Statistics Canada - Statistique Canada
Skip main navigation menuSkip secondary navigation menuHomeFrançaisContact UsHelpSearch the websiteCanada Site
The DailyCanadian StatisticsCommunity ProfilesProducts and servicesHome
CensusCanadian StatisticsCommunity ProfilesProducts and servicesOther links

Warning View the most recent version.

Archived Content

Information identified as archived is provided for reference, research or recordkeeping purposes. It is not subject to the Government of Canada Web Standards and has not been altered or updated since it was archived. Please "contact us" to request a format other than those available.

11-010-XIB
Canadian Economic Observer
November 2003

Feature article

The changing role of Inventories in the business cycle

by P. Cross and G. Salvatore*

Changes in inventory levels have been one of the driving forces of the business cycle, accounting for most of the drop in output in recessions since World War II. But firms overall have steadily lowered their inventory-to-sales1 ratio (Figure 1). This paper examines whether better inventory control has been one reason behind the steadier growth of the economy over the past decade. It also looks at the reduction in the economy-wide ratio of inventories to sales and which sectors have or, just as interestingly, have not participated in this decline.

Figure 1

All the sectoral data used in this study come from the Income and Expenditure Accounts and are in nominal dollars (with the focus on the ratio of stocks to sales, deflating both by prices to convert to constant dollars makes no difference). Inventory data are available for manufacturing, wholesale and retail trade, as well as ‘other’ non-farm industries (which include mining and utilities).2 Data for individual industries come from the monthly surveys of manufacturing and wholesale trade,3 but these are only available back to 1992.

The volatility of GDP

Table 1 shows the variability of quarterly real GDP growth over the last four decades (the end points of 1970, 1982 and 1991 were selected so that each decade includes a full business-cycle expansion and contraction). The results show that the standard deviation (a measure of variability) of GDP growth was little changed at about 1.0 up to 1991, except for a brief increase during the economic upheaval of the 1970s that culminated in the 1981-82 recession. During the 1960s and 1970s, the variability of GDP excluding inventories was slightly less than overall GDP, implying that inventory changes were aggravating the instability of the economy. This is consistent with the results of researchers in the US who, unexpectedly, found that output was more variable than sales and that stocks did not act as a buffer against unexpected fluctuations in demand (Blinder and Maccini, p. 74).

Table 1: The variability* of Real GDP and Final Sales Growth

  GDP GDP ex non-farm inventories
     
1961-1970 0.897 0.838
1971-1982 1.065 1.012
1983-1991 0.888 0.956
1992-2003 0.519 0.615
* As measured by standard deviation

This began to change in the 1983-1991 cycle, when the variability of GDP was 7% less than GDP excluding inventories. This coincided with the introduction of just-in-time inventory systems pioneered in Japan (notably in the auto industry) and the initial diffusion of computer technology to aid the monitoring of inventories. As well, the federal government in 1986 abolished a 3% tax break for inventories (Phillips, p. 43).

Figure 2

By plotting the standard deviation of real GDP for successive 20-quarter intervals over the last four decades, Figure 2 shows how the variability of growth has fallen.4 The last decade has seen a marked drop in the volatility of output. The standard deviation of GDP growth fell 46% from the 1980s to just 0.52, half its average of the previous three decades. Reasons for this drop are numerous, including smaller fluctuations in inflation and interest rates as well as fewer shocks to supply; the most notable manifestation was the absence of a recession during this period. But better inventory control also played an important role: the standard deviation of GDP was 19% lower than GDP excluding inventories, on top of the initial gap of 7% that had opened up in the 1980s. (We do not attempt to disentangle whether better inventory control was the cause of more stable output or the result of smoother sales).

