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First Thoughts
  By Dan Gilmore - Editor-in-Chief  
  April 16, 2009  
  Supply Chain News: Measuring Inventory Performance  

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.

Gilmore Says:

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.

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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.

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April 20, 2009

What you touch on towards the end is key.

For my money the measures must address the return on the inventory levels, and customer service as well. These two should be the gold standard. With things like turns placed on a second tier. If you have high turns but cannot ship on time you have other problems.

To your earliest point what is a slavish focus on turns doing to your broader performance measures like ROIC. So however turns are measured it is critical to provide a context for that measure. On time delivery to customer requested dates provides that, along with ROIC. As for how we measure turns, in our supply chain function we capture inventory levels daily and look at average inventory over any number of days required. Corporately we tend to use end of period which as you observe can create some gamesmanship over getting those snapshots as low as possible.

Supply chain finance is about going after lowest total cost. That is how we have structured our approach to supply chain design and inventory optimization. Overall working to understand the total cost, to deliver as requested, and achieve our target ROIC levels. Not just a focus on price but on all the total cost drivers, including lead-times, and demand and supply variability.

I would also suggest it is not only that supply chain professionals need to get better at finance, but that finance and other professionals need to get much better at understanding supply chains.

Scott Brown CPIM, CSCP, CIRM
Manager Supply Chain Analysis & Design
Plexus Corporation


April 20, 2009

The Inventory Quality Ratio (IQR) is another measure of inventory performance that has the added benefit of providing actionable information to help us improve our inventory performance. IQR is an additional tool that we use along with our ERP operating system.

IQR pulls the specific data from our ERP system and provides us reporting and drill down capability that has assisted us with our inventory management from new products, spares support and excess and obsolete inventory.

I really like the fact that when we put action comments on a particular part number it provides everyone the information in real time. We have heavily used the customs report functionality to slice and dice the information to segment actionable items, when the information is fresh it gives us a fighting chance to consume inventory for use.

Jerry Kukuruda
LSI Corporation
North American Planning Manager


April 18, 2009

I am very much looking forward to your continued discussion on metrics that represent or incorporate both the physical and financial supply chain.

In my time at GE in the Trade Finance business I have been extremely excited as I learned about the levers of working capital that are controlled by the supply chain - DIO, DPO and in some ways DSO (had spent my previous time in the supply chain software world).

The impact of decisions made around inventory policies, including strategies like JIT, VIM, timing of title change and the newly packaged financial products that target supply chain finance require significant thought and discussions.

I have spoken at 20+ conferences (low cost sourcing, multiple university settings, supplier, procurement, physical supply chain conferences etc.) in the last three years on the integration of the physical and financial supply chain. In my discussions with attendees, University Professors, and industry analysts I have been surprised at the lack of understanding of working capital as it relates to common supply chain strategies.

I have come to believe the power of using the CFO metrics is that the organization begins to find a language to communicate in, that is understood in the C levels and on Wall Street.

I also believe the going back to the DuPont Model in the 1960s that there has always been an academic understanding of the supply chain impact on the balance and income statement but I do not believe that has gotten to senior leaders in our supply chain and procurement organizations.

But, I do think that it is changing as I am finding more and more senior supply chain and procurement executives are being assigned working capital goals and that these goals are part of the goals that the CFO has communicated to Wall Street (Kraft, Bristol Myers Squibb etc.)

I have attempted in my presentations to highlight the impact on working capital using two major supply chain themes for setting the stage -- VMI and Global Sourcing (low cost sourcing). I have found that the implications of time associated with global sourcing has been the number one driver of awareness around working capital in supply chain organizations: add a weaker supplier that cannot own the inventory for 40 days on a boat, 30 days in a warehouse and handle terms of 60 days and a strong buyer organization begins to feel the impact on their working capital.

I believe the financial metrics of DIO, DPO etc produce a strong basis for comparison and a strong common language. They are not necessarily great for benchmarking as stand alone numbers without the association of industry, geography, role and size. I find that these numbers many times highlight the power of channel masters in pushing terms out, or forcing title change for their advantage.

But in my way of thinking the key thing is that we now have metrics that are relevant within our organization and they support the goals of the C-level executive and Wall Street, something I think is incredibly important for understanding where to go next. I think your discussion on the retail supply chain is a case in point: less inventory may save costs but it may also reduce revenue.

Dan, thanks for your articles always great reading and thought provoking.

Bob Belshaw
Senior Vice President
GE Trade Services


April 17, 2009


I first wanted to say that I look forward each week to see what you have to say! I subscribe to many newsletters, but yours is the only one I keep and archive!

