Inventory Write-Downs Explained: Accounting Methods, Tips, and Best Practices
September 8, 2021
Unless it’s an original Picasso painting or a classic Chanel handbag, most tangible items lose their value over time.
Running an online business, it’s important to keep value depreciation in mind when tracking, managing, and reporting on inventory.
In an ideal scenario, when all your inventory gets sold at a net profit, you achieve maximum ROI. But, in the real world, things work a little differently.
It’s not uncommon to report a small loss due to inventory value depreciation. When this occurs, an inventory write-down is required to ensure you still end up with healthy profit margins.
In this article, learn what an inventory write-down entails, inventory accounting best practices, and how a 3PL like ShipBob can help you better track, manage, and report on your inventory.
What is an inventory write-down?
An inventory write-down, also referred to as “inventory impairment,” is an accounting term that recognizes when your inventory’s market value falls below the book value, but it still considered sellable.
When inventory loses partial value, it must be recorded as an inventory write-down expense on a company’s balance sheet, and it must be made as soon as possible to lessen tax liability.
The write-down affects your business balance sheet and income statement, and it can cause a drop in net income, which, in turn, reduces the shareholder equity and retained earnings.
Note: You might have also heard the term “inventory write-off,” which is very similar, but there’s a slight different. Inventory write-down is written down when an asset’s value depreciates but still holds some value, whereas a write-off is when an asset loses all of its value and must be removed from accounting records entirely.
What causes inventory write-downs?
From ordering too much inventory to begin with, to a decline in demand, there are several reasons why inventory can lose its value. Here are some of the most common reasons that can lead to an inventory write-down.
Many times, retailers tend to order too much inventory, based on a gut feeling, without taking projected future demand into consideration. Apart from inaccurate demand forecasting, poor sales efforts can also result in a stockpile of dead stock.
The longer the unsold inventory stays in the warehouse, the higher the holding costs and more you’re at risk of carrying obsolete inventory (i.e., product that is no longer in demand). This expense includes the cost of capital and storage fees, both of which will need to be written down.
Physical inventory of perishable goods have a shorter shelf life. Once inventory becomes expired, it is no longer sellable.
If SKUs are left unsold in your warehouse for too long, they cross the expiry date and completely lose value. At this point, the expired inventory can no longer be written down but rather “written-off” and counted as a complete loss.
Keeping accurate and up-to-date inventory records and making sure the first batch of inventory is sold first can help reduce inventory waste.
Purchased inventory can get damaged in transit, while being picked, or even in storage. Storing and shipping fragile items are more prone to getting broken, bent, or otherwise defective, which then leads to revenue loss.
Luckily, much of it can be prevented. A well-designed warehouse setup, the right equipment, well-trained warehouse staff, appropriate shipping of fragile items, and proper warehouse receiving processes can all help reduce the risk of inventory losing value.
Accounting methods for writing down inventory
For inventory write-downs specifically, there are two primary inventory accounting methods: direct write-off and allowance method.
The inventory valuation method you choose depends on how significant the inventory write-down is. Here is a deeper dive into the two different methods.
Direct write-off method
The direct write-off method requires writing down unsold inventory that’s lost value as a “bad debt expense.”
For example, a company that sells mobile phones had inventory worth $10,000 in the beginning of the year. Of this lot, $1,000 worth of inventory was outdated by year-end. So, the company’s accountant will decrease the inventory account by the write-off value and COGS increases accordingly.
It’s worth noting that smaller write-offs can be reported as COGS, rather than a write-down. But larger amounts must always be entered as a separate line on the income statement.
But, adding the write-off amount to the COGS account can create a misleading picture of your businesses’ gross margin, since there is no matching journal entry for the revenue secured by the sale of the SKU.
Note: Recurring inventory write-offs can be a red flag and could be perceived as inventory fraud. Always consult your CPA or accountant on the best way to report inventory value.
The allowance method is a more elaborate process since some money is set aside to cover inventory that might lose some or all of its value in the future.
Unlike the direct write-down method, the allowance method requires you to report bad debt expenses every fiscal year.
This method allows you to track the total size of the write-down and keep tabs on the historical cost in the original inventory account.
This predicted drop in inventory value is credited to a separate contra asset account (i.e., inventory reserve or allowance for obsolete inventory) which offsets the inventory line item in the balance sheet. It is also debited from the expense account.
For example, a mobile phone retailer has assets worth $10,000 and tags goods worth $1,000 for disposition. Then, they immediately create an inventory reserve account, to which they add $1,000 and deduct the same amount as an expense.
When the inventory is disposed of, you can debit the inventory reserve and credit the inventory account.
Tips for reducing inventory impairment
Did you know that inventory accounts for 45-90% of your business’s overall budget? When you invest so much capital, you would want to get good returns.
Inventory write-downs can cause an increase in COGS and a decrease in gross profit, which is why it is advisable to plan ahead and find ways to maintain optimal inventory levels to meet demand.
Here are some inventory optimization tips and best practices to reduce inventory value depreciation.
Track inventory expiration with an inventory management system
Regular inventory audits play a huge role in reducing risk of expiry, especially of SKUs that have a shorter shelf life.
For instance, ShipBob’s lot feature allows you to separate items based on their lot numbers. When you send us a lot item, we will not store it with other non-lot items, or other lots of the same item.
With lot tracking, ShipBob also uses the first in, first out (FIFO) inventory valuation logic designed to identify shelves that contain items with an expiry date first and always ship the nearest expiring lot date first. If you have items stored in different bins — one with no lot date and one with a lot date — we will always ship the one updated with a lot date.
