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The theory of inventory (MIS) management
In the white-goods industry, inventories lag a year behind sales. Why does management miss so badly in inventory control?
the THEORY of INVENTORY
(MIS) MANAGEMENT
ROCCO CARZO, JR.
USINESS inventories are a chronic sore spot for both the decision-maker and the general economist analyzing the problem of economie stability. Inventory management is peculiarly frustrating for the businessman because his commodity stoeks are never really under control; their level depends not only on how much he produces or buys but on how much he sells. And the economist sees fluctuations in inventories as the most frequent and intractable source of general swings in business activity. The American economy has suffered three minor recessions since World War 11-1948-49, 1953-54, and the one now in progress. All three lhave been called "inventory recessions." The label is not appropriate in each ease, but
B
108
inventory behavior does figure in all such problems. The role of inventories in business cycles has been described by Lloyd A. Metzler in a notable theory. 1 In his explanation of the short eycle (the inventory cycle), Metzler assumes that businessmen attempt to maintain a constant normal relationship of inventories to sales. Structural (not speculative) inventory cycles, according to the theory, result from the faet that output tends to lag behind changes in demand. Metzler assumes that the length of this lag is approximately one-fourth of an entire short cycle or about six months. The lag causes inventory levels to become abnormal in relation to sales; thereafter, output will be 1 Lloyd A. Metzler, "Nature and Stability of Inventory Cycles,'" Review of Economic Statistics, xxlii (August, 1941); "Business Cycles and the Modern Theory of Employment," American Economic Review, xxxvi (June, 1946); and "Factors Governing the Length of Inventory Cycles," Review of Economic Statistics, XXlX (February, i947).
104
BUSINESS HORIZONS
changed not only to meet changed demand but to restore the normal relationship of inventories to sales. The efforts of businessmen to change output causes further changes in income and subsequent changes in consumer and business expenditures. Thus, Metzler's model is one that involves self-generation. To be more specific, suppose that income and expenditures increase. Inventories will decline because producers are unable to increase output enough to meet the increase in demand. Thereafter, businessmen will increase production not only to meet the larger demand but also to restore inventories to their normal level. Attempts to meet the new demand and replace stocks cause income to rise further; demand also rises, and stocks remain abnormally low. As long as inventories are below the normal level, income will accumulate. Income will reach its peak when inventories have finally accumulated to the normal level. Thus, Metzler's model is one that involves self-generation. T h e reversal of business activity is described as follows: "As income rises, inventories also rise, and this process continues until a normal relation between inventories and expected sales is established. Thereafter businessmen plan no. further increases in stocks; they attempt instead, to. produee only w h a t they expect to sell. Since production plans in earlier periods included production for stocks as well as for sale, the decision to produce only for sale means an absolute decline in total output. As a result, income in the hands of consumers declines, sales are reduced, and a period of general contraction develops. The contraction is accelerated b y the fact that sales fall below expectations, since this causes inventories to become abnormally large and businessmen therefore reduce output still further in an attempt to restore their stocks to a normal level."2
As inventories are reduced to the normal level, income will begin to rise because businessmen have ceased producing less than they sell. Thus, the self-generating cycle repeats itself. There is much evidence to support the view that inventories are a major factor in economic fuctuations. Moses Abramovitz, in a study of five business cycles identified by the National Bureau of Economic Research for the years "'Business Cycles and the Modern Theory of Employment," p. 288.
1919-38, established the fact that inventory investment-on an average-constituted 23 per cent of the change in total output during expansions, 47 per cent for contractions, and 32 per cent for full business cycles. He concluded that, on the average, a considerable portion of the cyclical changes in total output has been in the form of a change in the volume of goods added to or withdrawn from stocks. Also-and most important-"inventory investment, in terms of violence of fluctuation, is the most volatile of the main components of output. ''3 Inventory change has also been of great importance during the time since the Abramoritz study. As shown in Table 1, the four quarters of 1948 were characterized by inventory accumulation; during the last quarter, GNP reached a high for the year. From inventory accumulation, the 1949 downturn witnessed inventory liquidation, speeded by impact of a steel strike, and a decline in GNP in the fourth quarter. Thus, while GNP was declining by $8.5 billion from the fourth quarter of 1948 to the fourth quarter of 1949, inventory investment was declining by $8.7 billion. The shift in inventory investment represented more than the entire contraction in national output. The 1953-54 recession was marked primarily by a decline in defense outlays, but inventory investment still played an important part in the fluctuation. * Table 1 reveals that GNP declined by $8.0 billion from the second quarter of 1953 to the third quarter of 1954. Inven3 Moses Abramovitz, Inventories and Business Cycles (New York: National Bureau of Economic ReSearch, 1950), pp. 5-8. 4 In periods of business recovery, inventory change plays a lesser but still important role. GNP increased $50.2 billion from the second quarter of 1950 to the second quarter of 1951. This large increase resulted from both Korean defense expenditures and rising prices. The inventory investment rate in the second quarter of 1950 was more than doubled in the final quarter of 1950, and increased still more in the second quarter of 1951. The total change in inventories, a measurement of recovery, from the third quarter of 1954, a period of inventory liquidation, to the second quarter of 1955, a period of inventory accumulation, amounted to $9.1 billion. The c~P gain in this period came to $28.3 billion. Measured from the third quarter of 1954 to the fourth quarter of 1955, GNP increased $43.4 billion, and inventory increased $10.8 billion.
