If you’re a stock-based business, then getting your stockholding and product costings right can be tricky at the best of times. But recently, the effect of high shipping costs, long lead times, material shortages and inflation have made the job even harder.
Get it right and you will have a strong cash flow, happy customers, efficient use of space and most importantly, profit on every item you sell! Get it wrong and you risk letting customers down, locking-up valuable working capital and reducing your margins. Our handy guide talks you through the different methods of holding and valuing your stock along with some other considerations you might need to take into account.
Stock holding and management
We’re often asked, “is it best to have less stock, limit our exposure but risk not being able to fulfil an order or hold more stock and fulfil every order with some to spare?” The answer is simple – it is not that straight forward…
First and foremost, you need to decide how you are going to purchase, hold and supply your products. It may be that across an entire range you employ different stock holding methods for each product, subject to a myriad of different criteria such as where/how it is made, lead times and even size.
Many people talk about optimum stock levels, but even optimum levels can change with the season, buying habits and trends so its not as simple as picking a figure for each product line/Stock Keeping Unit (SKU) and leaving it there. The optimum stock holding for each product will be dynamic and unless your stock management software can actively predict it based on sales volumes and trends over a given period, it may remain something of a moving target.
There are various methods of managing stock, so for each item you may need to consider what is the best method of stocking and supplying it. Here we explore the main stock management methods:
- Just in Time (JiT) – With JiT you hold very little stock for very short timescales. You have guaranteed supply lines, and the stock arrives with you within days or even hours of you selling it. An increasingly fashionable example is selling the goods whilst in transit e.g., on a ship whilst it travels from point of manufacture to the UK.
- Back-to-back – Again this method limits your stockholding as you effectively only purchase sufficient stock to fulfil the sales order(s) in hand. You match (or ‘back-to-back’) your sale with a purchase – sometimes on a 1:1 basis. You rarely hold any stock in your warehouse and if you do it is on a transit basis as it is already sold when it arrives.
- Drop ship – Your product goes direct from the manufacturer to your customer, so you never actually hold it in your location or (from an accounting perspective) own it. It does still carry a cost of course.
- 3rd party fulfilment – Basically, someone else holds the stock for you. You own the stock, but space becomes their issue. You just need to make sure they have the stock on their shelves when you sell it.
- Traditional stock holding – You own and hold the stock and it is down to you to manage it according to demand and space availability.
Which product costing method is best for me?
The cost price you apply to each item of your stock matters. From an accounting perspective, this is the amount that is notionally deducted from the price of each sale to create your gross margin. Your overhead costs are then removed from that figure to create your net margin. Obviously, your net profit is not worked out on each item as it includes all your overhead costs such as salary, taxes etc, but your gross margin is a direct calculation. As an example, an item that costs £1 that is sold for £2, makes a gross margin of £1 per item. But does that product always cost £1…? Probably not. And that is because it depends on a range of different factors including currency variance, shipping costs, duty, and material prices. That is why you must apply a costing method to ensure your gross margins are accurate and reflect the actual price paid for that item.
Here’s a guide to the key methods of cost price valuation with some worked examples:
- Last in first out (LIFO) – As it sounds, this valuation method assumes that you will sell your most recently purchased stock first and gradually work back to the oldest item in the warehouse. In this example, the last delivery cost £110 for 100 items, creating a cost price for each item of £1.10 (110/100). The product is sold for £2, meaning that the next 100 items sold will have a gross margin of £0.90p per item. However, you still have 10 items in stock from a previous shipment. These items were purchased as part of a wider shipment of 100 items but the cost price for those was £150 for 100 units. So, these carry a cost price of £1.50 each (150/100). They also sell for £2/item and so their gross margin is just 50p.
- First in first out (FIFO) – Effectively the complete opposite to LIFO. This method will assume you’re drawing down your oldest stock first – so those items that cost £1.50 each. Once these are sold out, you will then begin selling the items that cost £1.10 each.
- With both FIFO and LIFO, it doesn’t matter which stock holding the physical item comes from (unless you use serial numbers of batches (see below) – it is purely from an accounting perspective that the cost price is calculated.
- Batch – Most often used in food and pharmaceutical businesses, the product is purchased or manufactured in batches with an associated cost price. Items will then be sold based on their batch/serial numbers and will pick up the relevant cost price. This does not assume FIFO or LIFO as stock may be drawn out of multiple batches to fulfil order quantities and therefore it will be the batch that determines the price, not the time of arrival in the warehouse.
- Average Cost (AVCO) – Another method that is relatively straightforward and as it sounds. With average cost, you’d take the 100 items at £1.50 each and the 100 items at £1.10 each and take an average price of the two. So, with a total price of £260 (£150+£110) for 200 units, you end up with an average cost per item of £1.30. This method is typically used by companies where the cost price is fixed or at least stays within a defined (and acceptable range).
Other stock management considerations
When thinking about how and where to hold your stock and how best to calculate your cost price, you may also need to take these factors into consideration.
Exactly what constitutes the cost price of the product can vary and is sometimes an individual determination made by the business. Typically, the cost price will be the manufactured price of the product. Some however, may wish to include the full cost of manufacture and shipping i.e., the total cost into their warehouse, divided by the number of items.
In certain industries, the final cost price may be a roll up of all the intermediary costs associated with getting that product to a point ready for sale. Take a bottle of wine for example. This will include the bottle, the ‘juice’ which will then have a further breakdown covering growing and harvesting costs, the cork, the label and maybe the outer box packaging. Some winemakers will even add in a storage cost to the item given the time and space it needs to sit before it is ready for sale.
Your supply chain
If you are using any of the methods above which mean you don’t have the stock on your shelves, can your suppliers support your brand values in terms of lead times and delivery to customers?
A safe bet or a fad?
Is the product a solid seller with no seasonal limitations or is it merchandise tied to a film or fad for instance? Avoid holding the latter and consider upping your purchase quantity of the former in a bid to drive down your cost price and increase margin. One of the hardest decisions you may have to face when reviewing your stock management is when to cut a slow-moving line and how best to do it.