|Image from wikipedia.org|
It's not just about physical goods anymoreAlthough this concept of "cost of an overstock vs. cost of a stockout" is most closely associated with inventory management of physical goods in a retail environment, it's also highly applicable to service industries and can be applied to software and virtual good and services as well. In this post we'll cover what to consider when making these overstock vs. stockout decisions
Traditional use in managing retail inventory and ordering decisions
Retailers rely on this concept every day as try to maintain sufficient quantities of inventory on-hand to satisfy customer demand, while working under the constraints of finite storage space and capital. If they can accurately predict future sales, they can optimize orders to satisfy demand while minimizing unnecessary inventory. There are lots of algorithms and formulae for a) using historical sales patterns to predict future sales and b) getting the timing and quantity of replenishment orders right, but we won’t go into those details.
Traditionally, a STOCKOUT is when a retailer runs out of a particular item. An OVERSTOCK is when a retailer has too much of an item and can’t sell it all.
Expanding the definition:
Think resource management, not just inventory management
In this post, we’ll expand these concepts so that you can also apply them to non-retail situations and revenue sources other than products.
For example, if you’re in the service industry, your “inventory” might be your employees and their capacity to serve clients. A stockout would be if you don’t have enough staff to take on another client or project. An overstock would be if you’re paying a lot of salaried employees but don’t have enough revenue-generating projects to assign them to.
If you're selling virtual services online, your "inventory" might be servers, storage capacity, or developers. Whatever extra resources that aren't fully utilized but kept on hand to satisfy unpredictable customer demand would be overstock. A stockout would be if you don't have enough of a particular resource available to satisfy a new customer or order.
In a future post, I’ll go over how you can apply this stockout / overstock trade-off concept to other decisions.
COST OF A STOCKOUT
There are many sources of lost revenue opportunities when a company experiences a stockout. When calculating the cost of a stockout, make sure you’re considering every possible source of financial impact. Common sources include:
1. LOST REVENUES
The most obvious is the immediate cost of lost sales for every unit that customers would have bought if the item had been on hand. If your customers are patient and will wait for the stockout to be resolved, these would just be delayed revenues. Unfortunately, in many cases your customers have other alternatives and will take their business elsewhere. In those cases, the revenue that they were prepared to pay you is permanently lost.
2. GOOD WILL AND REPUTATION
In addition to losing transactions during your stockout, you might also lose current and future customers. By forcing your customers to look elsewhere, you’ve opened the door for your competitors and substitutes to replace you. If it happens enough, you might earn an unwanted reputation with prospective customers, too, who will go to more reliable vendors.
3. FOLLOW-ON BUSINESS
If you have loyal customers who buy from you repeatedly and/or in large volumes, one stockout could put all of your future business with them in jeopardy. Or, if you sell complementary products or services as an add-on or follow-up to an initial sale (e.g., warranties, parts, service) , then those additional revenue opportunities are also lost when you lose the initial sale due to a stockout.
COST OF AN OVERSTOCK
If overstocks carried no negative consequences, these decisions would be easy – you’d always carry way more inventory than you would ever need. Unfortunately, that is not the case, and your inventory “safety net” increases in cost as it increases in size. Here are some common costs associated with overstocks:
1. OPPORTUNITY COSTS
For most companies, inventory costs money, and that capital can’t be deployed elsewhere if it’s sitting around in the form of overstock. If it’s products, you’ve likely paid some amount of money to have those goods available to you. If it’s personnel who provide services, it’s what you’re paying them regardless of whether or not they’re working and generating revenue.
2. HOLDING COSTS
Unless you’re product is digital or virtual, you’ll be paying for physical space to hold your inventory. For products, you’ll be paying for warehouse space and, depending on the product, additional costs for features like high security or climate control. For personnel, it might be office space where they can keep busy and remain available until a paying job comes along. Even if your product or service is digital or virtual, you might have overstock costs in the form of extra server capacity, bandwidth, or storage.
3. EXPIRED GOODS AND DISPOSAL COSTS
Most physical products have value that is perishable, although their shelf lives might vary greatly. Once they expire, not only do you have to replace them, but you might incur significant expense while disposing of your expired goods.
Meat, fish, poultry, and produce come to mind as highly perishable inventories that can spoil while waiting to be sold. Pharmaceuticals eventually expire and might require extra expense to dispose of properly and legally. Apparel and shoes go out of style and might need to be sold at a loss. Software can become obsolete. Even if you’re delivering services, your personnel’s knowledge could become outdated and your "disposal costs" might be in the form of severance payments or retraining.
COST OF A STOCKOUT vs. COST OF AN OVERSTOCK: BALANCING THE TRADE-OFFS
Ultimately, you’ll want to make inventory decisions that take into account your:
- Tolerance for risk
- Ability to withstand stockouts
- Willingness to pay for overstocks
EXAMPLES OF WHEN TO ERR ON THE SIDE OF OVERSTOCK (TOO MUCH INVENTORY)
- Each unit drives way more profit than it costs
- You rely on repeat and/or high-volume customers
- Each sale opens additional revenue streams
EXAMPLES OF WHEN TO ERR ON THE SIDE OF STOCKOUT (TOO LITTLE INVENTORY)
- Your product is costly and highly perishable
- Your inventory costs a lot to store and maintain relative to the profit it generates
- Your customers don’t have easily leveraged alternatives