Dealing with Obsolete Inventory

Author: Larry Chester

For manufacturers, retailers, or wholesale distributors, inventory is likely the largest item on their balance sheet. A particular problem that often rears its ugly head is the issue of obsolete inventory. So, the question becomes: how do you decide when to just let it go?

Bringing Value Through CFO Insights

Companies are very careful about what they pay for their inventory—as they should be. For many companies, but especially those that have seasonal inventory, a policy should direct what to do when items become obsolete. There are two major issues here: (1) how do you decide when something becomes obsolete and (2) how do you price it for quick sale?

• Business – Dress Manufacturer
• Location – Chicago, Illinois
• Sales – $10,000,000
• Ownership – Family

Initial Contact – The business owner reached out because the company was running out of cash. Their bank didn’t have confidence in management’s ability to guide the company and was limiting their borrowing—in spite of their line having plenty of availability. Unfortunately, financial reporting had been inconsistent, so the owners wanted help putting together a set of financials that the bank would accept.

Significant Findings and Recommendations:

Obsolete Inventory

The company’s mainstay was formal, high-fashion dresses that they sold to small designer dress shops. When that market began to weaken, the inventory of unsold dresses began to grow. The company also started a sportswear line, but that didn’t sell due to a significant manufacturing error in incorrectly sizing the items. The result was that the 100,000 sq. ft. warehouse was filled with inventory that wasn’t being sold. Some of it was nearly 10 years old. Obviously, this was costing the company money.

Recommendations

• Reduce the price of the inventory to minimal levels and promote the sale of the garments through internet channels.
• Look for a distressed inventory company to buy the inventory in total, at any price.
• Find charities that will take the inventory. This would at the very least provide the company with a tax deduction.

If these three efforts are unsuccessful, the last resort is to just dispose of the old inventory in order to regain usable warehouse space.

Establish a policy of what to do with product left over from a season just past, so that this inventory build-up doesn’t happen again.

For example:

• Provide a range of increasing discounts over a period of months immediately following the season. This should reduce inventory significantly.
• Donate any inventory left after six months to free up warehouse space.

Financial Reporting Inconsistencies

The company had lost significant money over the past few years. In addition, the projections and budgets for the last few years bore no resemblance to the actual results. The bank reported a loss of confidence in management as a result of the inconsistent financial reporting.

Recommendations

• Change the company’s operating financial reports to accrual basis, rather than cash basis.
• Reconcile the general ledger balances from the start of the year. This will provide an accurate starting point for all the upcoming transactions on an accrual basis.
• Verify the accuracy of certain classes of transactions for the current year, one month at a time, to build accuracy to the current month.
• Review the operational workflow to verify that the financial transactions were accurately mapped from the operational transactions.
• Verify inventory receipts. This may be after the fact, but the shipping paperwork and accounts payable detail should match.
• Ensure the sales register matches the individual invoices.
• Match cash receipts to bank activity.
• Match AP payments to bank activity.

Aging Computer System

The company was using an old IBM computer system that was costly to operate. Outside resources provided maintenance and programming. Their inventory records and order processing flowed through that system, and it appeared accurate. There was consistent detail and many reports available. Although they were slowly migrating to a new ERP program, they were having difficulty leaving the comfort of the old system. Since business operations were still processed in the IBM system—and there was no import tool available—weekly activity reports were printed and then manually entered into the new ERP software.

Recommendations

• Custom program an import tool that will transfer the needed data from the IBM system so that it can be imported into the new ERP.
• Put a strategy together to eventually migrate all of their transactions to their new ERP system, saving costs and the need to use multiple software programs.

Business owners are always concerned about company profits. Unsold inventory doesn’t show up on the income statement. Products sold at a loss push down margins and profits, so in an effort to maintain strong profits and “good looking” reports for the bank, there may be a tendency to hold on to items that don’t sell, rather than disposing of them at a loss.

But that’s the wrong approach. Inventory is a tool to achieve profitability. A company can only make money when business is transacted. So, inventory sitting on the warehouse floor is just like money under your mattress. It may have value, but you can’t use it. Obsolete inventory consumes space and ties up cash. There is no upside. For every day that passes, it loses more and more value. So, even selling inventory at 50% of cost would provide the company with cash that they can use to buy products that will generate income. Holding on to obsolete inventory just locks any remaining value in a box that you can’t touch, until there is no value left.

Every decision that you make flows down to the financials. Some, like introducing new and exciting products, will improve the bottom line. Other decisions, like disposing of obsolete inventory, can’t contribute. But you always need to look towards the future. Think about how that decision will look in two weeks or two months. Will the situation look better? In the case of hanging on to that obsolete inventory, not likely.