Inventory ties up the most cash for any product-based business—thus, it’s also an area with plenty of opportunities for savings.
The U.S. Census Bureau says that at the end of July 2020, the total business inventory/sales ratio, based on seasonally adjusted data, was 1.33. That means that, as July ended, U.S. manufacturers and retailers were holding approximately $1.33 of inventory for every $1 in sales.
One way companies can beat the inventory odds is by minimizing the volume of unsold or unused goods or raw materials they have on hand, but that requires mastering inventory management. It’s worth the effort, though, because solid inventory management is good for cash flow; with the right data and technology, businesses can limit the amount of stock they need to write off and free up that money for growth initiatives.
What Is Obsolete Inventory?
Obsolete inventory, also called “excess” or “dead” inventory, is stock a business doesn’t believe it can use or sell due to a lack of demand. Inventory usually becomes obsolete after a certain amount of time passes and it reaches the end of its life cycle.
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.
Raw materials may also become obsolete. Minimizing both is a function of inventory best practices and analysis techniques.
- Organizations should immediately review their balance sheets to see if obsolete inventory is negatively impacting their finances.
- Poor forecasting, faulty design, imprecise purchasing and outdated inventory management systems yield poor inventory visibility. These are root causes of obsolete inventory.
- Companies can limit the need to write off stock by monitoring inventory in real time and regularly measuring inventory turnover, days of inventory on hand and other key metrics down to the SKU level.
- Employing inventory forecasting and management best practices plus technology delivers dual benefits: You keep large amounts of excess inventory from piling up and help leaders spot slow-moving stock and figure out how to sell it before it loses all value.
Obsolete Inventory Explained
Businesses that sell physical products, as well as those in the maintenance and repair industry, need to track obsolete inventory. The amount of obsolete inventory an organization has is an important indicator of whether it’s optimizing purchasing and inventory management, aka material requirements planning (MRP), or needs to reevaluate those aspects of its business.
Because obsolete inventory can lead to major cash flow problems, it can hurt a business’ ability to weather a rough patch. If a company with slim margins consistently finds itself with obsolete inventory and doesn’t address the problem, it could end up in a deep hole.
How Does Obsolete Inventory Work?
Businesses must come up with their own parameters for when different types of inventory become obsolete, and this will vary between industries—think about food vs. furniture, for example—and product categories. Start with industry-specific standards to build guidelines for when inventory items should be categorized as slow-moving, excess and obsolete.
Reasons inventory could become obsolete include problems with the product, poor forecasting, inventory management shortcomings or other issues. But the good news is companies can minimize dead inventory by closely tracking their inventory positions: If you can spot items while they are still in the slow-moving or excess stages, you can earn some money from them before they become obsolete.
In a recent Brainyard panel of retailers, distributors and manufacturers, the majority of participants cited forecasting demand as a top area of concern.
Why Does Obsolete Inventory Matter?
Since obsolete inventory is stock a company can no longer sell, it can negatively affect a company’s overall financial health. The business has already invested money and, in the case of manufacturers, time in these goods and can no longer recoup those costs—and the longer you store the unprofitable inventory, the more money it will end up costing.
As much as 20% to 30% of business’ inventory is obsolete at any given time, and they may write off most or all of those goods as a loss. That’s a big number, and could represent the breaking point for a struggling organization.
Even for a healthy business, it hurts the bottom line.
It’s critical that companies regularly take a close look at inventory levels and trends as part of their efforts to maximize supply chain visibility and efficiency.
Staff should review sales numbers as part of their inventory analysis on at least a monthly basis and compare those to current inventory levels, often determined with a physical inventory count. Businesses can use these numbers to calculate inventory turnover, which is a ratio of how often it sells-through inventory over a certain period of time.
The formula for calculating inventory turnover is:
Inventory Turnover = Sales / Average Inventory
An organization may find that certain products are highly seasonal—they’re much bigger sellers in the fall and winter than the spring and summer, for example—or that sales dropped off suddenly for a certain category of goods. In this case, they may perform inventory cycle counting for specific categories.
Another metric that can help spot the source of obsolete inventory is days (or months) of inventory on hand. This tells a company how long it’s had certain stock in its warehouse. To measure days on hand, use this formula:
Days of Inventory On Hand = Average Inventory / Cost of Goods Sold x 365
Reviewing these and other inventory metrics regularly will help businesses improve purchasing and inventory management, which helps decrease obsolete inventory.
