Question

Choose and describe a business that would have a significant amount of inventory and share a photo of that business (or company logo). Briefly explain whether you expect the business uses a periodic or perpetual inventory system, and why. If the image is not your own, be sure to cite the source in your description.

Answer 1

Inventory management is one of the keys in turning a small business into a large, successful corporation that’s able to generate millions of dollars in annual revenue. However, the act of scaling doesn’t come without its own set of hurdles. If your business is in the food distribution, ecommerce, consumer goods, or electronic devices industry, it’s time to listen up. Inventory management is of the utmost concern.

Nestlé (Malaysia) Berhad started in Malaysia in 1912 and was listed on Bursa Kuala Lumpur on 13 December 1989. The company manufactures a wide range of products including instant beverages, milk product, ice cream, cereals, chilled products and many more. Meanwhile, Nestlé (Malaysia) Berhad has a lot of brand names. For instance, MILO®, NESPRAY®, NESCAFÉ®, MAGGI® and KIT KAT® (Nestlé Berhad, n.d.). Like other trading and manufacturing company, Nestlé (Malaysia) Berhad purchases raw materials as the input for production of final goods. It is then to be sold to the customers with the intention of earning profits. The valuation of inventories used by Nestlé (Malaysia) Berhad is first-in first-out (FIFO) method. Since it is a big company with a large amount of inventories, it has been proved that a ‘good control over inventory must be maintained’ (Reeve, Warren and Duchac, 2007, p.308). A little mistake made will have a significant impact on the financial statements.

Nestlé (Malaysia) Berhad manufactures various types of products and has several categories of inventories. It includes raw and packaging materials, work-in-progress, finished goods and spare parts (Nestle (Malaysia) Berhad, 2012).

Finished goods

Work-in-progress

Raw materials

Nescafe

Milo

Smarties

Kit Kat

Haagen-Dazs

Nestea

Roasted coffee beans

Chocolate crumbs

Skim milk powder

Cocoa paste

Sugar

Coffee beans

Vanilla

Palm oil

Salt

Milk

Inventories are valued by comparing between the cost and net realisable value (NRV). The lower value one will be the amount of closing inventories. This is based on the Lower Cost Method (LCM) rule which is the lower of cost and market value (WebFinance, 2012).

There are two types of methods commonly used by most of the companies to calculate cost of inventories:

First-in first out (FIFO)

Weighted Average COST (WAC)

The NESTLE company uses the first-in first-out (FIFO) method to evaluate their company’s inventories. This is because it is simple to understand and easy to operate. The FIFO method means that whichever goods that are purchased first will be sold first to the customers. In another words, the oldest goods will be sold first. Hence, the goods most recently purchased are the closing inventories at the end of the year and made up of most recent costs (Murray, 2012).

By using FIFO method, the closing inventories consist of most recent purchase prices which show the current market price. For big company like NESTLE Berhad, this method enable the company to have fewer amount of obsolete inventories. However, this method may lead to errors if the prices fluctuate frequently. The cost of sales will also be understated during inflation and causes profit to be overstated. This contradicts with prudence concept where the profits and assets should not be overstated while losses and liabilities should not be understated (Rabi Gupta, 2012)

The periodic and perpetual inventory systems are different methods used to track the quantity of goods on hand. The more sophisticated of the two is the perpetual system, but it requires much more record keeping to maintain. The periodic system relies upon an occasional physical count of the inventory to determine the ending inventory balance and the cost of goods sold, while the perpetual system keeps continual track of inventory balances. There are a number of other differences between the two systems, which are as follows:

· Accounts. Under the perpetual system, there are continual updates to either the general ledger or inventory ledger as inventory-related transactions occur. Conversely, under a periodic inventory system, there is no cost of goods sold account entry at all in an accounting period until such time as there is a physical count, which is then used to derive the cost of goods sold.

· Computer systems. It is impossible to manually maintain the records for a perpetual inventory system, since there may be thousands of transactions at the unit level in every accounting period. Conversely, the simplicity of a periodic inventory system allows for the use of manual record keeping for very small inventories.

· Cost of goods sold. Under the perpetual system, there are continual updates to the cost of goods sold account as each sale is made. Conversely, under the periodic inventory system, the cost of goods sold is calculated in a lump sum at the end of the accounting period, by adding total purchases to the beginning inventory and subtracting ending inventory. In the latter case, this means it can be difficult to obtain a precise cost of goods sold figure prior to the end of the accounting period.

· Cycle counting. It is impossible to use cycle counting under a periodic inventory system, since there is no way to obtain accurate inventory counts in real time (which are used as a baseline for cycle counts).

· Purchases. Under the perpetual system, inventory purchases are recorded in either the raw materials inventory account or merchandise account (depending on the nature of the purchase), while there is also a unit-count entry into the individual record that is kept for each inventory item. Conversely, under a periodic inventory system, all purchases are recorded into a purchases asset account, and there are no individual inventory records to which any unit-count information could be added.

· Transaction investigations. It is nearly impossible to track through the accounting records under a periodic inventory system to determine why an inventory-related error of any kind occurred, since the information is aggregated at a very high level. Conversely, such investigations are much easier in a perpetual inventory system, where all transactions are available in detail at the individual unit level.

This list makes it clear that the perpetual inventory system is vastly superior to the periodic inventory system. The primary case where a periodic system might make sense is when the amount of inventory is very small, and where you can visually review it without any particular need for more detailed inventory records. The periodic system can also work well when the warehouse staff is poorly trained in the uses of a perpetual inventory system, since they might inadvertently record inventory transactions incorrectly in a perpetual system.