By Dan Gilmore, Editor-in-Chief
Through a special arrangement, what follows is an excerpt of a current article from Supply Chain Digest, presented here for discussion.
In early 2006, a look at the past several years of data from the annual CFO Magazine working capital report showed continuing upward pressure on inventory levels, despite the great focus on supply chain management improvements in most companies. This year's report shows the same trend--average inventories across all industry sectors grew 2.1 percent in 2006.
The largest driver of this increase is generally thought to be the rise in offshoring. As a greater percentage of a company's total sales comes from offshore sources, its inventory levels are likely to rise, as higher inventories are used to buffer the impact of the longer supply chains, increased inventory risk, etc.
I believe this issue is compounded by the relative lack of experience the average company has in managing global supply chains, an issue we analyze in detail in our report on The 10 Keys to Global Logistics Excellence. So, the inherent upward pressure on inventories from offshoring is compounded by the years it takes to really get good at the process.
I believe another factor is the increase many companies have seen in raw material prices, as commodities from corn syrup to plastic resins have seen strong increases in supply prices. If a company cannot raise its own prices in step, as many have not been able to do, it has the effect of increasing the inventory level metric, as the cost of raw materials and work-in-process inventories goes up relative to sales. There has also been some forward buying of raw materials to lock in costs of commodities expected to rise.
The CFO data, compiled by consulting firm REL, measures three elements that impact Working Capital, of which average inventory levels is one. The report actually uses Days Inventory Outstanding (DIO), which is the other side of the coin from the Inventory Turns metric used by many supply chain professionals. It is generally good if Inventory Turns numbers are increasing; the opposite is true with DIO.
Across all industry segments, the average DIO for 2006 was 31.2 days in 2006, up a little more than two percent from 2005.
So just to cover the basics, why is DIO important? For several key reasons. First, working capital tied up in inventory can't be used for more productive purposes that could generate higher returns or growth for the company.
Second, inventory is a component of the company's overall capital investment. Those firms that can generate a given level of profit with a lower level of investment in inventory will generate higher cash flows and better return on invested capital. Third, higher levels of inventory tend to lead to more problems with write-offs of slow, excess and obsolete inventories (SLOBs), which can hammer a company's profit line, especially in today's environment of rapid product lifecycles.
Just to be clear, for large companies even a small change in the number of days of inventory being held, positive or negative, can be worth tens of millions of dollars in working capital swings.
Discussion Questions: What factors do you think are driving inventory numbers up? Have we reached a plateau of performance improvement that will be difficult to break through?