11 Stock

Need to know

Stock can comprise inventory in three stages of production: raw materials, work in progress and finished goods. Exactly how stock is classified depends on a company’s business activities. For example, supermarkets classify uncooked frozen meat as ‘finished goods’ as it is ‘ready for sale’ by the business even though it is not ‘ready for consumption’ by the consumer. In contrast, a pie manufacturer would classify its stock of frozen meat as raw materials.

Why is this important?

Purchasing or holding stock ties up a company’s cash resources. Efficient and effective stock management is critical to the successful running of any business.

Companies that buy excessive stock may suffer liquidity problems or suffer losses if they cannot sell stock at a profit. Excessive stock holdings also tie up funds that could be invested elsewhere (see Chapter 24 Working capital and liquidity management).

Equally, companies that hold too little stock will be unable to meet customer demand, losing customers and profitable sales opportunities.

To minimise risks, management can apply different techniques to manage their stock.

A JIT (just in time) approach involves ordering and receiving goods only as they are needed. Typical in the manufacturing sector (e.g. automotive), JIT aims to minimise the risk of ‘stock-outs’ (running out of stock) while at the same time eliminate overstocking. A pre-requisite to operating a JIT approach is that the business must have accurate stock tracking and demand forecasting systems.

Businesses can monitor carefully key stock ratios to identify problems such as overstocking. The stock days ratio is a key metric that can identify whether stock levels are appropriate for the business (see below).

Stock days

The commercial success of a company depends in part on how quickly it can sell or ‘turn over’ its stock to realise cash.

Stock days is a ratio that calculates the number of days it takes to sell stock. It is calculated using historic sales activity information, as follows:

$\frac{\text{Stock}}{\text{Cost of sales}}\times \text{365}$

The cost (£) of stock held (typically at the year end) is compared to the cost (£) of stock sold during the year. This gives an indication, based on actual sales activity, of the ‘number of days’ stock being held by the organisation.

For example, a company holds £1,000 of stock at the year end. During the year, the cost of stock sold was £2,000. Using past activity as a guide to future sales, the stock days ratio indicates that the company is holding 6 months’ worth of stock, i.e. it will take half the year to sell the stock still held by the business.

$\frac{\pounds \text{1,000}}{\pounds \text{2,000}}\times \text{365 = 183 days (i}\text{.e}\text{. 6 months)}$

Stock days are often compared between businesses in the same industry to assess relative efficiency. There is, however, no ‘right’ number for stock days.

Stock days will differ between sectors and industries. Understanding the industry (or industry norms) is important when assessing whether the level of stock held is appropriate for the business.

Greggs plc versus Kingfisher plc (owner of B&Q)

Stock held by Greggs plc, a bakery chain, comprises raw materials (flour) and work in progress (snacks at various stages of production). Stock held by Kingfisher, a home improvement company, comprises (only) finished goods, including DIY items such as paint and lawnmowers.

Stock days calculated shows that Greggs plc holds stock for about 27 days before it is sold. In contrast, Kingfisher holds stock for much longer periods. This shorter period should be unsurprising given the perishable nature of items sold by Greggs plc.

A longer stock cycle ties up cash for longer periods so management will focus continuously on ways to manage (bring down) stock days. Reducing stock days will release cash more quickly and enable the business to repeat the cycle or make the cash available for use elsewhere in the business.

Stock turnover

Stock turnover is a complementary measure to stock days and shows the number of times stock ‘turns over’, i.e. is sold during the year. It is calculated as: cost of sales/stock.

Stock turnover (cost of sales/stock)

When is this important?

A commercial objective for businesses should be to optimise stock holding. This means avoiding unnecessary holding of stock while also minimising the risk of a ‘stock-out’ (i.e. running out of stock).

Optimising stock holding is a continuous (some might say impossible) challenge due to the uncertainty of demand patterns. In attempting the impossible, however, supermarkets have developed highly responsive JIT supply chains that enable them to change levels of stock rapidly to respond to unexpected spikes in demand. For example, when celebrity chef Delia Smith caused a ‘run’ on rhubarb following the screening of a television advert, Waitrose switched to importing supplies to meet the surge in demand. Stocking up in anticipation of higher sales is an alternative but more costly way of achieving the same objective.

The JIT model has recently come under pressure due to the Covid-19 pandemic. In addition, the fragility of supply chains was exposed in 2021, when the vessel Ever Given grounded and blocked the Suez Canal for six days. These and other events may contribute to companies increasing inventory holdings to protect against significant, uncertain future events.

Year-end accounting

Stock must be counted and valued accurately for inclusion in the financial statements. Stock purchased but unsold at the end of each accounting period is reported as (closing) stock in the accounts.

All but the smallest businesses are likely to have a stock system that shows the ‘book’ quantity of each line of stock the business holds. Stocktakes, which should be carried out at least annually, are physical counts of stock that are used to verify that recorded (book) quantities are physically held, and to uncover discrepancies, for example due to theft. Inspecting the condition of stock during the stocktake also helps to identify obsolete or damaged stock, which in turn affects the value at which stock is recorded in the financial statements.

‘Valuing’ stock can be a complicated process for a number of reasons:

• 1Stock is typically purchased at different times during the year at differing prices because costs typically fluctuate over time. Calculating the year-end stock cost will require detailed tracking of purchase cost invoices to identify the original cost at which each item of stock (held at year end) was purchased. Accountants have developed costing methods, such as First-In-First-Out (FIFO) and Average Cost (AVCO), to arrive at the year-end cost of stock (see Optional detail section below).
• 2Even when the cost of stock has been established, there is no guarantee it can be sold at a profit. The sale price will depend on economic factors such as competition, tastes and fashion etc. Stock can become obsolete very quickly, especially in fast moving, innovative industries such as the technology sector.

