2.7 Tools: The Cost of Logistics Service Failures

Recall the thought exercise at the beginning of this chapter. When your desired product is out of stock, what are your options? From personal experience with out-of-stock situations, you know that you can substitute, delay, or switch. This is where things get interesting. You need to carefully evaluate the impact and costs of each option. Equally important, you need to figure out who pays these costs. After you have thought about these issues for a minute, take a look at Table 2-4.

Table 2-4

Cost of Different Options 1

Options	Costs
Buy a substitute product at the same retailer.	You may pay more for the substitute product, you settle for your second choice If the substitute product has a lower margin, the retailer’s margins are negatively impacted The maker of the out-of-stock product loses a sale—and the opportunity to impress you
Postpone your purchase.	Because you must return later, your costs go up—both in terms of time and transportation
Go to a different store to buy the product	Your search and acquisition costs go up The retailer loses a sale (and maybe the value of other products you might have purchased if you had stayed in the store to shop) The company that makes the out-of-stock product retains the sale—but from another partner. This may affect margins
Be so ticked off that you swear you will never shop at that store again	You lose out on future deals available only at that retailer The retailer loses the current sale as well as all of the purchases you would have made in the future The company that makes the out-of-stock product may lose future sales if other retailers carry a smaller portfolio of its product line
Be so ticked off that you post on social media and tell everyone you know about your “horror” story	The retailer loses your current sale and future sales. Damage to the brand among your peer group (which may be very large in today’s socially networked world) may reduce sales The company that makes the out-of-stock product may lose future sales if other retailers carry a smaller portfolio of its product line

Customer Responses to Stockouts

After reviewing Table 2-4, two points are clear: calculating the true costs of a stockout is messy work and the costs of stockouts are not shared equally among members of the supply chain. But, you really don’t know how much money to invest in your logistics service capabilities if you don’t quantify your stockout costs. To help you design a winning logistics system, let’s take a closer look at the three ways customers are likely to respond when your product is out of stock:

Backorders

occur when you don’t have sufficient inventory to fill an order and the customer decides to keep her business with you. As a rule, you ship what you have and fill the rest of the order once your inventory has been replenished. Because you have to fill the order twice, your costs go up and your profitability goes down. Further, you lose the ability to take advantage of scale economies in the delivery process as you pick, pack, and ship two smaller quantities created by splitting the original order. If you have to expedite the second part of the order, per unit costs can go up dramatically.

Lost Sales

Lost sales occur when the customer takes her business elsewhere. Consider the math: If an order was for 500 parts with a sales price of $50 each and a profit margin of 15%, the customer’s decision to defect will cost you $3,750 (500 units x $50/unit x 15% profit margin). Lost sales are more expensive than the margin you lose. You have given your customer a reason to test a rival’s capabilities and your customer might not come back.

Lost Customers

If your customer decides to take her future business elsewhere, what are your costs? Few companies have done the homework necessary to calculate the true value of a loyal customer. Despite its importance, the concept of or profits is seldom used to design order fulfillment systems.

The Costs of Stockouts

To calculate the true cost of a stockout, follow this three-step process.

Step 1: Evaluate Customer Response. How do your customers really respond to stockouts? As Table 2-4 illustrates, some customers substitute, others delay, and some switch—for one order or for life. If you have tracked customer behavior, you may be able to accurately profile customer responses to past stockouts and use this data to forecast future behavior. Otherwise, you need to start from scratch and build an accurate behavioral profile. For our current example, let’s say 50% back order, 30% make a one-time buy elsewhere, and 20% switch permanently—removing you from the approved supplier list.
Step 2: Estimate Consequence Costs. Calculate the costs incurred for each customer choice using customer and operating data. For instance, imagine the added processing, labor, packing, and transport costs driven by a backorder average $100 per backorder. Using the lost sales costs from above, you assign a cost of $3,750 to the average lost sale (i.e., 500 units x $50/unit x 15% profit margin). Finally, let’s assume that you have done the analysis to estimate the lifetime stream of profits attributable to a customer (let’s say $50,000).

Step 3: Calculate the Expected Stockout Cost. Building on Steps 1 and 2, you calculate the expected cost of a stockout as follows:

Customer Response	Probability (i.e., frequency)	Cost per Incident	Expected Cost
Back Order	.50	$100	$50
Lost Sale	.30	$3,750	$1,125
Lost Customer	.20	$50,000	$10,000
Expected Cost per Stockout			$11,175

Based on this analysis, if you experience 100 stockouts per year, you can justify investing $1,117,500 to eliminate stockouts through improved logistics service (perhaps more inventory, better information, or improved relationships). Service improvements promise additional benefits: a better reputation, higher levels of satisfaction, and greater customer loyalty.

For years, many of Target’s most loyal customers in cities on the U.S. border were Canadian citizens. Lured by Target’s famously “cheap chic” reputation for trendy products at great prices, they were happy to make the drive. After all, Target didn’t operate any stores in Canada. In fact, until 2013, Target didn’t operate stores in any international market. (The U.S. based Target should not be confused with its Australian twin, which uses the same name and logo).

Because Target had developed a large and devoted group of cross-border shoppers, it decided to make Canada its first international expansion. Unfortunately, after promising investors that the Canadian venture would be profitable by the end of 2013, losses mounted into 2014. More importantly, many loyal cross-border shoppers had begun to drift away. Stores were understocked and the product line was limited. Customers simply didn’t find what they wanted on the shelf. To make matters worse, prices were higher than customers expected. After visiting a new Toronto store, Nadia Yee commented, “You’d go sometimes and the racks would be empty. I’ve been a little bit disappointed.”

Target knew it would struggle to match U.S. prices. The 124 Canadian stores could not match the scale economies produced by the 1,800 stores in the U.S. But vendor agreements, regulations, and a sparse logistics infrastructure imposed extra costs and limited product availability. Devoted and die-hard fans became disillusioned when they encountered empty shelves and signs that said, “We apologize for any inconvenience.” The financial result: Canadian gross margins are 4.4%—a fraction of the 30% margins in the U.S.

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