Obsolete Inventory: the Deadweight That Sinks Profit Margins

Most e-commerce businesses aim to stock up their inventories to meet consumer needs and be ready for any unexpected rises in demands. It is always tempting for business owners to order more to be on the safe side. The ideal inventory turnover ratio for most industries should be between 5 and 10. This translates to companies selling and restocking their inventory items every 1 to 2 months of the financial year.

Read on to learn about obsolete inventory and the best practices to manage it to reduce loss and maintain profit margin.

Obsolete inventory in E-commerce

What are Obsolete Items in Inventory?

Some items in the inventory do not sell or cannot be used further for several viable reasons. They reach the end of their lifecycle when they are not in demand anymore or have lost their market value. These inventory items have various names, such as ‘excess inventory’, ‘dead inventory’, or ‘dead stock’, but are most commonly known as obsolete inventory.

While any product can become obsolete with time, some industries and sectors are more prone to carrying obsolete inventory. Apparel, furniture, and electronics are some industries with a high risk of having obsolete inventory due to the following reasons:

  • As the market evolves and innovations are born daily, products rapidly lose their market worth and demand.
  • New technologies are adapted periodically to cut down manufacturing costs, and this can disrupt the way products are manufactured.
  • With global market competitors, businesses must continually upgrade their inventory items to stay ahead of the competition.
Obsolete inventory in E-commerce

Understanding Obsolete Inventory

As the demand for a product starts to fall and its market value depreciates, the product slowly reaches the end of its lifecycle. Market analysts pinpoint various telltale signs for different sectors to understand when an inventory item becomes obsolete. For example, in retail and wholesale, the product sales slowly diminish until it becomes negligent or does not sell. In afterparts servicing, the product is not required by customers at all, and in the case of manufacturing, the requirement for consumption dries up totally.

The accountancy department classifies these products under slow-moving inventory. If you plot the sales on a graph, you will see a fall or a continuous decline with occasional lumps (denoting periodic demands and no demands at all) until the curve becomes flat, indicating the demand or consumption has dried up wholly. When this happens, it is classified as obsolete inventory.

The rate at which products attain obsolescence varies from industry to industry, its nature, and the marketplace it caters to. For example, in the case of electronics, innovations come up daily, and the existing products are continually upgraded to make new ones. The same happens in the case of the apparel and fashion industry, where tastes change quickly, and hence the demand for the same item rarely lasts long.

Goods with low shelf-life also degrade quickly and therefore rapidly attain obsolescence. However, sectors focusing on long-lasting pieces of machinery, such as cars or boilers, have the added advantage of not carrying obsolete inventory as their products take years to become obsolete.

The primary reasons behind obsolete inventory are poor inventory management practices such as shoddy inventory replenishment and inaccurate forecasting. If any business is holding excess inventory, such as there are more products in stock than there is demand in the market, due to erroneous forecasting or misreading of the market demand, then those products are bound to remain unsold or deteriorate or expire as time passes.

Obsolete inventory in E-commerce

How Does Obsolete Inventory Work?

Businesses stock items in their inventory with the expectation to sell them off and generate profit sometime in the future. However, it is not always so because several factors, such as environmental or market conditions, can make inventory items obsolete. The businesses now cannot sell them in the market as expected. When a firm discovers that a portion of its stocked-up products must be recognized as obsolete inventory, compelling the asset to decline in market worth, it must design an allowance on its company balance sheet. The outcome of this allowance will raise the cost of goods sold, which adjusts the income statement suitably.

E-commerce warehouse executives in a discussion | Locad

Why Does Obsolete Inventory Matter?

Obsolete inventory remains a part of the business that might be unavoidable for some reason or the other. While all businesses strive to decrease the amount of obsolete inventory, it can still be a financial burden bringing a lot of economic repercussions along with it:

  • Obsolete inventory can tie up working capital which turns up as a financial liability on the balance sheet of companies. Firms cannot invest this capital or money in other aspects of business, such as recruitment, technology, advertisement, retention, or stocking up of inventory items.
  • The stock turn or inventory turnover ratio is a key performance indicator of inventory and accounting management that can be used to measure the number of times the stocked product has been replaced, used, or sold. It helps businesses estimate the efficiency of stock control processes and warehouse management. Obsolete inventory or slow-moving inventory affects this stock turn negatively.
  • Dead inventory can eat up valuable warehouse space or a business’s storage capacity and increase all carrying costs in the process.
  • Obsolete inventory usually leads to businesses either writing them off or selling them at a lower net resaleable value or discounted prices to get rid of them. Thus, slow-moving inventory can affect the bottom line of any business at the end of the financial year when the cost gets usually absorbed in the Cost of Goods Sold (COGS) on the company’s balance sheet tallying profit and loss.
Obsolete inventory in E-commerce

