Not every product is going to sell like hotcakes. It’s a reality — and cost— of doingbusiness. When, for various reasons, inventory doesn’t sell and loses all marketvalue, a company must report the loss as a “write-off” on its balance sheet andincomestatement using one of two main accounting methods. This article examines the main causes ofinventory write-offs, how a business can write them off and strategies for keepingwrite-offs to a minimum.
What Is an Inventory Write-Off?
An inventory write-off occurs when a company formally acknowledges that products it intendedto sell have lost all value and can no longer be sold — when it becomes dead stock or obsoleteinventory. There are many reasons a company doesn’t sell all of its inventory, whichincludes raw materials, component parts and finished goods. Items may become obsolete due totechnological advancements, such as the introduction of faster equipment, like a computer orcellphone, or more sophisticated software. Fashion trends change over time, too, as is thecase with clothing or home décor, resulting in items left on shelves. Food that expiresorspoils 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 determinedthat a piece of inventory will not sell, the company reduces the amount of its grossinventory by the cost of the obsolete inventory item.The company will also recognize an expense of an equal amount on its income statement. Ifthe expense is negligible, the expense can be recognized in the company’s cost ofgoods sold. But it’s advisable that a more substantial write-off be broken out as aseparate item, rather than amending its original entry, to make tracking losses easier andavoid the risk of distorting the gross margin.
Write-offs reduce a company’s assets, which means they also reduce the company’soverall value. And because the write-off results in an expense, the company’s netincome 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. Themilk, which is considered inventory, is recognized as a $50,000 asset on ABC Grocery’sbalance sheet. Let’s say it must dispose of $5,000 worth of milk because the sell-bydate was yesterday. The company then creates a $5,000 write-off that reduces the value ofits inventory to $45,000. It also creates a $5,000 expense that appears on its incomestatement and reduces net income.
Some companies recognize the likelihood of future write-offs by establishing an inventoryreserve. The inventory reserve carries a credit balance — an estimated amount tooffsetwrite-offs, based on how much was needed in previous years. In accounting terms, theinventory reserve is a contra asset account that reduces the value of gross inventory toarrive at net inventory. At the same time as an inventory reserve is created on the balancesheet, an expense of the same amount is included on the income statement. When an inventorywrite-off actually occurs, gross inventory and the inventory reserve are both reduced by theamount of the write-off. No expense is created, because the cost was already expensed whenthe inventory reserve was established.
Returning to our earlier example, let’s say ABC Grocery knows that 10% of inventorytypically spoils. The company has $50,000 worth of gross inventory, so it creates a $5,000inventory reserve on its balance sheet, which also shows net inventory of $45,000. At thesame 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 andinventory 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 theinventory 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 anyworth. Awrite-down occurs when the inventory’s fair market value falls below the cost of theinventory recorded on the balance sheet, but the item can still be sold for some amountnorth of zero.
The write-down amount is the cost of the inventory item minus the current market value ofthat item. To account for a write-down, a business reduces the value of its inventory by thewrite-down amount. Assuming no inventory reserve exists, an inventory write-down expenseaccount is created and included on the income statement. Both inventory write-offs andwrite-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 salefor $1.50. It then must write down its inventory by 50 cents — the difference betweenwhatit paid and the sale price — times however many gallons are affected. But that’sbetter than if the milk expires and it has to take a full $2 write-off for each gallon ofmilk.
9 Ways to Reduce Inventory Write-Offs
Write-offs lower a company’s net income and retained earnings. That’s whyit’s important for businesses to properly manage their inventoryand regularly evaluate whether items have become obsolete or reduced in value. The goal, ofcourse, is to minimize how much inventory needs to be written off. Here are nine tacticsaimed at accomplishing that.
Don’t buy too much inventory. It’s easy to be optimisticabout future business and order too much inventory. Supply chain issues may beanother reason for overordering. Regardless, an excess of inventory ties up cash andadds 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 thepast. Then factor in anything that may have changed and will impact future sales. Isthe current economy as strong as it was in past years? Are customers as financiallyhealthy as they were last year? Have tastes or trends changed? It’s quitepossible those orange throw pillows are no longer the rage.
Reevaluate purchasing plans. Inventory write-offs may be reduced ifa business places more frequent, smaller inventory orders. This tip is especiallyimportant for perishable items, but it also holds true for anything that can sooneror later be replaced by a newer model or be deemed unfashionable. Ordering insmaller batches also helps managers respond more quickly to changes in demand.
Before going this route, however, it’s important to understand that placingsmaller orders may result in some additional costs through economies of scale. Forexample, a business may no longer be eligible for the same bulk discount and have topay more per item. More frequent shipments mean transportation and employee costsmay also increase. And in inflationary environments, items are more likely to costless today than they will just a few months down the road.
Check inventory upon arrival. When inventory arrives at thewarehouse, make sure everything that was ordered (and paid for) indeed wasdelivered. Thoroughly inspect items for damage and return any goods that aredamaged. Later on, managers should periodically check whether their inventory datamatches the actual merchandise they hold in inventory.
