The effect of transaction costs, payment terms and power on the level of raw materials inventories

This paper proposes and tests an explanation for the level of raw materials inventories based on transaction cost economics theory and the role of power in a supply chain. According to this explanation, raw materials inventories are larger the higher a company's transaction costs and the lower its storage‐related production and management costs. Factors that affect these costs are the company's vulnerability to opportunism, whether the input becomes more or less costly to store and manage as it moves through the supply chain, payment terms and the company's power in relation to its supplier. This explanation for the level of raw materials inventories was tested on a large sample of customer industries matched to their main supplier industries. Consistent with this theory, the empirical results show that companies hold larger raw materials inventories the more money their suppliers spend on research and development and the less important the customers are to their suppliers. These results are important because they indicate companies must consider a wider range of factors than previously thought necessary when establishing inventory policy.