“We also have easy ways to manage subscription orders as well as expiration dates and lot numbers, so inventory goes in First In, First Out (FIFO).”
Leonie Lynch, Founder & CEO of Juspy, a ShipBob merchant
Forecast demand to keep optimal stock levels
By taking a look at historical data, you can predict future demand for each SKU and make informed decisions to avoid purchasing too much of an item that might lose its value before it gets sold.
Rather than ordering more than enough inventory to ensure you meet demand, having data-driven predictions on how much inventory to have on hand can significantly reduce the risk of holding onto inventory that is at risk of losing value.
With better inventory forecasting, you not only improve and optimize your ideal stock levels, but you also improve cash flow and even free up funds for other areas of the business, including ecommerce warehousing.
Keep in mind that if you partner with a 3PL, you may have this data to refer to. For instance, ShipBob offers inventory forecasting data and insights to help you discover:
- How quickly products are selling and which items are slow-moving
- How many days of inventory you have until you are expected to run out based on SKU velocity
- How your current demand compares to previous time periods
- How your sales are affected by different seasons and months
- And much more
“Between shipping new collections for wholesale earlier in the year and Q4 madness for direct-to-consumer sales, we’ve been able to get through our heaviest seasons while staying ahead of production using ShipBob’s inventory forecasting tools — even as our order volume more than quadrupled in less than a year.”
Ryan Casas, COO of iloveplum
Use reorder points to minimize overstocking
Online retailers can use historical data to estimate future demand and set reorder points accordingly to balance consumer demand and supplier reliability.
Data-backed inventory replenishment decisions can reduce the amount of dead stock you have as well as inventory carrying costs. Optimally restocking inventory becomes a breeze with tech-powered inventory management solutions.
For instance, ShipBob’s technology provides visibility into how many SKUs and units you have in each location and also provides tools with built-in reorder point notifications for better inventory control, so you can identify an ideal stock amount needed to fulfill customer orders on time.
“ShipBob’s analytics tool is also really cool. It helps us a lot with planning inventory reorders, seeing when SKUs are going to run out, and we can even set up email notifications so that we’re alerted when a SKU has less than a certain quantity left. There is a lot of value in their technology.”
Oded Harth, CEO & Co-Founder of MDacne
Outsource fulfillment to an experienced 3PL partner
The good news is that you can outsource fulfillment to a tech-enabled 3PL like ShipBob. With ShipBob, not only do you save time and money by delegating order fulfillment to the experts, but you also gain more visibility into operations with access to a user-friendly dashboard with built-in inventory management tools.
ShipBob offers everything you need to track SKU velocity and forecast demand. With data at your fingertips, you can identify:
- How quickly products are selling
- Which items are slow-moving
- How many days of inventory you have until you are expected to run out
- How your sales are affected by different seasons and months
- Your best selling items and the percentage of your business they account for
“I used to have to pull inventory numbers from three places everyday and move all the disparate data into a spreadsheet. ShipBob has an analytics tab in their dashboard with all of this information, which is great for end-of-month reconciliations. It’s really nice to not have to operate three 3PLs.
Wes Brown, Head of Operations at Black Claw LLC
How ShipBob helps you prevent inventory write-downs
Understanding how to identify and track changes in product value can help you make better decisions on how to manage your inventory, so you can stay profitable.
ShipBob’s integrated fulfillment software helps retailers expand across an international fulfillment network while tracking operations all from one dashboard. This way, you can track the flow of inventory throughout the supply chain — from warehouse receiving to returns management.
Our highly connected retail fulfillment network is powered by a proprietary warehouse management system (WMS) that connects inbound and outbound logistics, including your sales and distribution processes as well as upstream purchasing and manufacturing.
You can count on ShipBob’s processes, premium technology, and expertise to help you prevent inventory shrinkage and optimize inventory levels to meet demand and reduce costs.
“We have access to live inventory management, knowing exactly how many units we have in Texas vs. Chicago vs. New York. It not only helps with our overall process in managing and making sure our inventory levels are balanced but also for tax purposes at the end of the year. ShipBob simplified the entire process for our accountants and for us.”
Matt Dryfhout, Founder & CEO of BAKblade
To learn more about how ShipBob can help you better manage your supply chain, click the button below to start the conversation.
Inventory write-down FAQs
Here are answers to the top questions people have about inventory write-downs.
What is inventory impairment?
Inventory impairment, better known as “inventory write-down,” is an accounting term that recognizes when your inventory’s market value falls below the book value, but it still considered sellable.
Is inventory an expense?
No, inventory is considered an asset, not an expense. An ending inventory balance is reported as a current asset on the balance sheet at the end of an accounting period.
Can you write down inventory for tax purposes?
Yes, writing down obsolete, expired, or damaged goods can be a good way to secure tax deduction. It does so by reducing your total liability or taxable income. Note: Be sure to consult with your CPA on the best method to write-down unsold inventory that’s lost value.
What is the difference between a write off and a write down?
In accounting, think of a write-off as a more advanced form of a write-down. A write-down is performed when the inventory suffers a drop in value but still has some market value. But if inventory completely loses value, then it is written off (i.e., eliminated from the books altogether).
When can you write down inventory?
As soon as inventory value depreciates, it must be written down. Once you charge the losses to expense, your financial statements will reflect the lower inventory value amount.
Does inventory get impaired?
Inventory can get impaired when the value of goods decline. Once inventory loses value, it must be reported on immediately, as it can impact a company’s net income.