Days sales of inventory (DSI) is an accounting measure that gives an idea of how much inventory is on hand in a company. A large number means the company is generally inefficient at turning raw materials into profit. The formula for DSI is:
The average inventory is calculated as follows:
Make sure that the cost of goods sold matches the period for which average inventory was calculated.
The lower days sales of inventory is the better, though if inventory gets too low, there is a greater likelihood of stockouts.
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One of the basic tenets of Lean is to create flow. That means speed, flexibility, and responsiveness. Piles of inventory works contrary to that, so days sales of inventory and the closely related inventory turns are metrics that are commonly used to mark Lean progress.
The Cash Flow Cycle
Creating cash flow has several steps in it. Cash has to be spent on raw materials, and then on other business inputs (labor, rent, utilities, etc.) to turn it into a finished good.
The product must then be sold, and finally, the money has to be collected in order to start the cycle all over again. The more efficient each step is, the more cash is thrown off at the end of the cycle.
Bringing down the number of days sales of inventory reduces the size of this ‘cash wheel’. Not only does that make the process more efficient by having less inventory waste, but there is also less of an investment in it. More free cash means more opportunities.
Days Sales of Inventory and Inventory Turns
Inventory turns is a closely related metric, but is in much more common use in the financial world. It is a measure of how many times a year inventory is sold. The higher the number, the faster the inventory is ‘turning’, or being sold and replaced.
Days sales of inventory is a more intuitive metric for people with limited exposure to accounting. Most people can grasp ’21 days of inventory’ more readily than 17 inventory turns, even though both are identical.
In fact, the formulas for both use the same basic values, and can be easily converted with the following formula:
Don’t use blanket comparisons of inventory turns. There are differences between industries that prevents days sales of inventory from being a universal benchmark.
Don’t use this metric in isolation. A low inventory is good up until the point that shortages start affecting production.
The formula is most commonly used for an annual number. That is too long for most continuous improvement applications. If you use if for a shorter window, make sure you are matching the time period for the cost of goods sold and the average inventory.
A large DSI number is a warning sign for obsolete inventory. This is especially problematic in rapidly changing industries, like consumer electronics.
Watch for gamesmanship in this number. Selling off a lot of inventory at the end of a period can artificially lower DSI, even though there was a lot of inventory throughout the year. Even though this purge does manage to keep inventory in check, it is a very costly way to do it, as the reduction is normally done at a discount.