Inventory metrics are a hard one to standardize. We have an extremely seasonal product (ice cream) with a level of constrained capacity. We track our inventory to the average 3 month forward forecast. It works for us.

I am not sure if I trust anything coming out of finance. When it comes to supply chain management I try to keep them as far a way as possible. (I have found all they care about is closing the books as soon a possible and make there lives easier at the expense of everyone else.

On your question about S&OP, I have ready many of the recent articles on S&OP and have found so many of the article written by software consultants are all about the new S&OP and you need something from them to make it work!

 Did I mention I don't trust consultants either? Keep up the great work!

Scott Roy


April 17, 2009

This is a very complex journey you have embarked on Dan.

Supply Chain Finance has become an industry buzzword. CFOs and Treasurers of corporations are increasingly becoming responsible for Supply Chain finance solutions, yet there is a general confusion as to how SCF works and the role of different players.

For example, today's buzz words include reverse factoring, vendor financing, payables financing, receivables purchasing and trade payables backed financing, which all tend to be variations on the theme of the umbrella term supply chain finance. These all refer to post-shipment finance programs.

The reality is that companies are living in a world where there bank credit lines, if renewed, are done so at increasingly higher rates and tougher covenants. Banks have limited capital, and the capital they do have for trade has become more expensive under Basel II. Receivable Securitization programs can be very restrictive and costly to set up, and are generally only available for the biggest companies. Credit insurance to help enhance financing has become very difficult to find. Etc. etc.

While it is important to for supply chain professionals 'to get smart,' the devil is in the detail. A functional conflicts exist within Companies due to different success factors for Procurement (obtain best price), Finance & Credit (Increase DPO, reduce DSO, focus on buyer risk and maintain liquidity), and Sales (sell more and extend terms if need be).

These are not easily resolved. One thing in my years around trade is that it has always been about credit, but the good times masked this fact. Now companies have rediscovered this, and are finding sources of liquidity very dry.

I put the industrys first detailed guide together on SCF, and I can tell you while all the technology out there can be interesting and an enabler, most companies would work on spreadsheets if they can have access to liquidity when they need it.

David Gustin
Head of International Trade Programs
Global Business Intelligence


April 17, 2009

I was very interested to read your column.

It is clear that inventory, logistic and supply chain is going more and more visible. Not only because of the economy but also because business is not anymore the only adding value for a company.

I am calculating the Stock turn in the same way you do but not the DSO. I am using a DSI: Days Sales Inventory. My calculation excludes pricing initiative and so on as I am using the COGS. I use the COGS of the last 3 month, as less is not enough to have a full cycle and more is no more representative of the business evolution.

DSI = (inventory month end*90) / (COGS M-2 + COGS M-1 + COGS M)

Example = 5.000 K€ stock * 90 days (3months) /. 2.000 K€ + 1800K€ + 2150K€ = 75 days of stock.

This is really more related to inventory management. When I want to also include others action looking on the larger process (and it is all about supply chain) then I also calculate the GMROI.

John Gustin
Director European Supply Chain Development
Univar Europe


April 17, 2009

I enjoyed your article.

You are right, more people have to get back to the financial basics in measuring the effectiveness of inventory. As I read your article, I had a conversion filter in my head translating the message to 'service' inventory management.

Measuring inventory performance in the service industry is a little different. There are challenges in the service environment such as 'last-time-buys,' where companies are buying parts going out of production to enable support throughout the life of supporting the product.

Also, inventory purchases and inventory stocking usually supports less usage or demand in the service world, so indices such as turns or days-of-supply look skewed (lower turns).

In the service environment, inventory is often stocked per contractual entitlement (i.e., 4-hour response). It is more or less 'insurance' inventory. How do you measure the effectiveness of this inventory? Is it bad to be far lower than a manufacturing entity, at say 2 turns? Perhaps. Perhaps not. Service contract revenue is an important parameter to consider in judging the service inventory effectiveness.

Yes, I am putting inventory in locations where it sees very little activity -- but it is there to support a contractual obligation.

Raw excess calculations, looking at only demand history and forecast, may flag this inventory for removal. Looking at at an inventory-to-revenue index can help rationalize inventory in these conditions. Companies ask themselves, 'Am I getting compensated (service contract revenue) for this inventory?'

As with the complications you highlighted, an Inventory/Revenue measure can be collected many ways. What to use for the inventory number (average inventory, end of period inventory)? What to use for contract revenue (monthly by location, annualized, warranty)? Tracking this index for trends can be a signal for management to take action.

Mark Anderson
VP, Supply Chain Solutions
Baxter Planning Systems


April 17, 2009

An excellent article addressing an issue that is near and dear to our hearts at TCLogic; the performance of inventory.

