goods sold, and other transactions.
FIFO is a method used to calculate inventory that assumes that items purchased or produced earlier are sold first. Consequently, the items remaining in inventory at the end of the period are those most recently purchased or made.
For instance, if the soap company bought 100 soaps at ₹2 each in January and 200 soaps at ₹3 each in February, and sold 150 soaps in March, according to the FIFO method, the COGS would be (100*₹2) + (50*₹3) = ₹350.
LIFO is an inventory valuation method that assumes that the latest items purchased are the first to be sold.
Using the same example but applying the LIFO method, the COGS would be (150*₹3) = ₹450.
In this rapidly evolving eCommerce landscape, staying ahead of the game is crucial. A perpetual inventory system might just be the tool to give you that competitive edge.
So why not give it a thought? Remember, in the eCommerce business, it’s not just about surviving; it’s about thriving – and having the right systems in place, like the perpetual inventory system, can be a significant step in that direction.
Does Amazon use a perpetual inventory system?
Yes, Amazon uses a perpetual inventory system. It is one of the largest eCommerce businesses globally and uses this real-time tracking system to manage its vast inventory efficiently. The perpetual inventory system allows Amazon to maintain accurate stock levels, streamline operations, prevent stockouts, and optimise warehouse space, facilitating better customer service and enhancing operational efficiency.
How do you plan inventory for eCommerce?
Planning inventory for eCommerce involves the following key steps:
- Forecasting: Leverage historical sales data and market trends to predict future product demand. This information helps determine the volume of inventory required to fulfill customer needs.
- Safety Stock: Maintain an extra quantity of safety stock to account for unexpected demand fluctuations or supply chain delays, helping to prevent stockouts.
- Reorder Point: Establish a reorder point for each product, which signals when it’s time to restock. This tactic ensures a consistent product supply and aids in avoiding stockouts.
- Lead Time: Account for the lead time needed to replenish inventory, considering factors like order placement, shipment receipt, and product incorporation into the inventory.
- Inventory Optimisation Techniques: Implement techniques to enhance inventory management, such as inventory balancing across locations, kitting (product bundling), and just-in-time inventory approaches.
- Inventory Tracking: Employ a reliable system, such as inventory management software, to track inventory in real time. This provides accurate visibility into inventory levels, sales data, and product performance.
What businesses use perpetual inventory systems?
Businesses with larger, more intricate inventory structures and higher sales volumes commonly utilise perpetual inventory systems due to their ability to provide real-time stock-level information and streamline inventory management. Typical examples include grocery stores and pharmacies. Other sectors like eCommerce platforms, automotive dealerships, and technology firms also frequently adopt perpetual inventory systems, benefitting from their operational efficiency and decision-making capabilities.
Does the perpetual inventory system use FIFO or LIFO?
Yes, A perpetual inventory system uses either the First-In-First-Out (FIFO) or the Last-In-First-Out (LIFO) method for inventory valuation. The choice between FIFO and LIFO depends on the nature of the business, the kind of products it sells, and the specific inventory management objectives.
What is perpetual inventory also known as?
Perpetual inventory is also known as continuous inventory.
What is the difference between perpetual and physical inventory?
The difference between perpetual and physical inventory lies in how and when the inventory data is recorded.
A perpetual inventory system continuously updates inventory records as items are added or subtracted and keeps track of the cost of goods purchased and sold. On the other hand, a physical inventory system relies on periodic manual counts to track inventory and ascertain the cost of goods bought and sold.
Therefore, while perpetual inventory provides real-time inventory status, physical inventory offers updates at specific intervals.