Inventory to Sales Ratio and Labor Force Participation Rate (1992-2013)

Posted by PITHOCRATES - November 12th, 2013

History 101

Just-in-Time Delivery lowers Inventory Costs but risks Manufacturing Interruptions

Carrying a large inventory is costly.  And risky.  First of all you have to warehouse it.  In a secured heated (and sometimes cooled) building.  With a fire alarm system.  A fire suppression (i.e., sprinkler) system.  A security alarm system.  You need lighting.  And people.  Safety training.  Safety equipment.  Forklifts.  Loading docks.  Delivery trucks.  Insurances.  Property taxes (real and personal).  Utilities.  Telephone and Internet.  A computer inventory system.  Etc.  It adds up.  And the larger the inventory the larger the cost.

Then there are the risks.  Fire damage.  Theft.  Water damage (say from a fire suppression line that freezes during the winter because some kid broke a window to let freezing air in that froze the water inside the sprinkler line with the expanding ice breaking the pipe and allowing water to flow out of the pipe onto your inventory).  Shrinkage (things that disappear but weren’t sold).  Damaged goods (say a forklift operator accidentally backed into a shelve full of plasma displays).  Shifts in consumer demand (what was once hot may not be hot anymore which is a costly problem when you have a warehouse full of that stuff).  Etc.  And the larger the inventory the greater the risks.

In the latter half of the 20th century a new term entered the business lexicon.  Just-in-time delivery.  Or JIT for short.  Instead of warehousing material needed for manufacturing manufacturers turned to JIT.  And tight schedules.  They bought what they needed as they needed it.  Having it arrive just as it was needed in the manufacturing process.  JIT greatly cut costs.  But it allowed any interruption in those just-in-time deliveries shut down manufacturing.  As there was no inventory to feed manufacturing if a delivery did not arrive just in time.

A Rising Inventory to Sales Ratio means Inventory is Growing Larger or Sales are Falling

There are many financial ratios we use to judge how well a business is performing.  One of them is the inventory to sales ratio.  Which is the inventory on hand divided by the sales that inventory generated.  If this number equals ‘1’ then the inventory on hand for a given period is sold before that period is up.  Which would be very efficient inventory management.  Unless a lot of sales were lost because some things were out of stock because so few of them were in inventory.

Ideally managers would like this number to be ‘1’.  For that would have the lowest cost of carrying inventory.  If you sold one item 4 times a month you could add one to inventory each week to replace the one sold that week.  That would be very efficient.  Unless four people want to buy this item in the same week.  Which means instead of selling 4 of these items you will probably only sell one.  For the other three people may just go to a different store that does have it in stock.  So it is a judgment call.  You have to carry more than you may sell because people don’t come in at evenly spaced intervals to buy things.

We can look at the inventory to sales ratio for the general economy over time to note trends.  A falling ratio is generally good.  For it shows inventories growing as a lesser rate than sales.  Meaning that businesses are getting more sales out of reduced inventory levels.  Which means more profits.  A flat trend could mean that businesses are operating at peak efficiency.  Or they are treading water due to uncertainty in the business climate. Doing the minimum to meet their current demand.  But not growing because there is too much uncertainty in the air.  A rising ratio is not good.  For the only way for that to happen is if inventory is growing larger.  Sales are falling.  Or both.

The Labor Force Participation Rate has been in a Freefall since President Obama took Office

When inventories start rising it is typically because sales are falling.  Businesses are making their usually buys to restock inventory.  Only people aren’t buying as much as they once were.  So with people buying less sales fall and inventories grow.  Rising inventories are often an indicator of a recession.  As unemployment rises there are fewer people going to stores to buy things.  So sales fall.  After a period or two of this when businesses see that falling sales was not just an aberration for one period but a sign of worse economic times to come they cut back their buying.  Draw down their inventories.  And lay off some workers to adjust for the weaker demand.  As they do their suppliers see a fall in their sales and do likewise.  All the way up the stages of production to raw material extraction. 