In recent months, there is more exposure and interest with the performance of inventory, almost certainly as a result of our current economic climate. Organizations are desperately searching for ways to reduce costs and the investment of inventory provides a large opportunity for cost reductions.

Unfortunately, many companies are using a hatchet to reduce inventories by 10, 20 or even 30%, but they do so at a greater risk, as noted in your article, of exposing themselves to stock-outs.

So how are organizations addressing with the dilemma of reducing inventory while protecting service? The answer can be found with an inventory optimization solution. An inventory optimization solution provides the necessary intelligence to make smarter decisions about where to invest valuable inventory dollars that immediately improve business results such as: inventory turns, working capital, DIO, etc.

For some companies, slashing inventory is a necessary survival tactic. But a more strategic approach is to right-size the inventory, maintain high service levels, and prepare for the recovery. For full disclosure, TCLogic is a provider of inventory optimization solutions and I look forward to your future articles on inventory performance and supply chain finance.

Richard Murphy


April 17, 2009

I read your newsletter commentary on inventory performance and applaud you turning your attention to the topic. In short it is probably the FIRST topic any supply chain professional / business person should master before making decisions on a supply chain, what business to be in, best way to benchmark your business vs. your competition etc.

Another good way to get the brain thinking about the topic is to ask what is the inventory turn / IRR / ROA if you can sell a SKU before you have to stock and where can this be done ? Answer is quite obvious - a hint as a quote from Buzz Lightyear: “To infinity and beyond.”

Not all products can or should be sold before stocking / paying for but in my experience have never been in ANY business that cannot do some products as such which has a direct and immediate impact on overall inventory turns and use of working capital.

Jon Kirkegaard




April 17, 2009

I believe the best measure of inventory performance is to compare average inventory over a period of time (typically monthly) to the inventory consumption over the same period of time.

This is the only 'true' measure in my mind because it removes all the other variables contained in COGS so it is a true reflection of how well your inventory is turning or being managed.

If COGS or revenue is to be used it should at least look at forecast instead of historical numbers (COGS or revenue) because we are not bringing in inventory to support last months sales, rather next months sales.

Dwayne A Wildhagen, C.P.I.M.
Manager Demand Forecasting, Planning & Product Configuration
Springs Window Fashions LLC


April 17, 2009

I believe the best measure for inventory management/planning is Days Forward Inventory(DFW: inventory/(forward sales forecast/days in forward forecast period).

The forward forecast period may be set to reflect what is most meaningful for the respective business/need. The basis, or unit of measure, may be what is most meaningful…units, cv$, etc.

In the case of our business (HVAC equipment), the forward forecast period is 4 weeks and two metrics are used for management/planning: units and std costs/CV$.

Why a forward forecast as the denominator? Because the inventory is in place to satisfy forward demand. We, also, measure using actual sales, however, that is a trailing, performance measure lagging real execution planning by one month.

This metric is the core metric at all execution levels, SKU, product family, mfg faciliy, business. Another set metric is the 'quality' of inventory. This is more about the make up of the inventory and readiness to serve.

There are three: (1) available to commit inventory; (2) categories of inventory; and (3) SKU level/ mix performance. Available to commit is a readiness to serve metric for stock products and is the best bell-weather for customer facing service level performance(ie; fill rates).

This is a daily metricount of SKUs that are planned to have stock available and have free balance-on-hand inventory/count of SKUs that are planned to have stock available. The second metric is about the profile of statuses of the inventory(ie; good/sellable ATC; good sellable allocated to orders; quarantined; obsolete; asis)…sum of units by category/total sum of units in inventory & same calc but with CV$; and third metric is focused upon the balance or optimization of the inventory - count of SKUs with inventory within + or - 6% yr of targeted level/total count of SKUs. Working Capital/Cash Flow measurements are used as you note DIO and turns; however, for most larger companies these are at Net Inventory levels inclusive of a lot of financial acctg, full-ovhd, FIFO,LIFO reserves that have little relevance to current execution/inventory planning.

This is why I favor metrics that utilize standard CV costs for inventory - acknowledging the financial aspects of Cash Flow and Working Capital.

Fred Schafer


April 17, 2009

If I am calculating average inventory on an annual basis, I add up the ending inventory for each month and divide by 12. That picks up any differences on a monthly basis due to seasonality, spikes, etc. I think it is better than using just the beginning and ending period totals.