THE THEORY OF INVENTORY (MIS)MANAGEMENT
105
TABLE 1
Periods (in quarters)
1948 I II III IV 1949 I II III IV
G r o s s N a t i o n a l P r o d u c t a n d I n v e n t o r y I n v e s t m e n t 1948-58 (Seasonally adjusted at annual rates) aNP InventoryInvestment Periods GNe InventoryInvestment (billions of dollars)
(billions of dollars)
$247.9 255.5 261.9 264.0
$ 2.6 2.9 2.9 3.6
259.9 257.2 256.5 255.5
0.9 --2.0 -- 1.3 --5.1
264.9 275.9 294.4 305.0
2.6 6.3 3.5 13.3
1950 I II III IV 1951 I II III IV 1952 I II III IV
319.3 326.1 331.3 336.3
11.8 15.5 9.9 4.2
338.4 339.9 345.0 357.6
2.7 --2.1 3.5 6.9
(in quarters)
(billions of dollars)
(billions of dollars)
361.6 367.4 366.3 357.5
2.0 3.1 1.1 --5.2
357.6 358.5 359.4 367.1
--3.1 --1.7 --4.5 0.2
379.0 387.7 397.0 402.8
2.7 4.6 3.3 6.3
405.2 410.8 416.7 426.0
5.2 4.6 3.3 5.1
429.9 435.5 440.0 432.6
-0.3 2.2 2.3 --2.7
422.0
-9.0
1953 I II III IV 1954 I II III IV 1955 I II III IV 1956 I II III IV 1957 I II III IV 1958 I
Sov~tcn: G~-P figures and inventory investment changes for 1948-57 from the ANNUAL llEVIEV¢" NU?cIBEtt, SVaV~Y Or C U ~ N T BVSIN~SS, U.S. Department of Commerce (Washington: Gov't Printing Office), 1949-58 issues. Data for the first quarter of 1958 are from the May issue of the s v a v E v .
tory investment shifted d o w n w a r d b y $7.6 billion; almost all of the decline was in national output. In the most recent recessionary period, GNP declined b y $7.4 billion and inventory investment b y $5.0 billion from the third quarter to the fourth quarter of 1957. From the third quarter of 1957 to the first quarter of 1958, CNP shifted d o w n w a r d b y $18 billion, while inventory investment declined by $11.3billion.
tory decision-making praetices with extant theories of inventory management, the study was concentrated on selected firms of the home laundry manufacturers' industry. The businesses studied were: F R I G I D A I R E DIVISION O F G E N E R A L M O T O R S , Dayton, Ohio
GENERALELECTRICCOMPANY,New York and Louisville, Kentucky H O T P O I N T DIVISION O F G E N E R A L E L E C T R I C , Chicago, Illinois NORGE
A STUDY
OF ONE INDUSTRY
DIVISION
OF
BORG-WARNER
PHILCO CORPORATION,
Philadelphia, Pennsylvania
THE MAYTAG COMPANY,
For better understanding of the reasons underlying aggregative inventory behavior and to establish a basis for comparing existing inven-
CORPORATION,
Chicago, Illinois
Newton, Iowa
W E S T I N G H O U S E E L E C T R I C CORPORATION~
Pittsburgh,
Pennsylvania, and Mansfield, Ohio W H I R L P O O L C O R P O R A T I O N , S t . Joseph, Michigan
106
BUSINESS
HORIZONS
FIGURE 1
Factory Sales and Inventories for Washing Machines, Home Laundry Manufacturers' Industry (Seasonally adjusted)
o'J I..-
Z 14.
500
0
oo
Q Z 03 0 "r I--
400
• Shipments 300
"~
/~ a f) / .
~/
j LI'~[ L I
"-,,
[ ~.P"aJv
200
I00
y
~ 51
S o m e Basic Characteristics
Inventory
52
53
It is clear that washing machine manufacturers' finished stocks (in units ) tend to move inversely to shipments of machines ( in units ). Factory shipments began the downturn in January, 1953, and reached the lowest point in December, 1953. Finished stocks continued to rise throughout the contraction, reaching a peak (January, 1954) a month after sales touched the bottom of the trough. In 1954, sales started to recover in January and continued to expand until mid-1955. In other words, finished inventories did not turn downward until sales started upward. Liquidation of finished goods stocks continued throughout the period of recovery, except for a brief period in late 1954.
54
55
SOURCE: Constructed from data obtained from author's research.
Certainly no valid refutation or substantiation of the theory could be achieved in a study of this size. However, it is believed that the inventory practices of these firms are representative of a wide range of business; observations that are applicable to all manufacturers of consumer durables are thereby permitted. Since the sales and inventories of these firms represent virtually all of the total in the home laundry manufacturing industry, generalizations at least can be drawn for this area. Since the study of inventories is important insofar as they affect the output decisions of entrepreneurs, the classification that received most emphasis was the finished goods inventory. Accordingly, this analysis pays particular attention to finished stocks. I n d u s t r y Statistics
Industry statistics for inventories and sales were available only for the period 1950-56• These data, plotted in Figure 1 for the years 1951 through 1955, are significant because they embrace the recession of that period.
Before analyzing and comparing industry sales and inventory behavior with the theory, it is first necessary to review some basic characteristics of the industry and establish the reasons for maintenance of inventories. These firms are characterized by repetitiveprocess manufacturing with assembly-line operations. Products are made in expectation of customers' orders. Finished stocks are needed in this type of operation because rates of produetion do not and cannot exactly match rates of sales. Like any enterprise that delivers goods upon demand, producers of home laundry equipment rely on finished goods inventories to reconcile unavoidable discrepancies between output and demand. In fact, this is one of the ways in which they compete. Factories and channels of distribution in the industry, because of the competitive aspects of the market, are forced to maintain goods ready to meet demand; "stoekouts" usually mean lost business, Another basic consideration in finished goods inventory decision-making is that produetion scheduling is circumscribed by the relatively fixed capacity of each firm for the planning period and by lead-time considerations. The costs of revising the master production schedule are prohibitive for a certain portion of each future scheduling period. There has to be time to design the product, set up
THE THEORY OF INVENTORY (MIS)MANAGEMENT
107
the facilities for manufacture, determine manufaeturing and purchasing requirements, purchase materials, manufacture, and assemble and test the product. There is also the unpredictable element of bottlenecks, such as machine breakdowns and the inability of some work stations to maintain peak loads for extended periods of time, that arise with changing levels of production.
which vary with the company's degree of employment stability. Other reasons for maintaining finished stocks at factories or warehouses include the neeessity to provide for sizable orders that may be placed by channels of distribution. In addition, manufacturers in the home laundry industry find it necessary to maintain finished stocks to meet demand in models and colors.
