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Why are UK manufacturing inventory-output ratios falling?
production economics
ELSEVIER
Int. J. Production
Economics
Why are UK manufacturing
35 (1994) l-9
inventory-output
ratios falling?
LG. Black*, M. Peters Centre f;w Logisrics and Transportation.
Cranfield
1. The background At the end of 1991 inventories (or stocks as they are more commonly referred to in Great Britain) were valued at &119bn equivalent to 3 months output of the economy. In manufacturing industry, which holds 42% of the total inventory by value, the comparable figure was slightly under 6 months output. This inventory holding in manufacturing is divided between raw materials and fuel (30%) work is progress (35%) and finished goods (35%). Inventories held by wholesalers and retailers are an important component (26%) of total inventory holding. Retail inventories, for instance, are equivalent to approximately 2 months sales at retail outlets. International comparisons are difficult to make due to differences in accounting conventions and different methods of collecting national statistics. However tentative estimates from United Nations and OECD sources suggest UK inventory holding might be twice as high as Japan, and 50% higher than the USA [l]. No clear evidence is available to explain these differences. Even within regions in the UK there appears to be a significant difference in inventory holding. In
* Corresponding
author.
Univrrsil~,
Cranfield.
Beds. MK43 OAL, UK
a detailed study of Scotland [2] the author identified numerous factors that might explain the apparent excess inventory in the region (26-38% above the UK average). The nature of the production process, the lower cost of property rental and the quality of inventory management were advanced as possible explanations. However despite detailed analysis no firm conclusions were reached on the causes behind the discrepancy. Short-term fluctuations in inventories can have an important influence on output and employment in an economy at certain times. In the UK annual fluctuations in inventories have been equivalent to a change in output of l-3%. However in the 1980s the amplitude of these fluctuations was considerably less than that experienced in the 1960s and 1970s. Turning to the trends in inventory holding in the UK economy it is apparent that there have been a number of different trends. Looking at manufacturing industry (Fig. 1) it is possible to identify three distinct preiods. During the 1960s the inventory-output ratio was approximately constant. Short-term fluctuations were observed probably due to unanticipated increases or reductions as a result of short-term changes in demand. In the 1970s however, there was a steady increase in the ratio. This was followed in the 1980s by a persistent decline which has brought the level to below that of the 1960s. A slightly different perspective is given
0925-5273/94/$07.00 (0 1994 Elsevier Science B.V. All rights reserved. SSDI 0925-5273(93)E0096-E
I.C.
Black.
M. Prt<~r.silnt.
J. Production
1959-
Economics
35 (1994)
I-9
1990
120 110
-
100
-
90
Retail
% 0 -z E k a
80
-
70
-
60
Manufacturing
Manufacturing
inventory/Manufacturing
Fig. 1. Inventory
by comparing the sum of inventories to include those held by retailers and wholesalers (a large proportion of which will have stemmed from manufacturers). Here the upward trend in the 1970s and decline in the 1980s is still apparent but the level is little different from that found in the 1960s. Retail inventory has exhibited a similar pattern of increase and decrease but with a slightly more modest fall (in relative terms) in the 1980s. It can also be seen from Fig. 2 that this downward trend in manufacturing industry is reflected in all three components in the 198Os, although the experience prior to this was different for finished goods. The major research question, and the subject of this paper, is why have these trends, particularly the decline of the 198Os, in the long-run ratios occurred, and will they continue? There are two main sources of explanation. The first explanation stemming from macroeconomic analysis suggests that factors concerned with the monetary cost of
/
Output
9%,
Output
ratios
inventory holding are the major, if not the only, cause of the decline in the 1980s. The second explanation, stemming from microeconomic analysis, is that improvements in technology (information handling in particular) and management applications of new techniques (e.g. modelling, Just-inTime, Materials Requirement Planning) have led to the fall of the 1980s. However, the resolution of the relative significance of the two arguments poses formidable problems of interpretation of empirical data.
2. Monetarist
explanation
2.1. Review qf monetarist
explanation
Macroeconomic modellers are interested in forecasting the short-term (quarterly) fluctuations in the economy, partly to assist governments in controlling the economy and partly to provide information to companies and organizations about
I.G. Black, M. PeterslInt. J. Production Economics 35 11994) I-9
26 25 24
23 22 21 20 19 18 17 16 15 14 13 12
0
Moterlals
& Fuel
+
IWork in Progress
Fig. 2. Inventory
short-term trends in the economy. The behaviour of inventories comprise one element of GDP that needs to be explained and incorporated into an overall mathematical model of the national economy. Whilst the main emphasis of these models is on short-term movements long-term trends such as the declining inventory-output ratio are also of concern. The experience of macroeconomic modellers in their attempts to forecast changes in inventories during the 1980s was not an auspicious one. A study in the late 1980s [3] noted the poor performance of the equations used to predict inventories. In particular there was an almost universal failure to predict the decline in the inventoryoutput ratio in the early 1980s. The form of the models used and the relationships are sometimes published. For instance the model used by Her Majesty’s Treasury (one of more than 20 in the UK that produces regular forecasts) is described in a technical manual and is available in a
0
Finlshed
goods
ratios.
