All product-based businesses need to track the value of their inventory – and this goes double in a period of dramatic upheaval. The value of your inventory has likely changed thanks to the Covid-19 crisis, and you should consider revaluing it before you make any major business decisions. To help you understand the importance of tracking this metric we’ll illustrate several ways the value of your stock can change. But first, let’s look at some basic definitions.
What is inventory revaluation?
Inventory revaluation is the adjustment of the costs of inventory to reflect changes in the recorded cost. These changes may be due to exchange rate movements, disrupted supply chains, obsolescence, damage or spoilage.
Businesses value their inventory for a variety of reasons: financial reporting, tax purposes, and business decision-making. Under the International Financial Reporting Standards, companies are required to record the value of their inventory at the lower of cost or net realisable value.
Understand Net Realisable Value and make informed business decisions.
Understanding Net Realisable Value
A key metric in inventory revaluation is Net Realisable Value. Net realisable value (NRV) is the expected selling price of inventory goods after taking into account selling costs and manufacturing costs. It is based on what the goods are currently worth rather than their original cost.
NRV takes into account that the value of inventory can decline below its original cost. When this happens, the original cost of the goods should be written down to its NRV to reflect the loss in value. This ensures the value of inventory is not overstated on company financial statements.
3 scenarios where revaluing inventory is critical
Yes, you might be struggling to keep your business afloat in the wake of Covid-19, but you should start thinking about how your inventory value is going to be impacted. Don’t wait until the dust settles — it might mean serious consequences for your decision-making. Here are three scenarios that illustrate the importance of inventory revaluation.
1. Supply chain disruption
With entire cities in isolation and quarantine, companies are seeing demand jump for certain items and drop for others. However, it is difficult to respond to these demands because access to parts and labour around the world are disrupted.
Imagine you are a toothpaste maker, sourcing raw materials from overseas. However, you’re missing a crucial ingredient that is unavailable from your usual supplier. Sourcing it from a different supplier in another country will take four weeks by sea or one week by airfreight at a higher price. You want to pick the sea freight option as it will be cheaper, but that means your customer — customers at supermarkets — will not see your products on the shelf for a whole month!
You’ll need to make a business decision: risk your customers switching to a competitor brand while your products are off the shelves, or spend more on airfreight in order to quickly supply the supermarkets?
If you choose air freight, you should ensure these higher costs are factored into inventory so that the margins on your more expensive products are well understood.
2. Changes in your output
When manufacturing levels drop below standard levels, excess fixed overhead costs that can’t be allocated to production due to underutilised capacity must be expensed in the period they are incurred.
Let’s say that as a commercial baker, you make and sell 600 burger buns to three clients. Normally your fixed overhead costs – things like the power supply to your premises, rent and so on – are evenly distributed across your stock. Unfortunately, since non-essential businesses were shut down, you’re only able to supply a third of your stock to one client, who is an essential service provider. However, whether you produce 600 buns or 200 buns, the fixed overhead cost stays the same. That means you need to revalue your inventory.
Let’s assume a single bun costs $1 to make, and the fixed overhead costs make up 10 cents of that. When production drops from 600 to 200, you need to reallocate the costs from the 400 unmade buns to 200 buns by adding 10 cents from each of the 400 buns to the cost of 200 buns. This means that each bun now costs $1.20 to make.
Accurately costing your inventory by taking into account how your fixed overhead costs will be spread across fewer products will help you make good business decisions: will you stop selling the buns, put the price up, or simply wear the extra cost as part of your new customer retention strategy?
3. Your inventory becomes obsolete
Because of the coronavirus, some industries are struggling to meet demand spikes, while others have to shut their doors because demand has plummeted. When demand drops, businesses are left with unsold inventory, which incurs carrying costs.
Product businesses risk inventory going to waste and becoming obsolete — especially if their inventory has a short shelf life. Food and beverage businesses are especially at risk. Once products are spoilt, expired or obsolete, they have to be written off and the business has to dispose of them.
In a recently reported real-life example, American floral shop, Wallace Flowers had US$3,000 worth of inventory sitting in its refrigerated coolers. They typically have 300 to 400 orders four days before Mother’s Day, but due to Covid-19, that fell away to virtually zero. Wallace Flowers estimated they lost up to US$60,000 of business for that month alone, and they were forced to deal with their suddenly worthless inventory by giving it away. However, there are a range of approaches you can take with goods that have become obsolete.
4 ways to get rid of obsolete stock
Holding on to inventory you can’t sell is expensive. Here are four ways you can get unsaleable stock off your premises:
1. Bundle it with other products
Retailers in Japan have come up with a very popular lucky dip concept. Fukubukuro, or lucky bags, are filled with anything from clothes and concert tickets to food and makeup, depending on the retailer. What started out as a way for Japanese department stores to get rid of old stock in the new year has turned into an annual craze nationwide.
Try to bundle stock that’s hard to sell with more current items and price them at a discount, compared to what they are priced individually. This way, you can move a high volume of items quickly and get that dead stock out of the warehouse.
2. Host giveaways
A giveaway or a gift with purchase encourages customers to spend a little more to qualify. The perception of good value for money through gifts is a great incentive to get customers buying.
3. Make donations
Your dead stock might have value to a charity or not-for-profit organisation. You can even donate perishable items — just like restaurants in Marina Bay Sands did. Ahead of the month-long closure of non-essential businesses, the restaurants donated nearly 15,000kg of perishable food products to The Food Bank Singapore. From there it was redistributed to organisations such as aged care facilities, family service centres and soup kitchens.
Donating unwanted items generates goodwill with community groups and by documenting the transaction with receipts from the charity, you may receive tax benefits.
4. Check your supplier returns policy
If you’re stuck with products you can’t sell, check with your supplier if they will accept any unsold inventory — they may be able to move it on elsewhere. However, be prepared to take a loss when returning unsold products.
Determining the NRV is the first step.
How to revalue inventory on your balance sheet
Revaluing inventory influences your balance sheet and income statement. Assuming there is a decrease in the market value of your products due to Covid-19, the loss will have to be recorded on your income statement and as a write-down on your balance sheet.
If the market value of the goods in inventory suddenly drops below cost, the inventory will be overstated if you continue to carry the goods at their cost. If inventory is overstated at the end of the year, your cost of goods sold will be lower, inflating net income. The next year, your cost of goods will be overstated, decreasing net income. Sure the net effect over the two years cancels out, but this will minimise the comparative value of your numbers between the fiscal years.
If the value of your product suddenly decreases in the marketplace, you need to adjust the carrying value of your inventory. Determine the net realisable value (NRV) using the formula:
NRV = Market value of the asset – Costs related to the sale or disposition of the asset
Then create a separate line item called “loss on inventory” in your income statement. This will detail the decrease in inventory, which will decrease net income. After you’ve done that, decrease inventory by the relative amount.
Of course, all this is much more straightforward if you’re using accounting software that’s integrated with your inventory management software. Xero users can refer to this step-by-step guide on how to adjust and revalue inventory in Xero.