Story by Rachel Curry
Image by iStock/sorbetto
Raluca Chiorean’s research shows firms that use derivatives have better inventory management—but there’s a twist.
Financial derivatives are a complex beast—even for the most seasoned accountants. Derivatives (financial contracts like futures and options whose value is based on the performance of an underlying asset, index or rate) are, in some ways, poorly understood across the business spectrum. But with burgeoning research about how derivatives use impacts inventory management (for products like coffee beans, airline fuel and wheat), that’s changing.
“We found this association between derivative use and inventory management efficiency,” says Raluca Chiorean, assistant professor in the Lehigh Business accounting department. “Once firms initiate a derivatives program, their inventory management efficiency increases. They terminate the derivatives program, and the inventory management efficiency goes down.”
It’s not just the association that’s compelling, but the reason for it. Chiorean and her co-researchers at Singapore Management University found that installing a derivatives program helps firms improve managerial learning. In other words, because derivatives use requires such a thorough understanding of the business, these firms better understand their operations, helping them more accurately predict the future and sustain optimal inventory.
To look at how firms use derivatives to manage inventory, Chiorean uses coffee as an example. For a company like Starbucks, one of the biggest costs of operating is buying and storing coffee beans. “One type of derivative will help you lock in the price for purchasing coffee on a future date,” she says. “Regardless of whether the coffee bean prices go up or down, you know how much you’re going to pay for coffee.”
While coffee is a concrete example that helps bridge that gap between abstract financial concepts and everyday life, all kinds of companies benefit from derivatives programs. “There are many other examples you can think of, like Southwest Airlines and the price of fuel,” says Chiorean. “Companies hedge intensively when they have a large underlying exposure.”
This isn’t a profit arm, but rather an endeavor to minimize risk. “You’re not trying to make a profit on the contract itself,” says Chiorean. “You’re just trying to reduce the uncertainty.”
Naturally, an effective derivatives program requires companies to look in depth at what lies ahead.
“You have to forecast that demand, and then you’re using financial instruments, which can give a bit of information about where the prices are going to go in the future,” she says.
Chiorean’s research looked at whether derivatives programs helped firms by reducing cash flow volatility, lowering borrowing costs and minimizing risk exposures. However, the evidence shows it’s the managerial learning taking place that makes the real difference on inventory management efficiency.
“Derivatives use enhances the firm’s internal information environment and supports strategic inventory decision-making,” Chiorean and her co-researchers report. Being able to accurately forecast future demand, they found, is central to successful inventory management.
For firms focused on better managing their inventory for overall company success, installing a derivatives program provides a unique opportunity to learn about their inventory and operations on a deeper level.
Chiorean says, “By using derivatives, managers are learning more about their own business.”
The research showed a similar benefit to companies when complying with new reporting rules, restating their financial statements or receiving a comment letter from the SEC because firms are again required to improve their internal information environment to comply with the rules. “Every time there’s a new accounting or reporting mandate, firms are going to try to push back against it, because there is a cost,” says Chiorean. “However, our research showed there is a benefit to the firm when complying with the new rule.”
Why it Matters
Inventory management is “one of the most fundamental aspects of a firm’s operations,” Chiorean explains. Her research showed derivatives use spearheads efficiency in this area, ultimately giving companies the opportunity to bolster their operations and outlook.