Question

Discussion Inventory Issue

Assume a public company in the semiconductor industry that has been around for a long time. They have some “slow moving” inventory, which has a cost of $150 million. It is material when compared to annual net income, and very material compared to quarterly results. Total inventory at the most recent quarter end was about $600 million.

The inventory items in question are what this industry calls service inventory. Basically, it is spare parts that are not required for any of the products currently in production. Potential demand for these parts (if any) will come from current customers who have to replace worn-out components or from those seeking an upgrade.

In this case, slow moving appears to be an understatement, because there has been little demand for these parts over the past twelve months and internal forecasts are for no sales at all for the next 12 months. However, in all fairness, demand for these parts is extremely difficult to predict and there may be potential demand.

This “problem” didn’t just happen recently. It has been an issue for a while, but the company wants to do something about it now. The operations side wants to pare-down storage costs and more effectively manage the company’s “active” inventory. The accounting side wants to find a way to “get rid” of this inventory without dramatically impacting quarterly earnings. Another key fact is that the company’s inventory reserve is relatively small and it can’t come close to absorbing the slow-moving stuff.

The company has proposed the following “solution” to the problem, which has been approved by corporate accounting and the company’s CFO, i.e., it has widespread support within the company. (Also, the same firm has audited the company since inception, but they just changed auditors. It appears that the old auditors passed on any inventory adjustments.)

• The slow moving inventory items will be physically transferred to a warehouse and stored separately from the rest of the inventory to reduce storage costs and to get it out of the way of normal moving inventory.
• On the books it will be transferred out of active inventory and given its own category, but still classified as inventory on the balance
• The entire spare parts inventory ($150 million cost) will be amortized against income (straight-lined) over five years. I don’t know what will happen on the tax side, and this appears not to be an issue with the company.

My contact within the company strongly opposes this scheme. She has been told that it is consistent with “industry practice” but she has been given no examples of companies who have done this even though she has asked several times.

What do you think?

Answer 1

Given that,

Slow moving inventory costs $150million

It is material compared to the ompany's Annual net income and its quarterly results.
Total inventory at the most recent quarter end is about $600 million

So the slow moving inventory comes to 25% of the total inventory.

Demand for these products is not predictible.

Now the company's decision is-
The slow moving inventory items will be physically transferred to a warehouse and stored separately from the rest of the inventory to reduce storage costs and to get it out of the way of normal moving inventory.
On the books it will be transferred out of active inventory and given its own category, but still classified as inventory on the balance
The entire spare parts inventory ($150 million cost) will be amortized against income (straight-lined) over five years. I don’t know what will happen on the tax side, and this appears not to be an issue with the company

Suggestion/Opinion on the decision:

1. Amortisation of the slowmoving inventory cost against the income will drastically effect the income and it is not a better option to do so.

2. Moving them to another storage place will only be further increase in costs if there will no increase in the revenue over and above the cost of storage from the additional active inventory replaced in the place of this inventory.

3. Even if the company is following the industry practise since it is not a mandatory rule to follow that the company shall take into account the financial position of the company that gets effected from this decision and shall take this step only if it is advantageous to the company's position.

4. Some measures as followed can be considered if they are viable:

   a. Check if the spare parts can be used for any other machineries in the same industry or other and if so try to sell it to them who can use.
  
   b. Ask the current customers who have purchased the products if there will any likely demand of these that can arise to their products.
  
   c. Try to sell them to the current customers by giving some huge discount on price, so that the inventory handling and storage costs gets reduced.
  
5 If any of the above measures are not possible dispose them fully atonce and writting off on straight line method is not a correct measure,