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Sign of the times
Manufacturers, merchant wholesalers, and retailers have been facing an extremely challenging economic and financial environment over the past few years. Key among their concerns: an unexpected decline in sales combined with an increase in the inventories-to-sales ratio. While this situation is typical during a recession, the nature of both of these conditions was qualitatively different than it was for previous post-World War II recessions.
An unexpected sales decline in combination with an increase in the inventories-to-sales ratio typically implies an unexpected inventory accumulation and a reduction in demand. This stems from the inability of businesses to adjust inventory levels and prices. ("Unexpected" sales or inventories-to-sales ratios are defined as the difference between the forecast and the actual.)
[Figure 1] U.S. sales adjusted for inflation Enlarge this image
[Figure 2] U.S. inventory adjusted for inflation Enlarge this image
[Figure 3] U.S. inventory-to-sales ratio Enlarge this image
It's important to note that different types of companies have different capacities for dealing with unexpected inventory accumulations. Wholesalers and retailers usually are better able to manage them because they can initiate the cancellation of orders, implement price discounting, and get better and faster feedback from their customers. Manufacturers, on the other hand, have to be concerned about production cycles and assembly lines and therefore manage two different types of inventories: input inventories (work-in-progress, raw materials, and intermediate goods) and finished goods.
A different kind of recession
By examining the inventory and sales levels over the past 14 years, we can see how the two most recent recessions (2001 and 2007) differed from one another in terms of which types of business were affected as well as the severity of the downturn.
The 2001 recession (March 2001 through November 2001), also known as the "Dot-Com Recession," was driven by a downturn in business spending rather than by a drop in housing or consumer spending. Business investment adjusted for inflation suffered significant declines, however housing starts hardly moved and personal spending and retail sales, when adjusted for inflation, actually increased.
In the months leading into the 2001 recession, retail sales growth slowed and wholesale sales fell a bit, but manufacturing sales saw a relatively sharp decline as shown in Figure 1. This decline caused greater inventory accumulation (Figure 2) and a sudden rise in the inventoriesto- sales ratios (Figure 3). While manufacturing sales adjusted for inflation just barely surpassed its pre-2001 recession peak, wholesale sales, retail sales, and imports from China kept chugging along.
In contrast, the "Great Recession" (December 2007 through June 2009) and the subsequent anemic recovery have dramatically affected almost every aspect of the U.S. economy. This past recession was much more severe and qualitatively different than the previous post-World War II recessions. The impact on manufacturers was devastating, causing an almost 20-percent decline in real sales and an unprecedented spike in the inventories-to-sales ratio, as seen in Figures 1 and 3, respectively. While retailers and wholesalers fared relatively "better" leading up to and during the Great Recession, they did experience an approximate 12- percent decline in sales from peak to trough (see Figure 1). But they managed to reduce their inventory holdings through heavy price discounting and canceling orders of Chinese imports.
How strong a recovery?
Since the official end of the Great Recession in June 2009, the economic recovery has been relatively anemic by historical standards, with significant weaknesses in such key sectors of the economy as housing and household net worth. It has taken three years for retail sales and personal spending adjusted for inflation to finally surpass their previous peaks. Real wholesale sales are still slightly below their pre-Great Recession peak, while the manufacturing sector is struggling to make a full recovery.
The manufacturing recovery would be even weaker if not for a substantial increase in U.S. exports due to relatively strong growth in some emerging markets— namely China, India, and Brazil—and a weak U.S. dollar. In addition, business capital equipment and software spending has accelerated during the recovery period as businesses with healthy balance sheets focused on improving both productivity and inventory management without increasing payrolls.
What does all this mean for the near future? Currently inventories are lean, and as a result, we expect to see them increase. There should be a big bounce-back in automobile inventories—and therefore manufacturing—once the supply chain disruptions caused by the mid-March earthquake in Japan abate. We expect manufacturing inventory levels to surpass their Quarter 1, 2008 peak by early 2012.
Wholesale inventories will benefit from the same type of drivers as manufacturing inventories: exports, business equipment formation (capacity expansion), and replenishment. However, a significant portion of wholesale sales and inventory is targeted to the retail side of the economy, which has been showing considerable weakness recently.
The consumer side of the U.S. economy has softened considerably in the first half of 2011, with weakening retail sales growth and depressed levels of consumer confidence. Retail inventories are ultra-thin, and we expect the inventories-to-sales ratio to continue on its downward path due to technological innovations that help companies better match supply with demand together with increased efficiency in inventory management. The outlook for retail inventories remains relatively flat for the next couple of quarters with a slight pickup thereafter. We do not expect retail inventories to surpass their pre-Great Recession peak anytime soon since consumer spending has been very lackluster and the recent payroll numbers are not very promising.
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