What time is it?? It’s metric time!! This month we’re talking about Days in Inventory. If you have clients in industries like retail, wholesale, or manufacturing, you no doubt hear this term frequently – but how is it really measured and why is it meaningful? Read on…. This Month’s Metric – Days in Inventory Who uses it?
Any company that manufactures or sells physical goods or products – think about grocers selling food, consumer packaged goods companies manufacturing household products, or an aerospace & defense company manufacturing aircraft or military equipment. Even media & entertainment companies have inventory – a cable & satellite provider has the equipment it provides to customers; a movie production company will have its original programming and film inventory. Days in inventory is also referred to as days on hand.
How is it measured? In simple terms, days in inventory is the number of days it takes a company to sell its inventory. It’s a comparison between the cost of acquiring the inventory and the actual amount held in inventory; it’s calculated as total inventory divided by the daily cost of goods sold, which is the annual cost of goods sold figure divided by 365 days.
What’s in it? Total inventory typically includes three components – raw materials, work-in-process, and finished goods – but all three components don’t necessarily apply to all companies. A retailer will usually only have finished goods, which is the merchandise it carries on its shelves or is being held in distribution centers and warehouses. On the other hand, a manufacturer will have raw materials for the products it fabricates, there will be products that are not yet complete and are considered to be work in process, and they’ll also have finished goods – or those products that are ready for sale to a distributor or the end consumer.
Why is it important? Cash invested in inventory can tie up a significant amount of a company’s net working capital, which is a measure of operating liquidity, or how fast assets can be converted into cash. There’s a balancing act between having the right amount & types inventory available and having too much cash trapped in inventory, which can lead to product obsolescence and writedowns. Reducing or optimizing days in inventory – when done correctly – can free up cash to be invested in growing the business or paying dividends to the company’s shareholders.
What drives it? There are many things that drive days in inventory in different industries and individual companies, but there are several drivers that tend to be common across the business landscape. First is product mix – the types of products or merchandise a company sells can dictate inventory levels. A multiline retailer that sells grocery items along with household goods and apparel will have a lower days in inventory than a retailer that doesn’t have grocery as part of their product mix, as the perishability of food items is a key factor in lower days in inventory. Alternately, an industrial manufacturer may have a mix of build-to-sell versus build-to-order inventory – build-to-sell inventory levels will naturally be higher than build-to-order. New product launches or expansion into new markets or geographies can also impact days in inventory. As a company builds its inventory to launch that new product or unveil its merchandise in a new part of the world, days in inventory will typically rise fairly significantly. Sources of procurement can also affect days in inventory. As companies are looking for lower cost sources of materials & merchandise, this typically sends them in search of providers overseas – the result is that inventory levels rise in response to longer transit times and higher levels of safety stock.
What is the Goal? Typically, the lower the number of days in inventory, the better. However, it’s important to remember that the optimal number of days in inventory is a balancing act between the actual investment in inventory - including financing charges and the operating expenses associated with carrying inventory - and the impact to revenue. A company could arbitrarily reduce its investment in inventory as a way to free up cash, but if the lower inventory levels result in stockouts of items that customers are in need of, revenue may suffer as a result.
So HOW do you translate this into conversation about value with your clients? We’ll follow this up on Thursday with The KPI Connection, connecting this month’s metric to key business processes and ultimately measurable impact on your clients’ business, so check back for that. For a deeper discussion on Financial Metrics, Operational KPIs and how they drive sales, see our previous blog post at www.finlistics.com/blog