Inventory Analysis

Inventory analysis helps businesses to cater to consumers while keeping the cost of inventories low. It helps business owners determine the right amount of inventory items required to keep in stock while not bearing the burden of excessive allowance for obsolete inventory or eating up warehouse space. There are several techniques that business owners can resort to while performing inventory analysis. It depends on the type of business, the marketplace it caters to, and the sector it operates in. Some of the most common techniques of inventory analysis are:

ABC Analysis

ABC Analysis is the most popular inventory analysis method. This is the most common technique typically used in retail businesses. This technique ranks inventories using three buckets (A, B, and C) from the highest revenue and profit margins to the lowest.

VED Analysis

Business models can use this technique to determine how critical it might be to have an inventory item in stock. Manufacturers use this model to evaluate the components and parts they must keep in stock. With this analysis, they measure inventories based on:

  • Vital: Inventory items that must always be in stock at acceptable levels
  • Essential: These inventory items need to be always present in at least small quantities
  • Desirable: These inventory items are not that critical to always having in stock

HML Analysis

Manufacturing businesses make use of this analysis to estimate the inventories based on high, medium, and low costs. The accounting costs of inventories also depend on whether a business uses them as First In First Out (FIFO) or Last In First Out (LIFO) accounting. In the case of FIFO, businesses try to sell the inventory items they bought initially first, while LIFO business models sell the inventory items they bought last first. Another model is the First Expire, First Out (FEFO) where expiration dates of inventory items drive the sales. Businesses following this model try to exhaust the stock that will expire soon first.

SDE Analysis

Business models can use this technique to determine how critical it might be to have an inventory item in stock. Manufacturers use this model to evaluate the components and parts they must keep in stock. With this analysis, they measure inventories based on:

  • Vital: Inventory items that must always be in stock at acceptable levels
  • Essential: These inventory items need to be always present in at least small quantities
  • Desirable: These inventory items are not that critical to always having in stock

Material Requirements Planning (MRP)

Businesses use this inventory analysis technique to order inventory items based on stock and sales forecasts. So, any air-conditioning retailer will inadvertently order more products before the start of summer as demand will increase during that period.

Economic Order Quantity (EOQ)

Business models can use this technique to determine how critical it might be to have an inventory item in stock. Manufacturers use this model to evaluate the components and parts they must keep in stock. With this analysis, they measure inventories based on:

  • Vital: Inventory items that must always be in stock at acceptable levels
  • Essential: These inventory items need to be always present in at least small quantities
  • Desirable: These inventory items are not that critical to always having in stock

Fast, Slow, And Non-Moving (FSN)

Businesses use this analytical approach to categorize inventories into three brackets – fast-moving, slow-moving, and non-moving inventory. Managers evaluate the inventories and make new stock purchases based on the category they fall into. Businesses using the FSN model re-order fast-moving inventory most frequently.

Custom Par Levels

Businesses following this inventory analysis model set a fixed inventory allowance at which the firm must re-order each inventory item. This analytical technique needs extra work at the commencement of the procedure but can guarantee that the business rarely runs out of stock.

Obsolete inventory in E-commerce

Excess Inventory

Excess inventory constitutes inventory items that are yet to be sold and that surpass the projected consumer demand for those items. It is usually caused by poor inventory management and mismanagement of stock demand due to inaccurate forecasting, unforeseen natural calamities, over-buying, unpredictable consumer demand, or untimely delivery of ordered goods.

Businesses mainly pinpoint excess inventory due to disruptions caused in a product cycle. These factors that cause disruption are split into 3 categories:

60% Shipment Delays

Hold-ups can be caused by several factors like delays in processing times, order frequency, and international laws and regulations.

25% Technical Challenges

These technical issues are caused by factors such as purchase orders, lack of business visibility, absence of transparency, EDI processing, and system integration.

