Cost vs. Value: Why Inventory Sometimes Gets Reduced
In financial statements, inventory is generally measured at cost. However, if inventory’s expected economic benefit declines (for example, due to damage, spoilage, slow-moving stock, or obsolescence), keeping it at cost would overstate assets and profit. In those cases, accounting requires reducing inventory to a lower amount that reflects what you can realistically recover from selling it.
This reduction is commonly called an inventory write-down. It recognizes a loss (or expense) in the period the decline becomes evident, rather than waiting until the item is eventually sold or scrapped.
Common triggers for a write-down
- Obsolescence: newer models replace old ones; customers no longer want the item.
- Damage or deterioration: items are broken, expired, or spoiled.
- Price declines: market selling prices fall, reducing expected proceeds.
- Higher selling costs: increased costs to complete, rework, or sell the item.
Net Realizable Value (NRV): The Key Measurement
Net realizable value (NRV) is the amount you expect to realize from selling inventory, net of the costs necessary to make the sale.
NRV formula:
NRV = Estimated selling price - Costs to complete - Costs to sellIn practice, “costs to sell” often include commissions, shipping to customers (if you bear it), packaging, or other direct selling costs. “Costs to complete” apply when inventory needs additional work before it can be sold (finishing, rework, repackaging).
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When is a write-down needed?
A write-down is needed when NRV is lower than cost. The inventory should be reported at the lower amount, and the difference is recognized as a loss/expense.
| Compare | Result | Accounting action |
|---|---|---|
| NRV ≥ Cost | No decline below cost | No write-down |
| NRV < Cost | Value has declined | Write inventory down to NRV |
Step-by-Step: How to Compute a Write-Down
Step 1: Identify the inventory items affected
Focus on items that are damaged, obsolete, or slow-moving, or where selling prices have dropped. Often this is done through cycle counts, aging reports, and review of sales trends.
Step 2: Determine the inventory’s cost carrying amount
Use the current recorded cost for the specific items (or product group) being evaluated.
Step 3: Estimate NRV
Estimate the selling price you can realistically achieve, then subtract any costs to complete and costs to sell.
Step 4: Compute the write-down amount
Write-down = Cost - NRV (only if NRV is lower)Step 5: Record the journal entry
The entry recognizes an expense (or loss) and reduces inventory (directly or via an allowance).
Journal Entries for Inventory Write-Downs
Approach A: Direct write-down (reduce Inventory)
This approach credits the Inventory account directly.
Dr Inventory Write-Down Expense (or Loss on Inventory Write-Down) XXX
Cr Inventory XXXApproach B: Allowance approach (contra-asset)
This approach keeps the Inventory account at original cost and uses a separate contra-asset account (often called Allowance for Inventory Write-Down or Inventory Valuation Allowance) to show the reduction.
Dr Inventory Write-Down Expense (or Loss on Inventory Write-Down) XXX
Cr Allowance for Inventory Write-Down XXXOn the balance sheet, inventory is presented net:
Inventory (at cost) XXX
Less: Allowance for inventory write-down (XXX)
Inventory (net) XXXWhich approach is used depends on company policy and reporting preferences. Both reduce inventory’s reported amount and recognize the loss in the same period.
How Write-Downs Affect Gross Profit and Net Income
An inventory write-down increases expenses for the period and reduces profit. Where it appears in the income statement can vary by company policy (for example, included in cost of sales or shown as a separate line), but the economic impact is the same: profit decreases.
- Gross profit: If the write-down is included in cost of sales, gross profit decreases. If shown separately, gross profit may not change, but operating profit still decreases.
- Net income: Decreases by the write-down amount (before tax effects).
- Ending inventory: Decreases, which can also affect future periods because there is less inventory cost remaining to be expensed when the items are sold.
Timing effect (why the period matters)
Without a write-down, the loss would effectively be recognized later (for example, through a low selling price or disposal). A write-down recognizes the decline when it becomes known, improving the reliability of reported inventory and profit.
Scenario: Obsolete Items and a Write-Down Calculation
Situation: A retailer reviews inventory at month-end and identifies a batch of older model headphones that have become obsolete due to a new release.
- Units on hand: 120
- Cost per unit (carrying amount): $50
- Expected selling price per unit (clearance): $32
- Costs to sell per unit (packaging + marketplace fees): $4
- No costs to complete
Step 1: Compute total cost
Total cost = 120 units × $50 = $6,000Step 2: Compute NRV per unit and total NRV
NRV per unit = $32 - $0 - $4 = $28
Total NRV = 120 units × $28 = $3,360Step 3: Compute the write-down amount
Write-down = Cost - NRV = $6,000 - $3,360 = $2,640Step 4: Draft the journal entry
Option A (direct write-down):
Dr Inventory Write-Down Expense 2,640
Cr Inventory 2,640Option B (allowance approach):
Dr Inventory Write-Down Expense 2,640
Cr Allowance for Inventory Write-Down 2,640What changes after the entry?
- Inventory on the balance sheet decreases by $2,640 (either directly or net of allowance).
- Expense increases by $2,640, reducing profit for the period.
- Future gross profit may be higher than it otherwise would have been because some cost was recognized now rather than later (the inventory’s carrying amount is already reduced).
