Date of Original Version

4-2008

Type

Working Paper

Abstract or Table of Contents

Operations of publicly traded firms differ from privately owned firms because public firms' managers make decisions based on their own interests. In this paper, we study how stock market pressure may influence a manager's inventory and operational management. Our model is a straightforward extension of a two- period inventory management problem with correlated demand. The manager's compensation is partially based on the firm's stock price which is influenced by the reported sales revenues. With better information about the "real" demand, the manager may manipulate the stock price by shipping more than the real demand to downstream customers and claim higher than real sales revenues using a well known form of real earnings management called "channel stuffing" or "sales padding." As it does not correspond to real demand, the padded demand will return later to the firm after additional costs are incurred. Hence, channel stuffing destroys the firm's value. Based on a game between the manager and the stock market, we identify three factors that determine the manager's incentive to use channel stuffing: the marginal incentive, the boundary effect and the carryover effect. The marginal incentive is independent of the inventory problem. The boundary and carryover effects arise from the nature of the inventory management problem. When examining the initial inventory investment decision, we find that, compared to the optimal initial inventory level of an otherwise identical private firm, the manager who is aware of the costly consequence of padding may under-invest inventory due to the loss of margin as well as to limit the carryover effect, while he may also over-invest to limit the boundary effect on padding. Our theoretical analysis provides insights about how a public firm's inventory decision may be different from a private firm's inventory decision, which is the classical reference framework in operations management.