Description: A company needs to know the proportion of its inventory that is obsolete, for several reasons. First, external auditors will require that an obsolescence reserve be set up against these items, which drastically lowers the inventory value and creates a charge against current earnings. Second, constantly monitoring the level of obsolescence allows a company to work on eliminating the inventory through such means as returns to suppliers, taxable donations, and reduced-price sales to customers. Finally, obsolete inventory takes up valuable warehouse space that could otherwise be put to other uses; monitoring it with the obsolete inventory percentage allows management to eliminate these items in order to reduce space requirements.
Formula: Summarize the cost of all inventory items having no recent usage, and divide by the total inventory valuation. The amount used in the numerator is subject to some interpretation, since there may be occasional usage that will eventually use up the amount left in stock, despite the fact that it has not been used for some time. An alternative summarization method for the numerator that avoids this problem is to only include those inventory items that do not appear on any bill of material for a currently produced item. The formula is as follows:
Cost of Inventory Items with No Recent Usage
Total Inventory Cost
Cautions: A high level of obsolete inventory does not reflect well on the logistics manager, who is responsible for maintaining a high level of inventory turnover. If this person has any influence over the calculation, it is possible that he or she will attempt to alter the amount listed in the numerator, either by defining “recent usage” as anything within a very long time period, or by ensuring that all inventory items are included on some sort of bill of material, which is generally considered evidence that it may eventually be used. To avoid this problem, the calculation should be given to someone outside of the logistics department.