Inventory Days on Hand Analysis

In two articles around three years ago called 3 Low Cost Sources of Cash – Part 1 and Small Inventory – Big Benefits I discussed some of the benefits of keeping inventory to a level that would meet needs but would not be excessive. Let’s now look at a way to analyze inventory called inventory days on hand.

The Formula

The calculation for inventory days on hand is straight forward and is as follows:

(Inventory Balance / COGS) * 365 where COGS stands for Cost of Goods Sold. Let’s use the same numbers used in the first article mentioned above. If the inventory on hand is $1,000,000 and the annual cost of goods sold is $3,000,000 then the inventory days on hand is calculated as follows:

($1,000,000 / $3,000,000) * 365 = 122 days approximately of inventory on hand. Now, let’s further say that only 61 days of inventory needs to be on hand to meet needs. This is includes about a month of safety stock and is based on time from the placement of an order for inventory until receipt. In this case we might say it normally takes a little less than 30 days to receive an order.

Digging Deeper

With annual COGS of $3,000,000 that means the average daily COGS is:

$3,000,000 / 365 = $8,219.

Since only a 61 day supply of inventory is needed, then the excess inventory on hand is:

(122 days – 61 days) * $8,219 = $501,359. If you can get better control of the quantities of inventory carried then you could free up over $500,000 in cash for other purposes, possibly avoiding the need for loans and improving your ability to pay vendors on time, grow the business, and take advantage of new opportunities. This is a good picture of the significance of the inventory days on hand analysis.

A Little Refinement

Obviously, in the example above, if you carry a number of different inventory items it is unlikely that there will be a 122 day supply of each item. To see a simple example of this, let assume the scenario above consist of 4 inventory items and the breakdown is as follows:

inventory days on hand by itemIn this example the total inventory is $501,672, which is just slightly different from the $501,359 in the earlier calculation. This is due to rounding differences. Also note that this analysis gives an idea of what to attack first when trying to get your inventory days on hand under control. Representing over 32% of the excess and with nearly 3 times as many days on hand as needed (177 on hand versus 61 needed) Item 1 would be a logical place to start. In reality, though, you will probably be dealing with far more than 4 different inventory items. Based on Pareto’s Law (i.e. the 80/20 rule) the probability is high that about 20% of your items will account for 80% of your excess inventory. Using this rule and sorting your analysis on inventory days on hand by the percent of excess each item represents will help identify the inventory items to focus on first.

Do you have a handle on your inventory? Do you need some help working through this process? AimCFO is here to help.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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