The Relationship Between Inventory Management And Profitability

Published Date: 02 Nov 2017

A significant number of academic and industrial researches have been carried out in relation to the presence of an existing link or otherwise between inventory management and profitability as assessed from different views.

According to Coyle et al (2003), changes in inventory levels have an impact on return on assets (ROA); thus, reduction in inventory usually improves ROA, which is a positive indicator of performance for current and potential investors. They continued that when sales decline, inventory levels often increase, which has a double-edged effect on profits, thus higher inventory holding cost as well as negative impact (decrease) in ROA.

Notably however, the financial success of the many evaluated firms in academia and industry is often credited to their ability to decrease inventory levels (increase inventory turns), whilst admitting that unreasonably low inventories can be as damaging to a firm’s profitability as unreasonably high inventories, and attempts to link absolute inventory levels to the stock price have had limited success (Chen et al. 2005a, 2005b, Lai 2005). Suffice to say therefore that there are mixed and some admittedly paradoxical evidence to the claim that inventory management is associated with financial performance.

In view of the limited understanding of the connection between inventory management and financial performance, only a few analysts and fund managers use inventories to predict/explain superior accounting returns. A rare exception is David Berman, a hedge fund manager who is cited in (Raman et al. 2005) as arguing strongly that the financial and stock performance of public retailing companies can best be predicted by analyzing the joint dynamics of inventory and sales and not merely by looking at the conventional operational metrics such as margins and inventory turns.

Abdulraheem et al. (2011) on a narrower study on inventory management in small business finance; sought to assess the impact of inventory management on selected small businesses in Kwara State, Nigeria. Based on an analysis of secondary data on selected small businesses spanning a 10 year period, they tested the relationship between inventory management and performance-based profitability of the selected small businesses. They reported a positive relationship between inventory level and profitability of small businesses; where the profitability of small businesses increased with the employment of effective inventory management. This finding agreed with the discovery of Grablowsky (1976) about the existence of a significant relationship between various success measures and the adoption of inventory management policies. Abdulraheem et al. (2011) thus concluded that small businesses were likely to generate higher profit if they put an effective inventory management system in place.

In a related survey, Dimitrios (2008) undertook a study in Greece to test the hypothesis that efficient (lean) inventory management leads to an improvement in a firm's financial performance. His sample period covered three years and spanned the three representative industrial sectors in Greece; food, textiles and chemicals. His preliminary results revealed that the higher the level of inventories preserved (departing from lean operations) by a firm, the lower its rate of returns. He further tested the findings by the use of pseudo-likelihood ratio test to verify the robustness of the linearity of the relationship and hit the limitation/implication that, it was difficult to isolate the effect of inventories even by using large samples and advanced methodologies given the great number of possible determinants of performance.

Also, Eroglu Cuneyt and Hofer Christian (2011) conducted a study in the US on Inventory Types and Firm Performance. The study, with its setting in the manufacturing sector noted that the effects of inventory management on firm performance, though well documented, had focused on the performance effects of total inventories and ignored the potentially deferential performance effects of raw materials, work-in-process, and finished goods inventories. Their research therefore investigated the effects of various inventory types on firm performance. The empirical analyses of data from US manufacturing industries revealed that the magnitude of the inventory–performance relationship varied by type of inventory and across industries. Their key finding was that raw materials inventories had a greater impact on firm performance than work-in-process and finished goods inventories. Their results posited that raw materials and finished goods inventories asymmetrically affect each other over time.

They also argued that inventory leanness is the best inventory management tool as it positively affects profit margins. Their study also found that the effect of inventory leanness on firm performance was mostly positive and generally non-linear and also implied that the effect of inventory leanness is concave; in line with inventory control theory that, there is an optimal degree of inventory leanness beyond which the marginal effect of leanness on financial performance becomes negative.

Salawati Sahari, Michael Tinggi and Norlina Kadri (2012) also in their study on the impact of inventory management on the performance of malaysian construction firms observed that; managers act rationally in managing their inventory efficiently if they are convinced that the practice enhances firm performance. Their finding was that inventory management was positively correlated with firm performance and that there was a positive relationship between inventory management and capital intensity.

Aghazadeh (2009) presented a correlation between company’s annual inventory turnover and its performance in the retail industry. Using an empirical model, the author found that future stock performance could be predicted by an indicator, which is the variance of annual inventory turnover of the firms. Having analysed the inventory turnover of various firms in different segments, the author concluded that if managers were able to control inventory turnover, both the firm’s stock performance and management quality would be affected positively.

Gaur et al. (2005) also in an interesting twist analyzed inventory turnover performance in the retail industry in view of the correlation of inventory turnover with gross margin; capital intensity and sales surprise are investigated. They developed several empirical models to test and strengthen their hypotheses and reported that inventory turnover was negatively correlated with the gross margin, positively correlated with the capital intensity with some exceptions, and positively correlated with the sales surprise. They found that inventory turnover in the retailing industry declined from 1985-2000.

By extension to the study of the Gaur et al. (2005), Gaur and Kesavan (2007) observed the impact of firm size and sales growth rate on inventory turnover performance in retail industry and found that inventory turnover was positively correlated with sales growth rate and growth rate was also correlated with firm size. They re-tested the hypotheses in Gaur et al. (2005) with a larger and recent data set, and further obtained consistent results with Gaur et al. (2005), demonstrating that inventory turnover was negatively correlated with gross margin, positively correlated with capital intensity, and positively correlated with sales surprise.

On the other hand, a study by Cannon (2008) introduced contradictory findings. That study focused on assessing the relationship between inventory performance and overall firm performance and argued that inventory performance should not be measured as a robust indicator of overall performance. Their study tested the incorporation of the firm’s annual percentage change in inventory turnover as a measurement for inventory management towards return on assets (ROA) as a measurement of performance. The study indicated that when the effects of time were taken into account, turnover improvement on average had a slightly negative effect on ROA. Additionally, they posited that turnover improvement exhibited a prominent random effect, with result indicating that approximately 95% of the firm’s turnover-improvement slopes would fall within a negative range. This meant that substantial variability existed across firms with regard to turnover improvement and its resultant performance effects, with some turnover improvement resulting in increased ROA and other turnover improvement decreasing ROA. (Cannon, 2008) further explored the turnover-ROA dynamic by introducing capital intensity as a potential source of variability. It was found that capital-intensive firms tended to be below average with regard to ROA and the variable’s presence in the model did not significantly alter the relationship between turnover improvement and ROA over time. This therefore lent additional weight to the conclusion not to support the hypothesis that improved inventory performance will be associated with improved overall firm performance.

In conclusion, a review of the literature confirms that although several prominent companies have created business value through successful supply chain management (e.g., Dell, Amazon.com, Wal-Mart and Zara; see Cachon and Terwiesch 2005), it is not immediately obvious whether the financial success of these companies can be in full or in part attributed to their ability to manage inventories. This is especially because the financial success of these and other companies is often attributed only to their ability to decrease inventory levels (increase inventory turns).