INVENTORY MANAGEMENT

IN SERVICES
 Introduction
• In manufacturing, inventory is typically understood to consist
of the following:
– Raw materials, work-in-process and components used to assemble
finished products and
– The finished products themselves which constitute the finished goods
inventory.
• Inventory is deemed to be “cash sitting in product”.
• In other words inventory has no role in the business until it is
sold in exchange for a liquid asset such as cash.
• Till then inventory is just a cost item.
• Let us look at some key differences between Service and
Manufacturing:
 Introduction

Service Business Manufacturing Business

Simultaneous production and Consumption and production at
consumption different stages

Many critical aspects are intangible Many critical aspects are tangible
Concept of inventory may not be Usually inventory has material
material but can be virtual such as items and buffers
requests and in case of healthcare
patients waiting can be considered
as inventory
High variance in service delivery Little variation
 What is Inventory in Service?
• The concept of inventory in service is somewhat difficult to
explain.
• It appears to be a contradiction to talk about inventory
management in services, since one of the basic characteristics
of services is simultaneous production and consumption with
lack of inventory.
• Intangibility is a core definition of services.
• In service, inventory can take different forms depending upon
the context.
• In general, inventory in service cannot be compared with
inventory in a manufacturing context.
 What is Inventory in Service?
• Inventory in service is quite intangible and sometimes it is not
a “real good”.
• Some examples are:
– Inventory in an emergency room might be the people waiting there.
– Unused seats in a movie theatre or in an aircraft might be construed
as inventory for which there is no demand.
• However, many services are accompanied with facilitating
goods.
• Such facilitating goods constitute the inventory of the firm
and the quantum and type of such inventory is a strategic
decision and is a source of competitive advantage.
 Introduction
• Inventory decisions are vital for broadly four types of
services:
– 1. Retail (e.g. grocers, auto parts, department stores etc.)
– 2. Wholesale
– 3. Field service (e.g. computer repair, copier repair etc.)
– Military (e.g. number/type of goods to be put in a tank,
submarine, or soldier’s pack)
• For each of these, inventory is a major cost; also it entails a
major strategic trade-off
• For these cases, space is limited, making it especially valuable)
 Introduction
• Since the store size is limited, more inventory of one item
means less shelf space available for other items
• The strategic choice, then, becomes “lot of inventory of a few
items” or “little inventory of lot of items”
• Besides the general strategic direction, proper management
of inventory is vital
• Studies indicate:
– 10% of items in grocery and convenient stores are out of stock
– 35% of people fail to buy apparel they are shopping for, because of
stock outs of their size
• Inventory stock outs means lost revenue, so properly
managing inventory can substantially change profitability
 Inventory Management
Service vs Manufacturing
• Setup/Ordering costs high
• Number of products higher
• Limited shelf space
• Lost sales vs backorders
• Product substitution
• Demand variance higher
• Information accuracy (complication of
customers)
 Service versus manufacturing inventory
• There are inventory problems that are specific to
services
• The characteristics of service sector inventory
problems are fundamentally different from those of
manufacturing inventory
• These differing characteristics include:
– Set up / ordering costs,
– Number of products,
– Limited shelf space,
– Lost sales versus backorders,
– Product substitution,
– Demand variance, and
– Information accuracy
 Service versus manufacturing inventory
• Set-up / Ordering Costs
• Typical manufacturing inventory involves large, costly set-ups
• Because of this, manufacturing involves determining how long one
product should be produced before switching to another
• The trade-offs between setup costs and other inventory costs are
the main concern of techniques such as Economic Order Quantity
(EOQ)
• Although these techniques are somewhat applicable in services, in
most cases, the setup/ordering costs for all products combined can
be substantial, but the added cost of ordering any one product can
be trivial.
• For example, in grocery business, the combined warehousing and
distribution function is reported as 20% to 30% of cost of goods
sold, but the added cost of deciding to order or not to order a given
product is essentially zero.
 Service versus manufacturing inventory
• Set-up / Ordering Costs
• To understand this, let us look at a typical services inventory system
• Often the manager scans a computerized printout once every ordering
period and marks any changes to the orders recommended by the
computer
• The revised list is sent by computer to a distribution center, where the
order pickers pick cases of product and load them on a truck.
• When the truck arrives at the retail store, the product is moved to store
shelves. Altogether, it is an expensive process.
• The decision to order or not order any given product, however, involves
negligible cost.
• Consequently, we will be concerned only with inventory techniques that
are applicable to situations without ordering or set-up costs
 Service versus manufacturing inventory
• Number of Products:
• A manufacturing firm may sell a large number of products
(SKUs)
• However, the SKUs sold by such services as supermarkets, or
department stores, auto parts stores etc. are much more than
these – in the range of 40000 to 400000 SKUs.
• Many of these are ordered weekly or several times per week.
• This means that, although manufacturers may be pondering
over production decisions, the managerial time spent on
ordering decision of any one SKU by a service firm must be
short.
 Service versus manufacturing inventory
• Limited Shelf Space

