You run a company that makes gourmet food for pot-bellied pigs. You have $1 million of finished product in inventory...just bags and bags of feed sitting in your warehouse. You estimate that 5% of this inventory will eventually spoil without getting sold.
To recognize this fact on your books, you have to record an inventory reserve of $50,000 (0.05 x 1,000,000 = $50,000). The figure provides a quantified monetary version of your expectation that some amount of inventory will eventually go bad. That number represents the inventory reserve. You're setting aside (on your financial statements at least) some money, in anticipation of the fact that you'll end up having to eat the value of the spoiled inventory. (Hopefully, you don't end up literally having to eat the inventory. Even gourmet slop is still...slop.)
Inventory reserves are the accounting mechanism to account for inventory that will lose value in the future. This situation can happen for any number of reasons...spoilage, aging or obsolete products, or some change in the market (like...pot-bellied pigs are identified as carriers of the plague, and people stop keeping them as pets).
Related or Semi-related Video
Finance: What is Work In Process Invento...2 Views
finance a la shmoop what is work-in-process inventory well you're a
car assembly company named Shmord for any given car you have to buy a ton or [Lots of cars in a parking lot]
two of steel and four tires couple of windshield wipers a bunch of [Wipers on in the rain]
hoses wires vats a glass carpet and yards of rich Corinthian leather [Pictures of the materials]
with none of this stuff yet assembled into the car you're gonna sell it to a
dealership for twenty eight thousand eight hundred twenty three dollars it's [All the materials in a list]
just the inventory that is work in the process of being built why is it
important well for a lot of companies their inventory is highly valuable and
it comprises a lot of the actual asset value of the company it's also something
that clever accounting can jerk around to make the books look better or worse [Guy reading an accounting book]
than they actually are like there's a mountain of tires sitting in a portable [Tires piling up]
warehouse 12 feet off of the perimeter the border of the factory just sitting [A warehouse covers the tires]
there has Shmord paid for them well they're kind of sort of delivered but
not really so do those tires get counted as inventory what if you dragged the
porter shed twelve to fourteen feet closer to the factory then are they [The warehouse comes up to the factory perimeter]
counted as delivered and then you have to pay for them so then maybe you do so
and you recognize them as an asset maybe okay you get it
lots of accounting tricks that can be played in the short run in this category [Guy juggling balls with dollar signs on]
eventually however work-in-process inventory is work in the process of
being built into a finished product but that's still sitting there in inventory [Someone welding a car]
not yet sellable to people and the big accounting trick of moving the P beneath [A pea is hidden under one of three walnut shells]
the walnut shells only fools investors for so long eventually they're gonna
focus on revenues and free cash flow profits to be sure if you're not [Someone swipes away the walnut shells to reveal the pea]
tricking them well the big idea in this term set is that inventory takes a few
different forms it can be raw like just plain old tires or even the rubber to [Picture of tires]
then go be made into tires like sitting in a shed somewhere inventory can be [Bricks of rubber are thrown into a shed]
half-baked like a semi assembled chassis or like a thousand of them just sitting
around waiting to be uploaded with an engine and body and hydraulics and a [Computer screen showing a progress bar with each component of the car appearing]
steering wheel and it goes along you know the assembly process until finally
at the end of all of that work in process inventory stuff is in fact [Guy talking in front of the Shmord factory]
magically then turned into actual inventory that is sellable to a client [New cars in storage]
got it or a buyer whatever you want to call them okay
we didn't say it had to be pretty inventory just inventory [Guy smiling walking up to a Shmord dealership and a tiny car appears]
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