Days inventory outstanding definition
/What is Days Inventory Outstanding?
Days inventory outstanding measures the average number of days required for a business to sell its inventory. A low days of inventory figure is generally considered to represent an efficient use of the inventory asset, since it is being converted into cash within a reasonably short time. In addition, a short holding period allows little chance for inventory to become obsolete, thereby avoiding the risk of having to write off some portion of the inventory asset.
How to Calculate Days Inventory Outstanding
To calculate days inventory outstanding, divide average inventory by the cost of goods sold, and multiply the result by 365 days. The formula is calculated as follows:
(Average inventory / Cost of goods sold) x 365 Days
= Days inventory outstanding
The average inventory figure is used in the calculation, rather than the inventory balance on a specific date, because inventory levels can change significantly by day. The most common way to derive an average inventory figure is to take the average of the beginning and ending inventory balances for the measurement period. A more accurate option is to include in the average the ending inventory balance for every day of the measurement period.
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How to Reduce Days Inventory Outstanding
A business can improve its days of inventory metric by using a just-in-time production system. These systems are designed to only produce units when there are customer orders in hand; they are not designed to build to stock. They also minimize the amount of work-in-process, resulting in very low on-hand inventory counts. Another option is to promptly dispose of any inventory that does not sell well. This requires a constant analysis of sales levels for all finished goods items, with excess goods being dispositioned as soon as it becomes apparent that the firm cannot sell them directly. A third option is to accept more inventory stockouts by keeping fewer goods on hand. This represents a balance between annoying customers who have to wait for their deliveries, and shrinking the inventory investment.
When to Ignore Days Inventory Outstanding
There are a few situations in which the days inventory outstanding measurement is not a good performance metric for a business. Here are several applicable cases:
Fast fulfillment strategy. Some businesses prefer to accept a longer days of inventory figure in order to carve out a service niche. For example, a business may choose to maintain high inventory levels in order to advertise that it can fill any customer order within 24 hours of order receipt. In exchange for maintaining a large inventory investment, the company charges a high price for its goods.
Service parts strategy. A company positions itself to be a purveyor of spare parts, which requires it to maintain a significant inventory of spare parts that it may not sell for years. It makes money by charging very high prices for its parts, which customers cannot obtain anywhere else. In this case, having too little inventory could severely harm sales.
Thus, the days inventory outstanding figure can be misleading, depending on how a business chooses to use its inventory.
Example of Days Inventory Outstanding
For example, a business maintains an average inventory of $300,000. Its annual cost of goods sold is $2,000,000. Based on this information, its days inventory outstanding is calculated as follows:
($300,000 Average inventory ÷ $2,000,000 Cost of goods sold) x 365 Days
= 54.75 Days inventory outstanding