Most companies in the manufacturing and retail industries have Inventory. Slow-moving and obsolete Inventory can have a severe adverse effect on the profitability of the business. When we can’t realize our goods on hand, they lose value and may become useless for the company.
To account for this decrease in value, we write down or entirely write-off such items in our accounting records and recognize a loss. Slow-moving and obsolete Inventory can become a significant problem for many businesses.
This article will show you how to identify and battle obsolete Inventory, also known as dead stock.
Sometimes no inventory is better than obsolete Inventory.
What is the Obsolete Inventory?
Before we start looking into ways to manage it, we first need to understand what it is. Any materials or products we have in the warehouse can become obsolete Inventory. Some of the reasons might be:
- Product at the end of its life cycle
- Materials/parts we haven’t used in production for a long time
- Products that are no longer generating sales
- Goods that we cannot use because of legislation
Obsolete Inventory is one that the company still has on stock when it should have already sold or used it. Such items are usually a significant red flag to potential investors and financing institutions and need to be addressed timely. The reasons for accumulating obsolete Inventory can vary, but most commonly, we attribute such cases to poor planning on behalf of management, poor inventory management, or product quality. Inaccurate estimates for customer demand lead to overstocking and straining the business with significant cash tied up in slow-moving and excess inventory.
Setting up Brackets
Whenever you start to analyze your Inventory for slow-moving and obsolete items, it is good to set up some ranges. Now, these will highly depend on the industry and company, but a general manufacturing entity might have something like this:
- Slow-moving – more than three months without usage;
- Excess – more than six months;
- Obsolete – more than one year.
If you are not the inventory management process owner, it’s best to discuss the brackets with the people in charge of Inventory. You may also involve your auditors, or even the respective tax authorities, as there might be some local limits or requirements.
We can illustrate the process of inventory transformation to dead stock like this:
Obsolete Inventory Analysis
Usually, a company strives to achieve growth. One way to support that is by decreasing the slow-moving Inventory and replacing it with fast-moving items.
To manage goods levels properly and avoid generating dead stock, we regularly analyze inventory trends and movement patterns. This includes looking into purchases, production consumption, and sales to identify potential indicators for problematic items.
Such analysis aims to identify the slow-moving Inventory before it turns into a financial burden that puts stress on the business.
Months on Hand
One common way to identify slow-moving and obsolete Inventory is to perform a regular comparison between stock on hand and usage patterns, both in production and sales.
The Months on Hand ratio gives us the average number of months that an inventory item spends in our warehouse. It is a great starting point, especially if you have a small variety of products and analyze each one separately.
We would then look at MOH’s trend over time, compare it with lead times, and adjust our purchasing strategy as necessary. It is essential to consider any possible seasonality for the business, as it will heavily impact our analysis.
Inventory Turnover Rate
Another ratio we can calculate and analyze as part of our slow-moving and obsolete inventory analysis is the Inventory Turnover.
Here we calculate the Average Inventory as the average between the Opening and Closing balances of our Inventory accounts.
The higher this ratio is, the faster goods are leaving our warehouse. To get a more detailed and actionable insight, we can separate our stock into groups of similar items. And this is critical, especially if we have both materials and produced goods.
The ratio above refers to the items we sell to customers. But we can also calculate the Inventory Turnover for materials by replacing Sales with Consumption in Production.
Days Inventory Outstanding (DIO)
This metric is also known as Days Sales of Inventory (DSI) and is part of the Cash Conversion Cycle of the company. We calculate it with the formula:
The ratio shows us the number of days it takes for the company to convert Inventory to Sales. As we calculate it in a reverse matter compared to the Inventory Turnover we outlined above, this metric worsens when it goes higher. This means it takes more time for goods to exit our warehouse.
Holding Costs and Obsolete Inventory
The cost of holding on to obsolete Inventory is another factor we need to consider when analyzing our stock and preparing our action plan to decrease obsolescence. These consist mostly of warehousing expenses like rent (or depreciation if we use our premises) and include other relevant costs like equipment depreciation, salaries, and utilities.
Retaining obsolete Inventory only makes sense if future gross profits cover the accumulated holding costs.
As we start to perform a regular Slow-moving and Obsolete Inventory analysis, it is crucial to look at past periods’ performance and analyze the trends in the ratios we focus on. Only then can we start to forecast inventory movements with more accuracy, identify the potential dead stock, and estimate our goods’ life span.
When we have identified and evaluated our dead stock, we can write-down its value to reflect the fact of its slow performance. Or we can completely write-off the items if we believe none of the cost is salvageable.
We write-down when the realizable value falls under the cost at which we have recorded Inventory. And as soon as the stock has no value and we plan to take it off our records, we have to write it off.