Accordingly, all the firms studied attempt to smooth out production-that is, to cushion the effects of predictable and unpredictable changes in consumer demand rather than change production rates and employment. Their attempt here seeks to minimize total costs by balancing the costs of changing produetion rates against the eosts of carrying finished stocks.
The Inventory Decision-making Process
Two different sets of cost factors must be considered in this effort-those that increase as inventories increase and those that decrease as inventories increase. The costs that increase are the costs of carrying finished goods inventories, sueh as interest on investment, obsolescence, risk, depreciation, storage, and taxes. The costs that decrease as finished goods inventories are increased are the costs of changing production rates. These result from hiring and laying off workmen. With increased production, new men have to be trained. Their productivity is low, relative to that of other workmen. Labor contracts with seniority provisions require that workers having longer tenure with the company be given the opportunity to bid on new jobs. These same provisions also require that workers with tenure advantage have opportunity to take available jobs in times of furlough or layoffs. Thus, the changing of production rates means shuffling job assignments; it is obvious that this "chainbumping" of workers can become quite costly to management. Changing production rates also may involve the costs of changing commitments to suppliers, such as cancellation charges levied with decreased schedules or inereased tooling and material eosts to meet increased schedules, Also, there are the costs of state unemployment compensation insurance premiums,
Although the considerations presented above seem definitive, it must be emphasized that the companies studied exercise a great deal of subjective judgment, based on past experience, in making decisions about the level of finished goods inventories. Evidence of a lack of objectivity may be gleaned from the fact that the firms all operating under similar conditions have different ideas as to the most desirable level of inventories. Of the eight companies, two desired an eight-weeks' supply of projected sales; one, a six-weeks' supply; four, a four-weeks' supply; and one, a two-weeks' supply. As expected, the companies seek a certain return on investment and on sales for the manufaeture and sale of home appliances; they plan their operations to attain the desired returns. The sales forecast, basis for the planning of all company operations, provides guides for formulation of sales strategy, production planning, and financial management. Planned ending stocks of finished goods are usually determined by marketing executives. Their judgment is generally considered as the best informed of what is the most desirable level of finished stocks to service requirements of a succeeding period. It is standard practice in all the firms to measure finished goods inventories in terms of projected sales. In fact, inventory levels of finished goods are usually stated as a normal relationship in number of weeks supply or as a multiple of a succeeding period's sales. The planned level of ending inventories, as established by marketing executives, serves as a norm for determining requirements throughout the planning period. This norm is used as a guide in the firms studied, especially
108
BUSINESS HORIZONS
in financial planning, where it is considered a condition of estimated sales. However, the norm is not applied as a rigid requirement in planning production operations for the program period. Adjustments are made to this planned level of finished stocks to permit production leveling throughout the planning period, using inventories to cushion the effects of fluctuating sales.
INVENTORY
MISMANAGEMENT --AND WHY
How do these findings compare with the theory? As indicated, the research revealed that output did lag behind changes in demand. However, the theory assumed a one-quarter cycle lag of inventories behind sales; but, as shown in Figure 1, washing machine stocks for firms of the home laundry manufacturers' industry evidenced a half-cycle or about a year lag behind shipments. Does this finding indicate that inventory policy in this industry does not share the objective that theory attributes to decision-makers-namely, to keep inventories in a normal relationship to sales? It certainly is not healthy for the industry, the firms within the industry, or the economy to bear the burden of excessive inventories. The failure to maintain some normal relationship has been costly to all concerned, especially in terms of stability, because the long lag eventually causes more violent fluctuations in output than would otherwise be necessary. The executives interviewed do desire and do attempt to maintain a normal relation of inventories to sales, just as the theory suggests. However, the industry statistics show either that they are not very successful in this endeavor or that inventory policy fails to achieve desired objectives• Can the long lag be explained? Why do intelligent and skillful managers in this highly developed industry miss so badly in their inventory goals?
Overoptimism All the companies, in one manner or another, attempt to manipulate demand through prod-
uct, price, and sales promotion changes. While they cannot be criticized for this, they too often continue their efforts beyond the point of stimulation and will not readily accept a decline in sales as final. Instead of reducing production to permit adjustments of inventories to the lower sales level, the home laundry manufacturers first attempt demand manipulation. In other words, appliance manufacturers appear to be optimists. The current optimism is due in part to such postwar achievements as these: " . . . In the period 1946 through 1957, dealers have placed 365-million major appliances, TV and radio units into consumers' hands. Of products that were Virtually nonexistent before the war, the industry has supplied the nation's homes with-roughly 44-million automatic washers, 59million TV sets, 9-million home freezers, 8million clothes dryers, 8-million air conditioners, 4-million garbage disposers, 3-million ironers, and 2.6-million dishwashers. •
~' 5
Poor Forecasting Another reason for the long lag is the inadequate forecasting techniques used by manufacturers. It was found that the firms, lacking objective forecasting techniques, rely heavily on the level and trend of past sales as barometers for estimating future sales. These estimates are usually altered to include a consideration of each firm's belief in its ability to manipulate demand. In short, rosy forecasts and a state of overoptimism have characterized the appliance industry during the postwar period and have resulted in excessive inventories for long periods of time.
Poor Communications The lag may be explained, in part, by the fact that most of the home laundry manufacturers are poorly informed about activity in channels of distribution. Although all the firms use warranty card returns as an indication of retail sales, few use them intensively for market 5 "1957 Appliance Sales Sag in a Tough, Competitive Yeax," Business Week (January 4, 1958), tx 79.
