Obsolete inventory is any inventory for which there is no longer any use, either through inclusion in viable manufactured goods or by direct sale to customers. Generally accepted accounting principles (GAAP) state that obsolete inventory must be written off as soon as it is identified. Given the substantial level of interpretation that can be put on the “obsolete inventory” designation, it is evident that this subject area can have a large adverse impact on profitability. In this post, I provide practical insight approaches on how to locate obsolete inventory, how to dispose of it in the most profitable manner, how much expense to recognize, and how to prevent it from occurring in the real business world. Although this post will be most valuable for the people who are really involved in a real business. Observers should find it useful too. Some thoughts, words or questions are welcomed. Enjoy!
How to Locate Obsolete Inventory
There are several techniques to locate obsolete inventory, as it will be discussed in this section. However, be sure to gain the commitment of upper management to this search first; otherwise, the scope of the resulting expense [which can be substantial] may lead to multiple rounds of questions regarding how the company could have found itself saddled with so much obsolete inventory, all of which must be written off as soon as it is discovered as it is mandated by the GAAP.
Conducting a search for obsolete inventory may meet with a particular level of resistance if the management team is being awarded significant profit-based bonuses. If so, consider addressing the prevention of incoming obsolete inventory instead, which may reduce inventory levels over the long term, although it will not address the existing obsolete inventory.
It is certainly encouraging to see a manager eliminate obsolete inventory, but a common problem is to see some items disposed of that were actually needed, possibly for short-term production requirements, also for long-term service parts or substitutes for other items. In these cases, the person eliminating inventory will likely be castigated for causing problems that the logistics staff must fix.
Any solutions? A good solution is to form a “Materials Review Board [MRB]”. And here are how to perform:
The MRB is composed of representatives from every department having any interaction with inventory issues—accounting, engineering, logistics, and production. For example, the engineering staff may need to retain some items that they are planning to incorporate into a new design, while the logistics staff may know that it is impossible to obtain a rare part, and so prefer to hold onto the few items left in stock for service parts use. It can be difficult to bring this disparate group together for obsolete inventory reviews, so one normally has to put a senior member of management in charge to force meetings to occur, while also scheduling a series of regular inventory review meetings well in advance. Meeting minutes should be written and disseminated to all group members, identifying which inventory items have been mutually declared obsolete. If this approach still results in accusations that items have been improperly disposed of, then the group can also resort to a sign-off form that must be completed by each MRB member before any disposition can occur. However, obtaining a series of sign-offs can easily cause lengthy delays or the loss of the signoff form, and is therefore not recommended. Any simpler approaches? A simpler approach is to use a negative approval process whereby items will be dispositioned as of a certain date unless an MRB member objects.
The MRB is not recommended for low-inventory situations, as can arise in a just-in-time (JIT) environment, because an MRB tends to act too slowly for employees who are used to a fast-moving JIT system.
The simplest long-term way to find obsolete inventory without the assistance of a computer system is to leave the physical inventory count tags on all inventory items following completion of the annual physical count. The tags taped to any items used during the subsequent year will be thrown away at the time of use, leaving only the oldest unused items still tagged by the end of the year. One can then tour the warehouse and discuss with the MRB each of these items to see if an obsolescence reserve should be created for them. However, tags can fall off or be ripped off inventory items, especially if there is a high level of traffic in nearby bins. Extra taping will reduce this issue, but it is likely that some tag loss will occur over time.
Even a rudimentary computerized inventory tracking system is likely to record the last date on which a specific part number was removed from the warehouse for production or sale. Any approach to this? It is an easy matter to use a report writer to extract and sort this information, resulting in a report listing all inventory, starting with those products with the oldest “last used” date. By sorting the report with the oldest last usage date listed first, one can readily arrive at a sort list of items requiring further investigation for potential obsolescence. However, this approach does not yield sufficient proof that an item will never be used again, because it may be an essential component of an item that has not been scheduled for production in some time, or a service part for which demand is low.
If a computer system includes a bill of materials, there is a strong likelihood that it also generates a “where used” report, listing all of the bills of material for which an inventory item is used. How if it does not? If there is no “where used” listed on the report for an item, it is likely that a part is no longer needed. This report is most effective if bills of material are removed from the computer system or deactivated as soon as products are withdrawn from the market; this approach more clearly reveals those inventory items that are no longer needed.
An additional approach for determining whether a part is obsolete is reviewing engineering change orders. These documents show those parts being replaced by different ones, as well as when the changeover is scheduled to take place. One can then search the inventory database to see how many of the parts being replaced are still in stock, which can then be totaled, yielding another variation on the amount of obsolete inventory on hand.
A final source of information is the preceding period’s obsolete inventory report. Even the best MRB will sometimes fail to dispose of acknowledged obsolete items. The accounting staff should keep track of these items and continue to notify management of those items for which there is no disposition activity.