computerised form for company or research purposes [4]. Detailed analysis of the reasoning and empirical justification behind the equations explaining inventory holding is not always available for these models. However in 1990 a paper published by three economists from the Bank of England [S] provides an excellent statement of the Monetarist position. Using advanced econometric methods and an inter-temporal optimisation technique derived from economic theory they estimate a new model for the 1970s and 1980s to explain manufacturing inventory fluctuations. They conclude: “The expected level of output is not found to be a major determinant of the level of inventories. The main effect is now seen to be the conditional variance of output and the cost of stockholding. The 1981 collapse of stock levels is largely that the change in stock relief legislation worked through its effect on the cost of holding stocks was a principal factor. Moreover, as the level of uncertainty has fallen during the 1980s firms’ holdings of inventories have tended to fall which explains why stock-output ratios have fallen.”
I.G. Black, M. Prtersilnt.
4
J. Production
Validit?! cf monetarist
approach
Whilst the variance of output (which represents uncertainty) may contribute to the decline in the 1980s it cannot be the major cause as the authors’ research shows that it also fell dramatically in the second half of the 1970s. Changes in tax arrangements may also have contributed to changes in inventory holding but these could have been expected to lead to a shift in the overall level rather than a steady decline. A major variable in the Bank of England model is the interest rate (represented by two measures;
-16
1
I 60
I 62 61
I
I
I
64 53
55 35
I
50 67
,
70 69
72 71
35 (1994)
I-9
the 3-month inter-bank rate and the clearing banks’ base rate). The potential role of interest rates in explaining inventory movements can be seen in Fig. 3. This shows how the real cost (i.e. correcting for inflation) has changed over the last three decades. Actual borrowing costs for companies are likely to be somewhat higher than these figures which use the banks’ base lending rate. It can clearly be seen from the graph that the relatively stable inventoryyoutput ratios of the 1960s were accompanied by interest rates in the range l-4%. The 1970s however, saw negative real rates of interest due to the high rates of inflation experienced especially in the mid 1970s. With real rates of interest negative the cost of inventory holding will be low. The exact figure will depend on the physical costs of inventory holding, warehousing, deterioration etc. One study suggests an average figure for these costs of 15% of value [6] which means that changes in the monetary cost of inventory holding will be a major element in the total
Throughout the whole article there is no reference to changes in technology or changes in management practices (except in response to the above factors). Unfortunately the article does not provide detailed evidence to allow a reader to ascertain the relative importance of the different variables.
2.2.
Economics
I I I I I I r I I 74 76 78 80 82 84 06 ?a 90 73 75 77 79 81 33 a5 37 39 Yeor
Fig. 3. Real interest
rates.
I.G. Black, M. Pererslht.
J. Production Economics 35 11994) l-9
time to work through the economy. Companies are unlikely to change their holding policy from year to year in response to the expected increase or fall in interest rates and inflation. However, it seems quite plausible to suggest that after a number of years of negative or high real interest rates companies will start to change their policies. In other words companies change their policy in response to long-term expectations rather than short-term fluctuations which may be reversed. Regression analysis specifying a lagged response of inventories to real interest rates provided empirical support to this proposition. In summary the Monetarist explanation has some persuasive economic logic and is supported by the empirical and research evidence. The use of econometric methods [S, 73 provides strong statistical support for the importance of interest rates. Another strong point in its favour is that the explanation is also consistent with the opposing trends in the inventory-output ratio found in the 1970s and 1980s.
cost per annum. And it is, therefore, highly plausible to expect companies faced with the prospect of negative interest rates and perhaps a fall in the real cost of up to 50% to increase their inventory and vice versa. The 1980s saw a dramatic reversal in the real interest rate. From 1981 it was positive and between 1983 and 1990 varied between 5 and 8%. Given this significant change companies, recognising perhaps gradually the increasing cost of inventory holding, could be expected to reduce their holdings of inventory. But whilst there appears to be a correlation between inventory holding and real interest rates over the long-term (i.e. between decades) the research indicates that the relationship is much weaker on a year to year basis. Plotting the change in real interest rates and the change in inventories clearly highlights that the movement in total inventory for individual years are at best weakly associated with changes in real interest rates (see Fig. 4). It can be argued then, that the response to changes in real interest rates would take some
7
r
6
-
5
Changes
1960-
1990
74
-2
-
-3
-
-4
-
82 I -11
I
I
-9
I
I
-7
I,
I,,
I
-5 Change
-3 in Real
I
-1 Interest
Fig. 4. Total inventories.
