Managing inventory efficiently is crucial for product-based businesses as it involves a significant amount of capital. The U.S. Census Bureau reported in July 2020 that the inventory/sales ratio stood at 1.33, indicating that U.S. manufacturers and retailers held $1.33 of inventory for every $1 in sales by the end of that month.
To overcome inventory challenges, companies can reduce the volume of unsold goods or unused materials they maintain, which requires mastering inventory management. This effort is worthwhile because effective inventory management enhances cash flow. By leveraging the correct data and technology, businesses can minimize write-offs and allocate freed-up funds to support growth initiatives.
Obsolete inventory comprises items in stock that are no longer usable. Typically, these products have been superseded in the market by more advanced or cost-effective alternatives, resulting in diminished demand. As these goods are unsellable, their cost is either written off entirely or down to their remaining market value. A write-off removes the inventory asset from the accounting records, while a write-down reduces its value to the price at which it can still be sold.
Ideally, a business should maintain an obsolete inventory reserve, which is linked to and offsets the inventory asset accounts. This reserve’s balance should reflect the estimated amount by which the inventory asset will be written down once specific obsolete items are identified.
In some cases, certain obsolete inventory items may be sold at substantially reduced prices. The prices fetched can be higher if the materials management department vigilantly monitors inventory and disposes of things as soon as their usage declines.
A significant accumulation of obsolete inventory can raise concerns about a business’s financial health. It may signal a weak market for the company’s products or an inability to manage the inventory asset effectively.
Establishing criteria for when various inventory types become obsolete is a task unique to each business, and these criteria can differ significantly across industries and product categories. Consider the distinctions between, for instance, the food and furniture sectors. It’s advisable to begin with industry-specific standards to construct guidelines for classifying inventory items as slow-moving, excess, or obsolete.
Inventory obsolescence can stem from various factors, such as product issues, inaccurate forecasting, deficiencies in inventory management, and other challenges. However, the encouraging news is that companies can mitigate the accumulation of dead inventory by maintaining diligent inventory tracking. Identifying items in the slow-moving or excess stages provides an opportunity to recoup some value from them before they reach obsolescence.
Under GAAP (Generally Accepted Accounting Principles), companies are required to establish an inventory reserve account to address obsolete inventory on their balance sheets and to recognize this obsolete inventory as an expense upon disposal. This practice can lead to reduced profits or even losses. Companies disclose inventory obsolescence by debiting an expense account and crediting a contra-asset account.
When an expense account is debited, it signifies that the money spent on the now obsolete inventory is considered an expense. The contra asset account appears on the balance sheet right below the asset account to which it corresponds and serves to decrease the net reported value of that asset account.
Expense accounts encompass categories like cost of goods sold, inventory obsolescence accounts, and loss on inventory write-down. Contra asset accounts may include allowances for obsolete inventory and obsolete inventory reserves. Generally, if the inventory write-down is minor, companies charge the cost of goods sold. However, for significant write-downs, it is preferable to allocate the expense to an alternative account.
Suppose a company discovers $10,000 of obsolete inventory on its books. After a careful assessment, it determines that the stock can still be sold in the market but at a significantly reduced price of $3,000 due to changes in market demand or product obsolescence. In response, the company writes down the inventory’s value to reflect its current market worth.
The write-down involves reducing the recorded value of the inventory from its original $10,000 to the new market value of $3,000. The resulting difference of $7,000 represents the reduction in value that must be documented in the company’s accounting records, emphasizing the loss in value due to obsolescence or reduced market demand for the inventory.
Several common issues can result in inventory becoming obsolete. It’s essential for businesses to thoroughly examine their operations to identify these issues and take corrective action to avoid financial losses.
Inaccurate forecasting is a significant driver of obsolete inventory. When a company anticipates that specific product variations (SKUs) will be top sellers during the first two quarters, it often places substantial orders with suppliers. However, if the actual demand falls short of these expectations, surplus inventory accumulates, losing its value over time.
An ineffective inventory management system, with inaccurate data or insufficient reporting capabilities to provide a comprehensive view of current stock, worsens the problem of obsolete inventory. Discrepancies between the system’s information and warehouse quantities can lead to over-ordering. Additionally, the inability to monitor inventory turnover or stock days on hand leaves businesses guessing when to reorder.
Products can become obsolete due to quality or design issues. If items break easily, fail to function as advertised, or offer no advantage over existing market options, sales decline. Returns and negative reviews compound the problem, resulting in excess inventory.
Purchasing decisions should be based on data closely tied to forecasting and demand planning. When purchasing relies on anecdotal knowledge or unreliable factors, issues arise. Overenthusiastic purchasing managers, eager to buy in bulk to reduce costs per item, may lead to an overabundance of inventory.
Understanding lead times is crucial for buyers. They need to know when they will receive products after placing an order, especially if vendor lead times vary or unexpectedly long lead times can be problematic, as demand may decrease during the waiting period, resulting in excess inventory.
| Account | Debit | Credit |
| Inventory Obsolescence | $10,000 | |
| Allowance for Obsolete Inventory | $10,000 |
The allowance for obsolete inventory accounts serves as a reserve and functions as a contra-asset account. This arrangement allows the original cost of the inventory to remain on the inventory account until the time of disposal. When the obsolete inventory is disposed of, the asset and the allowance for obsolete inventory are zeroed out.