Retailers typically carry larger inventories than wholesalers or manufacturers.  To try and accommodate their diverse customer base.  So when their sales fall and their inventories rise they are left with bulging inventories that are costly to store in a warehouse.  They may start cutting prices to move this inventory.  Or pray for some government help.  Such as low interest rates to get people to buy things even when it may not be in their best interest (for people tend to get laid off in a recession and having a new car payment while unemployed takes a lot of joy out of having a new car).  Or a government stimulus program.  Make-work for the unemployed.  Or even cash benefits the unemployed can spend.  Which will provide a surge in economic activity at the consumer level as retailers and wholesalers unload backed up inventory.  But it rarely creates any new jobs.  Because government stimulus eventually runs out.  And once it does the people will leave the stores again.  So retailers may benefit and to a certain degree wholesalers as they can clear out their inventories.  But manufacturers and raw material extractors adjust to the new reality.  As retail sales fall retailers and wholesalers will need less inventory.  Which means manufacturers and raw material extractors ramp down to adjust to the lower demand.  Cutting their costs so their reduced revenue can cover them.  Which means laying off workers.  We can see this when we look at inventory to sales ratio and the labor force participation rate over time.

(There appears to be a problem with the latest version of this blogging software that is preventing the insertion of this chart into this post.  Please click on this link to see the chart.)

(Sources: Inventories/Sales Ratio, Archived News Releases

Cheap money gave us irrational exuberance and the dot-com bubble in the Nineties.  And a recession in the early 2000s.   Note that the trend during the Nineties was a falling inventory to sales ratio as advanced computer inventory systems tied in over the Internet took inventory management to new heights.  But as the dot-com irrational exuberance came to a head we had a huge dot-com economy that had yet to start selling anything.  As their start-up capital ran out the dot-coms began to go belly-up.  And all those programmers who flooded our colleges in the Nineties to get their computer degrees lost their high paying jobs.  Stock prices fell out of the sky as companies went bankrupt.  Resulting in a bad recession.  The fall in spending can be seen in the uptick in the inventory to sales ratio.  This fall in spending (and rise in inventories) led to a lot of people losing their jobs.  As we can see in the falling labor force participation rate.  The ensuing recession was compounded by the terrorist attacks on 9/11.

Things eventually stabilized but there was more irrational exuberance in the air.  Thanks to a housing policy that put people into houses they couldn’t afford with subprime mortgages.  Which lenders did under threat from the Clinton administration (see Bill Clinton created the Subprime Mortgage Crisis with his Policy Statement on Discrimination in Lending posted 11/6/2011 on Pithocrates).  Note the huge spike in the inventory to sales ratio.  And the free-fall of the labor force participation rate.  Which hasn’t stopped falling since President Obama took office.  Even though the inventory to sales ratio returned to pre-Great Recession levels.  But there is so much uncertainty in the economic outlook that no one is hiring.  They’re just shedding jobs.  Making the Obama economic recovery the worst since that following the Great Depression.

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Competition, Mom and Pop Store, Big Box Store, Cooperative, Internet Sales, POS System, Inventory Control System and Wal-Mart

Posted by PITHOCRATES - July 3rd, 2012

History 101

Big Box Stores offered More Choice and Lower Prices putting Mom and Pop Stores our of Business

Competition makes everything better for consumers.  Consumers love competition.  Because it gives them so much to choose from.  And choice is good.  Especially when that choice lowers prices.  And raises quality.  Which is why we love competition.  But it’s not very popular with businesses.  Especially the older ones.  Used to doing things the old way.  Who got into a comfortable rut.  Doing things the way they always did them.  Enjoying their comfortable incomes.  Until something arrived that shattered their world. 

America became the innovative capital of the world.  Thanks to their entrepreneurs.  In the land of liberty they were free to do great things.  Invent great things.  And go into business.  In cities and small towns everywhere moms and pops opened up shops.  Mom and pop stores.  Family affairs.  Serving their communities with quality goods and services.  At reasonable prices.  At least what people thought were reasonable prices.  Often times there was little competition for these mom and pop stores.  Apart from other mom and pop stores.

Mom and pop stores don’t have large sales.  Or large purchasing power.  So their prices are higher than a competitor who has large sales and large purchasing power.  Mom and pop office supply stores learned this lesson quickly when Office Max opened in town.  And Office Depot.  And Staples.  Big box stores that offered more choice and lower prices.  And no matter how much we loved our mom and pop stores when we had a chance to get more for less we chose to get more for less.  And these big box office supply stores put the mom and pop office supply stores out of business.