1 Rate
-
%
81 I
76
I,,,,,
3
5
7
6
I.G.
3. Technological 3.1, Review
Black,
M. Prter.~/Int.
J. Production
explanation
qf technological
explanation
A number of authors [1, 8, 91 have identified factors that could have been expected to lead to improved inventory management in the 1980s. These include ~ the emergence of requirements planning systems e.g. JIT (Just-in-Time), MRP (Materials Requirements Planning), DRP (Distribution Requirements Planning); ~ increased use of computerised information systems implying better and more reliable data; _ improved forecasting and decision making methods.
1980-1990
Economics
35 119941
1~ 9
All these methods, it is argued, should lead to better information and hence lower inventory holdings. Other technological factors that could be advanced as possible causes behind long-run changes in inventories are reduced transport costs (encouraging larger and fewer warehouses with a lower total system inventory holding) and reduced physical holding costs (which would encourage larger inventory holding).
3.2.
Validity
qf technological approach
The evidence for the impact of the improvements in information technology and management control on inventory holding is largely impressionistic
-
El985
0.1
0 .-0
5 ‘;
-0.1
-
-0.2
-
-0.3
-
-0.4
-
a
5
-T
6
7
Y .& .c % 5 5
I
I
-0.5 Metal
m
I
M tat Goods/Eng/vehcl sTextiles manuf Chemicals/Mmfibres Food,drink,tobacco
Raw
materials
m
Work
in Progress
clo/foot
Total
manuf
Other m
Finished
Fig. 5. Inventory ratios, 1980-1990 (f 1985). (1) Metal Manuf, (2) Chemicals & Manuf. Fibres, Vehicles, (4) Food, Drink and Tobacco, (5) Textiles, Clothing and Footwear and (6) Others.
Goods
(3) Metal
Goods,
Engineering
and
I.G. Black, M. PeterslInt.
J. Production Economics 35 (1994) I-9
1980-1990
-3
-
-4
-
s
-5
-
$3 I,xG 26 6’:
-6
-
-7
-
-8
-
.X E
:_2 .- iC.-
-9 -10
tk
-11
s
-12
6
Constant
prices485
-
-13
-14 -15 -16 -17
L
1
I Metal
iZB3R
M tat Gaads/Eng/vehcl sTextiles manuf Chemicals/Mmfibres Faad,drink,tabacca ow
Fig. 6. Change
materials
in inventory,
m 1980-1990
and anecdotal rather than scientific. An exception to this, which examined the decline in the inventory-GDP ratio in the USA, provides tentative statistical evidence that interest in JIT (measured by the number of articles per year in two learned journals) was a significant explanatory variable. None of the proponents of the technological viewpoint explain the increase in ratios during the 1970s or why there was such a dramatic change after 1980. Another perspective on the forces behind the decline in the inventory ratio in manufacturing can be gained from a disaggregation of the statistics into 6 industry groups. The first point that should be made is thar the changing composition of manufacturing industry during the period does not explain the decline in the inventoryyoutput ratio. Indeed the change in composition would have led
Work
in Progress
Constant
I
clo/faat
Total
manuf
Other m
Finished
prices (L 1985). (l)-(6)
Goads
as in Fig. 5.
to a slight increase in the ratio if the components (defined at the 2-digit level) had maintained their individual ratios. Inspection of Figs. 5 and 6 shows that all the industry groups, with the exception of Textiles, Clothing and Footwear, have shown a decline. It appears that factors specific to the Textile group have maintained the ratio at the same level throughout the 1980s. The level of interest rates experienced would have been the same as for other industries and the opportunities for improved management control would also have been the same. Of the other industry groupings, Metal Manufacture demonstrates the largest fall. Perhaps most striking of all is the similarity in the changes of the three components of inventory. Within the industry groups there is a consistency between the movements in Raw materials, Work-in Progress and
Finished Goods. This would seem to support the Monetarist argument with interest rates expected to influence all three elements of inventory whereas the improvements in technology identified above have been mainly focussed on raw material planning and to a lesser extent finished goods. Fig. 6 shows that of the actual fall in inventory (measured in constant & 1985 prices) the group Metal goods, Engineering and Vehicles contributed slightly over half. One other factor that should be borne in mind is that the restructuring of a logistical system may mean that whilst total system inventory remains the same, some proportion is reallocated from the manufacturing sector to the distribution sector. A vehicle manufacturer who decides to use a third party to deliver materials using JIT may reduce his own inventory ho,lding but this may be balanced by a comparable increase in the warehouses of the distribution sector. Detailed analysis of this proposition is not possible but examination of Fig. 1 provides some support for this hypothesis. The ratio of manufacturing inventories only has fallen much faster than that which refers to manufacturing inventories plus those held in the retail and warehouse sector. Given that most of these latter inventories will have derived from manufacturing industry then there does seem to be evidence that some inventories have been transferred from the manufacturing sector.