THE THEORY OF INVENTORY ( MIS ) MANAGEMENT
analysis, and only three of the eight use the returns as an aid in short-term forecasting. Executives pointed to the poor percentage of returns and the expense involved in compiling required information as reasons for not using the cards. As one executive put it, "In this business, we could get as much information as we wanted, even to the extent of sending researchers around to each consumer. But it is too costly. We feel that we can do just as good a job by projecting short-term sales from the data received from distributors." In other words, the expense, time, and effort involved outweigh the advantages to be gained from the information that would be obtained. When this point of view was expressed to an executive of a firm that used the warranty card approach for estimating retail sales, he charged that it has been this shortsightedness that has caused the excessive inventories and chaotic price situation characteristic of the home laundry appliance industry. The value of keeping track of current changes in retail sales forecasting is made clear by the hypothetical example presented in Table 2; inventories play an important role. (The example assumes that retailers, wholesalers, and manufacturers attempt to maintain a normal level of inventories in relation to projected sales, which is in accord with the reasoning of the inventory cycle theory and the findings of this study. The example assumes also that they are successful in maintaining this normal relationship, which is not in accord with either the theory or reality. ) Dealers' projected monthly sales are 7,000 units. The dealers' efforts to maintain a sixweeks' supply of inventories are successful (estimated monthly sales of 7,000 units divided by four [weeks] equals about 1,700 units per week; for a six-weeks' supply, about 10,000 units are needed ). The wholesalers' efforts to maintain a six-weeks' supply of inventory are successful (again, about 10,000 units ). The manufacturers' efforts to maintain a two-weeks' supply of inventories are successful (estimated monthly sales to wholesalers of 7,000 units plus 1,000 units in transit, or 8,000
109
units, divided by four [weeks] equals 2,000 units per week; a two-weeks' supply amounts to 4,000 units). The effect of an unexpected 10 per cent decline in retail sales becomes obvious. This decline will prompt dealers to liquidate inventories to the desired level of projected sales; they will not only reduce their purchases from distributors to compensate for decreased sales but also permit liquidation of inventories to the desired level of projected sales. Thus, their purchases will represent an 18 per cent reduction in the distributors' projected sales to dealers. Distributors will reduce their purchases from the factory not only to compensate for reduced sales but also to permit.liquidation of inventories to the desired level of TABLE 2
Hypothetical Example of Influence of Stocks and Sales Fluctuations on Production (In physical units) Normal Production, Sales, and Inventories
Retail ending inventory ( six-weeks' supply desired ) Projected monthly retail sales Dealer purchases Total available Wholesale ending inventory ( six-weeks' supply desired ) Projected monthly distributor sales Distributor purchases Total available In transit inventories Factory ending inventory (two-weeks' supply desired ) Projected monthly factory sales Factory production Total available SotrrtcE: Author's
illustration.
Projected 10 Per Cent Decrease of Retail Sales
10,000
9,450
7,000 7,000 17,000
6,300 5,750 15,200
10,000
8,622
7,000 7,000 17,000 1,000
5,750 4,372 12,994 1,000
4,000
2, !86
8,000 8,000 12,000
4,372 2,558 4,744
110
BUSINESS HORIZONS
projected sales. Thus, their purchases from the factory will represent a 45 per cent decline in factory shipmentsJ Following the same reasoning, factory production would be reduced by 68 per cent from the previous period. It is apparent from this example that finished goods inventories very definitely affect the output decisions of entrepreneurs, especially if they attempt to maintain some normal relationship between inventories and sales. It is also apparent that the manufacturer should have a very real concern about the present rate of retail sales, even if he can get only a rough approximation. The example, also shows that there is real necessity for attempting to project dealer sales. It is very probable that channels of distribution do attempt to maintain some normal relation between inventories and sales. If the manufacturer is not sensitive to d e m a n d or possible changes in d e m a n d at the retail level, the resulting backwash of goods and excessive inventories could be quite burdensome if not disastrous.
Other Causes The lag may be further attributed to the desire of manufacturers to level production and attain planned sales goals. The costs of changing production rates are such that manufacturers are willing to allow inventories to accumulate or decline for some time before altering operations. There is a definite reluctance in the firms studied to change production rates even in the face of cyclical or unforeseen fluctuations in sales. Another real reason for the lag is that managers generally feel an obligation to provide some guarantee of employment. This feeling was in clear evidence in the firms studied. There is also the possibility of losing skilled workers. IN C O N C L U S I O N It was noted earlier that the study of inventories is important only insofar as they affect
the output decisions of businessmen. The inverse relation of inventories t:o sales shown in Figure i implies that the firms deliberately accumulate stocks throughout periods of sales declines; it also raises doubts about whether or not finished goods inventory levels affect their output decisions. However, it is my belief that finished goods stocks do affect the output decisions of the manufacturers who participated in this study. In other words, they place a great deal of stress on production leveling, but they are not so shortsighted or optimistic that they continue their efforts to manipulate d e m a n d (rather than change production rates) when it is obvious that actual sales are so far off planned sales that further efforts would be fruitless. One of the most important factors that explains the inverse relation of inventories to sales is the promptness and decisiveness with which channels of distribution react to changes in sales and sales expectation. The actions of these channels have a marked effect upon the manufacturers they represent. (This is especially true in the home laundry manufacturers' industry, where a single manufacturer uses anywhere from 10,000 to 20,000 dealers and from 300 to 600 distributors. ) Two excerpts from the Whirlpool Corporation's Annual Report to Stockholders, 1957 support this view: "In November and December there was a precipitous sales drop at the factory level of approximately 30% below expectations. Analysis shows this did not reflect a drop in retail sales but rather a sudden and almost universal reduction of inventory of our goods in distributor channels. We met this drop in demand with extended factory shutdowns during December which resulted in substantial losses for that month . . . "During November and December we experienced a drastic and unforeseen drop in shipments of products to our customers. This condition resulted in a marked reduction in their inventories as related to sales, and an out of proportion increase of our finished machine inventories at year end."
the THEORY of INVENTORY
(MIS) MANAGEMENT
ROCCO CARZO, JR.
