The Effects of Stock-Based Incentives on Inventory Management

Classic inventory theories typically focus on the operational trade-offs to optimize inventory decisions. However, managers of public firms who obtain stock-based incentives may alter inventory operations to influence the stock price. We develop a stylized model, which shows that, in the presence of an interest in the stock price, managers over-install inventory when it can either inflate sales or deflate the reported cost of goods sold even if the market anticipates such actions. We analyze the joint and marginal effects of the stock-based incentives and the cost of using inventory to manage earnings, which may provide useful implications for the detection of inventory distortion and the design of management incentive plans. We then conduct an empirical analysis based on the financial data of U.S. publicly listed retailers and manufacturers. We find positive (negative) correlation between firms’ abnormal excess inventory and the stock-based incentives of their top executives (the inventory manipulation cost). Moreover, the marginal effect of the stock-based incentives on the abnormal excess inventory is the strongest when the inventory manipulation cost is intermediate. Our empirical analysis also shows that this effect becomes statistically weaker after the passage of the Sarbanes–Oxley Act. This is in line with the prediction of our analytical model about the effect of the accuracy of financial reporting.