There is another interesting way to use turns and that is to calculate it looking forward. The traditional calculation, regardless of how you determine average inventory, tells you what your past performance has been. Useful as a performance metric, but not for making decisions about how much additional inventory should be made or purchased. If a company has a financial projection for the current year which includes cost of goods sold and inventory, calculate 'projected turns,' that is a number that you can influence.

Another variation, use last month's ending inventory instead of average inventory. Now you have a very current projection which is more sensitive to current issues.

Herb Shields, CMC
HCS Consulting


April 17, 2009

Interesting post and timely given the increased focus on inventory as a way to reduce supply chain costs. The points you make about the inadequacies of Inventory Turns and DIO are valid, though I have to ask quite what is it that we need to measure?

While I agree that Purchasing is not strictly part of the supply chain if the supply chain is restricted, as you do in the article, to the storage and movement of inventory, I am not sure how the contracts set up by Purchasing are any different in concept from the equipment manufacturing decided to purchase. Both are decisions made with long term consequences for the efficient and effective storage and movement of inventory through the supply chain.

Very few companies have single source procurement processes, so as much as a company can make a decision of which manufacturing site/line to use to satisfy certain demand based upon capacity availability, throughput, customer delivery expectations, cost and a number of other variable which have a direct effect on the effectiveness and efficiency, so too they can decide which supplier to use.

So while DIO might be a broad measure I do not consider it to be a blunt measure. For example, Manufacturing may issue planned purchases with quantities and dates, but Purchasing will often consolidate orders in order to achieve a minimum order quantity or to get a full truck load in order to reduce the transportation costs. The consequence may be excess inventory, but overall reduced costs, or simply contract compliance.

This situation is made more complex in some industries, such as automotive, which have flex limits on the quantities ordered in a period. Order too much and you have to pay a penalty. Order too little and you have to pay a penalty. These are real constraints, as real as any capacity constraints, and should not be ignored when making supply chain decisions.

However, too often the contract terms are decided by Purchasing based purely on a piece price objective and little consideration for supply chain efficiency and effectiveness. In defense of Purchasing/Procurement, market conditions can change quite a lot over the course of a products life cycle, making the contract terms very inefficient in the new conditions even though they may have been perfectly reasonable under the market conditions prevailing at the time of negotiating the contract terms. I would argue that we cannot preclude these consequences from an overall evaluation of the supply chain efficiency and effectiveness.

Without a doubt I think it is necessary to drill down to greater detail to understand the root cause when a KPI such as DIO changes a lot or is not consistent with benchmark values. Though admittedly I do not have an answer for the situation you bring up when Cisco wrote off $2B in inventory.

Finance can wreck havoc on these metrics. Of course while snapshots of these metrics are useful, it is at least as important to understand how they change over time. In the Cisco case, the historical inventories could have been discounted to reflect the adjusted values, in which case the trends would be re-established.

My favourite supply chain metric is Cash-to-Cash cycle. Of course this brings in DSO and DPO. Undoubtedly these metrics confound Finance and Supply Chain management even more, but in the end Cash-to-Cash does measure the efficiency and effectiveness with which a company purchases goods to manufacture finished goods which are sold to customers.

The contract terms negotiated with customers are as much a constraint on the supply chain as are the contracts negotiated with suppliers. I would go further and say that the issue is that currently these constraints are not considered when planning how to satisfy demand, rather than DSO and DPO being inaccurate measures of the supply chain efficiency and effectiveness.

When planning how to satisfy future demand, and therefore determining how our company will perform in the future in a period in which Finance will have limited influence, payments terms -- both to suppliers and to customers -- should be taken into consideration. Yes, Finance can change the past, such as the Cisco situation you refer to in your article, but this can be addressed by recalibrating historical values to take this 'interference' into consideration.

At the heart of the issue is that most supply chain planning systems do not report these metrics or take them into consideration when making decisions. The focus is on satisfying customer demand with the least lateness, rather than at the highest gross margin.

Trevor Miles
Product Marketing

Editors Note:

We are in complete agreement about the scope of the inventory question. I simply pointed out that evolution from a logistics perspective (store and move) to a full supply chain perspective, which certainly includes procurement and all the issues and more that you smartly raise.

Dan Gilmore


April 17, 2009

Inventory turns: Sum Last 4 months COGS (annualized) divided  by M.E Inventory value (Raw mat + WIP + Fin Goods)

in conjunction with delivery lead time and on-time performance.

If these 3 measures are acceptable the customer is being satisfied quickly, on-time and inventory is managed good. If these measures are in line I am usually feeling pretty good.

J Senior


April  17, 2009

Great article!

Nigel Devenish
Commercial Director DSV Solutions
Ireland Ltd
Tougher Business Park
Ladytown Naas
Co Kildare

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