USINESS inventories are a chronic sore spot for both the decision-maker and the general economist analyzing the problem of economie stability. Inventory management is peculiarly frustrating for the businessman because his commodity stoeks are never really under control; their level depends not only on how much he produces or buys but on how much he sells. And the economist sees fluctuations in inventories as the most frequent and intractable source of general swings in business activity. The American economy has suffered three minor recessions since World War 11-1948-49, 1953-54, and the one now in progress. All three lhave been called "inventory recessions." The label is not appropriate in each ease, but
B
108
inventory behavior does figure in all such problems. The role of inventories in business cycles has been described by Lloyd A. Metzler in a notable theory. 1 In his explanation of the short eycle (the inventory cycle), Metzler assumes that businessmen attempt to maintain a constant normal relationship of inventories to sales. Structural (not speculative) inventory cycles, according to the theory, result from the faet that output tends to lag behind changes in demand. Metzler assumes that the length of this lag is approximately one-fourth of an entire short cycle or about six months. The lag causes inventory levels to become abnormal in relation to sales; thereafter, output will be 1 Lloyd A. Metzler, "Nature and Stability of Inventory Cycles,'" Review of Economic Statistics, xxlii (August, 1941); "Business Cycles and the Modern Theory of Employment," American Economic Review, xxxvi (June, 1946); and "Factors Governing the Length of Inventory Cycles," Review of Economic Statistics, XXlX (February, i947).
104
BUSINESS HORIZONS
changed not only to meet changed demand but to restore the normal relationship of inventories to sales. The efforts of businessmen to change output causes further changes in income and subsequent changes in consumer and business expenditures. Thus, Metzler's model is one that involves self-generation. To be more specific, suppose that income and expenditures increase. Inventories will decline because producers are unable to increase output enough to meet the increase in demand. Thereafter, businessmen will increase production not only to meet the larger demand but also to restore inventories to their normal level. Attempts to meet the new demand and replace stocks cause income to rise further; demand also rises, and stocks remain abnormally low. As long as inventories are below the normal level, income will accumulate. Income will reach its peak when inventories have finally accumulated to the normal level. Thus, Metzler's model is one that involves self-generation. T h e reversal of business activity is described as follows: "As income rises, inventories also rise, and this process continues until a normal relation between inventories and expected sales is established. Thereafter businessmen plan no. further increases in stocks; they attempt instead, to. produee only w h a t they expect to sell. Since production plans in earlier periods included production for stocks as well as for sale, the decision to produce only for sale means an absolute decline in total output. As a result, income in the hands of consumers declines, sales are reduced, and a period of general contraction develops. The contraction is accelerated b y the fact that sales fall below expectations, since this causes inventories to become abnormally large and businessmen therefore reduce output still further in an attempt to restore their stocks to a normal level."2
As inventories are reduced to the normal level, income will begin to rise because businessmen have ceased producing less than they sell. Thus, the self-generating cycle repeats itself. There is much evidence to support the view that inventories are a major factor in economic fuctuations. Moses Abramovitz, in a study of five business cycles identified by the National Bureau of Economic Research for the years "'Business Cycles and the Modern Theory of Employment," p. 288.
1919-38, established the fact that inventory investment-on an average-constituted 23 per cent of the change in total output during expansions, 47 per cent for contractions, and 32 per cent for full business cycles. He concluded that, on the average, a considerable portion of the cyclical changes in total output has been in the form of a change in the volume of goods added to or withdrawn from stocks. Also-and most important-"inventory investment, in terms of violence of fluctuation, is the most volatile of the main components of output. ''3 Inventory change has also been of great importance during the time since the Abramoritz study. As shown in Table 1, the four quarters of 1948 were characterized by inventory accumulation; during the last quarter, GNP reached a high for the year. From inventory accumulation, the 1949 downturn witnessed inventory liquidation, speeded by impact of a steel strike, and a decline in GNP in the fourth quarter. Thus, while GNP was declining by $8.5 billion from the fourth quarter of 1948 to the fourth quarter of 1949, inventory investment was declining by $8.7 billion. The shift in inventory investment represented more than the entire contraction in national output. The 1953-54 recession was marked primarily by a decline in defense outlays, but inventory investment still played an important part in the fluctuation. * Table 1 reveals that GNP declined by $8.0 billion from the second quarter of 1953 to the third quarter of 1954. Inven3 Moses Abramovitz, Inventories and Business Cycles (New York: National Bureau of Economic ReSearch, 1950), pp. 5-8. 4 In periods of business recovery, inventory change plays a lesser but still important role. GNP increased $50.2 billion from the second quarter of 1950 to the second quarter of 1951. This large increase resulted from both Korean defense expenditures and rising prices. The inventory investment rate in the second quarter of 1950 was more than doubled in the final quarter of 1950, and increased still more in the second quarter of 1951. The total change in inventories, a measurement of recovery, from the third quarter of 1954, a period of inventory liquidation, to the second quarter of 1955, a period of inventory accumulation, amounted to $9.1 billion. The c~P gain in this period came to $28.3 billion. Measured from the third quarter of 1954 to the fourth quarter of 1955, GNP increased $43.4 billion, and inventory increased $10.8 billion.
