PhilMur's thoughts on biz/tech/money/life

One objective of this blog is to dig into important business financial management issues as well, particularly as is relevant in a typical small or mid-market company.

In this post, I would like to explain one common metric that companies calculate and evalute periodically to determine the level of inventory they are carrying in their company at any one point in time — Days of Inventory On-Hand, or “DIO” for short.

In this blog post, I will first define DIO, explain why it is an important metric, and then wrap up with some calculation examples.  In Part 2 of this blog posting, coming in the coming days, I will discuss ideas on how to set a specific DIO goal for your company that is realistic to attain and how to ensure that the benefits of attaining the lower inventory levels outweighs the cost associated with the effort it will take to lower inventory on-hand.

First of all, I should make clear that the “I” in DIO is referring to product inventory (meaning, stock of items that you would sell and use in the ordinary course of business).  The DIO does not take into account the inventory of fixed assets and equipment you may use in your day-to-day business; it refers exclusively to inventory that you turn around and sell direct to your customers as a distributor, or use in a manufacturing or service environment.

Why is such a metric important?  Your DIO is important because, as mentioned above, it describes the level of inventory you are carrying in your company.  It also provides that information in the form of a number of “days of inventory”; in other words, it communicates the number of days of typical inventory usage/sales that your company has on hand as of the day of measurement.  Many a manager has seen Inventory numbers on a balance sheet, without understanding their relative magnitude or implications for the company.  The value of the inventory on-hand means little if you have no idea of how many dollars inventory your company is currently spending at recent sales volume levels.

For Company A, a distributor, a month-end inventory balance of $600,000 may be exceptionally low and efficient, because they sell $4,000,000 of products monthly (which is their customer’s price with markup; company’s cost basis of only $3,000,000), which would mean that assuming a 30 day calendar month, the company is carrying at month-end approximately 6 days worth of inventory usage in the $600,000 of inventory on-hand:

(  $600,000   /   $3,000,000       )   x   30              =  6.0
inventory        monthly usage          days            Days of Inventory
on-hand                                                  in month          On hand (DIO)

But for a smaller company — we’ll call it Company B, let’s say — that same $600,000 inventory balance may represent an entire month’s worth of inventory sales of $800,000 including customer markup.  Finally, Company C may sell $4,000,000 of services monthly with a material and labor component (materials only $1,000,000 of cost), and so relative to the other two companies Company C should have lower inventory needs.

The DIO solves this problem of relative comparison by converting the Inventory balance into the number of DAYS of inventory (the number of days of typical usage that you have sufficient inventory on-hand to cover), as explained in the illustration above.

Let’s look at some further DIO information for the fictitious companies I’ve just profiled.

Example              Gross              Monthly Inventory     Inventory          Daily           Calculated       DIO        Dollars under
Company     Monthly Sales             Usage                          Balance           Usage(1)       DIO(2)            Goal           or (over)

A                      4,000,000             3,000,000                   600,000        100,000            6.0             10.0            400,000
B                           800,000                 600,000                   600,000           20,000         30.0             15.0           (300,000)
C                       3,000,000             1,000,000               1,375,000            33,333           41.3            30.0           (375,000)

Note: * A 30 calendar-day month is assumed in the calculation of daily usage

Again, the DIO is calculated by the Inventory Balance by the Daily usage.  You will notice that Company A is carry 4 fewer days worth of inventory than they have set as their internal goal.  This frees up working capital (funds that could be used to meet other current needs) by $400,000.   Company B is carrying the same amount of inventory as A, and even though its DIO goal is a bit more relaxed (5 days higher), because its Daily Usage comes in at only $20,000 per day of usage there is much more inventory on hand than is needed.  Company C has a similar problem; they only exceed their DIO goal, but because of the size of the company, more dollars ($375,000) of working capital are tied up as a result of the excess inventory they are carrying.

Those of you paying close attention will recognize the fact that, had the goals above been set differently, then the companies may or may not have shown a the dollars of savings or overage that they did.  Goal-setting for this metric is an important issue indeed.  It is this topic that I will pick up with, along with a discussion and analysis of the conceptual underpinnings of the DIO metric, in part 2 of this topic.