Figure 3 confirms that the relationship of final sales and inventories has changed in a manner that dampens the business cycle. From 1982 to 1991, changes in demand and inventories reinforced each other, with an overall correlation of 0.77. Small dips in demand in 1982 and 1991 triggered large cuts to stocks. Without any initial build-up when sales first slumped, the drop in inventories suggests firms anticipated a prolonged period of weak demand. From 1992 to 2003, however, the correlation dropped to 0.37, with stocks moving in the opposite direction when sales suddenly changed course in 1995, 1996, 1999 and 2002. Inventories therefore acted more as a buffer shielding output against fluctuations in demand, helping to smooth out the business cycle. This may reflect the increasing confidence that firms have that, if sales jump unexpectedly, they can quickly replenish stocks (Filardo, p.30). As well, hoarding raw materials as a hedge against commodity shortages, as occurred in 1974 and 1980, has greatly diminished.5

Figure 3

In the next section we look at how diffuse the trend to lower inventories has been by examining the ratio of inventories to sales in the major non-farm sectors and the most important industries within each.

Who holds inventories?

Of the $180 billion of inventories in Canada in mid-2003, the largest part (38%) was held by manufacturers (Table 2). Of this, 40% were raw materials used to make goods; 33% finished goods; and the remainder goods at various stages of production (goods-in-process) or goods purchased for resale. By industry, transportation equipment alone accounted for one-fifth of all stocks in manufacturing (mostly in aerospace and railway cars, which held three times as much stock as the auto industry). The chemicals and computer and electronic product industries each held about 10% of all manufacturing stocks. Other notable holdings were in food, wood, primary metals and machinery.

Table 2: Inventories by sector*

  Level Percent of total
  (Billion$)  
     
Total non-farm 180.2 100.0
     
Manufacturing 69.2 38.4

Raw materials

27.7 15.4

Goods-in-process

14.1 7.8

Finished goods

22.5 12.5

Goods purchased for resale

4.8 2.7
Wholesale 49.4 27.4
Retail 47.0 26.1

Motor Vehicle

15.9 8.8
Other 14.6 8.1
* Data for second quarter, 2003

Outside manufacturing, wholesale and retail trade had just over 26% of all non-farm inventories.6 The motor vehicle industry alone accounted for nearly one-quarter of these stocks.

All three sectors began the 1990s with inventory-to-sale ratios of about 0.6 (Figure 4). This obviously included some stocks accumulated involuntarily by firms when sales slumped in the recession, since each sector quickly reduced its inventory ratio when demand recovered early in the decade. Thereafter, each followed its own course. Wholesalers slashed stocks steadily, while retailers consistently had the highest inventory ratio over the past decade. Manufacturers struggled to rein in inventories during their recent slump in demand, and saw the largest increase in the ratio of stocks to sales compared with the mid-1990s. Historically low interest rates since then also may have reduced the incentive to trim stocks further.

Figure 4


Manufacturing

Manufacturers have shown several distinct trends in their inventory control. From the end of the recession in 1991 to 1995 they made steady reductions, as more industries adopted new technologies and inventory management practices during the recovery. However, after 1995 the trend turned up, accentuated by the slack in sales after 2000. Since 1998, only 5 of 21 industries were able to further rein in their stocks. In fact, several industries had sharply higher inventories for several years, notably aerospace and computers and electronics, partly due to an extended slump in demand. This highlights how easily the forces of the business cycle can overwhelm technical and managerial advances. In fact, the upward pressure on inventories in recent quarters left only a minority (10 out of 21) of industries with inventory ratios lower than 10 years ago.

Several factors combined to produce this surprising increase in inventories in recent years. But a rising inventory ratio does not always mean flagging sales or poor cost control. The sharpest increase in stocks has been for goods in process, which reflects the success of aerospace and railroad equipment firms in booking new orders. These industries require long periods of on-site construction within the firm.

Figure 5


Inventories of raw materials fell slowly relative to shipments until 1995, but then began to creep up. For raw materials, this may reflect the exhaustion of gains to be made from new controls such as just-in-time. The auto industry has seen little change in its overall ratio of stocks to sales in the last decade, after its pioneering adoption of the just-in-time delivery of inputs in the 1980s. As a result, its ratio of raw materials inventories to shipments has been steady at less than 0.1—still by far the lowest of any industry. However, some industries saw raw materials inventories rise over time. In particular, the stock ratio for computers and electronic products nearly doubled in recent years (the collapse of sales in this area led to only a small uptick in stocks of finished products). As well, the chemical industry saw its raw materials inventory ratio nearly double in the last decade.

