INVENTORY MANAGEMENT ON
FINANCIAL PERFORMANCE OF LISTED
MANUFACTURING COMPANIES IN
SRI LANKA
BY
Lakshani K S
5724
i
Table of Contents
Abstract ....................................................................................................................................................... iii
CHAPTOR I ................................................................................................................................................ 1
INTRODUCTION ....................................................................................................................................... 1
1.0 Research Background ....................................................................................................................... 1
1.1
Research Problem ........................................................................................................................3
1.2
Research Questions and Objectives ...........................................................................................4
1.2.1 Research Questions ..................................................................................................................... 4
1.2.2 Research Objectives .....................................................................................................................5
1.3
Methodology .................................................................................................................................5
1.4
Significance of The Study ........................................................................................................... 5
1.5
Limitation .....................................................................................................................................6
1.6
Summary and Organization of the Chapter ............................................................................. 6
CHAPTOR II ...............................................................................................................................................7
LITERATURE REVIEW ...........................................................................................................................7
2.0 Introduction ....................................................................................................................................... 7
2.1 Techniques of inventory management .............................................................................................7
2.1.1. Basic Economic Order Quantity Model: ................................................................................... 7
2.1.2. Lean Inventory System: ............................................................................................................10
2.2 Concept of performance ................................................................................................................. 11
2.3 Inventory management and firm’s performance ......................................................................... 11
2.4 Manufacturing sector in Sri Lanka and Inventory management ...............................................14
References .................................................................................................................................................. 15
ii
Abstract
In present era competitive world having business is very important to control various costs to
sustain in the market. To sustain in the market, inventory management plays an important role to
make a control over the financial statement of the organization. Effective inventory management
is effect for the overall performance of the manufacturing company. The manufacturing
companies retain inventory as Raw materials, Work in Progress and Finished goods mainly and
stock value takes a significant percentage of among all assets. Main objective is this report find
out the relationship between inventory management and financial performance and find out the
impact of inventory management on financial performance in Sri Lankan manufacturing firms.
This study employed a descriptive research design and used quantitative method. All relevant
data get from the secondary sources such as annual report and published articles. The target
population was manufacturing firms In Sri Lanka while sample size was 30% of the target
population. The sampling design adopted was be random sampling techniques and Data was
analyzed by use of statistical package for social science (SPSS) regression and correlation. Data
was then presented using tables and figures.
The empirical results revealed a positive relationship between financial performance and
Inventory management at 0.05 significance level. Further, they showed that Inventory
management had a significant effect on performance with a beta coefficient of 0.743 in model 1
and 0.916 in model 2. The study suggests that owners/managers of manufacturing firm effective
inventory management as a tactic to further their financial performance and in overall
performance of their organization.
Keywords: Inventory Management, Economic Order Quantity, Inventory Turnover Ratio, and
Average Age of Inventory. Financial Performance
iii
CHAPTOR I
INTRODUCTION
1.0 Research Background
Working Capital (WC) is the heart of any organization because it directly affects the liquidity
and profitability of the company. Firms cannot operate day-to-day activities without proper
management WC. WC deals with current assets and current liabilities. When considering the WC
component, inventory is an important feature, and it represents a higher amount than other
current assets. So, the inventory management concept is the most valuable concept that can be
increased a firm’s performance and productivity. Excessive levels of current assets can easily
result in a firm’s realizing a substandard return on investment. Inventory management concept is
most valuable concept that can be increased firm’s performance and productivity. However,
firms with too few current assets may incur shortages and difficulties in maintaining smooth
operations (Horne and Wachowicz, 2000) (Nasr, 2007) . Therefore, inventory also must handle
accurately without excessive or very few levels. Many of business firm’s main objective is
maximizing the shareholder’s wealth. It is necessary to generate sufficient profit to achieve
organizational objectives. Therefore, sufficient WC is necessary to sustain sale activity. This is
referred to as the operating cycle. The operating cycle can be said to be at the heart of the need
for WC.
WC is the difference between Current Assets (CA) and Current Liabilities (CL). Having CA
provides insight about company’s liquidity. Liquidity is the length of time until assets are
converted to cash. It is an indicator of company’s ability to meet financial obligations. The less
liquid of the company is the lower its financial flexibility to settle promising investment and
expenses, and greater its risk of failure. So, inventory is a main component part of the WC, and it
is main expenses of manufacturing firms in Sri Lankan context. Inventories refer goods held for
sale as part of a company’s normal business operations or goods acquired for sale. Inventory
represents one of the most important assets that most businesses process, because the turnover of
1
inventory represents one of the primary sources of revenue generation and subsequent earnings
for the company’s shareholders (Zwilling, 2011).