THE THEORY OF INVENTORY (MIS)MANAGEMENT
105
TABLE 1
Periods (in quarters)
1948 I II III IV 1949 I II III IV
G r o s s N a t i o n a l P r o d u c t a n d I n v e n t o r y I n v e s t m e n t 1948-58 (Seasonally adjusted at annual rates) aNP InventoryInvestment Periods GNe InventoryInvestment (billions of dollars)
(billions of dollars)
$247.9 255.5 261.9 264.0
$ 2.6 2.9 2.9 3.6
259.9 257.2 256.5 255.5
0.9 --2.0 -- 1.3 --5.1
264.9 275.9 294.4 305.0
2.6 6.3 3.5 13.3
1950 I II III IV 1951 I II III IV 1952 I II III IV
319.3 326.1 331.3 336.3
11.8 15.5 9.9 4.2
338.4 339.9 345.0 357.6
2.7 --2.1 3.5 6.9
(in quarters)
(billions of dollars)
(billions of dollars)
361.6 367.4 366.3 357.5
2.0 3.1 1.1 --5.2
357.6 358.5 359.4 367.1
--3.1 --1.7 --4.5 0.2
379.0 387.7 397.0 402.8
2.7 4.6 3.3 6.3
405.2 410.8 416.7 426.0
5.2 4.6 3.3 5.1
429.9 435.5 440.0 432.6
-0.3 2.2 2.3 --2.7
422.0
-9.0
1953 I II III IV 1954 I II III IV 1955 I II III IV 1956 I II III IV 1957 I II III IV 1958 I
Sov~tcn: G~-P figures and inventory investment changes for 1948-57 from the ANNUAL llEVIEV¢" NU?cIBEtt, SVaV~Y Or C U ~ N T BVSIN~SS, U.S. Department of Commerce (Washington: Gov't Printing Office), 1949-58 issues. Data for the first quarter of 1958 are from the May issue of the s v a v E v .
tory investment shifted d o w n w a r d b y $7.6 billion; almost all of the decline was in national output. In the most recent recessionary period, GNP declined b y $7.4 billion and inventory investment b y $5.0 billion from the third quarter to the fourth quarter of 1957. From the third quarter of 1957 to the first quarter of 1958, CNP shifted d o w n w a r d b y $18 billion, while inventory investment declined by $11.3billion.
tory decision-making praetices with extant theories of inventory management, the study was concentrated on selected firms of the home laundry manufacturers' industry. The businesses studied were: F R I G I D A I R E DIVISION O F G E N E R A L M O T O R S , Dayton, Ohio
GENERALELECTRICCOMPANY,New York and Louisville, Kentucky H O T P O I N T DIVISION O F G E N E R A L E L E C T R I C , Chicago, Illinois NORGE
A STUDY
OF ONE INDUSTRY
DIVISION
OF
BORG-WARNER
PHILCO CORPORATION,
Philadelphia, Pennsylvania
THE MAYTAG COMPANY,
For better understanding of the reasons underlying aggregative inventory behavior and to establish a basis for comparing existing inven-
CORPORATION,
Chicago, Illinois
Newton, Iowa
W E S T I N G H O U S E E L E C T R I C CORPORATION~
Pittsburgh,
Pennsylvania, and Mansfield, Ohio W H I R L P O O L C O R P O R A T I O N , S t . Joseph, Michigan
106
BUSINESS
HORIZONS
FIGURE 1
Factory Sales and Inventories for Washing Machines, Home Laundry Manufacturers' Industry (Seasonally adjusted)
o'J I..-
Z 14.
500
0
oo
Q Z 03 0 "r I--
400
• Shipments 300
"~
/~ a f) / .
~/
j LI'~[ L I
"-,,
[ ~.P"aJv
200
I00
y
~ 51
S o m e Basic Characteristics
Inventory
52
53
It is clear that washing machine manufacturers' finished stocks (in units ) tend to move inversely to shipments of machines ( in units ). Factory shipments began the downturn in January, 1953, and reached the lowest point in December, 1953. Finished stocks continued to rise throughout the contraction, reaching a peak (January, 1954) a month after sales touched the bottom of the trough. In 1954, sales started to recover in January and continued to expand until mid-1955. In other words, finished inventories did not turn downward until sales started upward. Liquidation of finished goods stocks continued throughout the period of recovery, except for a brief period in late 1954.
54
55
SOURCE: Constructed from data obtained from author's research.
Certainly no valid refutation or substantiation of the theory could be achieved in a study of this size. However, it is believed that the inventory practices of these firms are representative of a wide range of business; observations that are applicable to all manufacturers of consumer durables are thereby permitted. Since the sales and inventories of these firms represent virtually all of the total in the home laundry manufacturing industry, generalizations at least can be drawn for this area. Since the study of inventories is important insofar as they affect the output decisions of entrepreneurs, the classification that received most emphasis was the finished goods inventory. Accordingly, this analysis pays particular attention to finished stocks. I n d u s t r y Statistics
Industry statistics for inventories and sales were available only for the period 1950-56• These data, plotted in Figure 1 for the years 1951 through 1955, are significant because they embrace the recession of that period.
Before analyzing and comparing industry sales and inventory behavior with the theory, it is first necessary to review some basic characteristics of the industry and establish the reasons for maintenance of inventories. These firms are characterized by repetitiveprocess manufacturing with assembly-line operations. Products are made in expectation of customers' orders. Finished stocks are needed in this type of operation because rates of produetion do not and cannot exactly match rates of sales. Like any enterprise that delivers goods upon demand, producers of home laundry equipment rely on finished goods inventories to reconcile unavoidable discrepancies between output and demand. In fact, this is one of the ways in which they compete. Factories and channels of distribution in the industry, because of the competitive aspects of the market, are forced to maintain goods ready to meet demand; "stoekouts" usually mean lost business, Another basic consideration in finished goods inventory decision-making is that produetion scheduling is circumscribed by the relatively fixed capacity of each firm for the planning period and by lead-time considerations. The costs of revising the master production schedule are prohibitive for a certain portion of each future scheduling period. There has to be time to design the product, set up
THE THEORY OF INVENTORY (MIS)MANAGEMENT
107
the facilities for manufacture, determine manufaeturing and purchasing requirements, purchase materials, manufacture, and assemble and test the product. There is also the unpredictable element of bottlenecks, such as machine breakdowns and the inability of some work stations to maintain peak loads for extended periods of time, that arise with changing levels of production.
which vary with the company's degree of employment stability. Other reasons for maintaining finished stocks at factories or warehouses include the neeessity to provide for sizable orders that may be placed by channels of distribution. In addition, manufacturers in the home laundry industry find it necessary to maintain finished stocks to meet demand in models and colors.
