Bought Too Much? 7 Options to Address High Inventory

Bought Too Much? 7 Options to Address High Inventory
By Jennifer Clement

Over the past 12 months, many businesses stocked up on inventory to keep customer service levels high. In a volatile global supply chain landscape—unpredictable factory shutdowns, rising prices, scarcity, long transit times—some companies felt forced to order beyond the forecast. The world of just-in-time shifted to just-in-case, and now it’s just too much.

High inventory creates all kinds of challenges. Beyond the obvious lack of available floor space, high inventories can tie up working capital, squeeze cash flow and force lenders to charge higher rates, all of which constrain business growth. If demand drops, being stuck with too much is a real risk. Evaluate your situation now to find opportunities and help plan for tax deadlines prior to year-end.

How We Got Here … and What to Do about It

The pandemic and government-imposed restrictions led to higher prices (and hoarding) that drove up material prices, logistics costs and lead times and created volatile currency fluctuations between trading partners. This is all starting to unwind.

Commodity pricing on steel, copper and plastics has come down substantially. Take aluminum, for example. In December of 2019, pre-COVID, aluminum cost around $1,800 per ton. By March 2022, it peaked at 128% over that baseline. By August 2022, the price of aluminum fell to 35% over December 2019 prices.

Material prices are just one contributor. Container pricing from Asia to U.S. seaports peaked at the end of 2021 and has been coming down for months. Exchange rates are also a factor; the Chinese renminbi has weakened significantly against the dollar since March 2022, making today’s U.S. imports from China cheaper than they were six months ago. Demand is also softening as consumers switch spending from goods to services.

Many businesses bought too much, paid too much and are now struggling with cash flow. During this era of high-value inventories, high inflation and softening demand, the goal is to put a forward-looking lens on the reserves needed to avoid an unpleasant surprise at tax time.

Strategize Options from a Tax Perspective
Though timing is critical, you can still plan and act before year-end. First, ask the key question: how much inventory is related to quantity or rising prices? Here’s a simple exercise: compare last year’s quantity, last year’s value vs. current year quantity and current year value. Then drill down. How many items have you had on hand for more than six months?

Next, decide what to do with your inventory — whether it makes sense to reserve against it, try to sell it, donate it or dispose of it. If you decide to dispose, take steps soon—you cannot write off what is still sitting on the books at the end of the year.

Option 1: Attempt to sell

Consider two scenarios:
If demand is rising …
For some, there may be buoyancy in backlogs. For items with longer lead times, consider asking for deposits to improve the reliability of orders. The goal is to create an incentive that discourages order cancellations and reduces the working capital risk of funding that demand.

If demand is dropping …
There are two ways to book inventory: at cost, or lower of cost or market (LCM). Most use LCM in manufacturing for financial reporting — but for tax recognition, the rules are a bit more precise. To recognize an inventory impairment for tax, you must list it for sale at the marked-down price within 30 days of the close of the year. If it doesn’t sell, then it can be disposed (discussed below) and deducted for tax (net of any proceeds from disposition).

Generally accepted accounting principles (GAAP) require you to carry a value of inventory that represents the lower of either the cost you paid for it or the net realizable value. In other words, assets cannot be booked at more than they are worth.

For companies using LCM, a “reserve” is created to handle the difference between initial price and the new market price. For example, if the former price was $100, and the new market price is $80, a reserve account is created for the $20. A landmark U.S. Supreme Court case, Thor Power Tool Co. v. Commissioner, confirmed you cannot take a tax deduction for an estimate (and a reserve is an estimate).

Many companies have not reviewed their reserve strategy for years. Before attempting to sell, check that your reserves are calculated properly.

Option 2: Dispose

Consider an example: Company A recently freed up nearly $24 million in working capital with targeted obsolescence for items that were no longer worth selling—using digital tools to identify and prioritize underperforming inventory.

In cases like these, the focus is not writing off inventory but scrapping it to get it off the balance sheet. It will be reported as an increase to cost of goods sold that can be deducted against ordinary revenue. Recently, the IRS has been looking a little more aggressively at this approach to expense recognition. Tax rules for reporting deductions are typically stricter than GAAP.

