FINANCIAL MANAGEMENT - 24.02.2010

Managing stock levels

Why is stock important?

Holding stock means tying up cash, and the majority of CFOs believe that their companies consistently carry 25 to 40% or more stock than is needed. Ideally, you should keep stock at minimum levels to meet sales forecasts and keep production running smoothly. So how can you help your board make sense of how well stock is being handled?

Physical stock count. Firstly, make sure that a physical stock count is carried out at least once a year. This can uncover problems such as losses due to theft, unused raw materials, obsolete parts etc. After the stock count, ensure that any losses are adjusted on the computerised records and the stock value for obsolete stock is adjusted. Stock should be valued at the lower of cost and net realisable value - no sale, no value. Once you’re happy with the value, then move on to KPIs.

Calculate KPIs. Secondly, you can help by calculating KPIs. A classic operating efficiency KPI, based on readily available financial information, is “stock turnover” which shows how fast stock is moving through the business:

Cost of sales

Average stock (half the sum of opening plus closing stock)

Interpretation. A high turnover could indicate a healthy and liquid inventory with lower demands on cash flow, but it could also mean stock shortages. A low turnover suggests overstocking although that could just be down to seasonal demand. These different interpretations show that calculating the average from only two days in a period is highly dangerous if they are not representative days (see The next step for a tool which calculates the stock turnover on a moving average).

Use more than one measure

Be wary of suggesting a change to the company’s stock policy purely based on stock turnover KPIs.If the CFO sees a stock turnover KPI which suggests inventory is rapidly piling up beyond what’s needed, the typical reaction is to enforce a clampdown on new purchases. However, this can create material shortages which can cause missed shipments, depressing revenue and customer service while increasing stocks and costs.

Tip. Calculate additional KPIs for stock management, such as:

1. Stock-outs in period. Stock-outs indicate where a demand can’t be met due to the absence of the required stock - monitoring the number of stock-outs in a period will tell you if you have the right mix of stock type and quantity.

2. Service level. Service levels can be calculated per individual customer and are calculated by reviewing the number of times an item has been issued divided by the number of times demanded - a low service level will indicate that customers invariably have to wait for parts and that stock held could be of the wrong type.

3. Lead time. Lead time is the length of time it takes to obtain stock from suppliers - long lead times can result in holding excess stock.

4. Stock cover. Stock cover is the length of time that inventory will last if current usage continues - it helps appraise the impact of changes in lead time or the potential for running out of stock.

For a free stock turnover calculator, visit http://financialcontroller.indicator.co.uk(FC 02.06.10).