Not every product is going to sell like hotcakes. It’s a reality — and cost — of doing business. When, for various reasons, inventory doesn’t sell and loses all market value, a company must report the loss as a “write-off” on its balance sheet and income statement using one of two main accounting methods. This article examines the main causes of inventory write-offs, how a business can write them off and strategies for keeping write-offs to a minimum.
What Is an Inventory Write-Off?
An inventory write-off occurs when a company formally acknowledges that products it intended to sell have lost all value and can no longer be sold — when it becomes dead stock or obsolete inventory. There are many reasons a company doesn’t sell all of its inventory, which includes raw materials, component parts and finished goods. Items may become obsolete due to technological advancements, such as the introduction of faster equipment, like a computer or cellphone, or more sophisticated software. Fashion trends change over time, too, as is the case with clothing or home décor, resulting in items left on shelves. Food that expires or spoils can’t be sold; neither can items that have been damaged, stolen or lost.
Inventory appears as an asset on a company’s balance sheet. When it’s determined that a piece of inventory will not sell, the company reduces the amount of its gross inventory by the cost of the obsolete inventory item. The company will also recognize an expense of an equal amount on its income statement. If the expense is negligible, the expense can be recognized in the company’s cost of goods sold. But it’s advisable that a more substantial write-off be broken out as a separate item, rather than amending its original entry, to make tracking losses easier and avoid the risk of distorting the gross margin.
Write-offs reduce a company’s assets, which means they also reduce the company’s overall value. And because the write-off results in an expense, the company’s net income will decline by a like amount (though some write-offs may result in a tax deduction).
Consider this example: ABC Grocery Superstore has $50,000 worth of milk on its shelves. The milk, which is considered inventory, is recognized as a $50,000 asset on ABC Grocery’s balance sheet. Let’s say it must dispose of $5,000 worth of milk because the sell-by date was yesterday. The company then creates a $5,000 write-off that reduces the value of its inventory to $45,000. It also creates a $5,000 expense that appears on its income statement and reduces net income.
Some companies recognize the likelihood of future write-offs by establishing an inventory reserve. The inventory reserve carries a credit balance — an estimated amount to offset write-offs, based on how much was needed in previous years. In accounting terms, the inventory reserve is a contra asset account that reduces the value of gross inventory to arrive at net inventory. At the same time as an inventory reserve is created on the balance sheet, an expense of the same amount is included on the income statement. When an inventory write-off actually occurs, gross inventory and the inventory reserve are both reduced by the amount of the write-off. No expense is created, because the cost was already expensed when the inventory reserve was established.
Returning to our earlier example, let’s say ABC Grocery knows that 10% of inventory typically spoils. The company has $50,000 worth of gross inventory, so it creates a $5,000 inventory reserve on its balance sheet, which also shows net inventory of $45,000. At the same time, it creates a $5,000 expense on its income statement, which reduces net income. When $5,000 worth of milk actually spoils, ABC Grocery reduces the gross inventory and inventory reserve by $5,000, but the net inventory amount of $45,000 remains unchanged. There’s no need to create an expense, because one was already taken back when the inventory reserve was established.
What’s the Difference Between a Write-Off and a Write-Down?
A write-off occurs when the value of inventory falls to zero — it no longer has any worth. A write-down occurs when the inventory’s fair market value falls below the cost of the inventory recorded on the balance sheet, but the item can still be sold for some amount north of zero.
The write-down amount is the cost of the inventory item minus the current market value of that item. To account for a write-down, a business reduces the value of its inventory by the write-down amount. Assuming no inventory reserve exists, an inventory write-down expense account is created and included on the income statement. Both inventory write-offs and write-downs should be recognized at once and not spread out over multiple quarters or years.
Let’s return to the grocery store example. ABC Grocery pays $2 for each gallon of milk, which it sells for $2.25. As the sell-by date gets closer, the company puts the milk on sale for $1.50. It then must write down its inventory by 50 cents — the difference between what it paid and the sale price — times however many gallons are affected. But that’s better than if the milk expires and it has to take a full $2 write-off for each gallon of milk.
