Inventory Costing, Information, and Investment Efficiency

We study a dynamic model of inventory management in which firms have private information about their quality and markets learn about product quality based on the firm's reported earnings. Earnings are computed according to full absorption costing: producing an additional unit of inventory lowers unit costs since fixed overhead costs are capitalized, but leads to inventory holding costs. We show that overproducing inventory is a noisy signaling device aimed at communicating the underlying product quality to the market. Higher-quality firms that expect more and faster demand arrivals manage their inventory policies to signal/separate themselves from lower-quality firms, and thus induce a higher price at the reporting date. We study the optimal timing of mandatory disclosure under full costing and differing degrees of fixed cost absorption. We also examine the impact of variable costing on signaling incentives.