Inventory Obsolescence | 5 mins read

How to Account for Inventory Obsolescence In Your Business

how to account for inventory obsolescence in your business
Hanh Truong

By Hanh Truong

What is Inventory Obsolescence?

Inventory obsolescence is when items in the warehouse reach the end of their product life cycle. This means the product has not had any sales for a long period and most likely will not be sold in the near future due to its decline in value and market demand.

Obsolete stock, or deadstock, can adversely impact a company's profit margin. For example, an overstock of unsalable items will take up valuable storage space in the warehouse, which can then accrue carrying costs.

Additionally, obsolete inventory must be written down or written off in business financial statements, according to regulations issued by the Financial Account Standards Board.

These mandates are known as generally accepted accounting principles (GAAP) and it requires companies to write down inventory if its market value is less than what is initially reported in financial statements.

Moreover, if inventory no longer has value and cannot be sold, it must be written off to formally recognize that the item has been eliminated from the books. Inventory that is written off or down is then treated as an expense and will reduce the business's net income for the financial year.

Inventory Obsolescence Accounting

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To conduct proper accounting of inventory obsolescence, businesses should report unusable stock by debiting an expense account. This will indicate that the amount of money used to purchase the obsolete inventory is an expense.

There are various kinds of expense accounts that companies will use, such as an inventory obsolescence account or a cost of goods sold account, which is usually only applied when a write-down is small.

After debiting the expense account, the value should be credited to a contra asset account, which is a type of asset account that has a credit balance. This is recorded on a balance sheet under the main account it relates to. That way, it can reduce the net value of the assets and allow companies to preserve the historical reports in the original account.

For example, a canned food company finds that they have parcels of obsolete cans worth $5,000. Management decides that it can still be sold in stores for $1,000 and writes down the value of the cans. Since the value decreased from $5,000 to $1,000, the difference ($4,000) needs to be updated in the company financial statement.

The company would then input $4,000 as debit into their inventory obsolescence account and $4,000 as a credit in their contra asset account.

How to Remove Obsolete Inventory

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Businesses that have obsolete inventory should promptly remove them from their warehouse to protect their profitability. Some methods companies can use to get rid of excess stock are-

Write It Off

Businesses will most commonly conduct write-offs for obsolete inventory. Usually, the stock would be charged to their cost of goods sold account, to which they will lose an amount of money for the fiscal year.

By donating unsold inventory to a nonprofit organization, companies can receive tax deductions. However, to get a deduction, the charity must be qualified by the Internal Revenue Service (IRS). Businesses should first find an organization that aligns with their values and then check if it is qualified by going on the IRS Tax Exempt Organization Search engine.

Change Marketing Strategies

Management teams can strategize different marketing techniques to sell excess stock. For example, products and their displays can be placed at a central location in the store so that it will draw more customers' attention.

Companies can also utilize social media to post content about the product so that their followers know they have the item available in stock.

Offer Discounts

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To boost sales and bring in customers, companies can discount the price of products. It is recommended that discounts start small, at about 10% - 20%. If the inventory is still selling slowly, then the discount can be slowly increased.

Bundle Products

Product bundling is when stores put together complementary products and sell them at discounted prices. For example, a luggage company has an excess of duffle bags that is originally worth $80. To quickly get rid of the bags, management can bundle them with a regular-sized suitcase valued at $120 and sell both for $150, instead of the original total of $200.

Customers will more likely purchase the bundle, seeing that they can save more money by buying both products.

Sell to a Liquidator

If sales are still down for certain products, businesses can sell them to liquidators. These are companies that will buy surplus inventory from businesses at the lowest price value and then resell them to general consumers.

How to Prevent Obsolete Inventory

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To avoid the financial losses of inventory obsolescence, businesses should-

Forecast Demand

Forecasting demand will help business owners identify trends in customer demands and prepare inventory accordingly.

The latest inventory management software will not only help users monitor demand, but it will also provide real-time sales trends. Managers can utilize these features to be proactive and to maintain stock at optimal levels at all times.

Understand the Company's Reorder Point

The reorder point is the minimum level of stock that a company should have before it must be reordered. To calculate the reorder point, executives can use the formula-

  • Reorder Point = (Average Daily Unit Sales x Average Lead Time in Days) + Safety Stock

Digital inventory tools can streamline the reordering process by using sales data, current stock levels, and supplier delivery times to provide suggested ordering. This will eliminate guesswork and instances of over-ordering.

Track Inventory In Real-Time

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By consistently tracking inventory, business owners can monitor their stock levels and make quick adjustments to their inventory and orders when necessary. Cloud-based inventory systems will enable users to track stock at any time and anywhere, as long as they are using an Internet-connected device.

Proper inventory management will help businesses minimize instances of obsolescence, therefore, ensuring that they maintain their profitability.