The Hidden Danger in Stock Valuation

I decided this month to discuss an issue that I have seen repeatedly in Small Businesses when I first get appointed.

The Symptoms

The Management Accounts show that the business is profitable and should be generating funds from operations.

Stock keeps growing and is growing far faster than Sales.

As a result, the business is under cash pressure.

Explanation One – Production / Purchasing Issue

If you are lucky, rising stock simply means purchasing or production is out of control.

The business is buying too much, making too much, or holding stock it does not need.

That is bad for cash, but at least the stock exists.

This is a relatively easy fix.

Review stock holding levels, stop producing certain lines until the levels are “sensible”.

Put in place purchasing controls.

The problem will be fixed and the cash position start to improve as stock decrease.

I have seen this, but not often.

Explanation Two – The Stock Valuation is Wrong

Sadly, this is more often the case.

In the past three years, I have ended up writing off over £1m of stock in three different businesses.

As you can imagine, management were delighted.

How does Stock end up Over Valued

In many small businesses, stock is valued outside the main accounting system.

The business does a monthly calculation of how much stock has been used.

They take sales and multiple it by an assumed margin.

Sometimes this is at a product level, sometimes a business level.

Broadly this happens

Sales are £1m, therefore cost of sales at 65% is £650k.

Opening Stock – 1,500

Less Cost of Sales above – (650)

Plus Purchases per system – 450

Closing Stock – 1,700

This assumed margin is rarely reviewed, often not fully understood and not updated regularly.

If the 65% is really 70% that’s a £50k variance in one month,£600k in a year.

The problem with assumed margins

Let us assume the margin was correct when it was first calculated.

Often, it was not.

Even then, things change.

Supplier prices change.

Freight costs change.

Customer discounts change.

Product mix changes.

Waste levels change.

Production efficiency changes.

Often, the original margin was calculated using an “efficient” production model rather than what actually happens in the factory.

The costing may assume ideal production volumes, ideal labour efficiency and very little waste.

Reality may be very different.

If those assumptions are not regularly reviewed, the business can continue reporting a margin that no longer exists.

It doesn’t take much for 65% to really be 70%

What should management do?

Reconcile stock to the accounts

The stock report should agree to the stock value in the balance sheet.

Any difference must be investigated.

Do not simply post a journal to make the two numbers agree.

Understand why the difference exists.

Carry out regular stock counts

Do not wait until the year-end.

Count a selection of stock every month, focusing on:

• High-value lines
• Fast-moving products
• Items with frequent discrepancies

Regular cycle counts identify errors before they become major write-offs.

Review stock line by line

Look beyond the total stock value.

For each significant line, review:

• Quantity held
• Unit cost
• Latest purchase price
• Months of stock cover

Ask whether the quantity exists and whether the unit cost is supportable.

Test product costs

Compare the cost held in the stock system with recent supplier invoices

Costs should reflect reality, not an old spreadsheet created several years ago.

Review actual gross margin

Compare gross margin:

• Against the previous month
• Against budget
• Against the same period last year
• By product
• By customer
• By sales channel

Investigate significant movements.

Do not automatically adjust the accounts back to the margin management expected.

The movement may be telling you something important.

Bridge the margin movement

Finance should be able to explain why margin has changed.

Was it caused by:

• Supplier price increases?
• Freight?
• Customer discounts?
• Product mix?
• Production inefficiency?
• Waste?
• Stock adjustments?
• Incorrect product costs?

A margin bridge turns a percentage into something management can understand and act upon.

It is unlikely that the information will exist to do this perfectly but an estimate that makes sense is better than not considering it.

The uncomfortable conclusion

If Stock is wrong,

Trading is wrong,

If Trading is wrong,

Trading Forecasts and Cash Forecasts are Wrong,

And you use those to make your decisions.

If you would like to find out more, please contact me, Jason Soars, Fractional FD, [email protected], 07894641231, www.linkedin.com/in/jasonsoars/