Inventory reserve is that portion of a company’s earnings set aside, or escrowed, to pay for and maintain company inventory. Since this figure is partly speculative in nature, hypothetical forecasting is part of arriving at a reasonable figure. Generally accepted accounting principles (GAAP) do give some general guidelines to help you arrive at a reasonable inventory reserve figure. Using sales figures for inventory moved in the recent past — for example, the last four to six quarters — will provide a basis for calculating the inventory reserve.
Count Your Inventory
Take inventory if you have not done so lately or do not have a regularly scheduled inventory as part of your management policy. Compare your counts to your three or four most recent inventory sheets. It is a good idea to go back farther if you have the information available. Make note of any glaring inconsistencies and determine the reason for them.
Determine Inventory Costs
Calculate your inventory costs. Maintaining inventory costs the company in more ways than one. You pay someone to manage it. You pay other inventory-related costs, such as shrinkage, spoilage, loss and disposal of obsolete inventory. You also pay the cost to store your inventory.
Use your current inventory count and as many of your most recent counts as you have to calculate cost percentages for your inventory upkeep. You may find that these costs offset or more than offset the inventory reserve money you have set aside. This is not unusual.
Determine Each Actual Item's Cost
Use either the item cost to the company at the time of purchase or the current market value to set the actual costs for every inventoried item. Generally accepted accounting practices require you to use the lesser of the two. For instance, if you paid $20 to make a starter, but due to the recent increase in vehicle recalls from that particular vehicle maker, the starter now has a market value of $15, your accounting entry must reflect this change in value. Record the value loss as a debit of $5 and credit your inventory $5.
Set Costs at Replacement Value
Set your costs for inventory at replacement value when there is a difference between replacement value and market value. Most inventory value is difficult to precisely assess as there are just too many variables in play. Replacement value is more readily determined. Be sure to keep these values reasonable and in line with current, acceptable values.
Consider Units Moved for Classification
Classify your inventory according to units moved. Determine what is most active in your inventory and label those products Level 1. Group the next most frequently sold products into a separate classification, labeling these Level 2. Continue the same method until you have accounted for every piece of inventory and its activity level.
Skew your reserves to the most active. Set up the rarely-if-ever moved items in the category "Available as Ordered" or "Available Upon Request." Require a deposit for these categories before ordering.
- AccountingTools: Inventory Reserve
- Investopedia: Inventory Reserve
- InvestingAnswers: Inventory Reserve
- Masao Nakamura, Sadao Sakakibara and Roger Schroeder. "Adoption of Just-in-Time Manufacturing Methods at U.S.- and Japanese-Owned Plants: Some Empirical Evidence," pages 230-231. IEEE Transactions on Engineering Management, 1988.
- Electronic Code of Federal Regulations. "Regulation S-X, 17 CFR Part 210: Sec. 210.5-02 Balance sheets." Accessed Aug. 1, 2020.
- Use your inventory reserve calculations to remove old, never sold items from your order sheets.
Chuck Brown is a freelance writer and former teacher and athletic coach. He has held professional stints as a business owner, personal fitness trainer, curriculum designer, website designer, market trader and real estate investor. Brown holds a bachelor's degree in English and a master's degree in Christian counseling.