9 Ways to Reduce Inventory Write-Offs
Write-offs lower a company’s net income and retained earnings. That’s why it’s important for businesses to properly manage their inventory and regularly evaluate whether items have become obsolete or reduced in value. The goal, of course, is to minimize how much inventory needs to be written off. Here are nine tactics aimed at accomplishing that.
Don’t buy too much inventory. It’s easy to be optimistic about future business and order too much inventory. Supply chain issues may be another reason for overordering. Regardless, an excess of inventory ties up cash and adds to expenses if sales don’t live up to rosy expectations. Before ordering, analyze how much the company has sold and how much had to be written off in the past. Then factor in anything that may have changed and will impact future sales. Is the current economy as strong as it was in past years? Are customers as financially healthy as they were last year? Have tastes or trends changed? It’s quite possible those orange throw pillows are no longer the rage.
Reevaluate purchasing plans. Inventory write-offs may be reduced if a business places more frequent, smaller inventory orders. This tip is especially important for perishable items, but it also holds true for anything that can sooner or later be replaced by a newer model or be deemed unfashionable. Ordering in smaller batches also helps managers respond more quickly to changes in demand.
Before going this route, however, it’s important to understand that placing smaller orders may result in some additional costs through economies of scale. For example, a business may no longer be eligible for the same bulk discount and have to pay more per item. More frequent shipments mean transportation and employee costs may also increase. And in inflationary environments, items are more likely to cost less today than they will just a few months down the road.
Check inventory upon arrival. When inventory arrives at the warehouse, make sure everything that was ordered (and paid for) indeed was delivered. Thoroughly inspect items for damage and return any goods that are damaged. Later on, managers should periodically check whether their inventory data matches the actual merchandise they hold in inventory.
Protect inventory against damage or theft. Proper storage, such as a dry location or on shelves high enough that products can’t be accidentally bumped into, can safeguard inventory from becoming damaged and, thus, unsellable. Another good idea is to install smoke detectors and perhaps a fire sprinkler system. To prevent theft, consider securing valuable inventory in locked areas and install security cameras and alarms.
Consider selling aging items at a discount. Consider discounting items that have been in inventory too long; it’s better to sell an item at a lower price than not to sell it at all. Another alternative is to offer old inventory items as a free gift with purchase, engendering customer satisfaction and loyalty.
Recall our milk example above. It was better for ABC Grocery to put the milk on sale for $1.50 than to keep it at its regular price and watch it expire, unsold shelf. Selling the milk for $1.50 results in a 50-cent per gallon write-down, rather than a $2 per gallon write-off.
Return the items to the manufacturer or sell them to another business. Try to sell aging inventory back to the manufacturer or to another business. They might have demand from other customers or be willing to purchase it at a discount.
Sell items for parts. Some inventory can be disassembled and sold for their parts or raw materials. Old computers, for example, have hard drives and memory chips that can be sold individually. Used cars have parts that can be sold separately, too. And some inventory items made of plastic or metals can be sold for scrap or be recycled.
Create an inventory reserve. Analyze how much inventory had to be written off in past years to predict how much should go into an inventory reserve, which a company uses to offset the costs of future write-offs. An inventory reserve is a contra asset account that is paired with gross inventory to arrive at net inventory on the balance sheet. The expense is also recognized on the company’s income statement.
Invest in software. The need for inventory write-offs may be a sign of poor inventory management. This is where inventory management software can help, first and foremost by providing a business with an accurate picture of its inventory. Software makes it easy to keep accurate records about what’s in stock, where it’s located and how long it has been there. Managers can use this information to help determine how much and how often they need to place orders — and when write-offs are in order.
Among other benefits, inventory management software can automatically notify business managers when inventory items are approaching their sell-by dates. It can also create or manage the documentation needed for the IRS when inventory is liquidated, donated or destroyed. In addition, software can pinpoint where write-offs are occurring frequently, so managers can identify and address problems.