For instance, if a company decides to dispose of its obsolete inventory by discarding it, it won’t realize the sales value, which, for example, could have been $3,000. In addition to writing off the inventory, the company must recognize an additional expense of $3,000.
This is achieved by releasing the allowance for obsolete inventory through the creation of a journal entry:
| Account | Debit | Credit |
| Allowance for Obsolete Inventory | $7,000 | |
| Inventory Obsolescence | $3,000 | |
| Inventory | $10,000 |
The journal entry efficiently eliminates the value of the obsolete inventory from both the allowance for obsolete inventory accounts and the inventory account.
In another scenario, if the company opted to sell the obsolete inventory for a reduced amount, such as through an auction for $1,200, the proceeds of $1,200 would fall $1,800 short of the original book value of $3,000. In this case, the $1,800 difference would be recognized as an expense, and the journal entry would document both the disposal of the inventory and the receipt of $1,200 from the auction:
| Account | Debit | Credit |
| Cash | $1,200 | |
| Allowance for Obsolete Inventory | $7,000 | |
| Cost of Goods Sold | $1,800 | |
| Inventory | $10,000 |
The sale proceeds of $1,200, subtracted from the original inventory’s net value of $3,000, resulting in an additional loss of $1,800, which is accounted for in the cost of goods sold account.
A substantial volume of obsolete inventory should raise concerns for investors. It may indicate issues such as product quality, inaccurate demand forecasts, or inefficient inventory management. Assessing the extent of obsolete inventory a company maintains provides investors with insights into product performance and the effectiveness of the company’s inventory management procedures.
Regularly examining inventory levels and trends is crucial for companies aiming to enhance supply chain visibility and efficiency.
To conduct an inventory analysis, staff should consistently review sales figures, typically monthly, and compare them with the current inventory levels, often assessed through a physical inventory count. These figures serve as the foundation for calculating inventory turnover, which signifies how frequently a company sells its inventory within a specific timeframe.
The formula for calculating inventory turnover is as follows:
Sales / Average Inventory = Inventory Turnover
An organization might discover that some of its products exhibit pronounced seasonality, with significantly higher sales during fall and winter compared to spring and summer, for instance. Alternatively, there might be a sudden decline in sales for a particular category of goods. In such situations, targeted inventory cycle counting can be employed to address these specific categories.
Another valuable metric for pinpointing the origin of obsolete inventory is the calculation of days (or months) of inventory on hand. This metric provides insight into how long specific stock has been stored in the company’s warehouse.
The formula for calculating days on hand is as follows:
Average Inventory / Cost of Goods Sold x 365 = Days on Hand
Regularly analyzing these and various other inventory metrics can assist businesses in enhancing their procurement and inventory management practices, ultimately reducing obsolete inventory.
Excessive amounts of obsolete inventory can significantly impact a business’s profitability and long-term viability. A decline in financial health can hinder the company’s ability to attract investors or qualify for loans.
Moreover, obsolete inventory is recognized as an expense on the balance sheet, a crucial financial document for any company.
Additionally, outdated inventory is frequently neglected for extended periods, occupying valuable warehouse space that could be used more profitably. Instead of efficiently storing high-demand products, this costly real estate is wasted as old stock collects dust and depreciates.
Dealing with obsolete inventory demands a thoughtful approach to mitigate financial repercussions. Organizations can start by repositioning items with sales potential, exploring different sales channels, and incorporating them into marketing campaigns.
While this may impact profit margins, offering discounts can expedite sales. Bundling less popular items with core products is another way to enhance appeal and reduce excess inventory. If these methods prove ineffective, liquidation might be an option.
Furthermore, donating obsolete inventory to charitable organizations not only eliminates disposal costs but also yields potential tax deductions.
As a last resort, organizations should follow Generally Accepted Accounting Principles (GAAP) by classifying obsolete inventory as an expense and utilizing inventory reserve accounts to offset losses.
To proactively prevent obsolete inventory accumulation, organizations should prioritize accurate demand forecasting, efficient inventory management, and the implementation of inventory software, thereby safeguarding their financial health.
Many businesses unnecessarily drain resources on obsolete inventory. Although minor write-offs are inevitable, there’s no need for outdated stock to become a significant burden on the balance sheet.
One way to recoup costs from excess inventory sitting in the warehouse for too long is to find alternative uses. Software providing detailed inventory insights and extensive reporting can help proactively prevent this issue by giving employees the necessary information for making more intelligent purchasing and inventory management choices.
Ultimately, reducing obsolete inventory is a straightforward method for product-based companies to enhance their financial performance.
Alexander Sterling is a renowned financial writer with over 10 years in the finance sector. With a strong economics background, he simplifies complex financial topics for a wide audience. Alexander contributes to top financial platforms and is working on his first book to promote financial independence.
Judith Harvey is a seasoned finance editor with over two decades of experience in the financial journalism industry. Her analytical skills and keen insight into market trends quickly made her a sought-after expert in financial reporting.