Accordingly, all the firms studied attempt to smooth out production-that is, to cushion the effects of predictable and unpredictable changes in consumer demand rather than change production rates and employment. Their attempt here seeks to minimize total costs by balancing the costs of changing produetion rates against the eosts of carrying finished stocks.
The Inventory Decision-making Process
Two different sets of cost factors must be considered in this effort-those that increase as inventories increase and those that decrease as inventories increase. The costs that increase are the costs of carrying finished goods inventories, sueh as interest on investment, obsolescence, risk, depreciation, storage, and taxes. The costs that decrease as finished goods inventories are increased are the costs of changing production rates. These result from hiring and laying off workmen. With increased production, new men have to be trained. Their productivity is low, relative to that of other workmen. Labor contracts with seniority provisions require that workers having longer tenure with the company be given the opportunity to bid on new jobs. These same provisions also require that workers with tenure advantage have opportunity to take available jobs in times of furlough or layoffs. Thus, the changing of production rates means shuffling job assignments; it is obvious that this "chainbumping" of workers can become quite costly to management. Changing production rates also may involve the costs of changing commitments to suppliers, such as cancellation charges levied with decreased schedules or inereased tooling and material eosts to meet increased schedules, Also, there are the costs of state unemployment compensation insurance premiums,
Although the considerations presented above seem definitive, it must be emphasized that the companies studied exercise a great deal of subjective judgment, based on past experience, in making decisions about the level of finished goods inventories. Evidence of a lack of objectivity may be gleaned from the fact that the firms all operating under similar conditions have different ideas as to the most desirable level of inventories. Of the eight companies, two desired an eight-weeks' supply of projected sales; one, a six-weeks' supply; four, a four-weeks' supply; and one, a two-weeks' supply. As expected, the companies seek a certain return on investment and on sales for the manufaeture and sale of home appliances; they plan their operations to attain the desired returns. The sales forecast, basis for the planning of all company operations, provides guides for formulation of sales strategy, production planning, and financial management. Planned ending stocks of finished goods are usually determined by marketing executives. Their judgment is generally considered as the best informed of what is the most desirable level of finished stocks to service requirements of a succeeding period. It is standard practice in all the firms to measure finished goods inventories in terms of projected sales. In fact, inventory levels of finished goods are usually stated as a normal relationship in number of weeks supply or as a multiple of a succeeding period's sales. The planned level of ending inventories, as established by marketing executives, serves as a norm for determining requirements throughout the planning period. This norm is used as a guide in the firms studied, especially
108
BUSINESS HORIZONS
in financial planning, where it is considered a condition of estimated sales. However, the norm is not applied as a rigid requirement in planning production operations for the program period. Adjustments are made to this planned level of finished stocks to permit production leveling throughout the planning period, using inventories to cushion the effects of fluctuating sales.
INVENTORY
MISMANAGEMENT --AND WHY
How do these findings compare with the theory? As indicated, the research revealed that output did lag behind changes in demand. However, the theory assumed a one-quarter cycle lag of inventories behind sales; but, as shown in Figure 1, washing machine stocks for firms of the home laundry manufacturers' industry evidenced a half-cycle or about a year lag behind shipments. Does this finding indicate that inventory policy in this industry does not share the objective that theory attributes to decision-makers-namely, to keep inventories in a normal relationship to sales? It certainly is not healthy for the industry, the firms within the industry, or the economy to bear the burden of excessive inventories. The failure to maintain some normal relationship has been costly to all concerned, especially in terms of stability, because the long lag eventually causes more violent fluctuations in output than would otherwise be necessary. The executives interviewed do desire and do attempt to maintain a normal relation of inventories to sales, just as the theory suggests. However, the industry statistics show either that they are not very successful in this endeavor or that inventory policy fails to achieve desired objectives• Can the long lag be explained? Why do intelligent and skillful managers in this highly developed industry miss so badly in their inventory goals?
Overoptimism All the companies, in one manner or another, attempt to manipulate demand through prod-
uct, price, and sales promotion changes. While they cannot be criticized for this, they too often continue their efforts beyond the point of stimulation and will not readily accept a decline in sales as final. Instead of reducing production to permit adjustments of inventories to the lower sales level, the home laundry manufacturers first attempt demand manipulation. In other words, appliance manufacturers appear to be optimists. The current optimism is due in part to such postwar achievements as these: " . . . In the period 1946 through 1957, dealers have placed 365-million major appliances, TV and radio units into consumers' hands. Of products that were Virtually nonexistent before the war, the industry has supplied the nation's homes with-roughly 44-million automatic washers, 59million TV sets, 9-million home freezers, 8million clothes dryers, 8-million air conditioners, 4-million garbage disposers, 3-million ironers, and 2.6-million dishwashers. •
~' 5
Poor Forecasting Another reason for the long lag is the inadequate forecasting techniques used by manufacturers. It was found that the firms, lacking objective forecasting techniques, rely heavily on the level and trend of past sales as barometers for estimating future sales. These estimates are usually altered to include a consideration of each firm's belief in its ability to manipulate demand. In short, rosy forecasts and a state of overoptimism have characterized the appliance industry during the postwar period and have resulted in excessive inventories for long periods of time.
Poor Communications The lag may be explained, in part, by the fact that most of the home laundry manufacturers are poorly informed about activity in channels of distribution. Although all the firms use warranty card returns as an indication of retail sales, few use them intensively for market 5 "1957 Appliance Sales Sag in a Tough, Competitive Yeax," Business Week (January 4, 1958), tx 79.