To determine if the inventory qualifies, be prepared to demonstrate an intent to abandon the property due to lack of usefulness and, ultimately, follow through on the disposition of such inventory.

Taxpayers often question the year in which a deduction should be reported. Most companies take a deduction in the year in which inventory is disposed. However, a tax deduction may be available in an earlier year, such as if management formally decides to scrap the inventory, places the inventory in a location where it is no longer held for productive use or offered for sale and can show that the inventory has no value.

Work with your tax advisor to determine the proper steps to secure a deduction. Be aware that the IRS may scrutinize and deny the claim.

Option 3: Operational changes

Sometimes it is possible to make operational changes that affect inventory in significant ways. For example, inventory turns increased for Company B from 2 to 3 (50% increase) by addressing $9 million of $40 million in inventory that was customized for a single end customer.

The company valued customer service as a differentiator; “out-of-stock” was not an acceptable option. So, to win business from large customers, the company built up its inventory with a mix of custom and off-the-shelf parts. When large customers unexpectedly took their business elsewhere, the company was stuck with customized stock that could not be sold to others.

The company therefore made two strategic operating changes:
Standard parts
A look at simple metrics—turnover by part and turnover by product family—showed how much cash was tied up in slow-moving items. This helped the purchasing department apply extra scrutiny to expensive and high-margin parts tying up lots of cash, and the sales department to discount and move parts collecting dust. Parts converted to cash, even at smaller margins of 5%, went straight to the bottom line and boosted operating cashflow.

Custom parts
Next, the company created capacity to handle final value-add activities in-house. Now it purchases bulk product, finishes the final assembly and performs customization only after the sale is made. This flexible approach eliminated the need to keep custom parts in inventory and dramatically reduced the risk of obsolescence.

Option 4: Re-visit capitalization

As inventory increases, the IRS expects to see increases in uniform capitalization costs. It might be worth revisiting your capitalization calculation to confirm that certain types of labor and overhead, most notably non-production costs or R&D related expenses, are not being attached to inventory.

Taking advantage of R&D tax credits is a good opportunity for enhancing your company’s value and reducing state and federal tax liabilities. Time spent innovating, engineering or organizing new manufacturing processes all may qualify. Post-launch, improving products and processes also may qualify.

Option 5: Last in, first out (LIFO)

If you feel that that today’s pricing is the new normal after months of inflation, then now’s the time to take a look at LIFO. However, if there is a lot of price volatility on inputs, LIFO is less attractive. Before making a change, look at your balance sheet to compare the new method vs. the old.

LIFO results in deductions for the inflationary effect on inventory. Higher inventory unit costs are woven into cost of goods sold on a P&L (profit and loss), versus being added to inventory costs on the balance sheet. On LIFO, the most recently acquired inventory — bought at a higher cost — is expensed. In an inflationary environment, LIFO allows you to defer income.

One of the downsides of LIFO is that it is complex and tim- consuming to administer. LIFO involves grouping inventory and establishing an inflation index for each pool.

There are two options for valuing each pool:
Internal — Use an inflationary index you create based on your company’s experience
External — Use a national inventory price index computation (IPIC) published by the Bureau of Labor Statistics

Some lean toward IPIC if it provides a higher inflationary index than a self-created index.

An important caveat: most accounting method changes involve a cumulative approach. If you elect LIFO for 2022, you cannot use it prior to 2022. A change to LIFO is done as of the beginning of the year. So, for this year, you would go back to January 1, 2022, to declare 2022 as the base.

Option 6: Donate it

You could donate inventory, which may have practical humanitarian benefits and an opportunity for positive PR. To calculate the value for a charitable donation for tax purposes, compare fair market value to the tax basis of the inventory, and use whichever number is lower. Basis includes costs related to the inventory (to buy it, transform it, warehouse it, etc.). In your basis calculation, you can include costs from earlier years. An appraisal or similar documentation may be required to quantify the charitable deduction.

After the donation, the charitable deduction amount must be removed from opening inventory, as it is no longer part of cost of goods sold.

Option 7: Return it

While not ideal, returning inventory might make sense if the raw material is still in market demand. With suppliers short and distribution uneven, this option may apply to certain types of commodities. Some type of restocking fee will likely apply.  In an era of falling prices, getting $0.75 on the dollar may be better than nothing.