In the realm of business, it’s a reality that not every product will experience swift sales. This is an inherent cost that every business must accept. When a company faces a situation where its inventory fails to sell and loses all market value for various reasons, it is required to recognize the loss through a process known as a “write-off” on its balance sheet and income statement.
What is an Inventory Write-Off?
An inventory write-off occurs when a company formally acknowledges that products initially intended for sale have depreciated to the point where they are no longer marketable—rendered as dead stock or obsolete inventory. Several reasons may contribute to a company’s inability to sell its entire inventory, including raw materials, parts, and finished goods. Obsolescence of some items can result from technological advancements, such as the introduction of faster equipment like computers or cell phones, or more sophisticated software. Additionally, changing fashion trends, as seen in clothing or home décor, can leave items unsold on shelves. Perishable goods reaching their expiration date or spoiling, as well as damaged, stolen, or lost items, are also ineligible for sale.
Inventory is listed as an asset on a company’s balance sheet. If it is determined that a certain inventory item will not be sold, the company decreases its gross inventory by the cost of the obsolete item. A corresponding expense of the same amount is recognized on the income statement. If the expense is minor, it can be included in the cost of goods sold. However, for more significant write-offs, it is recommended to treat them as a separate item rather than modifying the original entry. This approach facilitates loss tracking and minimizes the risk of distorting the gross margin.
Write-offs have the effect of reducing a company’s assets, consequently decreasing its overall value. Additionally, as a write-off incurs an expense, the company’s profits experience a corresponding decrease (although certain write-offs may qualify for a tax deduction).
Consider this scenario: XYZ supermarket displays $20,000 worth of bread as inventory on its shelves, recognized as a $20,000 asset on its balance sheet. Suppose it needs to dispose of $2000 worth of bread due to it reaching the sell-by date yesterday. In response, the company records a $2000 write-off, diminishing the inventory’s value to $18,000. Simultaneously, a $2000 expense is registered on the income statement, leading to a reduction in net income.
Certain companies anticipate future write-offs by establishing an inventory reserve, which maintains a credit balance representing an estimated amount to offset potential write-offs, based on historical needs. In accounting terms, the inventory reserve serves as a contra asset account, reducing the gross inventory’s value to determine the net inventory. When creating an inventory reserve on the balance sheet, an expense of an equivalent amount is also reported on the income statement. In the event of an actual inventory write-off, both the gross inventory and the inventory reserve are decreased by the write-off amount. In this case, no additional expense is incurred, as the cost was already expensed when the inventory reserve was established.
The Difference between Inventory Write-Off and Inventory Write-Down
A write-off is the outcome when the value of inventory reaches zero, rendering it devoid of any worth. On the other hand, a write-down occurs when the fair market value of inventory drops below the cost recorded on the balance sheet, but the item still holds a potential selling value above zero.
The write-down amount is determined by subtracting the current market value of the inventory item from its cost. To address a write-down, a business reduces the inventory value by the specified write-down amount. In the absence of an existing inventory reserve, an inventory write-down expense account is established and reflected on the income statement. It is crucial to acknowledge both inventory write-offs and write-downs promptly, without spreading the recognition over multiple years or quarters.
Returning to the supermarket example, let’s consider XYZ Supermarket, which buys a loaf of bread for $2 and sells it for $2.25. As the sell-by date approaches, the company puts the loaf on sale for $1.50. Consequently, it must write down its inventory by 50 cents – the variance between the purchase cost and the sale price – multiplied by the quantity of affected loaves. This proactive approach is preferable to the alternative of letting the bread expire, leading to a full $2 write-off for each loaf.
9 Ways to Reduce Inventory Write-Offs
Write-offs have a direct impact on a company’s net income and retained earnings. This underscores the importance for businesses to effectively manage their inventory, routinely assessing whether items have become obsolete or depreciated in value. The ultimate aim is to minimize the necessity for inventory write-offs. Here are nine strategies that can be employed to mitigate such instances:
Exercise caution in purchasing excess inventory
It’s common to be overly optimistic about future business prospects, leading to the overordering of inventory. Supply chain challenges may contribute to this phenomenon. Nevertheless, an abundance of inventory ties up capital and increases expenses if sales fall short of expectations. Conducting a comprehensive analysis of past sales, considering any changes that may impact future sales, is essential before making new orders. Factors such as shifts in the economy, customers’ financial health, and changes in tastes or trends should be taken into account.
