We are all a bit weary of articles focused on Covid-19 at this stage, so this week I’m focusing on a more general topic – stock valuations and how these can impact your profitability calculation.
Businesses that are experiencing unexplained fluctuations in their gross and net margins from year to year will often find the explanation lies in the accuracy of the stock valuations used in preparing the accounts.
Many business owners or managers look at the year-end stock take and valuation exercise as a nuisance. Even worse, if the pressure is on, shortcuts are taken, and the stock is often just estimated. Taking this approach to stocktakes is dangerous as the below example demonstrates.
The annual gross profit for your business is calculated by subtracting the total cost of sales (COS) for the year from the total sales for the year. The cost of sales is usually made up of the cost of the labour directly involved in producing the goods or delivering the service plus the value of materials consumed in the process.
Let’s use Company ABC Ltd to explain the point. In 2019 ABC Ltd had the following actual figures;
Total sales = €500,000,
Opening Stock Value on January 1, 2019 was €90,000
Closing Stock Value on December 31, 2019 was €95,000
Purchases during 2019 were €300,000.
Overhead and admin costs were €175,000.
The following formulae are used in the profit calculations.
The Cost of Sales (COS) is calculated as Opening stock minus closing stock plus purchases during the year – assuming there is no direct labour cost.
The Gross Profit is calculated as Total Sales minus COS.
The Operating Profit is calculated as Gross Profit minus Overheads and Admin Costs.
Based on these figures ABC Ltd had a COS of €295,000 in 2019 (calculated as opening stock minus closing stock plus purchases during the year). Its Gross profit was €205,000 and its Gross Margin (the gross profit as a percentage of sales) was 41%.
Its operating profit, which is calculated by subtracting the overhead and admin costs from the gross profit, was €30,000 or 6%. A reasonable result.
Now suppose ABC Ltd didn’t take time to do accurate stocktakes either year end and instead estimated the opening stock figure on January 1, 2019 as €100,000 and the closing stock figure on December 31, 2019 as €80,000, then the calculations look a lot different. Based on these estimates ABC Ltd had a COS of €320,000. Its Gross Profit is then calculated as being €180,000 and its Gross Margin (the gross profit as a percentage of sales) is 36%. This in turn gives an Operating Profit of €5,000 or 1%. Not a great result. In this example, the only things we changed were the value of opening and closing stocks.
A business owner presented with a set of accounts showing an operating profit margin of 6% is going to feel lot more confident about the future than one looking at 1%. In the latter case, the owner is probably starting to think about cutting costs, whereas the owner looking at 6% is thinking about expanding and developing the business.
The impact of inaccurate stock valuations can be more damaging if the stock is over-estimated one year and under-estimated the next and so on randomly from year to year. This makes it look like the gross and net margins are fluctuating up and down randomly.
This leads to confusion and a lack of confidence in how the business is performing. It usually leads to underperformance and under investment. Who will invest more money in a business when unsure of how profitable it is?
Companies often rely on system generated stock valuations. However, these are not always accurate – materials aren’t always booked out or in accurately, stock can be damaged, returned materials not processed correctly, etc.
So, system generated reports are not a substitute for a physical stock take at the year end. How work in progress is valuated can also have a big impact on the calculations and again great care is required when valuing this.
Apart from having the potential to mislead you with regards to the profitability of the business, stock is really money – you paid money for it and you will get money from your customers when you sell it.
You wouldn’t be careless if it was money that was lying on the shelves or the production floor. You would make sure to count it properly and to keep it safe. You need to look at your stock as being the equivalent of money and treat it / track it just as carefully.
While this isn’t a Covid-19 topic, the crisis has freed up a lot of time for businesses.
Why not use some of this to do a detailed accurate stock take? As part of the stock take, take time to consider how the counting process can be simplified for the future and document a stock take procedure which can be followed every year end to ensure you have accurate, consistent stock valuations every year end.