Inventory Reserve

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).