Consequences of Obsolete Inventory
High rates of obsolete inventory can ultimately affect profitability and the long-term viability of a business. As the financial health of an organization declines, that damages its ability to attract investors or qualify for loans.
Obsolete inventory also shows up as an expense on the balance sheet, one of a company’s most important financial documents.
Additionally, obsolete inventory is often ignored for far too long even as it takes up valuable space in the warehouse. Instead of using this costly real estate to store profitable and fast-moving products, old stock collects dust and continues to depreciate.
Benefits of Getting Rid of Obsolete Inventory
On the other hand, reducing obsolete inventory can boost a business’ financial health. It lowers overall inventory costs and the losses that come with writing-off this stock. Not wasting money on obsolete inventory frees up cash the company can invest in other areas to help it succeed.
For young businesses, avoiding obsolete inventory could be a critical step on the path to stronger unit margins.
Additionally, minimizing obsolete inventory makes it easier for companies to put together accurate financial statements and get a clear picture of their current inventory carrying costs. There are fewer chances for bookkeeping errors or to overlook excess inventory sitting in a dusty corner of the warehouse.
5 Causes of Excess and Obsolete Inventory
There are a number of common issues that cause inventory to become obsolete. Businesses should take a close look at their operations to see if any of these are issues and if so, address them before they lose money:
Poor forecasting is one of the biggest drivers of obsolete inventory. If a company forecasts certain SKUs will be top sellers for the first two quarters, it will naturally place large orders with the suppliers for those items. But if demand fails to live up to those expectations, the business is left with a lot of extra inventory. Over time, that inventory will lose its value.
Inadequate Inventory Management System
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.
Poor Product Quality or Design
Sometimes it’s not hard to see why products flop. Perhaps an item breaks easily or doesn’t work as advertised, due to either a design oversight or a mistake in the manufacturing process. Customers may return these items—a problem in itself—and leave negative reviews. As others hear about issues, sales plummet. Similarly, a new item that has no advantage over similar products already on the market could underperform and result in excess inventory.
Purchasing should be data-driven and closely tied to forecasting and demand planning. When it’s not, and the purchasing team is buying based on anecdotal knowledge or other unreliable factors, it leads to problems. Deal-hungry purchasing managers willing to buy everything in bulk to reduce the cost per item can also leave a company with too much product on its hands.
Inaccurate Lead Times
Lead times make buyers’ jobs more difficult. They need to understand how long after they place an order they will actually receive products, which could vary among vendors. Extended lead times, especially if they’re longer than expected, can be especially problematic because demand for a product could drop in the months that pass before an organization receives the goods.
6 Ways to Get Rid of Obsolete Inventory
As much as organizations might try to eliminate obsolete inventory, most will be left with at least a small number of items they cannot sell. When that happens, here’s what they can do with that stock, in order of what’s likely to drive the best financial returns:
If the items still have solid sales potential, rethink how you position them. This could include moving them to a different place in a store or on a website, or highlighting them in a marketing email to customers. Businesses could also experiment with different channels—if certain items aren’t selling in-store, promote them through social media or online ads that drive shoppers to the ecommerce site.
Sell It At a Discount
Promotions are a proven way to move products that aren’t selling as quickly as expected. While this might eat into profit margins, it offers a better return on investment than the other options listed below. Try a slight discount at first, and increase it as necessary until the product starts coming off the shelves at a faster clip.
Items that don’t sell well on their own may perform better as part of a package. Selling a core item with two or three related, inexpensive accessories could help you get rid of slow-moving or excess products. It’s a good idea to price the bundle lower than what it costs to buy all three items separately to encourage sales.
Liquidate Your Items
In most industries, there are liquidators that buy leftover inventory at a steep discount and then resell it. This is a good option if you tried remarketing, discounting and bundling and it didn’t move enough product. While the price liquidators pay may be at or below cost, it’s still better than writing-off obsolete stock as a loss.
Donate Obsolete Inventory
Businesses may be able to donate their obsolete inventory to charity. Not only is this much preferred to disposing of the items, but it can make organizations eligible for a tax deduction equivalent to the cost of those products. This option is more relevant for retailers and distributors that sell finished goods, rather than manufacturers or suppliers that work with raw materials.