Protect inventory against damage or theft. Proper storage, such as adry location or on shelves high enough that products can’t be accidentallybumped 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 installsecurity cameras and alarms.
Consider selling aging items at a discount. Consider discountingitems that have been in inventory too long; it’s better to sell an item at alower price than not to sell it at all. Another alternative is to offer oldinventory items as a free gift with purchase, engendering customer satisfaction andloyalty.
Recall our milk example above. It was better for ABC Grocery to put the milk on salefor $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 anotherbusiness. Try to sell aging inventory back to the manufacturer or toanother business. They might have demand from other customers or be willing topurchase it at a discount.
Sell items for parts. Some inventory can be disassembled and soldfor their parts or raw materials. Old computers, for example, have hard drives andmemory chips that can be sold individually. Used cars have parts that can be soldseparately, too. And some inventory items made of plastic or metals can be sold forscrap or be recycled.
See AlsoInventory Write offCreate an inventory reserve. Analyze how much inventory had to bewritten 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 reserveis a contra asset account that is paired with gross inventory to arrive at netinventory on the balance sheet. The expense is also recognized on thecompany’s income statement.
Invest in software. The need for inventory write-offs may be a signof poor inventory management. This is where inventory management software can help,first and foremost by providing a business with an accurate picture of itsinventory. Software makes it easy to keep accurate records about what’s instock, where it’s located and how long it has been there. Managers can usethis 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 businessmanagers when inventory items are approaching their sell-by dates. It can alsocreate or manage the documentation needed for the IRS when inventory is liquidated,donated or destroyed. In addition, software can pinpoint where write-offs areoccurring 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 historicalinventory data, as well as its current inventory position. This information can informbusiness managers who are making ordering decisions and prevent them from ordering too muchinventory, which may lead to write-offs. Inventory obsolescence is the symptom, not theproblem — the problem is a breakdown in the supply chain. The right software canhighlightitems that have remained in inventory too long and prompt managers to take appropriateaction to keep losses to a minimum.
NetSuite InventoryManagement provides a real-time view of inventory across a company’s locationsand sales channels. It helps business managers reduce inventory, free up cash and keepinventory costs low. It also helps avoid stockouts, optimize inventory levels and ensureproduct availability.
Conclusion
It may be inevitable that some of a company’s inventory will lose all value, forreasons that include obsolescence, spoilage or damage. For accounting purposes, thisinventory must be written off, which ultimately decreases the company’s net income andretained earnings. But there are also plenty of tactics business managers can use to helpkeep write-offs to a minimum, many of which can be guided by the right inventory managementsoftware.
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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. Wheneverthe market value of the inventory falls below the inventory’s book value, it should bewritten 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 iscreated and included on the income statement. Both inventory write-offs and write-downsshould 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’torder too much inventory. Before ordering, analyze how much inventory the company has bothsold and written off in the past. Then factor in anything that may have changed and willimpact future sales. Consider ordering smaller batches more frequently, particularly ifinventory is perishable or affected by changes in technology or fashion.
Inspect inventory upon delivery and return to suppliers any items that are damaged. Storeinventory in areas that will protect it from future damage and, preferably, in locationssecured by locks and cameras to prevent theft. If items are sitting in inventory too long orare approaching their sell-by dates, consider holding a sale so that any write-off can beminimized. Another alternative is to disassemble inventory and sell individual parts andmaterials. Consider contacting the manufacturer to see whether it is willing to repurchaseexcess inventory.
And, finally, invest in excellent software that can accurately track inventory and providebusiness managers with an accurate picture of a company’s inventory. Software makes iteasy to keep accurate records about what’s in stock, where it’s located and howlong it has been there. Software can help managers determine how much and how often theyneed to place orders.
Among other benefits, inventory management software can automatically notify businessmanagers when inventory is approaching its sell-by date. It can help create or manage thedocumentation needed for the IRS when inventory is liquidated, donated or destroyed. Inaddition, software can highlight areas where write-offs are occurring frequently so thatmanagers can identify and address problems.
How do you reduce inventory?
Inventory can be reduced by ordering the proper amount of inventory. Don’t order toomuch inventory. Before ordering, analyze how much inventory the company has sold and writtenoff 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 perishableor affected by changes in technology or fashion.
If items are sitting in inventory for too long or approaching their sell-by dates, considerholding a sale. Another alternative is to disassemble inventory and sell the resultingindividual parts and materials. Consider contacting the manufacturer to see if it is willingto repurchase excess inventory or parts and materials.
And, finally, keep inventory to a minimum by investing in excellent software that canaccurately track inventory and provide business managers with an accurate picture of acompany’s inventory. Software makes it easy to keep accurate records aboutwhat’s in stock, where it’s located and how long it has been there. Software canhelp managers determine how much and how often they need to place orders.
Among other benefits, inventory management software can automatically notify businessmanagers when inventory is approaching its sell-by date. In addition, software can highlightareas where write-offs are occurring frequently so that managers can identify and addressproblems.
