What it is:
Obsolete inventory is inventory that is essentially useless and/or unsellable.
How it works (Example):
For example, consider Company XYZ, a cheese manufacturer. Company XYZ makes a batch of 1,000 wheels of cheese that are no longer edible after December 31. Company XYZ is able to sell 750 wheels of the batch, but the other 250 are sitting in the warehouse. December 31 comes, and the cheese is no longer sellable. It is obsolete inventory.
Generally accepted accounting principles (GAAP) require companies to write off obsolete inventory as soon as it is identified. Physically, the company can still attempt to sell the products at a substantial discount (though in this example, that would probably be illegal), sell them as replacement parts or donate them to charity. In most cases, the company might choose to discard the products or sell them at scrap prices.
Why it Matters:
Accounting rules require companies to establish a reserve account for obsolete inventory on their balance sheets and expense their obsolete inventory as they dispose of it, which reduces profits. Thus, obsolete inventory can create huge losses.
In a more intuitive sense, obsolete inventory is a sign that a company may have "fallen behind the times," because the demand for its one or more of its products has clearly fallen. Alternatively, obsolete inventory might also indicate poor management practices, in that companies may have ordered or manufactured too much of a product due to poor sales forecasting methods, poor inventory management, inflexible operations or too much wishful thinking.