Inventories are the current assets which are expected to be converted within a year in the form of
cash or accounts receivables. Thus, it is a significant part of the assets for the business firms.
Inventories are the goods that are stocked and have a resale value in order to gain some profit. It
shows the largest costs for the trading firms, wholesalers and retailers. According to (Shardeo,
2015, p. 1) normally, inventory consists of 20-30% of the investment of the total investment of
the firm. Thus, it should be managed in order to avail the inventories at right time in right
quantity. Inventory refers to the stock of the resources which are held to sales and/or future
production. It can be also viewed as an idle resource which has an economic value. So, better
management of the inventories would release capital productively. Inventory control implies the
coordination of materials controlling, utilization and purchasing. It has also the purpose of
getting the right inventory at the right place in the right time with right quantity because it is
directly connected with the production. This implies that the profitability of the firm is directly or
indirectly affected by the inventory management.
According to (Sarin, 2007) there are several reasons for keeping inventory. Too much stock
could result in funds being tied down, increase in holding cost, deterioration of materials,
obsolescence and theft. On the other hand, shortage of materials can lead to interruption of
products for sales, poor customer relations and underutilized machines and equipment.
Inventories refer the finish goods, work in progress (WIP) and raw materials (RM) normally.
Most of businesses in Sri Lanka manage their inventory to gain strategic benefits. To take a more
benefits on inventory Company use several technics to manage inventory. Most popular technics
is Economic Order Quantity (EOQ) Model in Sri Lanka context.
(Colling, 1990) argue that in the United States of America and other Western countries,
improvement in productivity was achieved through reducing the direct manufacturing labour
expenses cost per unit of output. This strategy was justifiable because of the high labour content
in many manufactured products. However, the ratio of unit cost due to labour has constantly
2
decreased in recent years. Even large manufacturing firms, such as the United States (US) auto
assemblers, purchase up to 60 percent of the value of the product. This implies that management
of raw materials inventories is an area that shows great promise for productivity improvement.
Japanese firms earned more deserved attention in the mid-to late 1980s due to their notable
performance on quality and inventory management. The constant alert of the bar code being
scanned at a checkout lane shows a pillar of modern system of inventory management stock
tracking. In the earliest days of shop keeping, merchants write down procurement or they looked
at how many units were gone at the day’s end and then did their best to forecast future needs.
The key skills where experience and intuition, but it remains an imperfect method, even when
applied to operations that where quite small by today’s standards (Miller, 2010).
In this research, all manufacturing companies listed in the Colombo Stock Exchange (CSE) of
Sri Lanka are taken for analysis. All companies are public limited companies. Many inventories
are found at various stages in the manufacturing industry. So, after various discussions and
analysis, inventory management has some impact on the financial statement of the company.
1.1 Research Problem
In today competition it become mandatory to keep large current asset in form of inventories to
ensure smooth production it is necessary to strike a balance between all the inventories required
for the production. In this paper study about how manage existing inventory and to suggest ways
for reducing the inventory cost there by improving the profitability of the firm.
Most of studies and findings relating to the inventory management and financial performance
have been done in western countries and other countries In Sri Lankan context haven’t sufficient
research relating to this topic. Therefore, researcher can identify research gap in Sri Lankan
context related to this topic.
Other problem is customized product. The trend towards product customization that can be
observed is the result of many changes in the business environment. Nowadays Most of business
firms survive their customer needs by using product customization Concept. (Pine/Gilmore,
3
1999) defines customization as “producing in response to a particular customer’s desires.”
Manufacturing companies are all difference with respect to the way they meet the market
demand. Some companies meet their customer needs, anticipate customer’s demand and deliver
finish goods from their retained inventory. Other companies do not keep finish goods inventory
and manufacture new goods after receiving a tangible customer order. In here need of retained
finish goods inventory is not useful. But Raw Materials is more useful for survive customer
specific order.
The purpose of inventory management is to ensure availability of materials in sufficient quantity
as and when required and also to minimize investment in inventories. Because of the large size
of the inventories maintained by firms, a considerable amount of funds is required to be
committed to them. It is therefore absolutely imperative to manage inventories efficiently and
effectively in order to avoid unnecessary investments. A firm neglecting the management of
inventories will be jeopardizing its long run profitability and may fail ultimately. The reduction
in excessive inventories carries a favorable impact on the company’s profitability. Therefore,
firms have to manage inventory in correct manner for maximize organizational performance.