Avoid Inventory Write-Offs With Inventory Management Software
Inventory management software provides a full picture of a company’s historical inventory data, as well as its current inventory position. This information can inform business managers who are making ordering decisions and prevent them from ordering too much inventory, which may lead to write-offs. Inventory obsolescence is the symptom, not the problem — the problem is a breakdown in the supply chain. The right software can highlight items that have remained in inventory too long and prompt managers to take appropriate action to keep losses to a minimum.
NetSuite Inventory Management provides a real-time view of inventory across a company’s locations and sales channels. It helps business managers reduce inventory, free up cash and keep inventory costs low. It also helps avoid stockouts, optimize inventory levels and ensure product availability.
It may be inevitable that some of a company’s inventory will lose all value, for reasons that include obsolescence, spoilage or damage. For accounting purposes, this inventory must be written off, which ultimately decreases the company’s net income and retained earnings. But there are also plenty of tactics business managers can use to help keep write-offs to a minimum, many of which can be guided by the right inventory management software.
Inventory Write-Offs FAQ
Can inventory be written off?
Inventory should be written off when its market value has fallen below its book value.
How much inventory can you write off?
The amount of inventory written off is driven by the market value of the inventory. Whenever the market value of the inventory falls below the inventory’s book value, it should be written off. The inventory value can fall to zero if it is no longer worth anything.
How do you write off old or expired inventory?
To account for a write-off, a business reduces its inventory value by the write-off amount. And assuming no inventory reserve exists, an obsolete inventory write-off expense account is created and included on the income statement. Both inventory write-offs and write-downs should be recognized at once and not spread out over multiple quarters or years.
How can I avoid inventory write-offs?
Inventory write-offs can be avoided by ordering the proper amount of inventory. Don’t order too much inventory. Before ordering, analyze how much inventory the company has both sold and written off in the past. Then factor in anything that may have changed and will impact future sales. Consider ordering smaller batches more frequently, particularly if inventory is perishable or affected by changes in technology or fashion.
Inspect inventory upon delivery and return to suppliers any items that are damaged. Store inventory in areas that will protect it from future damage and, preferably, in locations secured by locks and cameras to prevent theft. If items are sitting in inventory too long or are approaching their sell-by dates, consider holding a sale so that any write-off can be minimized. Another alternative is to disassemble inventory and sell individual parts and materials. Consider contacting the manufacturer to see whether it is willing to repurchase excess inventory.
And, finally, invest in excellent software that can accurately track inventory and provide business managers with an accurate picture of a company’s inventory. Software makes it easy to keep accurate records about what’s in stock, where it’s located and how long it has been there. Software can help managers determine how much and how often they need to place orders.
Among other benefits, inventory management software can automatically notify business managers when inventory is approaching its sell-by date. It can help create or manage the documentation needed for the IRS when inventory is liquidated, donated or destroyed. In addition, software can highlight areas where write-offs are occurring frequently so that managers can identify and address problems.
How do you reduce inventory?
Inventory can be reduced by ordering the proper amount of inventory. Don’t order too much inventory. Before ordering, analyze how much inventory the company has sold and written off in the past. Then factor in anything that may have changed and will impact future sales. Consider ordering smaller batches more frequently, particularly if inventory is perishable or affected by changes in technology or fashion.
If items are sitting in inventory for too long or approaching their sell-by dates, consider holding a sale. Another alternative is to disassemble inventory and sell the resulting individual parts and materials. Consider contacting the manufacturer to see if it is willing to repurchase excess inventory or parts and materials.
And, finally, keep inventory to a minimum by investing in excellent software that can accurately track inventory and provide business managers with an accurate picture of a company’s inventory. Software makes it easy to keep accurate records about what’s in stock, where it’s located and how long it has been there. Software can help managers determine how much and how often they need to place orders.
Among other benefits, inventory management software can automatically notify business managers when inventory is approaching its sell-by date. In addition, software can highlight areas where write-offs are occurring frequently so that managers can identify and address problems.