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The Value of Excess and Obsolete Inventory
One of the issues that can affect the valuation of a 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 distributor 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.
Here is a 5 step process to Dispose of the excess and obsolete material that you currently have on hand. We have also included, after these steps, three suggestions related to Prevention.
Disposition of Inventory
- 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.
- 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?
- Sell at a discount: Some finished products and/or un-opened components can be sold through after-markets or brokers. Getting 25% of the original value in cash is certainly better than annually dusting and counting obsolete items.
- 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?
- 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 Education Assistance Ltd., 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. We really liked their home page heading, "Creating College Scholarships from Excess Inventory."
Prevention of More Excess and Obsolete
Here are 3 common situations that lead to the creation of excess and obsolete inventory. There are others, but understanding and controlling these will usually help:
- 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.
- Sales introduces new items that do not sell to forecast. Most distributors know which sales people are overly optimistic.
- Your purchasing or planning people buy in large lots to take advantage of quantity price breaks.
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?
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.
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. We have done this with several clients and the pay-off is always good. It is rarely a job anyone wants long term, so they have the incentive to work on the issue aggressively.
The Distributor Board has helped many companies with inventory issues. If you have any questions about anything mentioned in this newsletter, give us a call.