4. Resolution There has undoubtedly been a significant fall in the ratio of inventory to output in UK manufacturing industry during the 1980s. There have also been comparable changes in the warehouse and retail sectors. Looking at the cause behind the fall of the 1980s it would be hard to deny that either monetary factors or technological factors did not have some influence. Real interest rates have been significantly higher than the 1980s and a steady decline in the inventory-output ratio might be explained by a gradual readjustment of company policies to this higher cost-equivalent, perhaps to a doubling in cost compared to the late 1970s. Perhaps this higher cost has encouraged companies to seek out
means of reducing inventory holding costs and to adopt new technology and better management control earlier than they would have without the pressures on their finances. Despite the lack of hard empirical evidence, the distribution and logistics literature is replete with praise for the benefits of electronic systems such as EPOS and management methods such as JIT. Some caution needs to be expressed as to whether these automatically lead to reductions in inventory. (Nor should it be assumed a fall in inventory is always beneficial, if customer service is prejudiced, for example.) Cheaper methods of control may encourage a large variety of inventory holding rather than simply reduction in excess holdings. Without detailed longitudinal studies of company behaviour it is impossible to provide precise estimates of inventory savings. Certainly the variations shown by the disaggregation of manufacturing into 6 sectors suggest that other forces are at work rather than industry wide trends in costs and management methods. The final conclusion must be that our understanding of inventory movements on a national basis is far from perfect. In particular longitudinal studies of particular industries are needed in order to clearly identify the special factors that have influenced the change in holding policies of the 1980s. Even this approach, however, is bedevilled by the difficulty of interpreting the reason behind changes in company policy. Was it the adoption of the new technology or the monetary imperative behind its adoption that led to the fall in inventory? Turning to the 1990s can we expect further falls in the inventory-output ratio in the UK? With inflation predicted to remain at a low level (3% or less) and no prospect of a significant fall in European, and hence UK interest rates, real interest rates are likely to be in the same range as found in the 1980s or slightly lower. New technology and new management methods will continue to be adopted by industry. On both counts therefore we can expect further falls in the ratio. Eventually without further rises in real interest rates the fall may be mitigated as more and more companies have adapted their policies to the expectation of real interest rates around the 5% level. Experience in 1991 and 1992 is not a good guide to long-term trends as short-term inventory movements have
I.G. Black, M. Pe~rrs/Int. J. Production Economics 35 (1994)
been heavily recession.
influenced
by the
movement
into
References [I]
Waters, C.D.J., 1988. How Efficient is UK Inventory Management. in: Cooper, J.C., (Ed.), Logistics and Distribution Planning. Kogan Page, London. [2] Mckinnon, A.C., 1991. Regional variations in manufacturing inventory levels. Phys. Distribution Logist. Mgmt., 21. [3] Wallis, K.F., Fisher, P.G., Longbottom, J.A., Turne, D.S. and Whitley, J.D., 1987. Models of the UK economy: A Fourth Review by the ESRC Macroeconomic Modelling Bureau. Oxford University Press, Oxford.
1-9
9
[4] Treasury, H.M., 1982. H.M Treasury Macroeconomic Technical Manual, H.M Treasury, Mimco. [S] Callen, T.S., Hall, SC. and Henry, S.C.B., 1990. Manufacturing stocks: Expectation, risks and co-integration. Econom. J., 100. [6] O’Brien, J., 1986. 1985 Survey of distribution Costs. Focus on Phys. Distribution. [7] Hall, S.G., Henry, S.G.B. and Wren-Lewis, S., 1986. Manufacturing stocks and forward-looking expectations in the UK. Economica, 53. [8] Sohal, A. and Havard, K., 1987. Trade in Materials Management. Int. J. of Phys. Distribution Mat. Mgmt., 17. [9] Cooper, J., Browne, M. and Peters, M., 1991. European Logistics. Blackwell, Oxford. [lo] Mellis, C., 1986. H.M Treasury macroeconomic model. HMT GES Working Paper 90.