Finished goods also fell behind shipments until 1995, driven by the recovery from recession. But they rose sharply during slowdowns in demand in 1997 and 2001. The nosedive in aircraft sales after September 11 doubled the stock-to-sales ratio for aerospace manufacturers, while computer and electronics also edged up.

Figure 6

It is ironic that the computer and electronics industry saw the largest increase in its overall inventory-to-sales ratio, since it was the technology embedded in its products that is credited with helping to better control inventories in other industries. But some areas of this industry appear to have struggled to apply these principles to itself. While its inventory-to-shipments ratio was steady for most of the 1990s, the surge of demand related to the Internet and the Y2K bug coincided with an increase in the ratio to nearly 0.7 late in 1999, perhaps as the riches garnered by this industry reduced the importance attached to strict cost controls. The subsequent sales slump helped send inventories to above the level of sales, and the industry has struggled to reduce the ratio ever since. It is not clear why falling sales led to a sharper increase in stocks of raw materials than finished goods: while the initial increase in stocks in 1999 accompanied booming demand and may have reflected a build-up in anticipation of higher output, this has long since ceased to be a factor.

Figure 7

Goods purchased for resale reflect the wholesale activities of manufacturers. For example, if a manufacturing firm decides to specialize in producing one product line in Canada and import others, these imports would be classified as goods purchased for resale.7 The share of these goods in inventories has been little charged in recent years.

Wholesale

Wholesalers made the largest reductions in their stocks relative to sales of any sector in the economy, with a drop of nearly one-third over the last decade. Moreover, it is the only sector to have sustained its decrease throughout, leaving the ratio at 0.4, the lowest of any sector.

Even here, however, the drop in inventories was confined to a small number of industries. Figure 8 shows that the reduction in the inventory-to-sales ratios in motor vehicles and computers (including software) accounted for most of the decline. The fast growth of these two industries, especially computers in the late 1990s, also reinforced the overall drop for wholesalers, since they had inventory ratios below the wholesale average. A majority (4 of 7) of wholesale industries posted no significant decrease in their inventory ratios, while they showed the least volatility of any sector other than non-auto retail.

Figure 8

Retail

The recent levelling-off of the inventory ratio for retailers masks divergent trends. Auto retailers reduced their ratio of stocks to sales from over 0.9 in the early 1990s to as low as 0.55 in the sales boom when 0% financing was first introduced in the wake of the September 11 attacks, before rising to 0.7 when sales slowed in 2003. While trending down, auto retailers have among the most volatile inventory ratios of any industry, a reflection of the capriciousness of demand.

Figure 9

Excluding auto dealers, however, reveals little change in inventories in the rest of the retail industry, with a ratio hovering around 0.55 for most of the last 15 years. The absence of cuts in non-auto stocks is surprising given the proliferation of scanning and barcode technology. This may reflect the need for retailers to always have sufficient stock on hand (to avoid ‘stockouts’) in view of the impulsive nature of some consumer spending. Others speculate that rapid growth in retail capacity as new firms entered the market raised inventories, especially the trend to large stores that offer a wider selection of products (Lau, p.42). As well, the low level of stocks held by suppliers in manufacturing and wholesaling may have forced retailers to hold buffer stocks themselves.8 Still, the stability of their inventories (their ratio has the lowest standard deviation of any sector since 1988) also suggests that non-auto retailers have increased their technical ability to control stocks.

Conclusion

Firms have profited from their aggressive reduction of inventories relative to sales over the last two decades, particularly after the recession in the early 1990s. If the ratio of non-farm inventories to sales were the same today as in 1974, firms would be financing an extra $229 billion in stocks, plus the extra storage space required. At the current prime rate of 4.5%, this represents a savings of $10.3 billion, freeing these resources for other uses.