Advanced POS and Inventory Control Systems allow a Large Variety of Items at Low Prices

The mom and pop hardware stores suffered the same fate.  When the big box home improvement stores moved in.  Builders Square.  Home Quarters.  Home Depot.  Lowes.  Who served both consumers and contractors.  Giving them huge economies of scale.  Moving such a wide variety of material at low prices the small mom and pop hardware stores could never match.  Some survived.  Offering services like they did in the old days (like fixing a broken window).  And joining a cooperative (such as True Value or ACE Hardware) to match the purchasing power of the big box stores.  To get some economies of scale.  But more have gone out of business than stayed in business.

During the Eighties a lot of computer stores opened as the personal computer industry took off.  A lot of small stores custom built PCs.  Sold dot-matrix printers.  Fanfold printer paper.  Printer ribbons.  Floppy disks.  Cables.  External storage devices.  With the advent of the Internet they added dial-up modems.  As the industry grew the big box stores came in.  CompUSA.  Computer City.  The big box office supply stores.  Best Buy.  And Circuit City.  Put the small computer stores out of business.  By providing a huge variety at low prices.  They added software.  Games.  Uninterruptible power supplies.  And other electronic devices (PDAs, digital cameras, game boxes, game controllers, etc.).  Then Internet sales took off putting pressure on the big box stores.  Putting some of them out of business.

A big driver in the move away from the mom and pop stores to the big box stores is technology.  In particular inventory control systems.  Tied into their point of sale (POS) systems.  Buying a lot of goods and storing them in large warehouses is costly.  Because inventory doesn’t earn any revenue.  It costs to warehouse items.  And it takes cash to place things into inventory.  Businesses buy these things to sell them later.  If they buy too much of the wrong things they may sit in those warehouses.  Becoming less valuable as people’s interests change.  Requiring deep discounting to move these unwanted items out of inventory.  On the other hand, if you don’t carry a large inventory there is a chance you may run out of something that is popular and is selling.  This is where technology comes in.  When a cashier completes a sales transaction a lot of things happen automatically.   As people receive their change from the cashier the POS system automatically interfaces with the inventory control system.  It updates the system to show the reduction in inventory.  And the inventory control system places an automatic order to replenish the inventory.  The successful big box stores carry smaller inventories of each individual item.  Allowing them to carry a larger variety of items.  Which is how they can offer a larger variety at lower prices.

Stores like Wal-Mart are the People’s Hedge against Bad Fiscal and Monetary Policy 

The king of retail, Wall-Mart, got to be king with technology.  The ultimate big box store that sells just about everything under the sun (groceries, clothes, hardware, gardening supplies, electronics, prescription drugs, you name it).  They have taken inventory control systems to an art.  They combine economies of scale and efficiency that few can match.  They sell so much that they get to buy at the best prices.  And their sophisticated POS and inventory control systems keep the shelves stocked with the things people want to buy while keeping their inventories lean.  Few stores please consumers more by their wide variety and low prices.  Allowing them to fill their shopping carts without having to sacrifice other family needs.

Competition created Wal-Mart.  Because people wanted more choice and lower prices.  And Wal-Mart figured out how to do that.  Something the mom and pop stores just couldn’t do.  Which is why Wal-Mart stores are opening everywhere.  The people love them.  And the people want them.  Or they want the store that puts Wal-Mart out of business by offering even more choice at even lower prices.

Of course this begs the question why do people want more choice at lower prices?  Are they greedy?  Materialistic?  No.  They’re just not rich.  More and more of their income is taxed away at the local, state and federal level.  And prices keep rising thanks to Keynesian monetary policy.  Which continuously expands the money supply to ‘stimulate’ the economy.  Higher taxes and permanent inflation is why two-income households have become the norm and not the exception today.  And why shoppers love stores like Wal-Mart.  Because stores like Wal-Mart are the people’s hedge against bad fiscal and monetary policy.  Which is the true destroyer of mom and pop stores everywhere.

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