Take a company where a batch of products was not purchased and remained in the warehouse for a long time. We then did our analysis and identified these items as obsolete. The cost recognized in our accounting records is €10,000. However, our assessment shows that the maximum sale value for the batch is €2,000. This means we have to write-down the value of the products.
We do so by recognizing an expense for the write-down and an Obsolete Inventory Provision. We hold it in a separate credit account, which we present together with the Inventory accounts (as a decrease) in our financial statements.
The journal entry for this operation will look like:
Time passes, and we are unable to realize our dead stock. The management decides to write it off, as it’s accumulating too much holding costs. We do that by the following journal entry:
We close the provision and decrease our inventory account balance, as these items will no longer be our property.
However, what if we manage to sell them for let us say a €1,000. The journal entry will then reflect the inflow of cash and the additional decrease in value. We can record this as:
Remember that your ERP or accounting software might have a more complicated process in place, but the operations’ essence will be the same. Also, make sure you confirm the process with your local tax authorities, as there may be some requirements or limitations.
What to Do with Obsolete Inventory
Once we identify our excess stock, it’s time to figure out how to minimize it fast, reduce the company’s financial stress, and improve our cash flow.
One of the most common approaches is to try and realize the goods at a discount price. We can organize sales events and promotions to try and raise customers’ interest in the product.
If our product portfolio permits, we can try offering product bundles by selling slow-moving or obsolete items alongside products that perform well in the market. However, we need to keep those similar and be careful not to hurt the well-doing products’ performance.
As for parts and materials, we will try to include those in production. You can use them as a replacement for interchangeable parts in manufacturing. Or we can offer a client a reduced price if he purchases a batch using some of the obsolete inventory in the assembly.
Another option is to find competitors who might have more use of the items and sell to them. However, this will usually also happen at a significantly discounted price. We are trying to realize in bulk so that we can salvage at least some of the value.
It is essential to catch excess Inventory before it becomes obsolete, as options are quite limited.
We can hold on to the goods, in case we believe the products will make a return in the future and demand will increase. It is crucial to perform a critical evaluation of such expectations. Often, management ignores strong signs and believes in some almost miraculous ‘come back.’ And this seldom happens, resulting in piling up slow-moving and excess stock that slowly transforms into obsolete Inventory. Whenever we have identified dead stock, it’s best to deal with it straight away, so it no longer hurts the business with holding costs and tied up cash.
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Example Slow-moving and Obsolete Inventory Analysis
I will walk you through one of the simplest forms of overall analytical review you can perform on stock on hand at your company, to get you started on the journey of eradicating obsolete Inventory.
The first thing we need is a breakdown of the Inventory account, showing the opening balance for each item, the inflow (purchases) and the outflow (sales, or production consumption), and the closing balance. Some ERPs have this premade, but you will have to ask for such report to be generated in some cases.
It would be great to link the average monthly usage, especially for companies with seasonality, or the corresponding sales value, so that we can calculate the metrics we discussed. However, in most companies, this is tedious and time-consuming at best.
We can take another approach, which is common in audit reviews. It starts by calculating the Usage Percentage for each item. Doing so shows us what portion of the total of opening balance and the purchases we use during the period. Take product ABC, of which we have 50 pieces at the beginning of the year. Over the period, we purchase 50 pieces more and use a total of 75 pieces. This would yield a Usage Percentage of 75/(50+50) = 75%.
Now that we have the Usage Percentage, we can assign categories to our inventory items. Keep in mind, the brackets you use will highly vary based on your industry and business.
We will use the LOOKUP function in Excel to assign a Group to each item. The percentages will work as the bracket’s start, meaning we mark every item with a Usage Percentage between 5% and 25% as Slow-moving. Then we mark every item above 75% as Fast-moving, and so on.
With each item having an Evaluation, we use a simple SUMIFS formula to calculate each bracket’s value.
The results are worse than expected. We have €14 mil in obsolete Inventory, and another €17.5 mil in slow-moving goods, meaning almost 30% of our stock on hand is close to useless for the company.
As discussed above, arriving at these results is where the real work starts. We have to reevaluate our inventory management process and start looking into options to realize the obsolete and slow-moving items.
Slow-moving and obsolete Inventory is a problem many businesses face. If left unattended, it can grow into a severe red flag for investors and financing institutions. It can also choke the company’s cash flow with high holding costs. It is crucial to include an Inventory analysis as part of our month-end procedures to ensure that we follow the trends with which our stock moves. Looking at those over time will give us the insight we need to improve inventory management and planning.
If we end up with obsolete inventory, it is best to deal with it straight away to alleviate the company’s financial burden.
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