Excess Inventory refers to the stock that you have on hand which you have not sold as quickly as you had projected.
How to calculate excess inventory depends on the goals you have set for your inventory management efforts.
While a common goal of inventory management is to ensure that you have just the right amount of stock on hand, this is often just an ideal.
Not all businesses are able to project sales so accurately as to always have the optimal amount of inventory on hand.
The reality is that most businesses, at some point or another end, up with overstocking or understocking.
Understocking can lead to lost sales as customer orders cannot be fulfilled on time. Or it can force you into accepting backorders.
Excess inventory, on the other hand, can result in excess costs.
But how bad is excess inventory?
And how can you calculate the value of this excess inventory?
That’s what we will cover in this article.
What is Excess Inventory?
The definition of Excess Inventory is subjective. It largely depends on the industry and type of product being sold.
Businesses that sell in large volumes and at lower margins cannot afford to hold excess inventories for too long. Think of discount stores or grocery stores. If they hold onto a product for too long, by the time they sell it they may have lost money on it.
On the other hand, a jewelry store could afford to hold on to an expensive product for a long time before it can find a customer willing to pay a premium price.
Whether inventory is in excess or not can also be based on seasonality. For instance, a sports retail store could carry skis in its inventory throughout the summer without selling any. But if the same skis were to stay in the store long enough during the winter, we may classify them as excess inventory.
So, you need to decide what excess inventory means for your business based on the industry you operate in and the type of products you sell.
Calculate Excess Inventory
When calculating Excess Inventory, we look for two things:
- The monetary value of the excess inventory
- The effect of the excess inventory on your business
Option 1: Using Inventory Management Software
Let’s say that you decide that any inventory that hasn’t been sold for 3 months is to be considered excess inventory.
Then to calculate the monetary value of the excess inventory, simply go into your inventory management software and sort out the inventory that has been sitting in your warehouse or your store over the past 3 months.
Total up the value of this inventory and you get the net value of your excess inventory.
Option 2: Using Accounting Software
If you do not use inventory management software, then go into your accounting software and make a list of all products you’ve purchased for resale over the last 3 months. From this list remove all products you have sold in the same time period.
The difference is the list of products which you have in stock over 3 months. This is your overstock or excess inventory. Add the value of all items in this list and you get the value of your excess inventory.
Note, however, that this approach only works if you purchase finished products for resale.
However, if you purchase raw materials and make the finished product yourself, you’ll need to add the value of manufacturing to the cost of the raw materials to the value of the excess inventory.
Option 3: Manually
If you do not use any Inventory Management Software or any Accounting Software or if you do not keep a significant amount of inventory on hand, then a simple manual calculation of your excess inventory can be the best option for you.
A commonly used technique to value your inventory, including excess inventory, is the Specific Identification Method.
The impact of Excess Inventory: the details matter
Excess inventory, in itself, isn’t harmful. It depends on the type of inventory, agreements with your supplier and the quantity of inventory. As always, the devil is in the details.
For instance, if you have acquired inventory from a supplier in the form of a consignment, technically this inventory is not on your books. It’s still owned by your supplier. So, it isn’t a cost to you until you sell it to a customer.
Similarly, if you have in net60 or net90 payment terms agreement with your supplier, there many only be a small financing gap to bridge between then time you pay your supplier and the time you collect payment from your customer. If your inventory moves fast enough, a bit of excess should not be a problem.
Excess Inventory: Using the Inventory Turnover Ratio
Inventory Turnover refers to a business selling its stock and replenishing it with new stock.
Inventory turnover is typically measured using the Inventory Turnover Ratio.
The Inventory Turnover Ratio tells us how many times a business has sold and replaced its stock in a given period.
To calculate the Inventory Turnover Ratio for a given period, we first need to calculate the Average Inventory for that period.
Average Inventory Value = (Starting Inventory Value + Ending Inventory Value) / 2
Using the value of Average Inventory, we can calculate the Inventory Turnover Ratio like this:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Value
The Inventory Turnover Ratio can be an excellent metric to understand the impact of excess inventory on your business.
The higher the Inventory Turnover Ratio the better as this means your products are selling fast. A low Inventory Turnover Ratio can be a sign of excess inventory and waning sales.
Key Takeaways
- Excess inventory refers to the inventory which you have not been able to convert into customer cash as quickly as you had expected.
- While it can be good for your business to have a small buffer, too much excess inventory can be harmful.
- By calculating the value of your excess inventory, you can determine how harmful it actually is. You can calculate its value using an Inventory Management Software, using your Accounting Software or manually.
- The impact of your excess inventory depends on the details – your industry, your products and the payments terms with your suppliers.
- You can also understand its impact using the inventory turnover ratio which essentially tells you how many times your business has sold and replaced its stock in a particular time period.