I have been working hard trying to better understand inventory management, supply chain “finance,” and the bottom-line value of the supply chain.

I’ve been working on this for several years, actually, and I got good at the basics soon enough. But I am finding that getting to the deeper levels is a bit harder – and I consider myself pretty good on the numbers side.

Why this column now? In part, because of what’s going on in the economy, and how it has brought inventory management skills to the forefront.

As I noted in a recent contribution for our friends over at the RetailWire, I believe the imperative to reduce inventories in this recession, in many cases, has gone overboard and cost retailers and consumer goods companies sales revenue. I am less sure in other industries, since inventory decisions are less visible, but it is likely the same in many of those too.

As my friend Joe Shamir of ToolsGroup recently noted, this is not uncommon, as in periods of slowing demand, companies are often late picking up the signals, resulting in excess inventories. When the drop in demand later becomes apparent, they throw on the brakes too hard in the other direction, resulting in stock outs. I would argue the penalty for those stock outs is even greater in these times, as most companies really need every sales dollar they can get.

In a real sense, I think supply chain management, at its core, is about the efficient and effective management of inventory. Logistics is about processes and skills in moving inventory; supply chain is about optimally managing supply and demand across the full plan, buy, make, move, deliver and return processes, but in the end, those processes and the skill with which they are executed largely involves having the right level of inventory where its needed – at lowest total cost.

Since I started my career, however, I think the focus on inventory has become even greater, especially for public companies. I trace this, in part, to the incredible 2001 announcement by network equipment giant Cisco that it was going to take a charge of $2.25 billion (with a B) for the third quarter of that year for excess inventories. That caught the Wall Street analysts completely by surprise, and ever since, most have paid a lot more attention to a company’s inventory levels than they used to.

That’s especially true in any industry with rapid product lifecycles, such as the high tech and fashion sectors, although the reality is that today that includes an increasing number of industries and companies. Even if Clorox had been caught with as much excess inventory versus demand as Cisco did in 2001 (as the Internet bubble burst), it would not have had to take that type of write down. Why? Because, to the best of my knowledge, the bleach and other products Clorox sells don’t quickly become obsoleted by the next round of new product development introductions, as they do to companies like Cisco or Liz Claiborne. Time puts a more severe inventory penalty on Cisco than it does Clorox.

Measuring Inventory Performance

So, just how do we measure our inventory performance?

The traditional approach for most of us has been “inventory turns.” According to the CSCMO glossary of terms maintained by our columnist Kate Vitasek, the inventory turn metric “Measures how many times a company’s inventory has been sold (turned over) during a period of time.” It equals “the cost of goods sold, divided by the average inventory level of inventory on hand.”

So, if a company has cost of goods sold of $1 billion, and average inventory levels of $100 million, it has 10 turns of that inventory per year.

But as usual, there are complications.

First, just how is the “average inventory level” determined? Most commonly, in my experience, you take the starting and ending inventory levels for some period, add them together, and divide by two. In some cases, companies simply use the end of the period number. In either case, it can lead to issues with companies purging inventory at the end of a period, either due to sales patterns or tax efficiencies. If so, it may somewhat muddy the turn numbers.

Today WMS and ERP systems can give you a true average inventory number for a period, but I am not sure how many companies use that in their turn metrics.

Some companies may determine inventory turns using sales revenue and retail price to value inventory. I could even argue that there is merit in using “units” as the correct unit of measure, as it would remove some of the noise that can creep in as financial adjustments are made to inventory levels by the accountants. For example, back to the Cisco scenario, its current inventory level would have suddenly been reduced by $2.25 billion on the books after the write down occurred.

A related metric is “Days Inventory Outstanding” or DIO. This is the number CFO magazine uses each year in its annual Working Capital study that we generally summarize on these pages (See latest summary here: Interesting Inventory Times).

You calculate DIO by taking a company’s inventory levels for a period, dividing by total revenue, and then multiplying by the number of days in the period. This measures how many days of sales a company on average holds in inventory. Finance types like DIO because it is the cousin of such metrics as “Days Receivables Outstanding” (DRO) that measures how effective a company is in collecting on its invoices.

So, for example, if a company has $2 billion in sales for the year, and average inventory levels of $100 million, then $100 million in inventory, divided by $2 billion in sales, times 365 days in a year, equals average DIO of 18.5.

This is, in a sense (though not completely), the opposite of inventory turns. A company with a high level of turns will have a low DIO, and vice-versa.

One thing I don’t like about DIO, however, is that it mixes, in a sense, units of measures – cost for inventory and actual revenues for sales. This means that the effectiveness of the purchasing and/or manufacturing organization comes into play. If that same company was able to reduce the cost of what it paid for its goods or to make them more efficiently, its DIO would go down, not because of improved inventory management, but simply because the numerator of the equation was pushed lower by cost efficiencies.

But what none of these metrics really gets to is the real impact of inventory performance on working capital, the bottom line, and free cash flow. That discussion is coming on these pages soon.

There is growing recognition that supply chain professionals need to get better at “supply chain finance.” Let’s take some of that journey together.

What do you think is the best way to measure inventory performance? How do you calculate “average” inventory levels. Do most of us need to get better at Supply Chain Finance? Let us know your thoughts at the Feedback button below.