• Shelf space is a key consideration in many services

• Retails stores are far too small to carry all the items product
manufacturers would like them to carry

• A key decision is how to allocate that limited space among

products
 Service versus manufacturing inventory
• Lost Sales versus Back Orders
• Manufacturers often cannot immediately ship items, because
they are not in inventory
• It is common for manufacturers to quote a lead time or place
a requested item on back order and then fill the order weeks
later
• Although back orders may also occur in some service firms, a
more common result is a lost sale.
• Even though this distinction may not seem large in analyzing
what to do, it actually complicates theory greatly and makes
stocking out a much more expensive proposition.
 Service versus manufacturing inventory
• Product Substitution
• In many service inventory situations, retailers carry nearly
identical products from many manufacturers
• Hence, service inventory models need to consider the effects
of customer’s substitution behavior when faced with product
stock outs
• It mans the stocking levels of products should not be
considered in isolation of each other but groups of
substitutable products have to be considered as a whole
 Service versus manufacturing inventory
• Demand Variance
• The unpredictability of demand is often greater in services,
especially for SKUs in a given store with a small average
number of units sold
• For example, more than 50% of dry goods SKUs in
supermarkets sell fewer than one unit per week on an average
• However, on a given day, an interested customer may clean out
the entire stock.
• This high variance makes inventory decisions more difficult.
 Service versus manufacturing inventory
• Information Accuracy
• Many manufacturers as well as service firms spend millions of
dollars on information systems to track inventory
• Service firms, however, must deal with the aspect of
customers which manufacturers do not have to
• Though a grocery would keep track of inventory through the
computer by noting sales through scanners at the checkout,
but they also track inventory by physically walking through
aisles to see how much is on the shelf.
• When customers or employees steal goods, they
inconveniently don’t scan them
• Also, when goods are placed in wrong shelves by mistake, the
problem is magnified for retailers
 The Need for Inventory Science
• Due to the conditions discussed above, the service inventory
problem is different from manufacturing inventory problem
and the formulas normally found in manufacturing problems
are not especially helpful
• The grocers and department store managers use their own
intuition and gut feeling when ordering inventory
• However, services need inventory models because the
“common sense” inventory rules learned through experience
are no longer good enough
• The combination of time-based logistics practices,
technological innovations, and changes in manufacturer
product strategies radically altered the business environment
for services, which impacts inventory decisions
 The Need for Inventory Science
• A basic thrust of time-based competition is to compress the
amount of time required in the product delivery cycle
• Time-based competitive practices which began in
manufacturing sector are used in services as well
• Such practices are called “efficient consumer response” in the
grocery industry and “quick response” in the apparel and
general merchandise industries
• Generally service inventory policy addresses three decision
areas:
– Assortment: Deciding which products should be stocked
– Allocation: How much shelf space to give to each product in the
assortment
– Replenishment: When and how much to reorder
 The Need for Inventory Science
• Assortment and allocation are mainly decisions made by
marketing

• Assortment decisions are made by company buyers based on

what products the buyers think will sell, and allocation
decisions are often made on the relative sales between
products in a category