The other thing is there are lots of techniques to manage inventory. But what is the most useful
and suitable techniques to reduced cost not clear. In this study decide what the most applicable
inventory management technics is in Sri Lankan context. Therefore, this study examines the
effect of inventory management system on profitability.
1.2 Research Questions and Objectives
1.2.1 Research Questions
1. What is the relationship between inventory management and financial performance in the
manufacturing companies?
2. What is the impact of inventory management and financial performance in manufacturing
companies?
3. What are the most applicable and existing inventory management techniques in manufacturing
companies?
4
1.2.2 Research Objectives
1. To find out the impact of inventory management on financial performance in
manufacture firm in Sri Lanka.
2. To find out relationship between inventory management and financial performance in the
manufacturing companies
3. To identify existing inventory management techniques in manufacturing companies.
1.3 Methodology
This research belongs to descriptive research design which used prior knowledge about the
problem situation. In this research, secondary data collection methods are used to collect data.
The secondary data is gathered from published journals, published books and articles and some
reliable websites. After collecting data from the sources, we correlate the inventory turnover with
profitability of the firm using correlation concept. We will find the Pearson correlation
coefficient and analyze it to show the impact of inventory management on the profitability of the
firm.
1.4 Significance of The Study
The study findings may be significant in the various ways is hoped that study findings may be
used as basis for further research and investigations in form of literature, The findings may
provide information to managers in manufacture firms especially on knowing how to compare
actual performance and inventory management and findings may also be beneficial to other new
researchers to investigate further about the impact of inventory management on organizational
performance of other organizations other than manufacture firm in Sri Lanka.
5
1.5 Limitation
This study is based on only all public limited manufacturing companies at CES among all large
and medium scale manufacturing firm in Sri Lanka. So, it may reflect some partial view. In this
study is considered only five years as the period commencing from 2017-2021 and it is a short
time period. Also, inflation is the most crucial factor for financial terms. So, it is not considered
in any type of interpretation. Correlation technique is used as statistical tools to interpret the data.
Mainly this research based on secondary data, so it effects to more limitation on data collection.
1.6 Summary and Organization of the Chapter
First Chapter describe about significant of the topic, why this research do and about knowledge
gap which I am going to fill, research question and objectives, methodology, limitation on this
research and summery and organization of the chapter. The second Chapter is literature review
that focuses on the review of the related literature in line with the study variables. The researcher
mainly obtained the theoretical available written data by different authors about the variables
under the study and the reviewed information.
The third Chapter is Methodology that presents the research methodology which include;
Research design, study population, study area, study variables, instruments of data collection,
data processing, sources of data and data analysis.
The fourth Chapter is findings and suggestion that presents and discuss the findings of the study.
The findings serve to reinforce the existing knowledge proven about the relationship between
inventory management and performance of manufacturing firm in Sri Lanka. The fifth Chapter is
6
conclusions that contains summary of the study findings, conclusions, recommendations and
suggestions for further studies. It includes the summary of the study findings, conclusions and
recommendations were done in accordance with study objectives.
CHAPTOR II
LITERATURE REVIEW
2.0 Introduction
Traditionally the academic literature on inventory focuses on production and replacement as the
principal determinants of inventory policy and management. In here mainly focuses ordering
cost and holding cost characterizes the approach of Economic Order Quantity (EOQ) model
represented inventory management. But in recent years, buildup new concepts had been
developed of Operations Management. These more concept that Management oriented are
material requirements planning system (MRP), just – in- time (JIT) and ERP methods. Those
new concept play more important role in competitive business environment to determine optimal
inventory level.
This study investigates the effect of inventory management on firm performance. To find out
inventory performance, Inventory turnover ratio will be used and to measure firm performance
will be used profitability ratios. In general, if affect other micro and macroeconomics factor to
firm performance in here consider only inventory management that may influence to firm
performance.
2.1 Techniques of inventory management
2.1.1. Basic Economic Order Quantity Model:
7
Economic Order Quantity (EOQ) is the cost of inventory that -minimizes the total cost of
inventory management that has long been the most widely used inventory model. Its popularity
is due to a combination of simplicity and wide applicability. First introduced in 1913 by Ford W.
Harris, an engineer with the Westinghouse Corporation it has continued to be a key tool of
inventory management for nearly a century. But still R.H. Wilson is given credit for his early indepth analysis of the model (Arsham, 2006, p. 158) . The model is also known as the Wilson
EOQ model.
