Companies continually wrestle with the challenge of keeping costs in line, especially during periods of economic uncertainty. For inventory-based businesses, a significant portion of costs is wrapped up in inventory. Effective monitoring of inventory, and keeping obsolescent inventory at minimal levels, yields numerous benefits, including a positive impact on the bottom line.
Reducing levels of obsolescent inventory frees up warehouse space and pares labor costs associated with maintaining that product, thereby lowering overhead costs. Tax burdens also can be lessened by reducing levels of obsolescent inventory. Continually monitoring inventory for obsolescence also eliminates the need to write down the cost of a large volume of inventory all at once, thereby incurring a massive charge against income.
Analysis and reporting
In order to identify potential inventory obsolescence and recognize the benefits of low inventory levels, operations and inventory managers along with their accounting staff should regularly analyze various metrics to identify potential issues in a timely manner.
For public companies, that may mean evaluating inventory every quarter. For a nonpublic manufacturer, these analyses should be conducted on an annual basis, generally at the end of the fiscal year. It is also recommended that appropriate documentation be retained regarding these processes to support management’s estimates and conclusions.
There are varieties of reporting methodologies manufacturers may use. Ratio analysis in one, and monitoring important ratios over time can provide valuable insights.
For example, the inventory turnover ratio is cost of goods sold divided by average inventory and can be conducted by product line, division or other classification. Usually, the higher the ratio, the more profitable the company will be. A declining ratio could indicate the presence of obsolete or slow-moving products. Another important ratio is the comparison of current sales prices to unit costs. This ratio can help determine whether or not the inventory item generates a sufficient profit margin.
Movement reports illustrate how much time passes between when an item is recorded as inventory and when it is sold. These reports can be generated at the product level to identify a particular product as being a low-volume or slow-moving item. Years may pass between orders for that product. Accounting professionals can generate these reports and highlight potential issues, but managers with knowledge regarding company operations may recognize the importance that item holds for retaining a particular customer. With knowledge of that product and its customers, managers can use such a report to determine whether or not obsolescence is a concern.
Ratio analysis and movement reports provide insight based on historical information. With those report findings, managers can develop reasonable expectations regarding inventory levels and set benchmarks for operating performance. Unfavorable variances can be identified on a regular basis and remedied before the problem escalates to a higher concern.
Regularly recognizing reserves for obsolete inventory is another sound accounting practice. Recognizing such a reserve in the income statement reduces income for that period. Such regular recognition, though, helps a company avoid a situation where it must take a much larger write-off in one accounting period for obsolescent inventory that had accumulated for years.
Inventory represents a large financial commitment for any manufacturer. Effectively monitoring that inventory for obsolescence enables a manufacturer to operate much more efficiently and sustain itself through periods of economic uncertainty.
Becky Reeder, CPA, email@example.com, manager, and Brett Gregory, CPA, firstname.lastname@example.org, senior associate II work in the assurance services department for Weaver, the largest independent accounting firm in the Southwest.