The Roles of Excess Inventory with Stock Price Interest

The Roles of Excess Inventory with Stock Price Interest

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Abstract

Classic inventory theories typically focus on the operational tradeoffs to optimize the inventory decisions. However, managers of public firms might alter their inventory operations to influence their stock price. We develop a stylized model which shows that in the presence of an interest in the stock price, managers overinstall inventory when it can either stimulate the sales or deflate the reported cost of goods sold (COGS) even if the market anticipates such actions in equilibrium. We then conduct an empirical analysis based on the financial data of the U.S. listed public companies. We find that the increase of inventory in the last fiscal quarter has a significantly positive correlation with the top executives’ interest in their firm’s stock price (measured by the weight of their stock and option compensation and the firm’s earnings status). This effect becomes statistically weaker after the implementation of the Sarbanes–Oxley Act in 2002. Our empirical results also suggest that for the retailers, the excess inventory likely “pulls” future demand to the current period and thus negatively impacts the sales of the first fiscal quarter of next year, while for the manufacturers, the excess inventory likely “shifts” a part of the costs to the future and thus negatively impacts the gross margin of the first fiscal quarter of next year. On the other hand, the market might have taken such managerial incentives into account. We find that the stock price reacts less to a sales increase or a reduction of COGS but more to an increase of inventory, when the executives’ stock price interest is stronger.