When a company has a significant investment in inventory, one of the more essential accompanying metrics is the obsolete inventory percentage. This measurement is needed to derive that portion of the inventory that is no longer usable. The percentage should be tracked on a trend line and compared to the results of similar businesses, to see if a company is experiencing an unusually large proportion of inventory problems. The measure can also be tracked on a trend line, to see if there has been a gradual change over time that should be rectified.
Actions taken that relate to this percentage can include:
- Changes in the reserve for obsolete inventory, if the percentage is varying from the long-term trend.
- Changes in the amount of activity to disposition obsolete inventory in a manner as advantageous to the company as possible.
- Actions taken to reduce the underlying causes of obsolescence, such as buying in smaller quantities, switching to a production system that is based on customer orders, better management of engineering change orders, and so forth.
To derive the obsolete inventory percentage, summarize the book value of all inventory items which have been designated as not being needed, and divide it by the book value of the entire inventory. The formula is:
Book value of inventory items with no recent usage ÷ Total inventory book value
For example, the warehouse manager of Mole Industries wants to investigate the extent of obsolete inventory in his warehouse, so that he can remove items and consolidate the remaining inventory. He prints a parts usage report from the company's manufacturing resources planning system that only shows the cost of those items that are in stock and have not been used for at least two years. The total cost listed on this report is $182,000, which is 19% of the total book value of the entire inventory. The warehouse manager brings this high percentage to the attention of the purchasing manager, who immediately contacts suppliers to see if they will take back the obsolete items in exchange for a restocking fee.
The main problem with the obsolete inventory percentage is figuring out which inventory to include in the numerator. Whatever method is chosen should be used in a consistent manner, so that trends in the percentage can be more reliably tracked over time.