Figure 2.1: EOQ with Constant Demand 1
Source: International Journal of Innovative Science
(Muckstadt, 2010) discussed that EOQ model was determined by minimizing the total annual
cost incurred by the company by virtue of its ordering cost and carrying cost. The expression for
total annual cost is:
TC = D/Q * S + Q/2 * H
8
Were,
TC = Total Annual Cost
Q = Order Quantity
D = Annual Demand
S = Ordering Cost
H = Annual Carrying Cost Per Unit
(Muckstadt, 2010) also said that the first component of this equation represented the inventory
management costs and the second component represents the ordering cost. EOQ minimizes the
sum of holding and setup costs. Differentiating with respect to order quantity, the expression for
EOQ was obtained as indicated in the equation below.
Q = 2DCo /Ch
Were,
D = Annual Demand
Co = Ordering/Setup Costs
Ch = Cost of Holding One Unit of Inventory
According to the (Horne V. , 1989) a company should introduce policies to reduce lead time,
regulate usage and thus minimize safety status. Therefore, the finance manager should ensure
that only an optimum amount is invented in inventory to achieve the trade of between
profitability and liquidity (Pandey, 1995). Materials management is there a managerial process of
counting planning, coordinating, control, monitoring and motivation. (Plasecki, 2001) defines
EOQ model as an accounting formula that determines the point at which the combination of
order costs and inventory costs are the least. EOQ is the number of units that a company should
add to inventory with each order to minimize the total cost of inventory, such as holding costs,
ordering costs and stock out costs. EOQ is used as part of continuous review system in which the
level inventory is always monitored and fixed quantity is ordered each time the inventory reaches
a specific reorder point (Lysons, 2012).
9
2.1.2. Lean Inventory System:
(Womack, 2003) Lean production principle was pioneered. This principle was linked with
reduced inventories. Lean Management is getting more and more attention in today’s highly
competitive environment. In recent years, several systems have been developed in the field of
operations management to deal with excess inventory problem. Management–oriented systems
include the Just-In-Time (JIT) and Materials Requirements Planning systems (MRP).
Just-In-Time refers to a collection of practices that eliminate waste. These organization wide
practices encompass the entire supply chain. The elements of JIT include shared product design
with suppliers and customers, movement towards single sourcing proximate suppliers, reduced
machine set- up times and total preventive maintenance. It is an inventory strategy that is
implemented to improve the return on investment of a business by reducing inventory and its
associated carrying costs. In order to achieve JIT, the process must have signals of what is going
on everywhere within the process. JIT can lead to dramatic improvements in a manufacturing
organization’s return on investments, quality and efficiency. It emphasizes that production
should create items that arrive when needed, neither earlier nor later.
Quick communication of the consumption of old stock, which triggers new stock to be ordered,
is key to JIT and inventory reduction. This saves warehouse space and costs. The basic
philosophy of JIT is that inventory is defined as waste. The technique was first used by Ford
Motor company. It was subsequently adopted and publicized by Toyota Motor Corporation of
Japan in the 1950s.
MRP system is defined as product- oriented computerized technology aimed at minimizing
inventory and maintaining delivery schedules. It relates the dependent requirements for materials
and components comprising a product to time periods over planned horizon based on forecasts
provided by marketing and sales and other input information (K Lysons, 2003) . This system is
based on the recognition that demands for an item may be dependent on the demand for other
inventory items. The emphasis is on the end product into which related parts are incorporated.
The inventory quantities required are specified based on future demand. The demand for
10
inventory items is precisely determined from the master production schedule for the end products.
The operation of a lean inventory system such as JIT and MRP result in relatively low inventory
levels. The warehousing costs and material handling costs are significantly reduced. These
increases return on assets through decreased conversion costs.
2.2 Concept of performance
Performance is a measure of the results achieved. Performance efficiency is the ratio between
effort extended and results achieved. The difference between current performance and the
theoretical performance limit is the performance improvement zone. Performance assumes an
actor of some kind, but the actor could be an individual person or a group of people acting in
concert. The performance platform is the infrastructure or devices used in the performance act
(Malcom, S. 2005).
According to (Likert, 2003) there are two main ways to improve performance: improving the
measured attribute by using the performance platform more effectively, or by improving the
measured attribute by modifying the performance platform, which in turn allows a given level of
use to be more effective in producing the desired output. Performance can be measured by
obtaining the magnitude of a quantity, such as length or mass, relative to a unit of measurement,
such as a meter or a kilogram.
