Businesses may end up with obsolete inventory when they fail to accurately forecast demand based on historical sales data, market trends, and other factors. In this article, we discuss how to avoid, identify, reduce, and manage obsolete inventory to ensure a more profitable business. This guide aids in proactively identifying, accounting for, and addressing the disposition of excess and obsolete inventory. It also assigns accountability for continuous improvement activities focused on mitigating excess and obsolete inventory occurrences by pinpointing and tackling their root causes. The first step in accounting for obsolete inventory is to identify it, Accounting Tools explains. Larger companies set up a materials review board to judge when inventory is worthless.
Start with industry-specific standards to build guidelines for when inventory items should be categorized as slow-moving, excess and obsolete. Products that become obsolete or dead go through multiple steps before they become unsellable. It usually starts as slow-moving inventory, then becomes excess inventory and finally turns into Obsolete inventory. When an expense account is debited, this identifies that the money spent on the inventory, now obsolete, is an expense. A contra asset account is reported on the balance sheet immediately below the asset account to which it relates, and it reduces the net reported value of the asset account. Though obsolete inventory can still impact ideal profit margins, putting items on sale can help replenish some of the costs by attracting bargain shoppers.
Reasons to avoid obsolete inventory
The deduction received in this case is equal to the amount of the fair market value, less what you are able to recover for the item. After you identify the obsolete inventory, you next determine the disposition price. For an outdated cellphone, maybe you drop the price by a third to attract bargain hunters. Industry standards and guidelines, as well as your own business experience, help with the judgment call.
And depending on what it is, it may also need attention, in which case it’ll be taking up your employees’ time without benefit to you. Census Bureau, the inventory/sales ratio at the end of June 2021 was 1.25, meaning that for every $1 in sales, the company has $1.25 of inventory. This is problematic for both small and large companies because the money already invested then becomes a financial loss for them. Too many financial losses can add up and put the company at risk of debt and closures. Not only do you have to work with your system, but you also need to analyze the data the system helps to provide.
The analytics of your software should allow you to identify trends in sales, helping you achieve a new understanding of your customers, what they purchase and how they do so. Search for any patterns in the data and adjust your sales tactics and inventory to reflect the analytics. What defines an outdated or inadequate inventory system varies between companies because a company with greater stock and higher demands may need a more advanced system than a smaller retailer with little inventory. Although some companies may use less advanced systems, the more business a company does, the less likely cheap or basic systems will work effectively.
Under Generally Accepted Accounting Principles (GAAP), it should list the obsolete inventory as an expense and use an inventory reserve account (a type of contra asset account) to offset the loss. An inventory management system that shows inaccurate numbers or lacks the reporting capabilities to give a comprehensive view of current stock will only exacerbate the obsolete inventory problem. If the inventory management system tells a retailer it has 100 pairs of pants in a certain size, but there are actually 400 pairs in the warehouse, for example, it will end up buying more product than it needs. Similarly, if a business can’t monitor inventory turn or days of inventory on hand, it has to guesstimate when it should order more inventory.
Why Does Obsolete Inventory Matter?
It’s how you ensure having what you need where you need it without being stuck with too much of anything. Everyone loves a bargain, so discounted sales and clearance events can be a powerful way to clear out obsolete inventory. Hold flash sales, create an outlet store, or dedicate a clearance section on your website. Seasonal or themed sales events can also attract customers and help you move excess stock at a reduced price. At Finale Inventory we are a fast-paced and adaptable inventory management system that collaborates with companies to help meet their specific inventory management needs.
- It includes current inventory, future inventory, and you manage it as you sell items, ship items, and add new stock to fill the shelves.
- By implementing an inventory tracking system, you can get a closer look at inventory days on hand, sales, and buying trends.
- The Months on Hand ratio gives us the average number of months that an inventory item spends in our warehouse.
- While businesses will often liquidate all of their inventory before closing shop, a company can always consider liquidating a certain segment of their inventory that’s fallen into obsolescence.
There are different rules that need to be considered for Generally Accepted Accounting Principles (GAAP) vs. tax methods. It includes other problems besides obsolescence, such as spoilage and theft losses. GAAP doesn’t lay down a timeline for disposal of obsolete inventory because that varies among businesses, NetSuite notes. Industry standards and your own experience can help you figure out when inventory is just moving slowly and when it’s never going to move.