ELSEVIER
Int. J. Production
Economics
Why are UK manufacturing
35 (1994) l-9
inventory-output
ratios falling?
LG. Black*, M. Peters Centre f;w Logisrics and Transportation.
Cranfield
1. The background At the end of 1991 inventories (or stocks as they are more commonly referred to in Great Britain) were valued at &119bn equivalent to 3 months output of the economy. In manufacturing industry, which holds 42% of the total inventory by value, the comparable figure was slightly under 6 months output. This inventory holding in manufacturing is divided between raw materials and fuel (30%) work is progress (35%) and finished goods (35%). Inventories held by wholesalers and retailers are an important component (26%) of total inventory holding. Retail inventories, for instance, are equivalent to approximately 2 months sales at retail outlets. International comparisons are difficult to make due to differences in accounting conventions and different methods of collecting national statistics. However tentative estimates from United Nations and OECD sources suggest UK inventory holding might be twice as high as Japan, and 50% higher than the USA [l]. No clear evidence is available to explain these differences. Even within regions in the UK there appears to be a significant difference in inventory holding. In
* Corresponding
author.
Univrrsil~,
Cranfield.
Beds. MK43 OAL, UK
a detailed study of Scotland [2] the author identified numerous factors that might explain the apparent excess inventory in the region (26-38% above the UK average). The nature of the production process, the lower cost of property rental and the quality of inventory management were advanced as possible explanations. However despite detailed analysis no firm conclusions were reached on the causes behind the discrepancy. Short-term fluctuations in inventories can have an important influence on output and employment in an economy at certain times. In the UK annual fluctuations in inventories have been equivalent to a change in output of l-3%. However in the 1980s the amplitude of these fluctuations was considerably less than that experienced in the 1960s and 1970s. Turning to the trends in inventory holding in the UK economy it is apparent that there have been a number of different trends. Looking at manufacturing industry (Fig. 1) it is possible to identify three distinct preiods. During the 1960s the inventory-output ratio was approximately constant. Short-term fluctuations were observed probably due to unanticipated increases or reductions as a result of short-term changes in demand. In the 1970s however, there was a steady increase in the ratio. This was followed in the 1980s by a persistent decline which has brought the level to below that of the 1960s. A slightly different perspective is given
0925-5273/94/$07.00 (0 1994 Elsevier Science B.V. All rights reserved. SSDI 0925-5273(93)E0096-E
I.C.
Black.
M. Prt<~r.silnt.
J. Production
1959-
Economics
35 (1994)
I-9
1990
120 110
-
100
-
90
Retail
% 0 -z E k a
80
-
70
-
60
Manufacturing
Manufacturing
inventory/Manufacturing
Fig. 1. Inventory
by comparing the sum of inventories to include those held by retailers and wholesalers (a large proportion of which will have stemmed from manufacturers). Here the upward trend in the 1970s and decline in the 1980s is still apparent but the level is little different from that found in the 1960s. Retail inventory has exhibited a similar pattern of increase and decrease but with a slightly more modest fall (in relative terms) in the 1980s. It can also be seen from Fig. 2 that this downward trend in manufacturing industry is reflected in all three components in the 198Os, although the experience prior to this was different for finished goods. The major research question, and the subject of this paper, is why have these trends, particularly the decline of the 198Os, in the long-run ratios occurred, and will they continue? There are two main sources of explanation. The first explanation stemming from macroeconomic analysis suggests that factors concerned with the monetary cost of
/
Output
9%,
Output
ratios
inventory holding are the major, if not the only, cause of the decline in the 1980s. The second explanation, stemming from microeconomic analysis, is that improvements in technology (information handling in particular) and management applications of new techniques (e.g. modelling, Just-inTime, Materials Requirement Planning) have led to the fall of the 1980s. However, the resolution of the relative significance of the two arguments poses formidable problems of interpretation of empirical data.
2. Monetarist
explanation
2.1. Review qf monetarist
explanation
Macroeconomic modellers are interested in forecasting the short-term (quarterly) fluctuations in the economy, partly to assist governments in controlling the economy and partly to provide information to companies and organizations about
I.G. Black, M. PeterslInt. J. Production Economics 35 11994) I-9
26 25 24
23 22 21 20 19 18 17 16 15 14 13 12
0
Moterlals
& Fuel
+
IWork in Progress
Fig. 2. Inventory
short-term trends in the economy. The behaviour of inventories comprise one element of GDP that needs to be explained and incorporated into an overall mathematical model of the national economy. Whilst the main emphasis of these models is on short-term movements long-term trends such as the declining inventory-output ratio are also of concern. The experience of macroeconomic modellers in their attempts to forecast changes in inventories during the 1980s was not an auspicious one. A study in the late 1980s [3] noted the poor performance of the equations used to predict inventories. In particular there was an almost universal failure to predict the decline in the inventoryoutput ratio in the early 1980s. The form of the models used and the relationships are sometimes published. For instance the model used by Her Majesty’s Treasury (one of more than 20 in the UK that produces regular forecasts) is described in a technical manual and is available in a
0
Finlshed
goods
ratios.
