Peter Patel was recently hired as a new manager for Stanley Storage Systems. The company manufactures and assembles office storage systems. His compensation is composed of a base salary and a bonus based on gross profit. The bonuses are to be paid monthly, as determined by the gross profit for the preceding month.
Stanley Storage Systems currently uses a periodic inventory system, but Peter would like to see the company move to a perpetual system. The company’s owners are willing to consider the change, provided that Peter prepares a written analysis outlining the two methods and detailing the benefits and costs of switching to the perpetual system.
Required:
Prepare a report that Peter could present to the owners of Stanley Storage Systems to support his request to change to a perpetual inventory system.
SOLUTION
Report on Advantages of a Perpetual Inventory System
For Stanley Storage Systems (SSS)
There are two types of accounting system available to companies to internally account for their inventory – a periodic system, which SSS currently uses, and a perpetual system. A periodic inventory system is one that captures all the costs of inventory purchased throughout the accounting period in one “purchases” account, but, as its name suggests, relies on periodically taking a physical count of the actual inventory left on hand at the end of the period in order to accurately determine the cost of goods sold in the period and the gross margin and income earned for the period. A perpetual inventory system is one that continually, or perpetually, keeps tracks of the cost of inventory on hand by recording the cost of all purchases of the specific items acquired as additions to the inventory account and the cost of all goods sold as reductions to the inventory account.
While a perpetual inventory system would be more expensive to develop and to maintain on a continuing basis than the periodic system we now have, the benefits of a perpetual system far outweigh its additional cost. These benefits include the following:
Because records are kept for each significant type of inventory item used, SSS could reduce the occurrence of stock-outs. This will improve labour efficiency and production times in our manufacturing operations, and improve our operating capabilities and customer relations.
A perpetual system would allow us to account for the manufacture of customer contracts on an individual basis by accumulating the specific costs incurred on each. This would allow us to better control costs and improve our cost estimation abilities for bidding on other contracts in the future.
The expression “what gets measured gets managed” is very true, and a perpetual system permits us to be on top of what inventory we should have at all times. This has the advantage of reducing the likelihood of losses due to theft, spoilage and obsolescence.
Finally, a perpetual system reduces the need for physical inventory counts in order to establish the cost of inventory on hand. The system updates the inventory accounts for purchases, for goods placed into production, for goods transferred to finished goods, and for goods removed from the warehouse and sold to customers. An annual inventory count would still be required to ensure that the inventory information in our accounting system corresponds with our actual inventory on hand.
These advantages also offer the ability to more accurately determine the gross profit and net income earned each month. This makes our financial statements more reliable for presentation to the bank in support of our outstanding loans and reduces the need for significant year-end adjustments. On a personal level, it also allows for a more accurate determination of my monthly bonus and reduces the uncertainty of me having to repay amounts previously received when the financial statements are prepared at year end.
Based on the extent of the net benefits associated with the perpetual inventory system, I recommend that we move to this superior method for Stanley Storage Systems. Please let me know if you have any questions.