Past research shows that inventory turnover varies substantially across firms as well as over time

Economical sciences/6. Marketing and Management

Yarmak T.M.

National University of Food Technologies, Kiev, Ukraine

The Firm Size Effect on Inventory Turnover Performance

Inventory turnover varies substantially across firms and over time. A significant portion of this variation can be explained by gross margin, capital intensity, and sales surprise. The effects of firm size were investigated. With respect to size, we find strong evidence of diminishing returns to scale. With respect to sales growth rate, we find that inventory turnover increases with sales growth rate, but its rate of increase depends on firm size and on whether sales growth rate is positive or negative. These results may be useful for managers to make aggregate-level inventory decisions by showing how inventory turnover changes with size and sales growth, for employing inventory turnover in performance analysis, for identifying the causes of performance differences among firms.

Inventory constitutes a significant fraction of the assets of a retail firm. Specifically, inventory is the largest asset on the balance sheet for 57% of publicly traded retailers in our dataset. The ratio of inventory to total assets averages 35.1% with buildings, property, and equipment (net) constituting the next largest asset at 31%. Moreover, the ratio of in ventory to current assets averages 58.4%. Inventory is not only large in dollar value but also critical to the performance of retailers. For example, according to Standard & Poor’s industry survey on general retailing, “Merchandise inventories are a retailer’s most important asset, even though buildings, property and equipment usually exceed inventory value in dollar terms.” Thus, the importance of improving inventory management in retail trade cannot be overemphasized.

The signals that managers and analysts use to determine how well a retailer is managing its inventory include inventory turnover (defined as the ratio of cost of goods sold to average inventory), inventory growth rate, and payables to inventory ratio. The statistics for these variables are publicly available from the financial statements of those retailers that are listed on the stock exchange (NYSE, AMEX or NASDAQ). Such data can be used to study a variety of research questions regarding the inventory productivity performance of each firm and of the retail sector as a whole.

The relationship between sales growth rate and inventory turnover is commonly tracked by managers and analysts. For example, the aforementioned industry survey on general retailing by Standard & Poor’s states that year-over-year growth in inventory should be in line with sales growth rate; if inventory growth exceeds sales growth rate, then it may be a warning that stores are over-stocked and vulnerable to markdowns. A case study presenting a hedge fund investor who uses the ratio of sales growth rate to inventory growth rate as one of the metrics in making investment decisions on retail stock was shown. The case presents several examples from financial performance of firms to illustrate this metric. It also makes a separate point that this relationship is ignored by financial investors. In this paper, we focus on examining evidence for the relationship of sales growth rate with inventory turnover, but do not assess its use by investors.

Arguments for inventory turnover to be positively correlated with size using the effects of economies of scale and scope were explained. Economies of scale and scope can manifest themselves for each item, or in a growth of number of stores, or in a growth of number of items at each retail location. In all three cases, it was expected inventory to increase less than linearly in sales, so that size and inventory turnover would be positively correlated. In the first case, if the mean demand for items at a retail location increases and the retailer maintains a fixed service level, then its safety stock requirement at the location increases less than proportionately because standard deviation of demand typically increases in the square root of mean demand. This relationship is precise when demand follows a Poisson distribution. For other distributions, this relationship has been tested by estimating the first two moments of the distribution. As another example, it was estimated the relationship among analysts’ forecasts of total sales of firms, actual sales realizations and standard deviation of total sales. Therefore, if safety stock increases less rapidly than cycle stock as sales increase, then inventory turnover should increase with the size of each location due to economies of scale. Second, inventory turnover should increase with sales when a retailer expands its geographical market by opening new retail locations which are served by existing warehouses or distribution centers. Thus, as a firm adds new retail locations, it can achieve a more than proportionate reduction in its inventory level, and a corresponding increase in inventory turnover due to economies of scale in its distribution network. Third, as a retailer grows in size, it is able to provide more frequent shipments to its stores due to economies of scale and/or economies of scope in fixed replenishment costs as explained by the EOQ model. For example, such economies of scale and scope can be realized in transportation costs through better utilization of labor and transportation capacity. They would result in an increase in inventory turnover with the size of the firm.

References:

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