computerised form for company or research purposes [4]. Detailed analysis of the reasoning and empirical justification behind the equations explaining inventory holding is not always available for these models. However in 1990 a paper published by three economists from the Bank of England [S] provides an excellent statement of the Monetarist position. Using advanced econometric methods and an inter-temporal optimisation technique derived from economic theory they estimate a new model for the 1970s and 1980s to explain manufacturing inventory fluctuations. They conclude: “The expected level of output is not found to be a major determinant of the level of inventories. The main effect is now seen to be the conditional variance of output and the cost of stockholding. The 1981 collapse of stock levels is largely that the change in stock relief legislation worked through its effect on the cost of holding stocks was a principal factor. Moreover, as the level of uncertainty has fallen during the 1980s firms’ holdings of inventories have tended to fall which explains why stock-output ratios have fallen.”
I.G. Black, M. Prtersilnt.
4
J. Production
Validit?! cf monetarist
approach
Whilst the variance of output (which represents uncertainty) may contribute to the decline in the 1980s it cannot be the major cause as the authors’ research shows that it also fell dramatically in the second half of the 1970s. Changes in tax arrangements may also have contributed to changes in inventory holding but these could have been expected to lead to a shift in the overall level rather than a steady decline. A major variable in the Bank of England model is the interest rate (represented by two measures;
-16
1
I 60
I 62 61
I
I
I
64 53
55 35
I
50 67
,
70 69
72 71
35 (1994)
I-9
the 3-month inter-bank rate and the clearing banks’ base rate). The potential role of interest rates in explaining inventory movements can be seen in Fig. 3. This shows how the real cost (i.e. correcting for inflation) has changed over the last three decades. Actual borrowing costs for companies are likely to be somewhat higher than these figures which use the banks’ base lending rate. It can clearly be seen from the graph that the relatively stable inventoryyoutput ratios of the 1960s were accompanied by interest rates in the range l-4%. The 1970s however, saw negative real rates of interest due to the high rates of inflation experienced especially in the mid 1970s. With real rates of interest negative the cost of inventory holding will be low. The exact figure will depend on the physical costs of inventory holding, warehousing, deterioration etc. One study suggests an average figure for these costs of 15% of value [6] which means that changes in the monetary cost of inventory holding will be a major element in the total
Throughout the whole article there is no reference to changes in technology or changes in management practices (except in response to the above factors). Unfortunately the article does not provide detailed evidence to allow a reader to ascertain the relative importance of the different variables.
2.2.
Economics
I I I I I I r I I 74 76 78 80 82 84 06 ?a 90 73 75 77 79 81 33 a5 37 39 Yeor
Fig. 3. Real interest
rates.
I.G. Black, M. Pererslht.
J. Production Economics 35 11994) l-9
time to work through the economy. Companies are unlikely to change their holding policy from year to year in response to the expected increase or fall in interest rates and inflation. However, it seems quite plausible to suggest that after a number of years of negative or high real interest rates companies will start to change their policies. In other words companies change their policy in response to long-term expectations rather than short-term fluctuations which may be reversed. Regression analysis specifying a lagged response of inventories to real interest rates provided empirical support to this proposition. In summary the Monetarist explanation has some persuasive economic logic and is supported by the empirical and research evidence. The use of econometric methods [S, 73 provides strong statistical support for the importance of interest rates. Another strong point in its favour is that the explanation is also consistent with the opposing trends in the inventory-output ratio found in the 1970s and 1980s.
cost per annum. And it is, therefore, highly plausible to expect companies faced with the prospect of negative interest rates and perhaps a fall in the real cost of up to 50% to increase their inventory and vice versa. The 1980s saw a dramatic reversal in the real interest rate. From 1981 it was positive and between 1983 and 1990 varied between 5 and 8%. Given this significant change companies, recognising perhaps gradually the increasing cost of inventory holding, could be expected to reduce their holdings of inventory. But whilst there appears to be a correlation between inventory holding and real interest rates over the long-term (i.e. between decades) the research indicates that the relationship is much weaker on a year to year basis. Plotting the change in real interest rates and the change in inventories clearly highlights that the movement in total inventory for individual years are at best weakly associated with changes in real interest rates (see Fig. 4). It can be argued then, that the response to changes in real interest rates would take some
7
r
6
-
5
Changes
1960-
1990
74
-2
-
-3
-
-4
-
82 I -11
I
I
-9
I
I
-7
I,
I,,
I
-5 Change
-3 in Real
I
-1 Interest
Fig. 4. Total inventories.
