• A company can realize improvements in manufacturing efficiency and lower investments
in direct materials and work-in-process inventories. Such improvements reduce inven-
tory and, consequently, decrease days inventory outstanding. Although a good sign, it
does not yield any information about the desirability of a company’s product line.
Companies strive to optimize their inventory investment. Carrying too
much inventory is expensive, and too little inventory risks stock-outs and lost sales (current
and future). Companies can make the following operational changes to optimize inventory.
Improved manufacturing processes can eliminate bottlenecks and the consequent buildup
of work-in-process inventories.
Just-in-time (JIT) deliveries from suppliers, which provide raw materials to the produc-
tion line when needed, can reduce the level of raw materials and associated holding costs.
Demand-pull production, in which raw materials are released into the production pro-
cess when final goods are demanded by customers instead of producing for estimated
demand, can reduce inventory levels.
, for example, does not manufac-
ture a motorcycle until it receives the customer’s order; thus, Harley produces for actual,
rather than estimated, demand.
Reducing inventories reduces inventory carrying costs, thus improving profitability and
increasing cash flows. The reduction in inventory is reflected as an operating cash inflow in the
statement of cash flows.
There is normal tension between the sales side of a company that argues for depth and breadth
of inventory, and the finance side that monitors inventory carrying costs and seeks to maximize
cash flow. Companies, therefore, seek to
inventory investment, not minimize it.
Days Payable Outstanding
Most companies purchase inventories on credit, meaning that suppliers allow companies to pay
later. The supplier sets credit terms that specify when the invoice must be paid. Sometimes the sup-
plier will offer a discount if the company pays more quickly. A typical invoice might include pay-
ment terms of 2/10, net 30, which means that the seller offers a 2% discount if the invoice is paid
within 10 days and, if not, requires payment in full to be made in 30 days. Business-to-business
(B2B) payables are usually non-interest bearing. This means accounts payable represent a low-
cost financing source and companies should defer payment as long as allowed by the vendor. The
average length of time that payables are deferred is reflected in the
days payable outstanding
ratio, computed as:
Days payable outstanding
Average accounts payable / COGS
Similar to the days inventory outstanding ratio, COGS is in the denominator because payables
relate to the purchase of inventories, which are reported at cost. For Home Depot, days payable
outstanding for 2016 is:
Days payable outstanding
365 ($6,565 $5,807)/2