‘I was always a kid trying to make a buck. I borrowed a dollar from my dad, went to the penny candy store, bought a dollar’s worth of candy, set up my booth, and sold candy for five cents apiece. Ate half my inventory, made $2.50, gave my dad back his dollar.’
Guy Fieri, restaurateur, author, TV personality
In a nutshell
Stock (or inventory) is typically one of the largest assets in the balance sheet of any manufacturing /retailing business. It is through the sale of stock that a business generates revenue and profit.
Holding stock carries significant commercial risks as it ties up cash. Stock may cause liquidity problems if it cannot be sold on a timely basis or result in losses if it cannot be sold at a high enough price. Conversely, holding too little stock could mean missing out on commercial opportunities and losing customers to competitors.
Stock is recorded in the balance sheet as a current asset and should be physically counted at least once every year.
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.
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).
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:
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.
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.
Stock days | 2020 | 2019 |
Greggs plc | 27.3 | 20.9 |
Kingfisher (B&Q) | 125.0 | 127.5 |
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 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)
2020 | 2019 | |
Greggs plc | 13.4x | 17.5x |
Kingfisher (B&Q) | 2.9x | 2.9x |
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.
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:
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.
WIP is a term applied to goods in various stages of manufacture, the provision of services and long-term (construction) contracts.
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.
For service businesses (which do not have a physical output) ‘stock’ is work in progress, calculated as the value of time spent not billed.
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.
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.
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).
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.
For the authors’ reflections on these questions, please go to financebook.co.uk
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.
15. Inventories | |||
---|---|---|---|
Group and Parent Company | |||
2020 £m | 2019 £m | ||
Raw materials and consumables | 13.3 | 19.4 | |
Work in progress | 9.2 | 4.5 | |
22.5 | 23.9 |
The write-down of inventories that was recognised as an expense in the period was £34.9 million (2019: £33.9 million).
(j) Inventories
Inventories are stated at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and selling expenses. The cost of inventories includes expenditure incurred in acquiring the inventories and direct production labour costs.
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 392.