In this session we will use Little's Law to define a new variable, that we will call inventory terms. Inventory terms is based on a somewhat funny view to an operation. Think about an operation as a big black box, where you have individual dollar bills go into the operation. And then with some delays, kind of being spit out of the operation. We can then for every individual dollar bill compute a really odd number, and with the amount of time that that dollar bill has spent inside the operation. This is really the intuition behind the concept of inventory terms. Once we have defined inventory terms, we can also compute the cost advantage which a company has if it's turning its inventory faster than its competitors. Here's a comparison between to computer companies Dell and Compaq. I know that Compaq is long gone from the landscape, but for the sake of comparison I've picked that data for Dell and Compaq in the year that Compaq ended up merging with HP. And we'll give you some updated data about Dell in just a moment. Now look at these computations, we want to look at how many dollar bills flow through Dell per unit of time, in this case, per year. And then we apply Little's law. The number of dollar bills in the organization is simply $391 million. The flow of dollar bills through the operation is the COGS, the cost of goods sold, which is 20 billion, 20,000 million. This suggests that if we sold 14 the average dollar bill spends $391 divided by $20,000 and it is expressed in years in the operation. You multiply this with 365 days in a year. We're going to get roughly seven days as a time that the dollar bill spent was in debt. Now, do the similar calculation for the case of Compaq. The inventory here, is $2 billion. The flow rate is slightly larger, 25.263 x T. And if you solve for T, you will get roughly 29 days. So while the dollar has only spent 7 days at Dell, was spent four times longer, 29 days at Compaq. Instead of saying that Dell keeps their dollar bills for seven days inside the operation, we can refer to 1/T as the inventory turns. If you're keeping your dollar bills for seven days, given that they are 52 times seven days in the year, you're turning your inventory 52 times in the year. This is the concept of inventory turns. One over T in the above equation is simply COGS divided by inventory. We see that Dell turns its inventory roughly 51 times in the year, while Compaq is turning it roughly 12.6 times in the year. Now when you do these calculations, be careful. Use COGS, not revenue to do these floor unit analysis because the margins that the companies make have really no impact on these calculations. How the inventory turns changed over the years at Dell in the early years you saw that Dell is roughly making 10 inventory turns per year. Over the late 90s, Dell perfected it's business model and together with a strong tech bubble was able to turn it's inventory way faster than 50 times per year. In their best state Dell was actually getting the money from the customers before they even had to pay their suppliers, leading to negative working capital. Here in the 2001 space, you see the birth of the tech bubble. You see the big decrease in inventory turns as the bubble bursts at around 2001. Dell restored its inventory levels subsequently. The more recent downfall of the inventory turns has to change, has to do with the change in Dell's business model. More recently, Dell has emphasized making many other things than made-to-order computers, including televisions, PDAs and other things. These things oftentimes held at Dell's inventory which has hurt Dell's inventory turns. To see the economic endpoints of inventory trends, consider the following data. This is data compiled by my colleagues, Gall, Fisher, and which shows the gross margin and the inventory turns for large publicly traded U.S. retail. To understand the economic implications of inventory turns, we have to first understand the concepts of inventory costs. Ask yourself, how much does it cost a retailer to hold one item in inventory for an entire year? At the minimum, we have to finance that item and most large public companies incurring capital cost of roughly 10%. But you have to also store the inventory and especially if it's a computer, a fast living item, you also have to adjust the cost of obsolescence. Say for sake of argument these cost, capital, storage and obsolescence together, are 30% for the players to show here in this data. Now let's pick two retailers that are competing head to head in roughly the same retail segment, retailer B and retailer A. Now, notice that neither of these retailers is holding its inventory for an entire year. So neither of them is having to pay for 30%. But you notice that retailer A which is turning its inventory four times per year. We have to divide the 30% by the four turns, and we see that for every segment of sales for 75.5% as an inventory cost. We can think of this as something like a tax rate that we have to pay to the Gods of inventory. Here's the data from retailer B. Retailer B turns its inventory faster, and that allows them to only pay 3.75%. Now this difference between retailer A and retailer B, 3.75W% is the difference between the two of them Is a dramatic number. This is an industry where typical net margins range between 1 and 2%. So simply by turning the inventory faster we're gaining a dramatic competitive advantage. >> Holding inventory is expensive. Unless you're holding French red wine in inventory that might gain in value as it gets older, most of the things lose value. At the same time you have to finance the inventory which takes working capital. For this reason, inventory turns is a very powerful metric. To capture how well you're using your working capital. The margin advantages you might get from faster turns looks initially small. However, if you compare it to the net margin of a business, in most businesses fast returns has a very significant impact on the bottom line.