In order to make any of these review systems work, it is necessary to create policies and procedures as well as ongoing scheduled review dates. By doing so, there is a strong likelihood that obsolescence reviews will become a regular part of a company’s activities. In particular, consider a Board-mandated policy to conduct at least quarterly obsolescence reviews, which gives management an opportunity to locate items before they become too old to be disposed of at a reasonable price. Another Board policy should state that management will actively seek out and dispose of work-in-process or finished goods with an unacceptable quality level. By doing so, goods are kept from being stored in the warehouse in the first place, so the MRB never has to deal with it at a later date.
How to Dispose of Obsolete Inventory
As mentioned in the beginning that; as soon as obsolete inventory is identified, GAAP mandates that it be written off at once. However, this only applies to the unrecoverable portion of the inventory, so one should make a strong effort to earn some compensation from an inventory disposition. This section outlines several disposition possibilities, here they are:
Approach#1. Ask service department to sell them to existing customers as replacement parts.
Begin with full price sales and moving down through options having progressively lower returns. In some situations, one can recover nearly the entire cost of excess items by asking the service department to sell them to existing customers as replacement parts. This approach is especially useful when the excess items are for specialized parts that customers are unlikely to obtain elsewhere, because these sales can be presented to customers as valuable replacements that may not be available for much longer. Conversely, this approach is least useful for commodity items or those subject to rapid obsolescence or having a short shelf life.
Approach#2. Keep some parts on hand for few years.
It is possible that some parts should be kept on hand for a few years, to be sold or given away as warranty replacements. This will reduce the amount of obsolescence expense and also keeps the company from having to procure or remanufacture parts at a later date in order to meet service/repair obligations. The amount of inventory to be held in this service/repair category can be roughly calculated based on the company’s experience with similar products, or with the current product if it has been sold for a sufficiently long period. Any additional inventory on hand exceeding the total amount of anticipated service/repair parts can then be disposed of. Of particular interest is the time period over which management anticipates storing parts in the service/repair category. There should be some period over which the company has historically found that parts are required, such as five or ten years.
Approach#3.Return the goods to the original supplier.
Another possibility is to return the goods to the original supplier. Doing so will likely result in a restocking fee of 15% to 20%, which is still a bargain for otherwise useless goods. Rather than buying back parts for cash, many suppliers will only issue a credit against future purchases. This option becomes less likely if the company has owned the goods for a long time, because the supplier may no longer have a need for them stock them at all. Of course, this approach fails if the supplier will only issue a credit and the company has no need for other parts sold by the supplier.
Approach#4. Sell them online through an auction.
It may be possible to sell goods online through an auction service. The best known site is eBay, although there are other sites designed exclusively for the disposition of excess goods, such as salvagesale.com. These sites are more proactive in maintaining contact with potential buyers within specific commodity categories, and so can sometimes generate higher resale prices.
Approach#5. Sell them to salvage contractors by allowing them to pick up sound profitable items.
A poor way to sell off excess inventory to salvage contractors is to allow them to pick over the items for sale, only selecting those items they are certain to make a profit on. By doing so, the bulk of the excess inventory will still be parked in the warehouse when the contractors are gone. Instead, divide the inventory into batches, each one containing some items of value, which a salvage contractor must purchase in total in order to obtain that subset of items desired. Then have the contractors bid on each batch. Although the total amount of funds realized may not be much higher than would have been the case if the contractors had cherry-picked the inventory, they will take on the burden of removing the inventory from the warehouse, thereby allowing the company to avoid disposal expenses.
Approach#6. Donate them to a charity and get tax deduction.
There are some instances where a company can donate excess inventory to a charity. By doing so, it can claim a tax deduction for the book value of the donated items. This will not generate any cash flow if the company has no reportable income, but the deduction can contribute to a net operating loss carry-forward that can be carried into a different tax reporting year. If this approach looks viable, request a copy of nonprofit status from the receiving entity, proving that it has been granted nonprofit status under section 501(c)(3) of the Internal Revenue Service tax code.
Approach#7. Through them in a dumpster and get more spaces for fresh inventory.
Finally, even if there is no hope of obtaining any form of compensation for obsolete goods, strongly consider throwing them in the dumpster. By doing so, there will be more storage space in the warehouse, the space to be allocated to other uses. Furthermore, the amount of inventory insurance coverage will be less, resulting in a smaller annual insurance premium. Depending on the local tax jurisdiction, one can also avoid paying a property tax on the inventory that has been disposed of. In addition, the number of inventory items to track in the warehouse database can be reduced, which can lead to a reduction in the number of cycle counting hours required per day to review the entire inventory on a recurring basis.
Expense Recognition for Obsolete Inventory
In brief, the proper expense recognition procedure for obsolete inventory is to determine the most likely disposition value for the targeted items, subtract this value from the book value of the obsolete inventory, and set aside the difference as a reserve. As the obsolete inventory is actually disposed of or estimates in the disposition values change, adjust the reserve account to reflect these alterations. Please read the detail on other post of mine [Expense Recognition for Obsolete Inventory]. It is indeed a simple mechanical process. But beware, there are number of problems in recognizing obsolete inventory that can lead to inventory fraud, one can accelerate or delay the sale in order to drop some gains into a reporting period where the extra results are needed. It could be done easily by altering the timing of actual dispositions and many more types of alteration. You can prevent those from happening. How? Go and read it completely and get all the practical insights [here].