• If product A sells twice as much as B in the same category, A

gets twice the shelf space in the same category
 Basic Inventory Model
• The newsvendor (single period or perishable) model is a
mathematical model used to determine optimal inventory
levels.
• It is known as the newsvendor problem because the
prototype is the problem faced by a newsvendor trying to
decide how many copies of newspaper to stock on a
newsstand before observing demand.
• The newsvendor is faced with both overage and shortage
costs if he orders too much or too little.
• The problem is to decide the size of a single order that must
be placed before knowing the demand.
 Basic Inventory Model
• Typical characteristics of this model are:
– Single period problem – ordering decision made in every period.
– Demand is highly uncertain.
– Order must be placed before the demand materializes.
– Order can be placed only once in each period.
– There is cost involved with ordering too much quantity and also cost
for ordering too little quantity.
• Examples include:
– Fashion Products
– Perishable Goods
• This model is similar to the basic EOQ Model for inventory
management in manufacturing operations.
 Development of the Model
• We use Marginal Analysis to develop the newsvendor model
taking an example from the fashion industry.
• Example 1: The Fashion Store
• The store sells fashion items which need to be ordered several
months in advance of the season to realize good price.
• Each unit costs the store Rs. 100 and the selling price is Rs.
250 per unit.
• Items not sold during the season can be returned to outlet
store at Rs. 80 per unit.
• If the store runs out of stock of an item during the season then it can be
obtained from alternative sources at a cost of Rs. 190 per unit (including
freight).
• The store manager needs help in deciding the initial quantity to be
ordered to maximize the net contribution.
 Development of the Model
• Marginal Analysis
• We first analyze the historical demand data given in the following table.
• Using this data we construct a frequency table with corresponding cumulative
probabilities for each demand value.
• We also find from the table that the sample mean is 85 units and the standard
deviation is 4.43 units.
• 86 94 90 86 82 84 91 76 85
83 92 82 89
• 88 79 83 83 85 89 90 73 84
86 90 90 92
• 83 91 85 85 82 81 81 76 81
81 78 85 84
• 82 88 86 85 88 86 89 87 84
83 79 90 87
• 83 87 82 81 85 84 87 89 82
80 92 85 88
• 85 83 87 84 84 86 80 87 80
89 79 83 80
• 86 85 81 93 91 89 80 86 87
86 88 84 81
• 84 84 82 77 93 94 97 87 75
• Table 1: 100 demand data points for the Fashion Store
 Development of the Model
• Suppose we decide to order initial inventory of 85 units (mean
value) to start with.
• We need to decide whether we should increase the order
quantity to 86 units.
• If the extra item is not sold, we incur a marginal cost of 100 – 80 = 20.
• If the extra item is sold, we earn the difference between the contribution
we make by having the item on hand and the contribution we would have
made if we would not have had the item on hand.
• Thus we make a marginal contribution of
• (250 – 100) – (250 – 190) = 190 – 100 = 90.
• For computing the marginal net contribution, we need the probability
values.
• P (The 86th item is not sold) = P (Demand ≤ 85)
• P (The 86th item is sold) = P (Demand > 85);
• We obtain these probability values from the frequency table given below.
• Demand Frequency P (Demand) Cum. Prob.
• (D) P (D) P (Demand ≤ D)
• 73 1 0.01 0.01
• 75 1 0.01 0.02
• 76 2 0.02 0.04
• 77 1 0.01 0.05
• 78 1 0.01 0.06
• 79 3 0.03 0.09
• 80 5 0.05 0.14
• 81 7 0.07 0.21
• 82 7 0.07 0.28
• 83 8 0.08 0.36
• 84 10 0.10 0.46
• 85 10 0.10 0.56
• 86 9 0.09 0.65
• 87 8 0.08 0.73
• 88 5 0.05 0.78
• 89 6 0.06 0.84
• 90 5 0.05 0.89
• 91 3 0.03 0.92
• 92 3 0.03 0.95
• 93 2 0.02 0.97
• 94 2 0.02 0.99
• 97 1 0.01 1.00
• 100 1.0
• Table 2: Frequency table from demand data for the Fashion Store
 Development of the Model
• Using these probability values, we compute asunder:
• Expected Marginal Cost = P (Demand ≤ 85) x 20
• Expected Marginal Profit = P (Demand > 85) x 90
• Thus we would increase the order from 85 to 86 if
• Expected Marginal Cost < Expected Marginal Profit
• P (Demand ≤ 85) x 20 < P (Demand > 85) x 90
• That is, 0:56 (20) < 0:44 (90)
• 11:2 < 39:6
• Letting Co be the cost of excess and Cs be the cost of shortage, in general
we increase our Inventory B while
• P (Demand ≤ B) x Co < P (Demand > B) Cs:
• We would stop increasing B at B*, the optimal stocking level, when
• P (Demand ≤ B*) Co = P (Demand > B*) Cs:
 Development of the Model
• Rewriting this last equation we get
• P (Demand ≤ B*) Co = (1 – P (Demand ≤ B*)) Cs
• 0 = Cs – P (Demand ≤ B*) (Cs + Co);
• Which becomes P (Demand ≤ B*) = Cs / (Cs + Co)
• The left hand side is by definition the service level.
• From our Fashion Store example we have Co = 20 and Cs = 90. So,
• SL* = Cs / (Cs + Co) = 90 / (90 + 20) = 0.8182
• From the frequency table, for a service level of 0.8182, we get B* = 89.
• Note that we always move up to cover the service level.
 Service Level
• Service level is defined as “the probability that demand is
satisfied immediately from on-hand inventory
• Suppose the newsstand stocks quantity B newspapers daily.
• The data collected by them showed that stock out occurred
on 73 out of 365 days.
• Thus the newsstand provided an average service level of (365
– 73) /365 = 80%.
• It means that they were able to satisfy the demand for a day
on 80% of the days.
• On any given day, the service level is either 0% when stock out
occurs or 100% when no stock out occurs.
• We use service level as a probability or proportion of periods
in which there are no stock outs.
 Service Level

