Should inventory policy be lean or responsive? Evidence for US public companies

Using financial accounting panel data from the COMPUSTAT database for a representative sample of 722 manufacturing, retailing and wholesaling companies accounting for 30% of US business inventories, we develop a statistical methodology that links managerial decisions related to inventory with accounting returns. We find that superior earnings are associated with the speed of change/responsiveness in inventory management, after controlling for industryand firm-specific effects. Namely, we find that, in the pooled sample, inventory elasticity with respect to sales, lead times and sales uncertainty is consistently positively associated with both current and forwarded returns on assets. This result provides statistical evidence that public companies that are more responsive in inventory management are, on average, more profitable. Furthermore, we show that higher relative volatility of sales and longer lead times are negatively associated with profitability, due to difficulties in matching supply with demand. Surprisingly, we find no support for the “lean operations” principle: inventory levels alone do not have a significant and negative relation with current or future profitability. Our findings indicate the importance of matching supply with demand when (i) the environment is volatile and (ii) demand is nonstationary, such that responsiveness in inventory management matters more to profitability than do absolute inventory levels. 1 The authors are grateful to the Fishman-Davidson Center for Service and Operations Management at the Wharton School for financial support of this project, and to Manu Goyal, Kevin Hendricks, Richard Lai, Marvin Lieberman, Marcelo Olivares, Raj Rajagopalan, Taylor Randall and seminar participants at the 2005 INFORMS Annual Meeting in San Francisco for helpful comments.