1 Rate
-
%
81 I
76
I,,,,,
3
5
7
6
I.G.
3. Technological 3.1, Review
Black,
M. Prter.~/Int.
J. Production
explanation
qf technological
explanation
A number of authors [1, 8, 91 have identified factors that could have been expected to lead to improved inventory management in the 1980s. These include ~ the emergence of requirements planning systems e.g. JIT (Just-in-Time), MRP (Materials Requirements Planning), DRP (Distribution Requirements Planning); ~ increased use of computerised information systems implying better and more reliable data; _ improved forecasting and decision making methods.
1980-1990
Economics
35 119941
1~ 9
All these methods, it is argued, should lead to better information and hence lower inventory holdings. Other technological factors that could be advanced as possible causes behind long-run changes in inventories are reduced transport costs (encouraging larger and fewer warehouses with a lower total system inventory holding) and reduced physical holding costs (which would encourage larger inventory holding).
3.2.
Validity
qf technological approach
The evidence for the impact of the improvements in information technology and management control on inventory holding is largely impressionistic
-
El985
0.1
0 .-0
5 ‘;
-0.1
-
-0.2
-
-0.3
-
-0.4
-
a
5
-T
6
7
Y .& .c % 5 5
I
I
-0.5 Metal
m
I
M tat Goods/Eng/vehcl sTextiles manuf Chemicals/Mmfibres Food,drink,tobacco
Raw
materials
m
Work
in Progress
clo/foot
Total
manuf
Other m
Finished
Fig. 5. Inventory ratios, 1980-1990 (f 1985). (1) Metal Manuf, (2) Chemicals & Manuf. Fibres, Vehicles, (4) Food, Drink and Tobacco, (5) Textiles, Clothing and Footwear and (6) Others.
Goods
(3) Metal
Goods,
Engineering
and
I.G. Black, M. PeterslInt.
J. Production Economics 35 (1994) I-9
1980-1990
-3
-
-4
-
s
-5
-
$3 I,xG 26 6’:
-6
-
-7
-
-8
-
.X E
:_2 .- iC.-
-9 -10
tk
-11
s
-12
6
Constant
prices485
-
-13
-14 -15 -16 -17
L
1
I Metal
iZB3R
M tat Gaads/Eng/vehcl sTextiles manuf Chemicals/Mmfibres Faad,drink,tabacca ow
Fig. 6. Change
materials
in inventory,
m 1980-1990
and anecdotal rather than scientific. An exception to this, which examined the decline in the inventory-GDP ratio in the USA, provides tentative statistical evidence that interest in JIT (measured by the number of articles per year in two learned journals) was a significant explanatory variable. None of the proponents of the technological viewpoint explain the increase in ratios during the 1970s or why there was such a dramatic change after 1980. Another perspective on the forces behind the decline in the inventory ratio in manufacturing can be gained from a disaggregation of the statistics into 6 industry groups. The first point that should be made is thar the changing composition of manufacturing industry during the period does not explain the decline in the inventoryyoutput ratio. Indeed the change in composition would have led
Work
in Progress
Constant
I
clo/faat
Total
manuf
Other m
Finished
prices (L 1985). (l)-(6)
Goads
as in Fig. 5.
to a slight increase in the ratio if the components (defined at the 2-digit level) had maintained their individual ratios. Inspection of Figs. 5 and 6 shows that all the industry groups, with the exception of Textiles, Clothing and Footwear, have shown a decline. It appears that factors specific to the Textile group have maintained the ratio at the same level throughout the 1980s. The level of interest rates experienced would have been the same as for other industries and the opportunities for improved management control would also have been the same. Of the other industry groupings, Metal Manufacture demonstrates the largest fall. Perhaps most striking of all is the similarity in the changes of the three components of inventory. Within the industry groups there is a consistency between the movements in Raw materials, Work-in Progress and
Finished Goods. This would seem to support the Monetarist argument with interest rates expected to influence all three elements of inventory whereas the improvements in technology identified above have been mainly focussed on raw material planning and to a lesser extent finished goods. Fig. 6 shows that of the actual fall in inventory (measured in constant & 1985 prices) the group Metal goods, Engineering and Vehicles contributed slightly over half. One other factor that should be borne in mind is that the restructuring of a logistical system may mean that whilst total system inventory remains the same, some proportion is reallocated from the manufacturing sector to the distribution sector. A vehicle manufacturer who decides to use a third party to deliver materials using JIT may reduce his own inventory ho,lding but this may be balanced by a comparable increase in the warehouses of the distribution sector. Detailed analysis of this proposition is not possible but examination of Fig. 1 provides some support for this hypothesis. The ratio of manufacturing inventories only has fallen much faster than that which refers to manufacturing inventories plus those held in the retail and warehouse sector. Given that most of these latter inventories will have derived from manufacturing industry then there does seem to be evidence that some inventories have been transferred from the manufacturing sector.