Review and adjust procurement strategies
To minimize inventory write-offs, consider adopting a strategy of more frequent and smaller inventory orders. This recommendation is particularly crucial for perishable items but is applicable to anything that could eventually be replaced by a newer model or fall out of fashion. Opting for smaller order quantities also enables managers to respond swiftly to shifts in demand.
It’s essential to recognize that implementing smaller orders may entail additional costs due to changes in economies of scale. For instance, a business might lose eligibility for the same bulk discounts, resulting in higher costs per item. More frequent shipments can lead to increased expenses related to transportation and personnel. Additionally, in inflationary environments, items are likely to be more cost-effective when purchased today compared to a few months into the future.
Verify inventory upon receipt
Upon the arrival of inventory at the warehouse, ensure that all items ordered and paid for have been correctly delivered. Conduct a thorough examination of the items to identify any damage and promptly return any goods that have been compromised. Subsequently, managers should routinely compare their inventory records with the physical merchandise on hand.
Safeguard inventory from damage
Adopting proper storage practices, such as placing items in a dry location or on elevated shelves to prevent accidental damage, can protect inventory from harm, making it sellable. Additionally, installing smoke detectors and potentially a fire sprinkler system is a prudent measure.
Consider offering discounts on aging items
Contemplate reducing the price of items that have lingered in inventory for an extended period; it is preferable to sell an item at a discounted rate than not selling it at all. Another option is to present aged inventory items as complimentary gifts with a purchase, fostering customer satisfaction and loyalty.
Recall the earlier example with bread. It was more advantageous for ABC Grocery to place the bread on sale for $1.50 than to maintain its regular price and risk it remaining unsold on the shelf until it expires. Selling the bread for $1.50 results in a 50-cent per loaf write-down, as opposed to a $2 per loaf write-off.
Return items to the manufacturer or sell them to another business
Explore the possibility of selling aging inventory back to the manufacturer or to another business. They may have demand from different customers or be open to purchasing it at a discounted rate.
Sell items for their components
Certain inventory items can be disassembled and sold for their individual parts or raw materials. For instance, old computers may contain valuable hard drives and memory chips that can be sold separately. Used cars also have components that can be sold independently. Additionally, items made of plastic or metals can be sold for scrap or recycled
Establish an inventory reserve
Examine previous years’ write-offs to estimate the appropriate amount for an inventory reserve, which serves as a buffer against future write-off expenses. The inventory reserve operates as a contra asset account, paired with gross inventory to determine net inventory on the balance sheet. Simultaneously, the corresponding expense is recognized on the company’s income statement.
Invest in software solutions
The occurrence of inventory write-offs may indicate inadequate inventory management. This is where warehouse management software proves valuable, primarily by providing an accurate depiction of a company’s inventory. Software simplifies the task of maintaining precise records regarding available stock, its location, and its duration in storage. Managers can leverage this information to make informed decisions about the frequency and quantity of orders and identify instances where write-offs are necessary.
In addition to its core benefits, warehouse management software can automatically alert business managers when inventory items are approaching their sell-by dates. It also facilitates the creation and management of documentation required for tax purposes when inventory is liquidated, donated, or discarded. Furthermore, the software can pinpoint areas where write-offs occur frequently, enabling managers to identify and address underlying issues.
Reduce Inventory Write-Offs with Warehouse Management Software
Warehouse management software offers a comprehensive overview of a company’s historical and current inventory data, aiding business managers in making informed ordering decisions and preventing overordering that might lead to write-offs. The software addresses inventory obsolescence as a symptom, highlighting the underlying issue of supply chain breakdowns. By identifying items lingering in inventory, the right software prompts managers to take timely actions, minimizing losses.
PALMS™ Smart WMS provides a real-time inventory view across company locations and sales channels. This tool assists business managers in reducing inventory, freeing up cash, and maintaining low inventory costs. It plays a crucial role in preventing stockouts, optimizing inventory levels, and ensuring product availability.
While it is inevitable that some inventory may lose value due to factors like obsolescence, spoilage, or damage, accounting for such inventory write-offs diminishes a company’s net income and retained earnings. However, effective strategies, guided by suitable warehouse management software, empower business managers to minimize write-offs and optimize inventory management.