Manager Incentives for Channel Stuffing with Market-based Compensation1

We study an extension of a two-period inventory management problem with positively correlated demands in which the manager’s compensation is partially based on an external, market-based assessment of the firm’s value. As typically the “real” demand is only observed internally in the firm, the manager may ship more than the real demand to downstream customers and report higher than real sales revenues to influence the external firm valuation, which is known as “channel stuffing.” As it is costly and does not reflect the real demand, channel stuffing destroys the firm’s value. We identify three factors that drive the manager’s incentives for channel stuffing: the marginal effect, the boundary effect and the carryover effect. The marginal effect, analogous to those earnings management incentives revealed in the literature (e.g., Stein, 1989), is independent of the inventory problem, while the boundary and carryover effects arise from the nature of the inventory problem. The boundary effect occurs when the real demand realization is high, but, still less than the available inventory: reporting a “sold out” situation censors the upper tail of the demand distribution, and hence, leads to an increase in market valuation that the manager would like to cash in with channel stuffing. The carryover effect occurs when the real demand realization is low. In this scenario, channel stuffing would make the firm’s future performance look more rosy because of positively correlated future demand and high future sales margin as the firm will be able to satisfy the future demand from the large current inventory. When examining the initial inventory decision, we find that under rational market valuation, both overand under-investment may arise in presence of channel stuffing incentives. Based on our model analysis, we derive empirically testable hypotheses for channel stuffing.