The Bee Hive

The motive for inventory performance metrics like inventory turnover and inventory days of supply is to know how much inventory is on hand and to help us decide if that amount is right for our business. That information is useful for finance so that it can reflect its current assets picture. To operations, it indicates the ability to cover production requirements and/or customer orders. But which is the better measure?

Finance is more interested in dollar-based measures of inventory. One example is the end-of-year total dollar investment in inventory, which is useful for creating financial statements. In today’s lean production environment, however, the finance department also may want to determine the inventory asset’s level of productivity. The formula for inventory turnover is (=Cost of Goods Sold/Average Annual Inventory Investment). It is an indicator of how well inventory is being used by a business. How many dollars of sales, at cost, are being supported by each dollar of inventory? That is what the formula tells you. Higher ratios are considered better, but this can be overdone in any given situation.

However, purely dollar-based measures of inventory are not particularly useful to operations. A customer pays a bill in dollars but buys specific items. From an operational perspective, items must be planned and controlled to match supply and demand. One measure of inventory at the item level is units on hand. This yields unambiguous quantity information item by item, which is useful for planning and control purposes. But it does not reveal whether the amount on hand is an appropriate amount. For that, you need a yardstick of some sort.

Traditionally, an appropriate amount was established by using independent demand inventory methods, such as Order Point/Order Quantity systems. But these methods failed to anticipate future demand and didn;t coordinate the availability of related items needed for joint use, for example, assembly.

Dependent demand planning methods, such as MRP, addressed both of these shortcomings by coordinating the planning of quantity and timing for related items and by driving that planning from known and projected requirements. With realistic lead times and realistic forecasts, the resulting inventories should have been “optimal” for the circumstances. Lack of realism in these areas, however, undermined the operation of MRP systems, yielding less-than-desired service and more-than-desired inventory.

Days of supply is an example of a time-supply measure of inventory. A common use of time-supply measures in inventory planning systems is to reduce the risks of excess and obsolete inventory by placing an upper limit on the time-supply of an item that can be stocked. One rule-of-thumb is “no more than one-year supply of C-items.”

Days supply could be calculated by inverting the inventory turnover figure and adjusting for units of measure. For example, a turnover of 5 (times per year) would be equivalent to a time-supply of 1/5 year or 1/5*365=73 days supply.  However please note that the turnover ratio is based on the cost of sales for the past year and on the average annual inventory investment in dollars. Aggregate dollars and a historical view aren’t very useful to operations, which needs to match supply and demand of specific items in future.

Days supply shoould be calculated at the item level, based on inventory currently on hand in units vs, known requirements and forecast demand in units per day for a specified period:

Days Supply= Inventory Currently On Hand/(Known Requirements+Forecast Demand) in Units/Day

Because time-supply and turnover are inversely related, the above result coould be inverted to project an inventory turnover figure for the future, which could be based on units not dollars. Generally, smaller days supply figures are considered indicative of a leaner, more productive use of inventory, but  again this can be carried too far. Fragile systems have “crashed” for lack of supply e.g. auto industry strikes at supplying plants shut down assembly plants rather quickly if there is not much buffer.