Inventory leanness and the financial performance of firms

Abstract

This paper examines the financial consequences that inventory leanness has on firm performance. We conduct an econometric analysis using 4324 publicly traded US manufacturing companies for the period 1980–2008. Using an instrumental variable fixed effects estimator we find a nonlinear relationship between inventory leanness and financial performance. However, we note that the maximum point of this inverted U-shaped relationship often lies at the extreme end of the investigated sample – suggesting a decreasing return from leanness rather than an optimal level. We show that the strength of this relationship is highly dependent on both the industry and inventory component (raw materials, work in process and finished goods) studied. The main novelty and direct implication of our findings is that most firms still have much potential to increase profitability by becoming leaner and they are unlikely to cross a threshold where profitability decreases with increased leanness. We display how much the average firm could gain by becoming leaner and show how this sensitivity changes by inventory component and industry. Finally, we highlight several new econometric aspects that we believe must be addressed when empirically investigating the inventory-performance link.

Keywords:

• empirical operations management
• inventory management
• inventory leanness
• firm profitability
• compustat data

Acknowledgements

We gratefully acknowledge financial support for this research project through a basic research grant from the Swiss National Science Foundation. In addition we would like to thank Beatrix Brügger, Rafael Lalive, Uysal Pinar, Julio Raffo and Markus Simeth for helpful comments and guidance on earlier drafts of this manuscript.

Notes

1. Through efficient management of inventories and accounts receivable and accounts payable, Dell has achieved a negative cash conversion cycle (Parrino and Kidwell 2009).

2. By means of a vertically integrated supply chain, Zara has managed to keep inventories low and profit margins high (Ferdows and Lewis 2004).

3. In 2009, Wal-Mart cut its inventory by 8% in 12 months (Biederman 2010).

4. In 2005, due to excessive stock, Chrysler paid dealers to reduce inventory levels (Connelly 2005).

5. In 2001, GoodYear made significant production cutbacks due to an inventory reduction programme (Newswire 2002).

6. Other potential reasons could be delisting, mergers and acquisitions or missing data. Firms that exit our sample prematurely have an average EBIT/sales of −0.002 while the average EBIT/sales in our sample is 0.058. We do not however, observe any noticeable difference in inventory between these two groups.