Introduction to Capital Management – Stock
In this third article of our series of articles relating to working capital management, we will explore the “stock” component, the crucial processes that should be in place for managing stock effectively, and the importance of good stock management to the success of a business’s operations.
Stock is considered a key driver in the operations of entities that are in the business of buying/producing goods for resale. For these types of businesses, if there is no stock, working capital is essentially non-existent and an entity cannot make money, causing it to run out of business. It is therefore crucial that processes are put in place to ensure that your business remains operational.
Importance of stock management
- It helps to prevent a business from running out of products to sell to its customer causing poor customer service, reduced demand for the entity’s goods, and eventual shut-down of operations.
- On the other hand, it prevents a business from holding too much stock which increases costs such as storage and unnecessary security.
- It helps to minimize losses in the form of wastages through damage, obsolescence, or theft.
- It ensures stock is accurately recorded in the books of the entity to give a true value of the business’s trading operations, its profitability and its worth.
- It helps management in making better decisions regarding the core operations of an entity, e.g. whether to expand (or reduce) its product lines, its capability to manage multiple locations, etc.
It is more preferable (especially in this modern day of increased technology) to manage stock using the various automated stock management solutions and systems, rather than using manual means which are prone to errors, inefficiencies, time-wasting and increased costs of maintenance.
Types of businesses
Businesses that require stock management range from large construction companies to small entities that sell goods. At one end of the scale, production companies hold various types of goods (usually for longer periods of time) that are either used to produce other final products, such as cars (for an entity in the business of producing cars for resale), or that are sold separately, like car parts. At the other end are entities that simply buy and sell products that do not go through a production process, such as supermarkets or small convenience stores. Wherever an entity falls on the scale, if it holds any stock, it benefits from putting in place a stock management process.
Businesses that fall in the middle, such as plumbers, electricians, or car mechanics, etc. usually buy materials or usable tools on the job. It would be also be beneficial for them if they put a system in place to enable them to account for all their materials on hand and also more accurately access the profitability of the jobs they perform for better pricing and quotations on future jobs.
Services companies such as accountants, lawyers and IT contractors usually do not hold any stock to resell, therefore in most cases will not need a stock management system.
Types of stock
For accounting purposes, stock is usually sub-divided into 3 categories:
- Raw materials – These products are usually bought for purposes of using them to produce an end-product, such as ingredients for foods items, and the examples mentioned above. They are usually not sold by an entity in their “raw” form (although they can be sold as part of an entity’s secondary product line), but are nonetheless stock that is held for the business’s main product line of completed goods. The value of these materials (recorded in the books of the business) is the cost price when purchased from suppliers.
- Work-in-progress – these are products still under production and are in an unfinished state therefore cannot be sold in their form, e.g. incomplete furniture (for a furniture production factory). The value of this type of stock is the total of the cost of the raw materials and the labour costs incurred to produce the product up to the state they are in.
- Finished goods – these are completed products, with a value in the accounting books equalling the total costs of materials and labour.
All of the above stock types require effective stock management processes detailed below in place.
For effective management, stock ideally should flow through a process, starting with perfecting the suppliers’ ordering process, which has been explained in more detail in the creditors’ article (https://www.invicta-accounting.com/blog-post/working-capital-management-creditors/), and ending with sale of the stock to customers.
Once stock has been ordered, systems must be in place to record the exact quantities received from the supplier, with their unit cost prices. As it is being sold (or taken out for production), records of the amounts sold should be maintained. At the end of a week or month (depending on the volume of transactions of stock movements for the entity), a calculation must be performed in the system (or on paper) of the how much inventory should be on hand.
This calculation of quantities of goods hand at the end of the relevant period is: Opening Stock quantities (at the beginning of the period) PLUS New Purchases (during the period) MINUS Goods Sold (during the period) = Closing Stock quantities (at the end of the period). A stock take should then be performed at the same time by physically counting the amount of the stock items that are still on the shelves or in storage. Then a comparison (reconciliation) is done between the calculation above, and the amounts physically counted.
These 2 amounts compared should be the same. Any differences could suggest that there is stock missing because of theft or damages and investigations would help to resolve the differences.
During the stock takes, any items that have expired or are damaged should be set aside for possible write-off as these won’t be sellable or usable. This process enables management to also assess demand levels so that if needed, further orders can be placed if stock is running low due to high demand. It also enables management to implement ways to reduce shortages through theft or waste (e.g. with more security or better storage).
Stock quantities management is more efficient with systems in place which minimize error and inefficiencies caused by manual intervention for more accuracy.
For accounting purposes, stock should always be recorded in the books at its cost price that was paid to the supplier, rather than the sell price. This is so that an accurate profit analysis can be done when the stock item is eventually sold. For items that are damaged or expired, it is common practice to write these off as they are unlikely to be in a condition to be sold.
This is a calculation that measures the average number of days an entity holds its inventory before selling it. It give management an indication of how long they hold stock on average and therefore has a direct co-relation to the working capital cycle which ultimately calculates how long it takes for cash to return back into the business through trading.
There are various ways to compute the inventory days, depending on the type of entity and its products. Please contact us for further guidance.
Custody, security and storage
As can be seen from above, there is risk of stock being wasted or lost through various ways such as theft or damage. Therefore it is crucial to employ effective methods of keeping stock safe and in a secure location. For perishable goods, it is important to use conducive storage facilities to maintain the state or standard of the products. Where there is high risk of theft, security measure need to be implemented, e.g. alarm systems, locked storage facilities, etc.
It is also common practice to try and push the oldest products for sell (first-in, first-out) in order to prevent holding stock beyond expiry. There are various stock holding models that can be implemented to minimise such risks, e.g. a Just-In-Time ordering model which ultimately tries to minimise the amount of time stock is held by only ordering from suppliers when needed or when inventory levels drop below a certain quantity.
These methods can only be archived with highly reliable supply chains, and also with a more automated (or up-to-date) inventory management systems which provide quantity levels at any given time.
What Invicta can do
Invicta makes use of inventory management modules within our cloud-based accounting systems for record-keeping, maintaining your business’s inventory and costings on-the-go.
We provide expert advice on the best practices of managing your stock, and we advise on the processes to follow periodically for more accurate reporting. Our group of experienced accountants can offer management with tools, reports and analyses to make better decisions regarding their inventory management.
Call Invicta Accounting on 01624 672358 or email us at email@example.com for more information, and be sure to refer to next two upcoming articles for more detail on the other components of working capital.