Assessing Inventory Management and Capacity Requirements Using Financial Reports

Using current financial report information, this study jointly assesses individual manufacturing firms' inventory management decisions and the magnitude of their capacity requirements. Ex ante decision making and ex post problems with respect to inventory management are characterized using the production smoothing and stockout/glut models, respectively. We focus on five scenarios derived from these models: (1) production smoothing to higher future demand; (2) production smoothing to lower future demand; (3) inventory glut; (4) inventory stockout due to capacity constraints; and (5) inventory stockout due to production problems. Firms are classified into scenarios based on their current growth rates for each of sales, inventories, and the order backlog. The usefulness of our classification scheme for assessing inventory management and capacity requirements is demonstrated by our findings that the change in the production cycle in the current year and capital expenditure growth in the subsequent year are predictably different for the five scenarios. The overall value-relevance of this classification scheme is demonstrated by our findings that current size-adjusted returns and future sales growth are predictably different for the five scenarios. We conclude by arguing that, with appropriate modifications for their superior information, management could employ similar classification schemes to assess inventory management and capacity requirements at the plant or product level.