As a small business owner, one of your biggest financial responsibilities involves ensuring that your business turns a growing profit. Part of making accurate financial projections includes making provision for inventory write-down or write-off. Although your inventory has a certain financial value right now, over time, some of it will decrease in value, become damaged or obsolete or be lost to theft. If you fail to make provision for this, you might overspend by thinking you are turning a larger profit than you actually are.
Inventory provision is a way of accounting for write-downs and write-offs in advance so they don't throw off your budget later.
Provision for Inventory Write-Down or Write-Off
When business leaders make provision for inventory write-down or write-off, they are admitting that not all of the inventory on hand will result in sales at market value. Because of this, they set aside a certain amount of money in each period to account for inventory loss. The percentage of inventory that is written off or down varies from industry to industry and business to business.
For instance, a farm stand that has to worry about produce rotting might have a larger percentage of inventory that is written down or off than a small stationery business that sells journals with no expiration date.
Excess and Obsolete Inventory Reserve Calculation
Past financial patterns or industry trends can help you make an accurate excess and obsolete inventory reserve calculation. For instance, a handmade jewelry business notices that last year, $500 in merchandise was broken or stolen during craft shows, accounting for 5% of the total inventory. This year, the growing business has $20,000 of inventory in stock and chooses to make a 5% inventory provision entry of $1,000 on the balance sheet.
Benefits of Accurate Inventory Provision
Stock provision is a big part of ensuring those books paint an accurate picture of your small business's financial health. Some benefits include:
- Fewer unpleasant financial surprises
- Easier write-downs and write-offs
- Accurate asset representation
- Better financial planning
- More accurate projections
If your small business is new and you are not sure what percentage to enter as an inventory reserve, try looking at industry trends or ask a financial adviser to help you arrive at a reasonable percentage.
Inventory Write-Downs and Write-Offs
Inventory write-downs and write-offs are related but aren't quite the same thing. A write-down happens when the value of inventory has decreased. On your accounting sheet, it is listed as a debit on the cost of goods sold line and then as a credit on your inventory line.
For instance, if a T-shirt designer has a leftover shirt from last year's Super Bowl, it might be worth $8 now instead of $19. The difference of $11 would be entered as a debit on the cost of goods sold line and then as a credit on the inventory line.
A write-off happens when inventory has been stolen or is otherwise unfit to be sold, so it has zero value. It must be added as its own journal entry on your accounting sheet and represents the entire previous value of the inventory as a loss.
Inventory Stock Provision and Taxes
Inventory stock provision reserves are not usually allowed as tax deductions until inventory has actually been unloaded. This is a common book-to-tax difference to keep in mind. If you want to ensure that your business has a tax write-off to account for written-down inventory, consider making a donation of these items to a nonprofit organization that can make use of them.
For instance, if you are a baker with $125 worth of written-down baked goods that will go to waste if not sold at the end of the day, donate them. You will then be able to claim a $125 donation of goods to a nonprofit on your tax return while also feeling good about helping those in need.