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EXCESS & OBSOLETE INVENTORY: A Diminishing Asset with Hidden Costs

By: Herbert C. Shields, CMC

Obsolete-Inventory

One of the issues that can affect the valuation of a manufacturing or distribution business is the amount of inventory on hand that is classified as excess and obsolete.  This could also affect the viability of an acquisition that you may be considering to take your business to the next level. Banks look at inventory carefully when considering working capital lending both to on-going businesses and for leveraged acquisitions.

Excess and obsolete inventory is costing the typical company 25% a year.  If you start the year with $100,000 of obsolete product, that inventory will have cost your business $25,000 due to storage, damage, shrinkage, and the cost of money by year-end. What could you have done with that $25,000 to grow your business?

Since the excess inventory is usually stored in the back of the warehouse, in the highest rack locations, or worst case, in an outside rented warehouse, most companies do not address the problem on a regular basis. This article includes a five step process to DISPOSE of the excess and obsolete material that you currently have on hand.  It also includes some recommendations designed to PREVENT the purchase of more of the same.

First, disposition of inventory that you have:

  1. Use as is – sometimes the inventory has been produced for one customer and that customer no longer wants it.  If you still have a business relationship with that customer, the sales department needs to work with that customer to explore all options.  If the original customer(s) are out of the picture, then you should look at other customers and determine if they have any requirement for a product similar to what is on hand.
  2. Re-work/modify – You may need to ask for help from your principle supplier to suggest how to modify or re-configure the merchandise to be saleable.  Even if there is a cost to modification or rework, if it is less than 25%, this might be a good deal. If the obsolete inventory is an old design, can it be brought up to the latest version of the product?
  3. Sell at a discount – some finished products and/or un-opened components or recovered ones can be sold through after-markets, online or brokers. Getting 25% of the original value in cash is certainly better than annually dusting and counting obsolete items.
  4. Use components – If your excess inventory is an assembled product or sub-assembly, can it be taken apart and at least some of the components re-used in other products or sold as spare parts?
  5. Donate for tax credit – once you have investigated options 1 – 4 and are convinced that you have no way to use even some components, you should consider donating the inventory for a tax credit.  Our colleague, Claudia Freed is the Director of EAL, a not-for profit organization that has helped many companies in this process. A past client with an industrial product worked with EAL and was able to dispose of their inventory, avoid costs associated with scrapping the material, and received a tax credit. Go to www.inventorydonations.org for more information.

Prevention of more excess and obsolete.  Here are three common situations that lead to the creation of excess and obsolete inventory. There are others, but understanding and controlling these will usually help.

  1. Customers do not buy as much as they forecast or order. Sales knows which customers represent real risk, build that information into your ordering decision process.
  2. Sales introduce new items that do not sell to forecast. Most distributors or manufacturers know which sales people are overly optimistic.
  3. Your purchasing or planning people buy in large lots to take advantage of quantity price breaks as may be the case with electronic components.

Note that all of these are based on good intentions, and may be critical to your business.  Measurement of these situations is what is usually lacking – i.e. what does history tell you about the first two, and what is the trade-off in inventory represented in the third?

Finally, if inventory write-offs and outside warehousing are continuous problems, you may want to consider assigning the disposition and prevention responsibility to a specific person. It is rarely a job anyone wants long term, so they have the incentive to work on the issue aggressively. Most ERP systems allow you to run an ABC listing of inventory items.  Force yourself to look at the C’s and D’s on the bottom of the list at least once a quarter and take action.

Remember, if you hold excess or obsolete inventory in storage, it is deemed to have value from the Internal Revenue’s perspective – if it’s not to be used – it’s subject to value diminishment at the least and taxation as a recovery against previous write-offs at the worst.

About the Author:

As President of HCS Consulting since 2000, Herb has delivered improved results for clients in their purchasing and inventory management activities.  Working with client personnel, Herb has reduced the cost of purchased materials and services, improved inventory turns and customer service, and enhanced peoples’ capabilities with customized training programs. Herb has 30+ years of experience as an operations executive in capital equipment, automotive, electrical machinery, and consumer products companies. Herb blogs for DC Velocity and has been a contributing writer for many other publications.  He is a frequent speaker on supply chain topics for many management and professional audiences.  Herb teaches Purchasing, Supply Chain Processes, and Energy Options at the Illinois Institute of Technology. 

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