4. Resolution There has undoubtedly been a significant fall in the ratio of inventory to output in UK manufacturing industry during the 1980s. There have also been comparable changes in the warehouse and retail sectors. Looking at the cause behind the fall of the 1980s it would be hard to deny that either monetary factors or technological factors did not have some influence. Real interest rates have been significantly higher than the 1980s and a steady decline in the inventory-output ratio might be explained by a gradual readjustment of company policies to this higher cost-equivalent, perhaps to a doubling in cost compared to the late 1970s. Perhaps this higher cost has encouraged companies to seek out
means of reducing inventory holding costs and to adopt new technology and better management control earlier than they would have without the pressures on their finances. Despite the lack of hard empirical evidence, the distribution and logistics literature is replete with praise for the benefits of electronic systems such as EPOS and management methods such as JIT. Some caution needs to be expressed as to whether these automatically lead to reductions in inventory. (Nor should it be assumed a fall in inventory is always beneficial, if customer service is prejudiced, for example.) Cheaper methods of control may encourage a large variety of inventory holding rather than simply reduction in excess holdings. Without detailed longitudinal studies of company behaviour it is impossible to provide precise estimates of inventory savings. Certainly the variations shown by the disaggregation of manufacturing into 6 sectors suggest that other forces are at work rather than industry wide trends in costs and management methods. The final conclusion must be that our understanding of inventory movements on a national basis is far from perfect. In particular longitudinal studies of particular industries are needed in order to clearly identify the special factors that have influenced the change in holding policies of the 1980s. Even this approach, however, is bedevilled by the difficulty of interpreting the reason behind changes in company policy. Was it the adoption of the new technology or the monetary imperative behind its adoption that led to the fall in inventory? Turning to the 1990s can we expect further falls in the inventory-output ratio in the UK? With inflation predicted to remain at a low level (3% or less) and no prospect of a significant fall in European, and hence UK interest rates, real interest rates are likely to be in the same range as found in the 1980s or slightly lower. New technology and new management methods will continue to be adopted by industry. On both counts therefore we can expect further falls in the ratio. Eventually without further rises in real interest rates the fall may be mitigated as more and more companies have adapted their policies to the expectation of real interest rates around the 5% level. Experience in 1991 and 1992 is not a good guide to long-term trends as short-term inventory movements have
I.G. Black, M. Pe~rrs/Int. J. Production Economics 35 (1994)
been heavily recession.
influenced
by the
movement
into
References [I]
Waters, C.D.J., 1988. How Efficient is UK Inventory Management. in: Cooper, J.C., (Ed.), Logistics and Distribution Planning. Kogan Page, London. [2] Mckinnon, A.C., 1991. Regional variations in manufacturing inventory levels. Phys. Distribution Logist. Mgmt., 21. [3] Wallis, K.F., Fisher, P.G., Longbottom, J.A., Turne, D.S. and Whitley, J.D., 1987. Models of the UK economy: A Fourth Review by the ESRC Macroeconomic Modelling Bureau. Oxford University Press, Oxford.
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9
[4] Treasury, H.M., 1982. H.M Treasury Macroeconomic Technical Manual, H.M Treasury, Mimco. [S] Callen, T.S., Hall, SC. and Henry, S.C.B., 1990. Manufacturing stocks: Expectation, risks and co-integration. Econom. J., 100. [6] O’Brien, J., 1986. 1985 Survey of distribution Costs. Focus on Phys. Distribution. [7] Hall, S.G., Henry, S.G.B. and Wren-Lewis, S., 1986. Manufacturing stocks and forward-looking expectations in the UK. Economica, 53. [8] Sohal, A. and Havard, K., 1987. Trade in Materials Management. Int. J. of Phys. Distribution Mat. Mgmt., 17. [9] Cooper, J., Browne, M. and Peters, M., 1991. European Logistics. Blackwell, Oxford. [lo] Mellis, C., 1986. H.M Treasury macroeconomic model. HMT GES Working Paper 90.