Inventory Management and Financial Performance

Vedran Capkun, professor at the accounting and management control department - April 15th, 2009
warehouse - inventory management

Key Ideas:

• There is a positive correlation between a company’s inventory management and its financial performance.

• This positive relationship becomes apparent when you consider three types of inventory: raw materials, partially manufactured products, and finished products.

• The strongest correlation between inventory levels and financial performance was observed for raw material stock, but this result varies depending on the industry. 

Vedran Capkun  ©HEC Paris

Vedran Capkun joined HEC Paris in 2006 and is a professor of accounting and management control. His research interests include financial accounting, operations management, (...)

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Companies like Dell and Toyota are considered masters in the art of minimizing inventory, and this skill has been credited with making them leaders in their respective markets. However, until now, no study has ever demonstrated a clear link between financial performance and operational speed. Vedran Capkun, Ari-Pekka Hameri, and Lawrence Weiss are the first to provide scientific insight on this topic. Their empirical study of American manufacturing companies shows a correlation between the levels of three types of inventory, gross profits, and operating profits.


OPERATIONS SPEED AND BUSINESS PERFORMANCE

Generally speaking, improving operational performance and, in particular, reducing the time between product manufacturing and market introduction requires improving processes throughout the supply chain. This means boosting total quality management, Just-in Time (JIT) processes, “zero waste” practices, lean management, etc. Many studies have shown that companies that focus on effective operations management win more market share, earn more profit, and produce higher quality products. Toyota’s adherence to this strategy made it a world leader in the automobile market, just ahead of General Motors.1 But does this prove that inventory management is related to financial performance?


INVENTORY MANAGEMENT AND FINANCIAL PERFORMANCE

Capkun, Hameri, and Weiss found a positive correlation between inventory management and operational gains. Even more significantly, they show that effective inventory management also leads to better financial performance, which they measured by considering gross and operating profits. The separation of inventory into categories shows that there are three types of inventory that influence financial performance: raw materials, partially manufactured products, and finished products. Degrees of correlation vary depending on the type of inventory and the financial performance reference.


DIFFERENT TYPES OF INVENTORY, DIFFERENT EFFECTS

Three types of inventory were considered to determine the root of the correlation between financial performance and inventory management quality.

• Raw materials: Management of raw material stock is most strongly related to financial performance, no matter how the latter is measured (gross profits or operating profits).

• Partially manufactured products: Strong correlation with gross profits.

• Finished products: Strong correlation with operating profits. The results of this study are consistent with the literature on operational management, which generally says that improvements in inventory management lead to significant value creation.


INDUSTRY SEGMENTATION AND VARIOUS CORRELATIONS

The study considers manufacturing companies in a range of industries. Individual analysis of each industry reveals that the impact of improved inventory management on profits varies from one industry to another:

• In assembly industries (i.e. automobiles, machinery, computers, etc.), financial performance is boosted by reductions of any type of inventory. Reducing inventories of partially manufactured products also reduces stocks of finished products, which enables companies to increase their responsiveness. This is especially true in industries that produce goods with short manufacturing cycles (electronics and, to a lesser extent, high tech goods).

• In consumer goods industries, inventories of (generally low-cost) raw materials and partially manufactured products do not have much of an impact on financial results. However, effective manufacturing processes lead to low inventories of finished products and generate high profits. This is also true in the fashion industry, where products that are introduced onto the market should be “consumed” rapidly. 


Based on an interview with Vedran Capkun and on the article, “On the Relationship between Inventory and Financial Performance in Manufacturing Companies” by Vedran Capkun, Ari-Pekka Hameri (HEC business school, University of Lausanne), and Lawrence A.Weiss (McDonough School of Business, Georgetown University). Forthcoming in the International Journal of Operations and Production Management.


1. In 2007, the Toyota Group manufactured 9.51 million automobiles, replacing General Motors (9.259 million automobiles) as the world leader in this market.

2. Number of companies per year multiplied by the number of years, equaling approximately 2000 companies per year

IMPLICATIONS
IMPLICATIONS

...FOR THE WORKPLACE 

In times of crisis, even small steps toward improving financial performance or cutting costs are worthwhile. Improving inventory management offers three main benefits:

• Greater production speed and thus increased sales;

• Savings on financing costs (equity capital or debt) that enable investment in new projects;

• Greater control over liquidity levels.

... FOR THE LEADERSHIP 

This study shows business managers why it is worth taking deliberate steps to reduce inventory. Practically speaking, it shows that the place to start is with raw materials, because inventory reductions in this area have the greatest impact on financial performance. 

METHODOLOGY
METHODOLOGY

The researchers studied 52,254 business years between 1980 and 2005.2

They used multiple regressions to determine the correlation between financial performance and various inventory levels. They measured:

• Financial performance: gross profits and operating results

• Inventory levels: raw materials, partially manufactured products, and finished products. Data was collected from the Compustat database.