Obsolete inventory is often as much as 20-25% of the total inventory of a company. Some estimates put the total obsolete inventory for all manufacturing, distribution, and retail companies in the US at nearly $1 trillion. Clearly this is a real problem, but how does inventory become obsolete, and why does it remain a part of inventory for so long?
The first challenge in dealing with obsolete inventory is identifying it. The definition of obsolete inventory can be unique to a company, depending on their business objectives. For example, a company may deem inventory that has had no sales activity for years as “just in case” inventory - there to support a customer order that could be received somewhere in the future. This situation is most common when replacement parts are held in inventory, and product lifecycles span decades.
In most cases, however, inventory that has had no activity for a defined period of time, is likely to be obsolete. Establishing clear guidelines that define when inventory becomes obsolete is an essential requirement to better manage inventory, and limit the amount of inventory that becomes obsolete.
These guidelines should be defined as part of an objective to eliminate obsolete inventory, rather than trigger activity to get rid of already obsolete inventory. This may sound like a lofty goal, but consider the most common drivers of obsolete inventory:
• Forecasting Errors
Overly optimistic sales forecasts can drive higher inventory levels, especially for items with longer lead times. This problem can be magnified when forecasting and planning systems are not integrated, and rely on manual activities to identify variances.
• Quality Issues
Products that are manufactured poorly or cannot meet customer requirements, both result in obsolete inventory, whether finished goods or raw materials. Lack of a strong go/no-go process in product development often triggers procurement of at risk material.
• Product End of Life
Significant planning is necessary to ensure that inventory is consumed when products are made obsolete or a model number is changed. This is typically a coordinated effort between sales, engineering, and supply chain on a continuous basis.
• Inaccurate Inventory
High variances in inventory accuracy are generally also accompanied by higher levels of obsolete inventory. Both situations are usually the result of inconsistent process execution, and often include a significant amount of manual activity.
Each of these contributors to obsolete inventory are able to be improved, and systematically improving all of them will dramatically reduce the amount of inventory that becomes obsolete. The two most common improvement tactics are process improvement and governance. When processes are not adequately fostering the necessary amount of collaboration, communication, and consistency, gaps are formed that can create blind spots to obsolete inventory. Additionally, lack of process governance inhibits consistent management of exceptions, and fosters a culture of non-accountability. Best practices suggest a strong governance model that clearly defines the following: (1) how process adherence will be managed, (2) who has responsibility for each portion of the process, (3) how exceptions will be handled, and (4) what techniques will be used to drive continuous improvement.
Preventing obsolete inventory requires a strong alignment between sales and supply chain. Any changes in demand must be communicated in real-time, to avoid building or procuring inventory that is at risk.
Although even the best run companies have some level obsolete inventory on their balance sheets, they differentiate themselves through early warning systems to identify it, and defined processes to eliminate it. The most common methods used to eliminate obsolete inventory include:
• Write-Off Obsolete Inventory
Eliminating obsolete inventory from the balance sheet can be accomplished by charging obsolete inventory to the cost of goods sold at year end. Ideally, reserves have been accumulated to offset the financial impact of the write-off. To the extent an entity has elected for tax purposes to carry inventory at “the lower of cost or net realizable value”, they should be able to write inventory down to that level (i.e. replacement cost).
• Donate Obsolete Inventory for a Tax Deduction
Certain surplus or obsolete inventory can be donated to a charity as a federal income tax deduction. C corporations may be able to deduct the cost basis of the inventory donated, plus one-half of the inventory’s unrealized appreciation, while S corporations, partnerships, LLC’s or sole proprietorships qualify for a deduction equal to the lesser of inventory’s cost basis or net realizable value.
• Sell Products to Other Customer or Through Other Channels
The explosion of e-commerce has enabled companies to reach non-traditional buyers and provided access to alternate sales channels. While these techniques will usually require deep price discounts and significant manual effort, they offer an opportunity to convert non-valuable inventory into cash. Obsolete inventory can also be liquidated through internet based companies focused solely on overstocked items (i.e. WeBuyExcess.com, and SliBuy.com).
In summary, obsolete inventory is a common occurrence that, in many cases, can be greatly reduced through process rigor, real-time tracking, and strong governance. Preventing the growth of obsolete inventory is easier than getting rid of it, despite the emergence of new e-commerce channels for disposition of excess or obsolete inventory.
If you have additional inquiries about this article, please contact FGMK. Michael Fenske is a Managing Director at FGMK, who co-leads FGMK's Management Consulting Practice.