According to (Halachmi, 2005) ; argued that financial ratios are useful indicators of a firm's
performance and financial situation. Most ratios can be calculated from information provided by
the financial statements. Financial ratios can be used to analyze trends and to compare the firm's
financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy.
2.3 Inventory management and firm’s performance
Empirical evidence related to the inventory management-performance relationship produced also
mixed results. Specifically, Milgrom and Roberts (1988) and Dudley and Lasserre (1989)
11
indicated that timely and informative customer demand data can result in improved firm
performance through reduced inventories.
Huson and Nanda (1995) (Wahba, 2016) proved that the improvement of inventory turnover led
to an increase in earnings per share.
(Deloof, 2003) documents a significant negative relation between gross operating income and the
number of inventories days for a sample of non-financial Belgian firms during the period 19921996, suggesting that managers can create value for their shareholders by reducing the number of
inventories days to a reasonable minimum.
Additional evidence from Belgium is provided by Boute et al. (2004), who found no overall
decrease of inventory ratios despite any increased focus on inventory reduction.
Boute et al. (2006) (Koumanakos, 2008) , who concluded that companies with very high
inventory ratios have more possibilities to be bad financial performers.
This is consistent with the findings of (Shin, 1998) which reported a strong negative relation
between the cash conversion cycle and corporate profitability for a large sample of public
American firms.
Chen et al. (2005) by examining how the market values the firms with respect to their various
inventories policies, reported that firms with abnormally high inventories have abnormally poor
stock returns, firms with abnormally low inventories have ordinary stock returns while firms
with slightly lower than average inventories perform best over time.
Furthermore, in a more recent study, (Shin, 1998) examined the empirical associations among
three constructs – inventory, IT investments and financial performance – using longitudinal data
that span four decades, where they conclude that reducing inventories has a significant and direct
relationship with financial performance.
12
(Koumanakos, 2008) prove that results obtained are less noisy while performance gains and
losses can be more plausibly linked to the strategy of inventory policy and in the majority of
sectors (food, textiles and chemical) and years under investigation the relationship between
profitability and inventory management is negative and statistically significant at least at 10 per
cent level of significance.
(Koumanakos, 2008) studied the effect of inventory management on firm performances. 1358
manufacturing firms operating in three industrial sectors of Greece, food, textiles and chemicals
were used in the study covering period of 2000- 2002. The hypothesis that leans inventory
management leads to an improvement in a firm’s financial performance was tested. The findings
suggests that the higher the level of inventories preserved by a firm, the lower the rate of return.
Some researchers have found that there is a positive impact of inventory management on
financial performance and some are argue that there is negative impact of inventory management
on financial performance. These deferent opinion lead to more research related to this topic and
there is a research gap to fulfill. Effectively and efficiency of inventory management depend on
inventory management techniques, survive business sectors and many of other environment
factors. Therefore, researcher findings are different and should do research as far. (Colling,
1990) in the United States of America and other Western countries, improvement in productivity
was achieved through reducing the direct manufacturing labor expenses cost per unit of output.
This strategy was justifiable because of the
high labor content in many manufactured products. However, the ratio of unit cost due to labor
has constantly decreased in recent years. Even large manufacturing firms, such as the United
States (US) auto assemblers, purchase up to 60 percent of the value of the product. This implies
that management of raw materials inventories is an area that shows great promise for
productivity improvement.
Japanese firms earned more deserved attention in the mid-to late 1980s due to there notable
performance on quality and inventory management. The constant alert of the bar code being
scanned at a check out lane shows a pillar of modern system of inventory management stock
tracking. In the earliest days of shop keeping, merchants write down procurement or they looked
13
at how many units where gone at the day’s end and then did their best to forecast future needs.
The key skills where experience and intuition, but it remain an imperfect method, even when
applied to operations that where quite small by today’s standards (Miller, 2010).
(Arnold, 2000). In Nigeria, the size of industry, small, medium, and large scale has a significant
effect on both the numerical strength of staff and level of involvement in inventory management
of both raw material and the finished product. The type of inventory system in practice in any
organization depends on many factors among which are economic stability of the place,
infrastructural facilities available, transportation network and many more which are called
constraints.
2.4 Manufacturing sector in Sri Lanka and Inventory management
Small, medium and large manufacturing firms have in Sri Lanka, and they used variance
techniques and practices to manage inventory as best level. EOQ model and lean inventory
systems are most popular among Sri Lankan manufacturing firms. The impact of inventory
management on finance performance depends on these inventory management techniques.
Limited number of research has related to this topic in Sri Lankan context and there isn’t clear
idea about this relationship.
14
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