Data Gold Mine: Use Industry Data to Measure Excess Inventory
Excess Inventory: How Much is Too Much?
We recognize that excess inventory is the key driver of inventory waste, but how much inventory is too much? To answer this question, you can start with the average inventory held by companies in your peer group.
Key Learnings: Average Inventory by Industry
In the above figure, I show the average inventory level for numerous industries. My data is based on filings of public companies, and I express inventory level as Inventory Days on Hand (often referred to as “Inventory DOH”).
As shown in this figure, companies that handle products with short life cycles typically hold the least amount of inventory. In this category, Computer Hardware Manufacturers hold 22 days on hand. In contrast, business that trade in Specialty Goods frequently maintain over 100 days of inventory.
This data reveals that businesses typically adapt their inventory management practices to align with the types of products they are handling. Your local grocery store has employed an inventory management system to manage the short expiration period of fresh produce. In contrast, producers of recreational goods must maintain a breadth of different product offerings to attract customers.
How to Use Industry Data to Measure Excess Inventory
First, identify the public companies that operate in your industry, and calculate the average inventory days on hand for each of these businesses. Then dive into the detailed financials of each business to understand the key drivers of their inventory levels. What are some specific circumstances at each business that may drive inventory higher or lower? Do they operate overseas manufacturing facilities, which may impact reported inventory?
You can then utilize this data to better estimate your ideal inventory level and calculate excess inventory at your business. In the following, I look at each of the broad groupings in more detail to better illustrate how to think about inventory levels within each industry. I do a much deeper analysis for my clients, but this helps you think about how to approach your own analysis.
Short Life Cycle Products
Producers and resellers of short life cycle products by nature will hold less inventory. Computer-related goods are famous for becoming obsolete in a short span of time, so it makes sense that these manufacturers keep about 20 days of inventory.
Within this same category, automakers also keep very little inventory. Auto manufacturers refresh their models on a yearly basis (sometimes twice per year). They are efficient at sending vehicles to dealer franchisees shortly after final assembly. To probe deeper, I reviewed a recent SEC filing from General Motors, and noted nearly half of their inventory is work-in-process. Thus, automakers most likely hold about 18 days of finished goods inventory. As soon as the vehicle is off the assembly line, it is soon leaving the plant on a railcar on its way to the dealer.
Retailers hold an average of 55 to 60 days of inventory. This is frankly a bit higher than I would have expected, but it is noteworthy that many large retailers (such as Target and Wal-Mart) have their own distribution centers.
These large retailers hold more inventory simply because these retailers also act as their own distributors. From my research, wholesalers (distributors) typically hold 40 days of inventory. Thus, it’s likely that these retail locations hold 2-3 weeks of inventory on average, which seems about right.
This group represents the broadest segment, as it includes manufacturers that are typically not constrained by short shelf life or product obsolescence. These businesses consistently hold between 60-65 days of inventory. Note that textile manufacturers hold higher levels of inventory (at 75 days on hand). Textiles are frequently manufactured in Asia, and the shipping time for ocean freight adds two to three weeks of time for textile inventory.
Durable Goods and Specialty
Manufacturers of Durable Goods maintain an average of 90 days of inventory. They hold relatively high inventory because of their long production process. For example, about 1/3 of Caterpillar’s inventory is comprised of raw materials, such as steel and rubber. Another 1/3 of its inventory is work-in-process, with finished goods representing the remainder.
Much like Durables, Specialty Goods often require a multi-step manufacturing process, which increases total inventory levels. Further, specialty products by nature have a lot of product variants. This breadth of product offering acts to increase the required level of inventory.
Conclusion: Using Industry Benchmarks to Estimate Excess Inventory
I provide the above as a framework to help you define excess inventory at your business. As a summary, I follow the below process in my own consulting practice:
- Identify the peer group of your company; this is typically businesses operating in your industry.
- Utilize publicly-available data to calculate the average inventory level for your peer group.
- Dive into specifics and ensure you understand the key drivers of inventory for your peer group. In the above, I pulled SEC filings for Caterpillar and General Motors to ensure I understood some of the industry-specific factors. If I were doing this for a client, I would look at inventory details for every company in the industry.
- Of your peer group, which company has the lowest level of inventory? What is unique about this business? I will research SEC filings, investor presentation, or earnings call transcripts of to find the ‘special sauce’ that helps the business maintain best-in-class inventory levels.