THE THEORY OF INVENTORY ( MIS ) MANAGEMENT
analysis, and only three of the eight use the returns as an aid in short-term forecasting. Executives pointed to the poor percentage of returns and the expense involved in compiling required information as reasons for not using the cards. As one executive put it, "In this business, we could get as much information as we wanted, even to the extent of sending researchers around to each consumer. But it is too costly. We feel that we can do just as good a job by projecting short-term sales from the data received from distributors." In other words, the expense, time, and effort involved outweigh the advantages to be gained from the information that would be obtained. When this point of view was expressed to an executive of a firm that used the warranty card approach for estimating retail sales, he charged that it has been this shortsightedness that has caused the excessive inventories and chaotic price situation characteristic of the home laundry appliance industry. The value of keeping track of current changes in retail sales forecasting is made clear by the hypothetical example presented in Table 2; inventories play an important role. (The example assumes that retailers, wholesalers, and manufacturers attempt to maintain a normal level of inventories in relation to projected sales, which is in accord with the reasoning of the inventory cycle theory and the findings of this study. The example assumes also that they are successful in maintaining this normal relationship, which is not in accord with either the theory or reality. ) Dealers' projected monthly sales are 7,000 units. The dealers' efforts to maintain a sixweeks' supply of inventories are successful (estimated monthly sales of 7,000 units divided by four [weeks] equals about 1,700 units per week; for a six-weeks' supply, about 10,000 units are needed ). The wholesalers' efforts to maintain a six-weeks' supply of inventory are successful (again, about 10,000 units ). The manufacturers' efforts to maintain a two-weeks' supply of inventories are successful (estimated monthly sales to wholesalers of 7,000 units plus 1,000 units in transit, or 8,000
109
units, divided by four [weeks] equals 2,000 units per week; a two-weeks' supply amounts to 4,000 units). The effect of an unexpected 10 per cent decline in retail sales becomes obvious. This decline will prompt dealers to liquidate inventories to the desired level of projected sales; they will not only reduce their purchases from distributors to compensate for decreased sales but also permit liquidation of inventories to the desired level of projected sales. Thus, their purchases will represent an 18 per cent reduction in the distributors' projected sales to dealers. Distributors will reduce their purchases from the factory not only to compensate for reduced sales but also to permit.liquidation of inventories to the desired level of TABLE 2
Hypothetical Example of Influence of Stocks and Sales Fluctuations on Production (In physical units) Normal Production, Sales, and Inventories
Retail ending inventory ( six-weeks' supply desired ) Projected monthly retail sales Dealer purchases Total available Wholesale ending inventory ( six-weeks' supply desired ) Projected monthly distributor sales Distributor purchases Total available In transit inventories Factory ending inventory (two-weeks' supply desired ) Projected monthly factory sales Factory production Total available SotrrtcE: Author's
illustration.
Projected 10 Per Cent Decrease of Retail Sales
10,000
9,450
7,000 7,000 17,000
6,300 5,750 15,200
10,000
8,622
7,000 7,000 17,000 1,000
5,750 4,372 12,994 1,000
4,000
2, !86
8,000 8,000 12,000
4,372 2,558 4,744
110
BUSINESS HORIZONS
projected sales. Thus, their purchases from the factory will represent a 45 per cent decline in factory shipmentsJ Following the same reasoning, factory production would be reduced by 68 per cent from the previous period. It is apparent from this example that finished goods inventories very definitely affect the output decisions of entrepreneurs, especially if they attempt to maintain some normal relationship between inventories and sales. It is also apparent that the manufacturer should have a very real concern about the present rate of retail sales, even if he can get only a rough approximation. The example, also shows that there is real necessity for attempting to project dealer sales. It is very probable that channels of distribution do attempt to maintain some normal relation between inventories and sales. If the manufacturer is not sensitive to d e m a n d or possible changes in d e m a n d at the retail level, the resulting backwash of goods and excessive inventories could be quite burdensome if not disastrous.
Other Causes The lag may be further attributed to the desire of manufacturers to level production and attain planned sales goals. The costs of changing production rates are such that manufacturers are willing to allow inventories to accumulate or decline for some time before altering operations. There is a definite reluctance in the firms studied to change production rates even in the face of cyclical or unforeseen fluctuations in sales. Another real reason for the lag is that managers generally feel an obligation to provide some guarantee of employment. This feeling was in clear evidence in the firms studied. There is also the possibility of losing skilled workers. IN C O N C L U S I O N It was noted earlier that the study of inventories is important only insofar as they affect
the output decisions of businessmen. The inverse relation of inventories t:o sales shown in Figure i implies that the firms deliberately accumulate stocks throughout periods of sales declines; it also raises doubts about whether or not finished goods inventory levels affect their output decisions. However, it is my belief that finished goods stocks do affect the output decisions of the manufacturers who participated in this study. In other words, they place a great deal of stress on production leveling, but they are not so shortsighted or optimistic that they continue their efforts to manipulate d e m a n d (rather than change production rates) when it is obvious that actual sales are so far off planned sales that further efforts would be fruitless. One of the most important factors that explains the inverse relation of inventories to sales is the promptness and decisiveness with which channels of distribution react to changes in sales and sales expectation. The actions of these channels have a marked effect upon the manufacturers they represent. (This is especially true in the home laundry manufacturers' industry, where a single manufacturer uses anywhere from 10,000 to 20,000 dealers and from 300 to 600 distributors. ) Two excerpts from the Whirlpool Corporation's Annual Report to Stockholders, 1957 support this view: "In November and December there was a precipitous sales drop at the factory level of approximately 30% below expectations. Analysis shows this did not reflect a drop in retail sales but rather a sudden and almost universal reduction of inventory of our goods in distributor channels. We met this drop in demand with extended factory shutdowns during December which resulted in substantial losses for that month . . . "During November and December we experienced a drastic and unforeseen drop in shipments of products to our customers. This condition resulted in a marked reduction in their inventories as related to sales, and an out of proportion increase of our finished machine inventories at year end."