Definition of Obsolete Inventory
Without proper inventory planning — including the tools and technology to help track inventory in real time — optimizing inventory levels can be a challenge. The responsibility of establishing reserves for shrinkage, obsolescence, and excess inventory lies with each financial controller and supply chain manager, based on the recommended steps outlined in this guide. To make the correct journal entry for obsolete inventory, you first subtract the disposition price from the value on your books. For example, you have $20,000 worth of appliances that aren’t moving, so you discount them 25 percent to a total of $15,000. Subtract that from the $20,000 and make a $5,000 journal entry for obsolete inventory reserve. You report this as a credit to Inventory Reserve and a matching $5,000 debit to Cost Of Goods sold.
Situations that cause usage trends to change quickly are at times self-generated. For instance, when new products are introduced, and previous versions are not phased out properly, a usage/sales trend line can immediately change without warning. Good communication between product development, sales, purchasing and inventory control, is essential.
Warehouse Management System
You should verify that the inventory count is conducted in accordance with the client’s policies and instructions, and that the count results are accurately recorded and reconciled with the accounting records. You should also select a sample of inventory items and trace them from the count sheets to the accounting records and vice versa, to check for any discrepancies or errors. Technological advances, changes in customer demand, governmental policy changes, or many other factors can cause obsolete inventory. Flash sales, buy-one-get-one offers, and other promotions can also help your company move obsolete inventory before losing its value. Flowspace’s solutions can help a brand determine how quickly products are selling, how many days until a product runs out, and how current demand compares to a previous time frame. For many brands, tracking and managing physical inventory levels is the most important thing and has the biggest impact on the bottom line.
Consistent and accurate inventory audits can also help you avoid and reduce obsolete inventory by understanding how much you’re paying in holdings costs to store slow-moving items that are at risk of going obsolete. By implementing an inventory tracking system, you can get a closer look at inventory days on hand, sales, and buying trends. This way, you have the insights needed to make better decisions on when to repurchase more inventory (or even discontinue an item). Not only can a lack of visibility cause obsolete inventory to go unseen (and therefore increase carrying costs), you also risk stockouts of your high-demand products.
Demand for them has plummeted, sending their value to a fraction of what it was. But candy still tastes good, and roses are still pretty—leaving sellers in a position to still move the products, even for less than they had hoped. Implement these strategies to effectively clear out obsolete inventory, streamline your warehouse operations, and ultimately improve your bottom line. While food products might become obsolete when their expiration date has passed, clothing products might become obsolete when they’re no longer in style. Inventory planning and managing are difficult tasks that take business operators a lot of experience to perfect. On the other hand, if you are not spending money on storing your obsolete inventory, it may take up space you could use for other, more profitable inventory ventures.
Accumulating too much obsolete inventory can be bad for business since it cuts into profit margins. Inventory is considered an asset since it’s purchased with the intent to sell. Though carrying some obsolete inventory is inevitable, it’s important to help avoid accumulating too much inventory that is at risk of losing its value. Generally, companies record allowance reserves to account for inventory losses arising from shrinkage, obsolescence, and excess inventory. Expecting dead stock to sell as your storage expenses pile up is far from efficient.
To avoid obsolete inventory, you must use this data to understand how much of a product to stock and when to stock it. Staff needs to know when they need to order an item to avoid under or overstocking. You can use inventory management software to trigger alerts about when a high-sale item’s stock runs low.
Not only does too much excess inventory cut into profit margins and cash flow, but it can also limit the chances of getting a business loan. SLOB inventory (Slow-moving and obsolete inventory) possibly already occupying a significant amount of space in your warehouse. The longer this unwanted inventory remains part of your stock, the more it can jeopardize your business.
As Accounting Coach says, clothes go out of fashion, food ages, and new tech comes out before you’ve sold the old stuff. Generally Accepted Accounting Principles (GAAP) rules require you to account for the loss promptly in your bookkeeping. We treat it as working capital that is tied up with virtually no promise of return on investment.
If not, it may be best to liquidate or donate the inventory to avoid overpaying storage fees. Regular, frequent trend analysis of usage/sales is the main method of identifying potential slow-moving inventory and the reduction of excess inventory. In the first example, the graph indicates a decreasing demand/usage and the “Months on Hand” at 10 months. A close watch on Item AB123 each month may determine an increase in inventory may create an excessive amount. Until there is a clear understanding of the market and production, it would make sense put further purchases on hold. The key to managing inventory levels is to have visibility to inventory trends.