Inventory depreciation is the loss of value of your products over time due to factors such as obsolescence, damage, or deterioration. It can affect your profitability, cash flow, and tax obligations. How do you manage inventory depreciation effectively and accurately? Here are some tips and best practices to help you.
When calculating inventory depreciation, you should consider your accounting standards, industry, and product characteristics. Common methods include First-in, first-out (FIFO), Last-in, first-out (LIFO), Weighted average cost, and Specific identification. FIFO reflects the actual flow of goods and minimizes depreciation costs, while LIFO increases depreciation costs and reduces taxable income. Weighted average cost simplifies the calculation and smooths out price fluctuations. Specific identification is the most accurate method but also the most complex and costly. Ultimately, you should choose the depreciation method that best suits your business needs and goals and apply it consistently and transparently.
One of the most effective ways to prevent inventory depreciation is to monitor and adjust your inventory levels and turnover. You can use inventory management software or tools to track and analyze your inventory data, such as the inventory turnover ratio, economic order quantity (EOQ), and safety stock. The turnover ratio measures how many times you sell and replace your inventory in a given period, while EOQ calculates the optimal number of units to order each time. Safety stock is the extra inventory you keep on hand to prevent stockouts and meet unexpected demand; however, it increases your inventory holding costs and depreciation risks. Calculating these variables correctly can help you minimize total inventory costs, maximize profits, avoid lost sales, and ensure customer satisfaction.
Also need to keep track of the carrying cost of inventory. Not added to the value of the inventory itself, but if you carried a slow moving item for 18 months, what did that cost you in working capital? When the cost of money was low (prior to recent increases in interest rates), this wasn't such a big deal. But with money being so much more expensive now (writing this mid-2023), it is more painful to carry too much inventory.
Another way to reduce inventory depreciation is to implement inventory control measures that ensure the quality and safety of your products. You should use proper packaging and labeling to protect your products from damage, theft, or misplacement. Additionally, the first-expired, first-out (FEFO) principle should be followed for perishable or time-sensitive products, so that you can avoid wasting or spoiling them. Moreover, regular inventory audits should be conducted to verify the accuracy and completeness of your inventory records and physical counts. Different methods of inventory auditing, such as periodic, cycle, or perpetual can be used for this purpose. It helps you detect and correct any discrepancies, errors, or fraud.
Finally, you should review and update your inventory valuation periodically to ensure that it reflects the current market value of your products. Doing so will help you report your inventory assets and liabilities accurately and comply with tax regulations. There are different methods of inventory valuation, such as cost, lower of cost or market (LCM), and net realizable value (NRV). Cost values your inventory at the original purchase price or production cost; LCM values it at the lower of its cost or market value; and NRV values it at the estimated selling price minus the estimated selling costs. Managing inventory depreciation is a crucial part of inventory management and can help you optimize your inventory performance, profitability, and compliance. By following these tips and best practices, you can manage inventory depreciation effectively and accurately.
You should use a contra asset account, namely inventory reserve, to offset the book value of inventory. The net of book and the reserve account amount is the LCM or NRV worth of your inventory. As conditions change in the market, and without being overly responsive in the short term (which creates a lot of noise in your inventory value over time), you can adjust the reserve account. Then when you sell the goods, you can realize the actual revenue but also measure gross margin accurately.