7. Drawbacks to Periodic

Let's look really quickly at some drawbacks of periodic systems. So periodic stands in contrast to perpetual, and perpetual means always. And so what do we perpetually know? We perpetually know inventory, and we perpetually know cost of goods sold, versus periodic, where we sometimes know inventory, and we sometimes know cost of goods sold. So under the periodic system, we decided that beginning inventory plus cost of goods purchased minus ending inventory equals cost of goods sold. Now, what do you think could be a problem here?

Let's assume that our accountants are keeping track of cost of goods purchased pretty well. Let's assume that's not really an issue. Let's assume that last year's ending inventory was counted correctly, so this year's beginning inventory, well, that's not really a problem. Let's assume that this year's ending inventory was counted correctly, but this still presents a little bit of an issue because we're using the count to determine the cost of goods sold. So let's look at a scenario. Let's say ending inventory was counted at $10,000, and let's say counted accurately. So ending inventory was counted accurately to be $10,000.

And let's say when ending inventory was $10,000, COGS was $20,000. So let's draw out a real quick formula. COGS is 20, ending inventory was 10, beginning was 5, and purchases were 25. So this is the scenario we're looking at. 5 plus 25 minus 10 is 20.

Now, I'm telling you that this $10,000 presents a problem, and the problem is this. What if instead of $10,000, it should have been $12,000, but somebody stole $2,000 worth of goods? Okay, well, it should have been 12. Somebody stole 10. I'm sorry. Somebody stole 2, so we end up with 10. This 2 just ends up in our cost of goods sold. We have absolutely zero insight into the fact that it should have been 12, but somebody stole 2, so we counted it at 10, and we passed it into this cost of goods sold. So what happens? So had we done it correctly, or rather, had we caught the thief, it would look like this, right?

Our ending inventory would be higher by $2,000, and our COGS would be lower by $2,000. So because we didn't know, because we weren't perpetually keeping track of cost of goods sold, we didn't know, and we ended up passing an extra $2,000 of an expense into our cost of goods sold, which reduces our net income by $2,000. And under the periodic system, we have absolutely no way of knowing, because what do we do? At the end of the year, we count it, and we count it accurately, and we decided $10,000, and we are calculating cost of goods sold, so we have no way to prove that $10,000 wrong.

Contrast that with the perpetual system, so we would do this. We would say $5,000 plus the 25 of purchases minus the $18,000, because we've been keeping track of this all along, right? Under perpetual, we keep track of it, so we know that our cost of goods sold is 18. So 5 plus 25 minus 18 gives us $12,000 of ending inventory.

That's what it should be. That's the estimate of what it should be. We go and we count, and we realize, uh-oh, we only have $10,000. We only have $10,000 of actual ending inventory, and so we know that we have a $2,000 loss, right? So under perpetual, we have this option because we know this number. Under periodic, we do not have that option because we're trying to calculate that cost of goods sold. So we end up saying, "Well, I don't know. Cost of goods sold must be 20 because ending inventory is 10," and you just have absolutely zero way of knowing.

And this "stole" doesn't have to be stole. It could be, uh, we had to get rid of it because it was defective. It could be it never even arrived maybe. We could have actually just lost it. We could have misplaced it, and now it's gone. But under periodic, you never get to know that. Under perpetual, you know the estimated ending inventory based on this cost of goods sold that you've been perpetually keeping track of, and then you go out to the warehouse and you count the actual, and you realize, shoot, we gotta recognize a $2,000 loss. But what that does is that separates.

So either way, it's a $20,000 expense, but that separates it into $18,000 cost of goods sold and $2,000 of loss. So when you're doing your financials and when you're trying to make management decisions, you're not operating under the assumption the cost of goods sold is 20. You're operating under the assumption that it's 18, and we need to have a better warehouse because we lost 10% to theft or whatever it is.