15% Other Factors

Consumer behavior and erratic market trends also play a significant role in causing excess inventory. Home apparatus and retail industries face this issue with the rapid change in seasonal trends. In the case of sectors trading in fast-moving consumer goods, demand is quite hard to predict, which may result in excess inventory. Often, these businesses fail to analyze market forecasts, resulting in over-buying of slow-moving inventory items.
According to the division, a company can focus on the products that help in providing value to the financial reports and maintain consistency in sales and inventory changes. ABC Analysis is the best method for a merchandise inventory to boost its performance effectively.
Obsolete inventory in E-commerce

Accounting For Obsolete Inventory

Inventories are bound to become obsolete over time, and so businesses are required to remove these obsolete inventory items from the inventory records. Firms need to form a materials review board that will review the obsolescence of the inventory items. These boards assess and formulate inventory usage reports by physically examining the inventories to determine products that need to be disposed of immediately.

Firm and warehouse managers can then go through these findings and reports to determine the most likely disposition prices of the obsolete inventory items, deduct these projected expenses from the balance sheet of the obsolete inventory items, and set aside the difference as a reserve. Businesses dispose of these inventory items, subtract the estimations to be received from the disposition charge, and adjust the reserve account accordingly to reflect the procedure.

An alternative strategy is to develop a reserve based on the historical rate of obsolescence of these inventory items. This approach might be easier to derive but is usually less accurate than the former.

Obsolete inventory in E-commerce

The Timing of Obsolete Inventory Recognition

Business firms can improperly modify the company’s reported financial results by changing the timing of the actual dispositions. For example, let’s hypothetically consider that a supervisor understands that they can obtain a higher-than-estimated price on the disposition of obsolete inventory items. They can either boost up or delay the product’s sale to divert profits into whichever reporting period of the financial year requires the additional profit numbers.

Business administrations may be hesitant to unexpectedly drop a considerable expenditure reserve into the financial statements, choosing instead to acknowledge small cumulative charges which make inventory obsolescence seem negligible. Since Generally Accepted Accounting Principles (GAAP or US GAAP) demand prompt acknowledgment of any obsolescence in inventory items as soon as they get detected, businesses may struggle to implement quick recognition over the complaints of the management.

Obsolete inventory is a minor problem as long as leadership assesses inventories on a routine basis so that the accumulative amount of obsolescence noticed is small in any given span. However, if leadership fails to review extended periods, it permits obsolete inventory to build up to massive proportions, along with an equally significant amount of expenditure recognition.

To evade this problem, perform periodic obsolescence reviews, and carry an expense reserve founded on historical or expected obsolescence, even if the specific inventory items are not yet identified.

Obsolete inventory in E-commerce

The Cost of Dead and Obsolete Inventory

Taking all additional expenses into account, the total cost of holding on to obsolete inventories can add up to a shocking 25-30% more than the unit cost value of the inventories of any business. Apart from this alarming estimate, businesses also need to consider the factor of tied-up capital in obsolete inventory-related expenses that cost an additional opportunity expense. This may be as high as 15% or maybe even more.

Hence, all businesses must strive to get an accurate and realistic measurement of the allowances and expenses related to stocking up and holding inventory items at par with market demands and financial forecasting. It is an intelligent, initial step in the long process of improving performance related to inventory turnover and customer satisfaction, becoming more competitive, boosting cash flow, and increasing profit margins.

The longer a business holds on to obsolete inventory, the higher the ongoing expenses will be. Due to this, all business firms should get rid of expired, slow-moving, and obsolete inventories. Businesses that successfully cut down their inventory costs and expenses through operational and managerial efficiency tend to experience tremendous benefits and growth spurts.

Merchandise inventory is usually purchased to sell its components in a stipulated accounting period or a fiscal year. Therefore, merchandise inventory is classified as an asset for the company. The leftover inventory at the end of an accounting period or fiscal year is reported as ‘ending inventory’ on the company’s balance sheet. However, the cost of goods sold (COGS) is considered an expense on the income statement per fiscal year.

Obsolete inventory in E-commerce

Solving Dead and Obsolete Inventory Problems

While all businesses try to get an accurate understanding and forecast of market trends when stocking up, there are bound to be some inventory items they cannot sell. These small amounts of products are termed obsolete inventory and can be a financial liability. Some of the best ways to eliminate obsolete inventory are:

Remarket Items

Businesses need to understand whether the unsold products have solid potential. If they do, the marketing teams need to re-think strategies to position them in the market again. They can be placed in a more viewable section of stores or online websites, highlighted in the market e-mails targetted at consumers, and promoted in a different package.

Suppose these inventory items are not getting sold in the physical shops. In that case, firms could promote them online through paid advertisements or sponsored posts on various social media platforms to drive new-age shoppers to the concerned store’s e-commerce site.