But the overall economy has also benefited from better inventory control. It is probably too soon to pass judgment on the claim that “the history of inventory-induced recessions has probably come to an end,”9 but fluctuations in GDP are less pronounced than in earlier decades and the absence of over-built inventory levels has contributed to our avoiding outright recession in the past decade.10

Nevertheless, the inventory-to-sales ratio has not dropped in all sectors of the economy. Wholesalers have led the way, driven by autos and computers. Manufacturers pioneered some of the techniques to reduce stocks, but recently have been unable to stop a build-up, notably in computers and electronics. Meanwhile, retailers have not reduced their inventory-to-sales ratio at all, especially outside autos, leaving the door open to more reductions in the future.

Bibliography

Blanchard, O. and J. Simon; “The Long and Large Decline in U.S. Output Volatility.” Brookings Papers on Economic Activity, 1: 2001.

Blinder, A. and L. Maccini; “Taking Stock: A Critical Assessment of Recent Research on Inventories.” Journal of Economic Perspectives, Vol. 5, No.1, Winter 1991.

Filardo, A.; “Recent Evidence on the Muted Inventory Cycle.” Federal Reserve Bank of Kansas City Economic Review, Second Quarter 1995.

Lau, H.-H.; “The Role of Inventory Management in Canadian Economic Fluctuations.” Bank of Canada Review, Spring 1996.

McDonough, W.; “Remarks Before the NY State Bankers Association Annual Financial Services Forum.” Federal Reserve Bank of New York, March 20, 2003.

Phillips, P.; “Inventories and the Business Cycle: Policy Implications.” Policy Options, April 1994.

Ramey, V. and K. West; “Inventories.” NBER Working Paper No. 6315, Dec. 1997.


Notes

* For more information on inventory data and concepts, contact G. Salvatore, Income and Expenditure Accounts (613) 951-3795.

1 Final sales of goods are defined as personal expenditure on goods, government current expenditure on goods, all fixed investment except transfer costs, and goods exports. Imports are not removed since it is unknown how much are in inventory or in final sales.
2 Since other industries account for less than 10% of inventories,
they are excluded from the sectoral analysis.
3 There are small conceptual differences between the two sources of inventory data, mostly related to the inclusion of goods purchased for resale in the Accounts. To make quarterly and monthly stock-to-sales ratios comparable, monthly inventories are divided by three.
4 The methodology is derived from a study of price and output instability by Blanchard and Simon (2001). McDonough (2003) uses similar techniques.
5 Changes in the variability of the economy-wide ratio of inventories to sales confirms this trend. From 1974 (when data begin) to 1991, its standard deviation was 0.21. Since then, that has fallen to just 0.05.
6 This is very close to the distribution of non-farm stocks in the US : manufacturing 37%, wholesale 26%, retail 26% and other 11% (Ramey and West, p. 74, Table 4).
7 In fact, the drop in the GPRS ratio in 1993 reflects the reclassification of the wholesale activities of auto firms from manufacturing.
8 Interestingly, data for department stores showed a downward trend from 1999 until the series was terminated in October 2002, although the ratio was still very high at nearly 3.0.
9 G. Epstein “Looking for Proof in All the Wrong Places: Economists Miss the Point on PCs and Output”, Barron’s, May 25, 1998. See also “The ratio that lost its relevance” by J. Kettle, Globe and Mail, Feb. 19, 1998.
10 At least one researcher speculated that one corollary of better inventory control in recessions is slower output growth during recoveries, as occurred in Canada in 1992 and in the US in 1992 and 2002. See M. McConnell and G. Perey-Quiros, “Output Fluctuations in the United States: What Has Changed Since the Early 1980’s?” The American Economic Review, Vol.90, No.5 (Dec.2000), p. 1475.

 



Home | Search | Contact Us | Français Return to top of page
Date Modified: 2008-11-21 Important Notices
Contents Tables Feature article Economic events Current economic conditions Charts User information PDF version