• For our fashion store example, the average service level

associated with inventory of 89 units is 84%.
• This means that the stock out rate will be 16%.
• However, it should be noted that the stock out rate does not
indicate the number of units of demand not filled.
• It merely indicates if there was a stock out or not without
differentiating whether we could not satisfy the demand of
one customer or 100 customers.
 Fill Rate
• Fill Rate is “the fraction of demand satisfied from on-hand
inventory”
• Fill rate indicates the fraction of demand units that are filled.
• If the demand D is less than the inventory level B, then the fill
rate is 100%.
• Otherwise, the fill rate is the ratio of inventory level (B) to
demand (D). This can be written as
• Fill Rate = Expected [min (B, D) / D]
• It is very difficult to measure fill rate accurately.
• Quite often, not every customer who walks into a store asks
to see a particular product if they cannot find it on the
shelves.
 Fill Rate
• Most customers leave without making their requirement known.
• Therefore, it is very difficult to get an exact count of the number of
customers that get turned away.
• Comparatively service level is easier to measure.
• Still, the fill rate information when available is a good indicator of the
efficiency of service.
• However, it is not necessary to be able to measure the fill rate in order to
decide inventory stocking policy which results in maximum expected net
contribution.
• All that is required is to set the optimal service level.
• In the case of our fashion store example, if we maintained the optimal
inventory of 89 units, and we had 100 observations as shown earlier, we
would have service level and fill rates as shown in the table below.
• Our average service level would have been 84% and average fill rate would
have been 99. 56%.
• Demand Frequency P (Demand) Cum. Prob. Service Level Fill Rate
• (D) P (D) P (Demand ≤ D) (%) (%)
• 73 1 0.01 0.01 100 100.0
• 75 1 0.01 0.02 100 100.0
• 76 2 0.02 0.04 100 100.0
• 77 1 0.01 0.05 100 100.0
• 78 1 0.01 0.06 100 100.0
• 79 3 0.03 0.09 100 100.0
• 80 5 0.05 0.14 100 100.0
• 81 7 0.07 0.21 100 100.0
• 82 7 0.07 0.28 100 100.0
• 83 8 0.08 0.36 100 100.0
• 84 10 0.10 0.46 100 100.0
• 85 10 0.10 0.56 100 100.0
• 86 9 0.09 0.65 100 100.0
• 87 8 0.08 0.73 100 100.0
• 88 5 0.05 0.78 100 100.0
• 89 6 0.06 0.84 100 100.0
• 90 5 0.05 0.89 0 98.9
• 91 3 0.03 0.92 0 97.8
• 92 3 0.03 0.95 0 96.7
• 93 2 0.02 0.97 0 95.7
• 94 2 0.02 0.99 0 94.7
• 97 1 0.01 1.00 0 91.7
• 100 1.0 84 % 99.56 %
 Product Substitution and Variance
• In many service sector inventory items, the gross profit
margins are considerably larger than the newspaper example
• For example, the gross profit margin in a typical dry grocery
item is approximately 40% of the selling price.
• Further, the cost of overage between order cycles continues
to decrease for many items due to improved logistics.
• It is quite common in service inventory items to take delivery
of a given product several times per week
• Consequently, for any individual inventory decision, the cost
of over-ordering non-perishable goods is just the cost of
holding that item on the shelf until the next order cycle
 Product Substitution and Variance
• For example, consider a product that sells for $10. the cost of
a stock out results in Cs = $4 in lost profit as well as some
additional cost for disappointing the customer
• This “disappointment” cost is real.
• Customers who routinely see favorite products out of stock
will take future businesses to a competitor. However, it is
difficult to put a solid number on disappointment for each
individual stock out
• Assuming that the customer disappointment costs an
additional $2, then Cs = $6