How Prevent Obsolete Inventory
Thus far, we have only reviewed a variety of ways to locate, dispose of, and account for obsolete inventory. The real trick is to avoid all of those topics by ensuring that there is no obsolete inventory to begin with. This is the hardest part to perform, but there are always approaches to take. This section addresses several ways to achieve this goal. Here they are:
Approach#1. Implement Just-In-Time [JIT] Purchasing Practices.
A major source of obsolete inventory is excessive purchasing volumes. The purchasing department may be purchasing in large quantities in order to save itself the trouble of issuing a multitude of purchase orders for smaller quantities, or because it can obtain lower prices by purchasing in large volumes. This problem can be avoided through the use of just-in-time purchasing practices, purchasing only those items authorized by a material requirements planning system, or by setting high inventory turnover goals for the materials management department.
A well run purchasing department will use bills of material to determine the parts needed to build a product and then order them in the quantities specified in the bills. However, if a bill of material is incorrect, then the items purchased will either be the wrong ones or the correct ones but in the wrong quantities. To avoid this problem, the bill of materials should be audited regularly for accuracy. An additional way to repair bills of material is to investigate why some kitted items are returned unused to the warehouse or additional items are requested by the production staff. These added transactions usually indicate incorrect bills of material. It is easy for a part to become obsolete if no one knows where it is. If it is buried in an odd corner of the warehouse, there is not much chance that it will be used up. To avoid this problem, there should be location codes in the inventory database for every part, along with continual cycle counting to ensure that locations are correct. A periodic audit of location codes will give management a clear view of the accuracy of this information.
Approach#2. Review all proposed product cancellations to determine how much inventory will be left “hanging” on the proposed cancellation date.
When the marketing department investigates the possibility of withdrawing a product from sale, it often does so without determining how much inventory of both the finished product and its component parts remain on hand. At most, the marketing staff only concerns itself with clearing out excess finished goods, because this can be readily identified. Those unique parts that are only used in the manufacture of a withdrawn product will then be left to gather dust in the warehouse and will eventually be sold off as scrap only after a substantial amount of time has passed.
To avoid this situation, the engineering, marketing, production, and accounting managers should review all proposed product cancellations to determine how much inventory will be left “hanging” on the proposed cancellation date. The result may be a revised termination date designed to first clear out all remaining stocks.
Approach#3. Determine the best time to effect the change that will minimize the old stock.
A related problem is poor engineering change control. If the engineering department does not verify that old parts are completely used up before installing a new part in a product, then the remaining quantities of the old part will be rendered obsolete. To avoid this scenario, have the accounting, production, and engineering managers determine the best time to effect the change that will minimize the old stock. Furthermore, if there is an automatic ordering flag in the computer system, shut it off for any items being withdrawn from use through an engineering change order. Otherwise, the system will reorder parts that have been deliberately drawn down below their reorder points.
Approach#4. Implement shelf live control.
Some products have limited shelf lives and must be thrown out if they are not used by a certain date. This certainly applies to all food products and can even be an issue with such other items as gaskets and seals, which will dry out over time. In a large warehouse with thousands of inventory items and only a small number of these limited-life products, it can be difficult to specially track them and ensure that they will be used before their expiration dates.
A mix of changes must be implemented to ensure proper shelf life control:
- First, the computer system must have a record of the ending shelf life date for each item in the warehouse. This calls for a special field in the inventory record that is not present in many standard inventory systems, so one must either obtain standard software containing this feature or have the existing database altered to make this feature available. The receiving staff must be warned by the computer system upon the arrival of a limited-shelf-life item, so a flag must also be available in the item master file for this purpose. With both of these software changes in hand, one can use the computer system to warn of impending product obsolescence for specific items.
- A simpler variation is to still have a flag in the item master file warn of the arrival of limited-shelf-life items, but to then have the warehouse staff manually track the obsolescence problem from that point on. This means clearly tagging each item with its shelf life date, so anyone picking inventory can clearly see which items must be picked first. Although this solution is much less expensive, it relies on both the receiving staff and stock pickers to ensure that the oldest items are used first.
- A third variation is to use a gravity flow rack. This is a racking system set at a slight downward angle to the picker and containing rollers. Cartons of arriving items are loaded into the back of the rack, where they queue up behind cartons containing older items. Pickers then take the oldest items from the front of the rack. Because of this load-in-back, pick-in-front configuration, inventory is always used in a first-in, first-out manner, ensuring that the oldest items are always used first. This is an excellent way to control item shelf life, because there is no conscious need to pick one item over another in order to use the oldest one first. Similar racking systems are available for pallet-sized loads.
However, this system does not absolutely ensure that items will be used before their shelf life dates; if there are many items in front of an item in a gravity flow rack, or if demand is minimal, then the older item still will not be used in time. If one can identify any of these problems as being the cause of obsolescence, quantify the cost of each problem and aggressively push for any changes that will eliminate it.