Sell It At A Discount

While promoting unsold items is a tried and tested technique of selling dead inventory, it can eat into businesses’ profit margins. Try to offer the unsold items at slightly discounted rates and keep increasing them as necessary until the products are sold.

Liquidate Your Items

Liquidators are operating in most industries that purchase obsolete inventory at steeply discounted prices before re-packaging them for reselling. While liquidators are bound to buy the inventory items at meager prices, it is still better than writing them off and bearing all the los

Bundle Products

Some products might not perform individually but will get off the shelves faster if packed together and offered as a package deal. Firms can try to sell off a core inventory item, coupling it with some inexpensive accessories to eliminate the obsolete inventory faster. In doing so, firms need to keep in mind to keep the cost of the packaged deal lower than the prices of the items sold separately to boost sales.

Donate Obsolete Inventory

This is a more viable option for distributors and retailers dealing in finished goods than suppliers and manufacturers working with raw materials. Donating obsolete inventory is better than writing them off since it boosts the company’s image as a charitable organization and is also tax-deductible, equivalent to the cost of the products.

Write-Off Obsolete Inventory

When businesses exhaust all other options and still cannot sell off the obsolete inventory, then they have no other option than to write these inventory items as a loss. Generally Accepted Accounting Principles (GAAP) mandate that firms list this obsolete inventory as an expense and use an inventory reserve account to offset the loss.

Obsolete inventory in E-commerce

Merchandising Inventory Methods

Let us say hypothetically that the U.S. tech giant Apple has $100,000 of excess cell phones as obsolete inventory. However, the company considers a market for the stock through a reseller in India, but only at a discounted price of $20,000. Accordingly, the controller acknowledges a reserve of $80,000 with the following journal entry

Obsolete inventory in E-commerce

Ways to Prevent Obsolete Inventory

While obsolete inventory may seem like part and parcel of business, here are some ways to avoid the hassle altogether.

Accurately Forecast Demand

An accurate forecast of market demands is the key to avoid ending up with obsolete inventories. Businesses should spend time conducting in-depth research of market trends and use powerful forecasting tools while building forecast models. They should also account for seasonal trends and other factors disrupting the production cycle.

Know Your Reorder Point

Software can help management to know the right time when to order more inventory items and how big and frequent those orders should be. However, supply chain analysts should study demands to look for a surge or drop in sales concerning certain inventory items. 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 essential in helping businesses optimize purchasing and inventory management. This helps cut down on obsolete inventory. Supply chain workers require regular access to inventory positions for every Stock Keeping Unit (SKU), so they can place purchase orders or promote products accordingly.

Use Inventory Management Software

A proper inventory management software will enable businesses to adopt all of the above-mentioned strategies and reduce the amount of obsolete inventory by tracking the movement of inventory items in and out of the warehouse as they happen and forewarning staff when the company is running out of a specific inventory item.

Conclusion

Obsolete inventory can be quite a headache for businesses as it is a financial burden resulting in cash tie-ups and losses. While writing off small quantities of obsolete inventory is usually inevitable, the obsolete stock does not require to be a significant contributor to liabilities on the balance sheet.  Inventory management software can provide businesses with detailed and extensive inventory visibility and findings to prevent them from hoarding up obsolete inventories in the first place. Ultimately, making intelligent decisions and accurate forecasts will help businesses do away with the problem altogether and help them boost their bottom lines. 

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FAQs

Businesses tend to stock more items in inventories to meet unexpected consumer demands or other surges in the market expectations. However, some of these inventory items might not sell, and as they reach the end of their lifecycle, they get termed obsolete inventory.

Businesses try to sell the obsolete inventories through resellers, promote them, sell them off at discounted prices, or donate them to charities if viable. However, some obsolete inventory remains, which they write off as losses on the company balance sheets.

Disruption in the production cycle, inaccurate forecasting, misunderstanding of market demands, overstocking of products, and items with relatively less shell life are some of the major reasons behind obsolete inventory. Financial factors and consumer behavior toward returning items also play a significant role.

Businesses need to track their inventory levels in real-time and use inventory management software that accurately forecasts demands. These will help them assess the number of inventory items they require to stock to avoid obsolescence.

Obsolete inventory eats up valuable warehouse space, decreases inventory turnover ratio, and acts as a financial liability by holding up cash reserves. All these things negatively affect the bottom lines, and they end up as losses in the financial statement.

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