Voluntary or Involuntary?

June 4th, 2013

by Eric Schaefer

That is the question analysts are pondering regarding the post-recession increase in the ratio of private inventories to gross domestic product (GDP). The ratio measures the value of inventories held by businesses, from manufacturers to retailers, to facilitate trade and economic activity.

Over the last forty years, the ratio has steadily declined. There are a number of causes for this secular trend. First, was the skyrocketing of interest rates during the 1970s. Higher interest rates raise the opportunity cost for businesses of holding inventories, whether financed (through loans) or paid for in cash. Double digit interest rates significantly eroded gross margins (the difference between an item's sales price and the cost to the business of buying or making the good). Self-preservation induced firms to slash inventory levels in order to survive.

The steadily declining cost of information technology was the second driving force. Cheaper (and smaller) computers allowed businesses to begin to monitor (in almost real time) the flow of items from the shipping dock, to the factory floor, to the warehouse and onto the end customer. Finally, the emergence and diffusion of lean manufacturing techniques and just-in-time inventory control created a new global standard for businesses - not just in goods producing industries but in the distribution chain (wholesaling and retailing) as well.

The result: the quantity or value of inventories needed to support or accommodate one dollar of economic activity has declined precipitously since the 1970s. For businesses — individually and in the aggregate — the inventory squeeze has reduced financing needs while bolstering profitability.

Will firms push inventory levels to zero? No. While theoretically feasible, the objective is not practically desirable. Businesses hold inventories as a buffer between production and sales. While a manufacturer can schedule production, it can rarely plan sales. If an item is unavailable, a buyer will try another outlet. It is this opportunity cost — of a lost sale and a disappointed client — that businesses manage through inventories.

But there are expenses associated with holding inventories. The financing expense is just one: warehousing, insurance and shrinkage (theft) are other costs a business must consider when striking a balance with the opportunity cost of a lost sale. Then there is obsolescence. Goods sought by consumers yesterday may be rendered worthless by technology or changing tastes tomorrow. No category is spared — all are subject to consumers' fickle fashions.

In computing GDP, an increase in inventories contributes to economic growth. No distinction is drawn between a voluntary increase (an investment to meet future expected demand) and an involuntary rise (caused when final sales slow). The latter is an important mechanism in recessions. Initially, when sales weaken, a business may be loathed to cut back production or purchases. But as sales continue to falter and stocks rise, firms will cancel orders or curtail production. This is how faltering demand translates into reduced supply (and higher unemployment).

Inventory ratios thus provide a barometer of an economy's future resiliency over a business cycle. Low ratios mean the supply chain is tight, whereas high ratios imply there is slack. The former suggests future orders will probably rise (to replenish diminished stocks), while the latter implies the opposite. In the current environment, the financing cost of holding inventory is at historical lows. And, the March 2011 earthquake and tsunami in Japan highlighted the vulnerably of a taut global supply chain. In the disaster's aftermath, firms opted to increase buffer stocks. These possible explanations aside, analysts at the moment are still trying to divine if this reversal of a secular trend is voluntary or involuntary.


Notes on Sources, Methods and Definitions:

Active duty U.S. military personnel data for the years 1790 to 2003 obtained from the Department of Defense (DoD), Washington (Sources: Department of Defense; Census Bureau; AIFS estimates.)

Chart illustrates the historical trend in the ratio of private inventories (non-government) to gross domestic production (GDP). Both series are in current or nominal dollars — that is, not adjusted for the impact of changing price levels.

GDP is a widely used measure of the total goods and services produced (consumed) by a nation over a period of time. Nominal GDP reflects the value of the aggregate goods and services at current price levels. Private inventories include goods or commodities held by farm, manufacturing, wholesalers or retailers whether raw materials, goods in production or finished products available for sale valued in nominal or current dollars.

(Sources: Bureau of Economic Analysis (BEA); AIFS estimates.)


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