Another major current asset which in most businesses requires similar attention to debtor control is stock. Stockholding in a manufacturing operation generally comprises raw materials, work-in-progress and finished goods, although in certain cases such items as spare parts for machines or tooling are included in the stock figure. The latter items are of a capital nature and care should be taken in instances where they are included, as this will result in misleading information being presented if, say, annual stock-turn is analysed.
Investment in stock can absorb relatively substantial amounts of working capital and it is obviously of paramount importance to the achievement of the twin objectives of most businessmen in terms of profit and cash that stockholding is maintained at an optimum level. Stock management is therefore an important management function. It should not, however, be confused with storekeeping, which is the physical control of stock. Nevertheless effective stock management cannot be undertaken unless adequate controls are exercised in the stockroom and on the factory floor. These controls should include:
1. The checking of deliveries into stock against the original order.
2. The maintenance of records detailing stock movement, stock levels, etc.
3. The issue of raw materials to the factory, the control of work-in-progress and the monitoring of the level of finished goods as compared with the original job card and issue of raw materials or components, etc.
4. Ensuring that all goods despatched are properly invoiced.
5. Stocktaking on a regular basis to ensure that ‘actual’ stock agrees with the ‘book’ stock.
It is also important to the effective operation of the stock management function that a satisfactory method of valuation is devised. It should be noted that any inconsistency in the valuation method used from one trading period to another will affect profitability.
Assuming that the business has a satisfactory information base in this area of stockholding, the management of the business will be in a position to make investment decisions in line with their objectives. However, it is not unusual to encounter certain problems when formulating a stock management policy.
There is often a conflict between the various aims of managers of different aspects of the business.
1 The sales manager will generally require a relatively high level of stock of finished goods in order that he and his colleagues can meet demand from stock immediately.
2 The production manager will require sufficient stocks of raw materials, components, etc to ensure that production efficiency is maximised, ie minimal levels of idle time, etc.
3 The purchasing manager’s aim may be to ‘bulk buy’ so that maximum discounts can be obtained, or alternatively to buy forward given the expectation that prices of raw materials will rise.
4. The finance manager’s aim will generally be to minimise investment in stock in view of the costs involved and to free working capital.
It is the job of the managing director of the business (who in many small companies will perform most, if not all, of the functions outlined) to balance these individual objectives and formulate a policy which, despite the inherent difficulties, will facilitate as far as is humanly possible the achievement of:
1. A first class service to customers.
2. Efficient production.
3. Investment in stock at an optimum level.
The liquidity and profitability factors which are undoubtedly uppermost in the minds of most businessmen are interrelated. Action to improve the liquidity situation will invariably improve the profitability of the business. The costs of holding stock can be high. These may include the costs of damage, theft, deterioration, the rent charge, wages and insurance. In addition, there are two other important costs:
1. The finance cost, which is highly relevant during a period of high interest rates.
2. The opportunity cost: if stocks include substantial amounts of obsolete or slow moving goods, the business may be losing opportunities to sell other lines profitably.
It is important to establish whether the investment in stock is excessive. A useful ratio which can be used here is cost of sales during a period compared to the average stock level. This will give a picture in broad terms but will tend to be misleading if the trading activity is highly seasonal. If this is the case an appropriate adjustment should be made. However, for the purposes of this article, we shall assume that we have a company whose stock-turn ratio suggests that some seven and a half months’ stock is in hand, valued at £150,000. The managing director, after further investigation, decides that his target stock level should be five months’ stock, an investment of £100,000. Achievement of this target will benefit cash to the extent of £50,000 and if it is assumed that stockholding costs are running at 20 per cent (not unreasonable given high interest rates), the improvement in profits could be in the region of £10,000. It is a salutary thought that if this company was achieving a profitability factor of 5 per cent on sales, the action taken in respect of stockholding could have a similar effect on profits as an increase in sales of £200,000.
Stock management can be highly complex, but in many small businesses it involves making some basic decisions, ie how much, in what quantities and when, to order. This involves in certain cases the establishment of safety stock levels, the analysis of lead times, which will involve the identification of minimum and maximum stock levels in line with usage. It may not be possible to develop this approach across the entire range of stock items in view of the costs involved: the costs should not outweigh the benefits! It may be appropriate, therefore, to single out the most significant items of stockholding, and Pareto’s Law can be of assistance in this respect. This is sometimes known as the 80/20 rule; it suggests that 80 per cent of the value of the total holdings is made up by 20 per cent of the items in stock. This is, of course, a generalisation and the percentages may vary. However, it has relevance in most businesses and often strict control over the top 80 per cent in value terms of the stockholding will be highly cost-effective. In addition to the top 80 per cent in value terms, high value/low volume items and any low value items necessary to smooth production should also be strictly controlled.
There are, of course, more sophisticated ways of controlling and managing stock, but an understanding of the various methods outlined in this article, coupled with well defined objectives and plans for the business, should facilitate the achievement of optimum stock levels.
