In early 2006, we took a look at the past several years of data from the annual CFO magazine working capital report. That data showed a continuing upward pressure on inventory levels, despite the great focus on supply chain management improvements in most companies.
This year’s report, summarizing data from 2006, is out earlier this year, and I don’t know if they saw what we did with their data, but for the first time it includes information from multiple years (2004 through 2006), making analysis about trends and performance by industry and individual company much easier.
The data show continued upward pressure on inventory levels, with average inventories across all industry sectors up 2.1% 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.
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 – key metrics Wall Street types use to value companies and determine stock prices.
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.
Across all industry segments, the average DIO for 2006 was 31.2 days in 2006, up a little more than 2% from 2005.
But overall numbers don’t tell you much, given the huge differences in processes, requirements and belief systems in different industry verticals. Just for example, DIO in the food manufacturing sector in 2006 was 45, up from 40 in 2005; in the restaurant industry, DIO was only 5.
Details can be found by sector and individual company in a downloadable spreadsheet from the CFO site (See 2006 Working Capital Report – be sure to go to the middle column on DIO). In almost every industry sector, DIO rose from 1-7 days. Examples: the beverage industry, which went from 19 days on average in 2005 to 20 in 2006; computers, up from 21 days in 2005 to 27 in 2006.
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.
Some noteworthy performances by sectors and companies we saw:
- Perhaps indicative of the experience effect in global supply chain taking effect, the “Multi-line Retail” sector (mass merchandisers and department stores) drove down DIO on average from 68 in 2005 to 63 in 2006.
- Within that sector, there has been continued improvement over the past three years in the Dollar stores retailers, as Dollar General has reduced DIO from 66 in 2004 to 63 in 2005 to just 57 in 2006; meanwhile, Dollar Tree’s numbers have shown the same pattern: 72, 62, 56 in the past three years.
- The CFO article notes the improvement made by electronics retailer Game Stop, which has developed a proprietary inventory-management system that it pairs with point-of-sale technology to allow it to see its daily sales and in-store stock by title, by store. Last year, the company shaved its DIO figure impressively to 46 from 71 in 2005.
- As we note nearby in News and Views (See Goodyear Finds New Insights to Inventory Management from Coping with Strike , tire maker Goodyear found during the challenges of a strike at its plants in 2006 that it could actually make do with less inventory that it thought. DIO is down 10% for the company since 2004.
- The pharmaceutical industry in general is thought to be paying more attention to supply chain issues, and it shows. DIO is down across all three years while most other sectors were rising, from an average of 52 in 2004 to 46 in 2006. Schering-Plough has seen its numbers go from 70 to 62 to 58, while Wyeth has moved from 52 to 45 to 44. There are a few pharma companies, however, that have moved strongly in the other direction.
- Chemical maker Lubrizol continues to make inventory progress, reducing DIO from 72 in 2004 to 59 in 2005 to 53 in 2006. Similar results from Olin, whose numbers go 47, 41, 30.
- Aerospace parts maker Precision Castparts has also seen continuous improvement, seeing its numbers go from 87 in 2004 to 66 in 2005 to 59 in 2006.
There is a lot of data here, and if I’ve missed any standout performers please let me know. And if you are one of these companies mentioned, or generally would like to tell your story about how you are reducing inventory levels, please send me an email at the Feedback button below.
All told, though, the numbers are flat to increasing for the majority of companies and industries. Interesting.
Is DIO a good indicator of inventory performance, especially when looked at over several years? 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? Let us know your thoughts at the Feedback button below.