Inventory Write-downs, Sales Growth, and Ordering Policy: An Empirical Investigation

If the market value of inventory declines below its original cost, for reasons such as damage or obsolescence, under U.S. Generally Accepted Accounting Principles a company should write it down to the new market value and recognize a loss. This paper uses publicly available data to conduct an empirical investigation of 290 firms, which experienced a first-time inventory writedown of more than 1% of average total assets between the years 2002 and 2004. The average inventory write-down in our sample is $13.2 million, which represents 3.7% of a firm’s average total assets. We show that these write-downs are associated with a severe negative impact on firms’ operating performance: The mean firm in our sample experiences a -15.4% return on assets in the year of an inventory write-down and a -21.6% market-adjusted return. We also examine the relationships between sales growth, purchasing policies, and inventory writedowns. Empirical evidence suggests that extreme sales growth firms are significantly more likely to experience a future inventory write-down than moderately growing firms. We find that, on average, all growing firms purchase more inventory than they sell, i.e., responding to growth, they tend to build up stock. The extreme sales growth firms, however, purchase less inventory than their moderately growing counterparts, indicating that these firms may be aware of the heightened risk of write-downs, which thus far has not been explicitly considered in the inventory literature. In addition, we find that extreme sales growth firms with write-downs build up more stock than extreme sales growth firms without write-downs. However, we do not find evidence of exuberant inventory purchases among these firms: In fact, inventory policy of an average extreme growth firm with write-downs is statistically indistinguishable from that of a firm experiencing only moderate or no sales growth. Future research may explore whether inventory policies used by moderately growing firms are inappropriate for extreme growth firms. This may lead to useful heuristics that would function well in a non-stationary demand environment with stochastic holding cost.