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    Jun162010

    How do I identify obsolete inventory?

    There are a number of techniques for identifying obsolete inventory, as discussed below.  However, be sure to gain the commitment of upper management to this search first; otherwise, the scope of the resulting expense (which can be substantial) may lead to multiple rounds of questions regarding how the company could have found itself saddled with so much obsolete inventory, all of which must be written off as soon as it is discovered.  Conducting a search for obsolete inventory may meet with a particular level of resistance if the management team is being awarded significant profit-based bonuses.  If so, consider addressing the prevention of incoming obsolete inventory instead, which may reduce inventory levels over the long term, though it will not address the existing obsolete inventory.

    The Materials Review Board

    Though it is certainly encouraging to see a manager eliminate obsolete inventory, a common problem is to see some items disposed of that were actually needed, possibly for short-term production requirements, but also for long-term service parts or substitutes for other items.  In these cases, the person eliminating inventory will likely be castigated for causing problems that the logistics staff must fix.  A good solution is to form a Materials Review Board (MRB).  The MRB is composed of representatives from every department having any interaction with inventory issues – accounting, engineering, logistics, and production.  For example, the engineering staff may need to retain some items that they are planning to incorporate into a new design, while the logistics staff may know that it is impossible to obtain a rare part, and so prefer to hold onto the few items left in stock for service parts use.

    It can be difficult to bring this disparate group together for obsolete inventory reviews, so you normally have to put a senior member of management in charge to force meetings to occur, while also scheduling a series of regular inventory review meetings well in advance.  Meeting minutes should be written and disseminated to all members of the group, identifying which inventory items have been mutually declared obsolete.  If this approach still results in accusations that items have been improperly disposed of, then the group can also resort to a sign-off form that must be completed by each MRB member before any disposition can occur.  However, obtaining a series of sign-offs can easily cause lengthy delays or the loss of the sign-off form, and is therefore not recommended.  A simpler approach is to use a negative approval process whereby items will be dispositioned as of a certain date unless an MRB member objects.  The MRB is not recommended in very low-inventory situations, as can arise in a just-in-time (JIT) environment, since an MRB tends to act too slowly for employees used to a fast-moving JIT system.

    How to Find Obsolete Inventory

    The simplest long-term way to find obsolete inventory without the assistance of a computer system is to leave the physical inventory count tags on all inventory items following completion of the annual physical count.  The tags taped to any items used during the subsequent year will be thrown away at the time of use, leaving only the oldest unused items still tagged by the end of the year.  You can then tour the warehouse and discuss with the MRB each of these items to see if an obsolescence reserve should be created for them.  However, tags can fall off or be ripped off inventory items, especially if there is a high level of traffic in nearby bins.  Though extra taping will reduce this issue, it is likely that some tag loss will occur over time.

    Even a rudimentary computerized inventory tracking system is likely to record the last date on which a specific part number was removed from the warehouse for production or sale.  If so, it is an easy matter to use a report writer to extract and sort this information, resulting in a report listing all inventory, starting with those products with the oldest “last used” date.  By sorting the report with the oldest last usage date listed first, you can readily arrive at a sort list of items requiring further investigation for potential obsolescence.  However, this approach does not yield sufficient proof that an item will never be used again, since it may be an essential component of an item that has not been scheduled for production in some time, or a service part for which demand is low.

    An advanced version of the “last used” report compares total inventory withdrawals to the amount on hand, which by itself may be sufficient information to conduct an obsolescence review.  It also lists planned usage, which calls for information from a material requirements planning system, and which informs you of any upcoming requirements that might keep the MRB from otherwise disposing of an inventory item.  An extended cost for each item is also listed, in order to give report users some idea of the write-off that might occur if an item is declared obsolete.

    If a computer system includes a bill of materials, there is a strong likelihood that it also generates a “where used” report, listing all the bills of material for which an inventory item is used.  If there is no “where used” listed on the report for an item, it is likely that a part is no longer needed.  This report is most effective if bills of material are removed from the computer system or deactivated as soon as products are withdrawn from the market; this more clearly reveals those inventory items that are no longer needed.

    An additional approach for determining whether a part is obsolete is reviewing engineering change orders.  These documents show those parts being replaced by different ones, as well as when the changeover is scheduled to take place.  You can then search the inventory database to see how many of the parts being replaced are still in stock, which can then be totaled, yielding another variation on the amount of obsolete inventory on hand.

    A final source of information is the preceding period’s obsolete inventory report.  Even the best MRB will sometimes fail to dispose of acknowledged obsolete items.  The accounting staff should keep track of these items and continue to notify management of those for which there is no disposition activity.

    In order to make any of these review systems work, it is necessary to create policies and procedures as well as ongoing scheduled review dates.  By doing so, there is a strong likelihood that obsolescence reviews will become a regular part of a company’s activities.  In particular, consider a Board-mandated policy to conduct at least quarterly obsolescence reviews, which gives management an opportunity to locate items before they become too old to be disposed of at a reasonable price.  Another Board policy should state that management will actively seek out and dispose of work-in-process or finished goods with an unacceptable quality level.  By doing so, goods are kept from being stored in the warehouse in the first place, so the MRB never has to deal with it at a later date.

    Podcast: A discussion of obsolete inventory is available on Episode 66 of the Accounting Best Practices podcast. Listen Now.

    Related Topics

    How do I report an inventory write down?
    How do I write down inventory?
    What is an inventory reserve?
    What is inventory shrinkage?

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    Reader Comments (3)

    If in financial statements inventory is adjusted already for obsolete stock, to arrive at stock turnover ratio do you add back obsolete stock to inventory and also cost of sales?

    January 9, 2011 | Unregistered CommenterBansari

    No, you do not add back the obsolete stock. It has already been charged to expense, so it is considered to be gone, even if the obsolete inventory is still on the premises.

    January 9, 2011 | Registered CommenterSteven Bragg

    Hi,
    What are the post inventory procedures I should perform as an auditor to determine inventory obsolescence allowance of the client to ensure that the inventory is correctly valued? confused!!!!

    September 27, 2012 | Unregistered CommenterSinah
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