Tuesday, February 17, 2009

Involuntary Inventory Accumulation: Still A Problem

The Lehmann Letter ©

On Thursday the Census Bureau released December data for business sales, inventories and the inventory/sales ratio: http://www.census.gov/mtis/www/mtis_current.html

The Bureau said that inventories had risen by 0.9 percent while sales were down 11.8 percent from a year earlier. Consequently, the inventory/sales ratio (sales divided by inventories) climbed from 1.26 to 1.44 (see following chart).

(Click on image to enlarge,)

To repeat what this blog said a month ago:

The recent rise interrupted the long-run downward trend. Over the past decade businesses have required fewer and fewer inventories to support their sales. That was a measure of improved efficiency.

But the ratio’s recent rise is ominous because it’s a symptom of involuntary inventory accumulation. If sales fall and inventories rise – as they have over the past year – that’s a sign that unsold goods are piling up on shelves. Businesses have not been able to reduce production and orders swiftly enough to prevent the involuntary accumulation of unsold goods. In other words, the drop in sales was worse than business anticipated and caught business by surprise. Hence: Involuntary inventory accumulation – the buildup of unwanted product.

Management’s solution: Production reduction as firms sell off their inventories rather than produce more product. Inventories must fall more rapidly than sales in order to return the inventory/sales ratio to the normal range. To accomplish that, production must also fall more rapidly than sales.

Business will, of course, eventually be able to bring its inventories under control. But, in a world of declining sales volume, that implies a drastic reduction in output and orders. When the ratio stops rising and begins to fall, the recessions full downdraft will be upon us.

That’s not a comforting prospect.

© 2009 Michael B. Lehmann

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