Cost versus net realisable value (NRV)

Holding stock carries the commercial risk that it may not be sold. This risk must be assessed at the end of each financial year. If the realisable value (potential sale price) of an item of stock is lower than its cost, its value must be ‘written down’ to a realistic, best estimate of its potential sale price (known as the net realisable value (NRV)), i.e. the loss must be recorded now. This is an application of the principle of prudence or conservatism (see Chapter 6 Revenue recognition).

For example, a fashion retailer may find it is left with stock of summer dresses at the end of the season. To shift the stock and attract customers, it will have to reduce the price to £80. If the dresses cost the retailer £100 each, it will have to reduce the carrying cost of stock in the balance sheet by £20 (£100 − £80) to recognise the loss immediately on the future sale. Recognising the value of stock at the lower of cost or net realisable value in the financial statements ensures that the business is not overstating the value of its stock in the balance sheet.

Nice to know

Work in progress (WIP)

WIP is a term applied to goods in various stages of manufacture, the provision of services and long-term (construction) contracts.

Goods

Valuing work in progress and finished goods can be particularly complex for manufacturing businesses as production costs include labour, materials and overheads. This requires a company to keep detailed cost and time records.

Services

For service businesses (which do not have a physical output) ‘stock’ is work in progress, calculated as the value of time spent not billed.

Long-term contracts

For businesses such as housebuilders engaged in multi-year construction projects, stock is recorded as ‘long-term work in progress’ because construction stretches over several years. The accounting for long-term contracts requires regular certification of the stage of completion.

Optional detail

Stock costing methods

The purchase cost of stock will invariably change throughout the year, due to volume discounts, renegotiation, inflationary price changes or perhaps engaging with different suppliers. Calculating the cost of stock unsold at year end, when bought at different prices may require the company to identify the order in which stock was bought and sold by the business.

First-in-first-out (FIFO)

A supermarket aims to sell foods with the earliest sell by date first (consider, for example, milk on supermarket shelves, the nearest-to-expiry date milk is placed at the front of the shelves). Therefore, for perishable items with an expiry date, first-in-first-out (FIFO) typically reflects the order in which stock will be sold by the business.

For year-end costing purposes, the cost of stock still on the shelves will relate to the most recent stock purchased from suppliers (as this should have the longest sell by date).

Average cost (AVCO)

In contrast, retailers like B&Q have little need to sell items in order of purchase because the items they typically sell are non-perishable, so the concept of a ‘sell by date’ is largely irrelevant. Items may be sold in any order, so an ‘average cost’ (of all items purchased) can be calculated to value stock unsold at the year end.

Therefore, for homogeneous (identical) products that do not have a short shelf life, average cost (AVCO) is used as it reflects the reality of how stock is sold. It is also a simpler method of recording and calculating year-end stock cost. AVCO is based on calculating the average cost of stock purchased and held.

The choice of costing method is relevant because it impacts a company’s reported profitability and balance sheet numbers. Because inflation increases cost, adopting FIFO reports higher stock balances than AVCO as the most recent stock items held will most likely have been bought at the highest cost (assuming inflation). FIFO will therefore also report a higher profit (because the cost of sales will comprise the lowest cost items purchased relative to AVCO, which uses the average cost of all items purchased).

While accounting standards (see Chapter 19 Accounting and financial reporting standards) permit the use of either method, the costing method selected should reflect the reality of how stock ‘flows through’ (i.e. is bought and sold by) the company as the method chosen will affect the profit reported by a business.

A company can apply both FIFO and AVCO methods if they are relevant and appropriate to differing stock lines held by the business. For example, supermarkets typically stock both food and non-food items.

Reflect and embed your understanding

• 1A company has a Stock Days ratio of 100.
  • aExplain what this ratio implies.
  • bHow might you assess whether the number is appropriate for the business?
• 2Whether an asset should be classified as stock (or fixed assets) depends on the nature and activities of the business, i.e. how it generates revenue. For each business below, identify the asset(s) that would be classified under stock and fixed assets:
  • aAutomobile manufacturers, e.g. Ford, Tesla
  • bHouse developers, e.g. Barratt, Crest Nicholson
  • cProperty investment companies, e.g. Land Securities, The British Land Company.
• 3Greggs plc does not report finished goods within its reported stock figures at year end (see the extracts below), yet its retail outlets will have stock ready for sale to customers. Reflect on why Greggs plc does not report (a value for) finished goods within the financial statements.
• 4What is the impact of stock on the financial statements? What stock-related decisions may be influenced by companies aiming to achieve a target result in their financial statements?

For the authors’ reflections on these questions, please go to financebook.co.uk

Where to spot in company accounts

The accounting policy note explains the policies adopted by the company.

Stock is included on the balance sheet under ‘current assets’ and in the profit and loss account within ‘cost of sales’.

Extracts from Greggs plc 2020 financial statements Appendix p. 471.

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 392.

Watch out for in practice

• →Significant year-on-year increases in stock balances indicating an obsolescence problem, unless matched by a year-on-year increase in sales.
• →An increase in stock days or a fall in stock turnover.
• →Stock as a percentage of current assets, to see the value tied up in non-liquid current assets.
• →Stock as a percentage of total assets to see the value tied up in stock.
• →It is common practice for businesses to undertake stock counts on an unscheduled basis through a publicised policy of undertaking ’spot checks’. These can also serve as a deterrent against theft.
• →Auditors will attend stock counts and seek to verify ‘cut off’ procedures, to ensure that stock is correctly recorded in cost of sales (profit and loss account) and in the balance sheet at the year end.