Does Effective Inventory Management Improve Profitability?: Empirical Evidence from U.S. Manufacturing Industries

Does Effective Inventory Management Improve Profitability?: Empirical Evidence from U.S. Manufacturing Industries

Hojung Shin (Department of LSOM, Korea University, Seoul, Korea), Charles C. Wood (Department of Information Systems Management, Duquesne University, Pittsburgh, PA, USA) and Minjoon Jun (Department of Management (MSC 3DJ), New Mexico State University, Las Cruces, NM, USA)
DOI: 10.4018/IJISSCM.2016070102
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Abstract

The present research investigates the effect of inventory performance on profitability. The objective is to find empirical evidence for the theory that operational excellence in inventory management improves profitability in the long run. To this end, the authors examine industry level longitudinal data (14 manufacturing industries at the SIC two-digit level) over the 1958-1999 period by employing a series of hierarchical regression analyses. The statistical results confirm that a lower inventory level measured as the industry inventory-to-sales ratio has a positive effect on industry profitability measured as the profit-to-sales ratio. This evidence is found significant in 9 out of the 14 U.S. manufacturing industries. This study also reveals that not all the inventories, categorized by stage of fabrication, equally contribute to improving industry profitability. For instance, the profitability of the primary and fabricated metal industries has benefited from reductions in finished goods inventories, whereas that of the petroleum and coal products industry has been affected mainly by declines in work-in-process inventories.
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Introduction

Does a firm’s excellence in operations management improve the financial performance of the firm? In fact, there are a vast amount of anecdotal evidence and numerous case studies that have led to an underlying management belief that operational efficiency is indeed a prerequisite for a firm’s long-term competitive advantage, survival, and profitability (e.g., Ahire & Dreyfus, 2000; Camacho-Minano, Moyano-Fuentes, & Sacristan-Diaz, 2013; Flynn, Sakakibara, & Schroeder, 1995; Kuruppuarachchi & Perera, 2010). Accordingly, companies have adopted and implemented diverse organizational performance improvement programs, such as six-sigma and lean manufacturing, for decades.

In academia, establishing empirical evidence for the positive relationship between a firm’s operational performance and its financial performance has long become an important research issue, but the findings of the extant literature have all been mixed (Camacho-Miñano et al., 2013). Fullerton, McWatters, and Fawson (2003) examine the relationship between JIT and financial performance, and find that despite the abundant information regarding the expected benefits of a successful JIT implementation, there exists only tenuous validation of the linkage between these two constructs. Fullerton et al. (2003) further suggest that the implementation of a greater degree of JIT practices has decreased (rather than increased) most of the sample firms’ profitability.

It is even more surprising that little research has been conducted to empirically validate the conventional wisdom that a firm’s efficient inventory management leads to its financial performance improvement. There are some possible explanations for the scant empirical research connecting inventory performance with profitability. For instance, superior inventory management epitomized by Toyota and Wal-Mart has long been considered a core competence in the operations management (OM) and supply chain management (SCM) literature. Because of these successful cases, researchers might have assumed without doubt that enhanced inventory efficiency would directly and positively lead to profitability.

A more plausible explanation would be associated with technical and practical challenges in data collection because it usually takes a considerable amount of time and cost to gather longitudinal data on inventory and profitability at the firm level (Capkun, Hameri, & Weiss, 2009). In fact, most of the empirical studies on inventory performance have used cross-sectional survey data (Ketokivi & Schroeder, 2004; Rungtusanatham, Choi, Hollingworth, Wu, & Forza, 2003) and failed to focus on the long-term financial impact of inventory performance. Acknowledging such methodological limitations in the extant literature, we attempt to empirically investigate the effect of inventory performance on financial performance based on longitudinal economic data. To this end, we analyze industry level archival data from 1958 to 1999 for 14 manufacturing industries (the SIC two-digit level) in the U.S. The sources of the data are the U.S. Census Bureau and the Bureau of Economic Analysis (BEA).

Inventory performance in each industry is scaled as the industry’s raw materials-to-sales, work in process-to-sales, finished goods-to-sales, and total inventory-to-sales ratios. Financial performance is measured as the industry’s profit-to-sales ratio (profitability). Hierarchical regression is chosen as a primary research vehicle to analyze these ratio scales. Note that our focus is not on creating a regression model with precise predictability. Rather, this research is intended to find the industry level empirical evidence to support the theory that operational excellence surrogated by inventory performance improvements ultimately enhances financial performance (profitability).

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