Magazine article Economic Review

Evidence of Improved Inventory Control

Magazine article Economic Review

Evidence of Improved Inventory Control

Article excerpt

The advent of the computer and changes in business management techniques are commonly believed to have improved inventory control. As evidence of such improvement, most analysts cite the decline in the ratio of inventories to sales in manufacturing. But improved inventory control implies a faster adjustment of inventories to changes in sales as well as a decline in the average ratio of inventories to sales. Moreover, there are other goods-stocking sectors to consider besides manufacturing.

Most economists who relate inventory behavior to the business cycle seem to take for granted that because aggregate inventory-sales ratios have declined in the last decade, inventory cycles have become much smaller. For example, one economist noted that the recent recession "was remarkable for the almost total absence of a recognizable inventory cycle, so far as one can judge from the behavior of aggregate inventory-sales ratios italics added!."(1) The effect of higher speeds of adjustment on inventory investment would, however, tend to offset that of lower inventory-sales ratios in evaluating changes in the size of inventory cycles. Thus, contrary to widely held opinion, improved inventory control can result in increased, rather than reduced, volatility in inventory investment.(2)

The question of whether inventory control has improved is an empirical one whose resolution is the primary purpose of this article. The resolution has important implications for the business cycle because recessions largely turn on the behavior of inventory adjustments.

In the following sections, we first review a popular model of investment that is often used in studies of inventory investment. We then use a basic form of this model to test the hypothesis of improved inventory control. Our objective is to focus on possible changes in parameters from one period of time to another, not to refine existing models or to add to the existing theory on inventory behavior.(3)

Our findings provide clear evidence of improved inventory control in manufacturing, both in finished goods stocks and in inventories of materials and supplies and work in progress. For retail and wholesale trade, our results are mixed.

Finally, we seek to determine empirically what effect these refinements have had on inventory investment volatility. Our findings show that, contrary to popular belief, investment volatility has increased in both the manufacturing and trade sectors.

A MODEL OF INVENTORY INVESTMENT

In the following discussion, we use a standard partial stock-adjustment model, first presented in Lovell (1961), to test the hypothesis of improved inventory control. In this model, the amount of inventory investment that takes place in a given period, II sub t , is the sum of desired, or planned, inventory investment and unanticipated inventory investment. Desired inventory investment during any period t is a fraction s of the difference between the actual stock of inventories KI at the end of the previous period and the desired stock KI sup d at the end of the current period. In addition, if firms use inventories as a buffer against unexpected demand shocks, any deviation of sales from expected sales will result in unintended inventory investment.

(equation 1 omitted)

where S sub t is sales and (symbol omitted) is expected sales. The variable s is commonly referred to as the "speed-of-adjustment" parameter because s determines how fast a given gap between actual and desired inventory levels is closed.(4) The variable c measures the extent to which inventories serve as a "buffer stock" against unexpected changes in sales.

We assume that the expected level of sales S sup e in period t + 1 determines the desired stock of inventories for the end of period t (i.e., going into period t + 1):

(equation 2 omitted)

The coefficient i measures the change in desired inventories accompanying a unit change in expected sales. …

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