Write-Off Obsolete Inventory
When an organization has exhausted all other options, it must write-off obsolete inventory as a loss. 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.
4 Ways to Prevent Obsolete Inventory
What’s even better than getting rid of obsolete inventory? Not getting stuck with it in the first place. Here are a few ways to sell as much of the stock you purchase as possible:
Accurately Forecast Demand
As noted earlier, forecasting is key to striking the right balance with inventory. Businesses should spend time closely studying historical demand, including seasonal trends for certain products, as they build forecasts. Powerful forecasting tools, such as an inventory optimization module, that can account for internal and external factors will help close the gap between expectations and reality. Accurate forecasting requires both the right people and the right tools.
Ensure Inventory Is Visible and Available Across Channels
If something isn’t selling through in store—but it is online or in another physical location—you’re able to tap into the inventory that is sitting and sell it off before it becomes stale and you don’t order more to replenish locations where it is selling through.
Know Your Reorder Point
To avoid unnecessary inventory, staff must know when they should order more items and how big those orders should be. Software can trigger alerts for purchasers when it’s time to reorder, but supply chain employees need to be on the lookout for a surge or drop in sales of a certain inventory item.
Here’s the general formula for calculating reorder point:
Reorder point = (Average Daily Unit Sales x Average Lead Time in Days) + Safety Stock
Track Inventory Levels in Real Time
Visibility into real-time inventory levels is critical in enabling organizations to optimize purchasing and inventory management, which will minimize obsolete stock. Supply chain employees need constant access to their inventory positions for every SKU so they can place purchase orders or promote products when stock is low or high, respectively. These numbers can change quickly, so employees need the most up-to-date information. ERP inventory systems draw on a variety of data sources to help companies better understand the performance history of various SKUs, among other insights.
Use Inventory Management Software
The right inventory management software will help companies adopt all of these strategies and cut down on obsolete inventory by tracking the movement of items in and out of the warehouse as they happen and alerting staff when the business is running out of a specific item. Inventory management software can automatically track inventory-relevant KPIs like reorder point, days of inventory on hand and inventory turn and deliver daily reports with key numbers. An inventory management solution can also help build more accurate forecasts when it’s integrated with sales and financial software.
Obsolete Inventory Example
Central City Electronics is a home-electronics retailer with four stores and a website. Last year, its profit fell for the first time in a decade, and through two quarters this year, total profit is still down. After reviewing the numbers, the retailer’s accounting team notices a recent rise in inventory costs.
Upon closer inspection, the accountants realize the company wrote off hundreds of thousands of dollars’ worth of product last year, much of it 1080p LCD televisions. Its forecast called for 1080p TVs to be big sellers, but far more people bought 4K and OLED sets instead. A purchasing manager made matters worse by buying 200 more 1080p sets than the forecast called for in exchange for a lower price per TV.
Central City Electronics only gets monthly inventory reports, so it doesn’t realize the problem until it’s too late. At that point, even most liquidators aren’t interested in TVs with this outdated technology.
This experience convinces the business to invest in an inventory management system that will update inventory numbers in real time. The system also allows Central City Electronics employees to view inventory turn and days of inventory on hand by product category or SKU and notifies them when it’s time to place a new purchase order—with suggested quantities. Any purchase order is automatically sent to a manager for approval to prevent over-ordering.
After two quarters with the inventory management software, obsolete inventory costs are down 70%, saving Central City a bundle of money and putting profit back on an upward trajectory. When the business does need to write-off inventory, an integration with the accounting system automates much of the work involved in creating an obsolete inventory journal entry that debits the write-off and credits from the contra asset account.
Many businesses waste way too much money on obsolete inventory. While writing off small amounts of inventory is often unavoidable, obsolete stock doesn’t need to be such a big contributor to liabilities on the balance sheet.
Finding a second home for inventory that’s lingered in the warehouse for too long is one way to recoup the cost of excess inventory. Software that provides detailed inventory visibility and extensive reporting can help prevent the problem before it ever happens by giving employees the information they need to make smarter purchasing and inventory management decisions.
Ultimately, reducing obsolete inventory is a painless way for product-based companies to boost their bottom lines.