• Assuming deliveries are made weekly and that the annual cost
of holding an item is 25% of the item cost
• Therefore, the cost of overage, Co = $10*0.25/52 = $0.05
 Product Substitution and Variance
• In this case, Co/(Cs + Co) = 0.008. this means one should stock
to ensure only a 0.8% chance of demand exceeding the stock
on the shelf.
• Or, the newsvendor model suggests stocking in this example
so that customers served 99.2% of the time.
• These extreme stocking levels near 100% are not unusual in
clothing stores and for dry goods at supermarkets
• The cost penalty for stocking too much inventory over the
optimal target number is relatively small compared to the
financial penalty for holding too little.
• The figure below provides a typical profit curve for ordering a
service inventory item:
 Product Substitution and Variance
• After the optimal solution is achieved as per newsvendor model, the
profits decline only slightly with the amount ordered, because the holding
costs are relatively small
 Product Substitution and Variance
• Consequently, if we were only concerned with satisfying the
demand for a single product in a store and not subject to
capacity restrictions, the diagram would depict the results of
potential choices. However, there are other considerations:
• Product Substitution
– When consumers are faced with stock outs of their preferred product,
many of them simply buy a competing brand
– Although this tendency would be of great concern to product
manufacturers, it would be somewhat “revenue neutral” from the
perspective of service sector inventory
– The level of substitution ranges from 40% to 100%.
– It means the service firms are not negatively affected by occasional
stock outs of certain products
– For our example, if consumer substitution were 90%, the real value of
Cs would be 0.10($6) = $0.60, rather than $6, and service level would
be set at 92.4%, rather than 99.9%. It represents a significant
difference in the amount of inventory ordered, because of high
variance
 Product Substitution and Variance
• The typical demand for a service sector inventory item can be described
by the negative binomial distribution, with variance higher than its mean:
 Product Substitution and Variance
• The shape of the distribution is shown graphically in the diagram and the same is
tabulated in the table below for product with mean demand =2 and variance = 10
 Product Substitution and Variance
• For this example problem (and for most service inventory problems), we
are concerned with a tail of the distribution, or service levels over 90%.
Without considering substitution, one would order 22 units to reach
service level of 99.9%. With substitution, one would order only 7 units to
reach service level of 92.4%, a nearly 70% reduction
 Multiple Products and Shelf Space Limitations
• Service inventory problems are difficult due to factors such as
enormous number of SKUs, high demand variance and other
factors
• Because of these difficulties, services historically considered a
less than scientific view of inventory management
• The most common method of ordering inventory in services is
the “weeks of demand” method
• Suppose it is felt that three average weeks worth of demand
should be on the shelf.
• So, if the demand for the past five weeks has been 100, 150,
50, 75, 125. this method indicates that 3*100 = 300 units
should be available
• While this method is easily implemented, it can be
outperformed by other methods
 Multiple Products and Shelf Space Limitations
• One way to get a better inventory policy is to consider the
demand variance of different items
• Suppose, item A has a demand of 500, 0, 250, 100, 400 and
item B has a demand of 250, 250, 250, 250, 250
• Clearly, one policy of “three weeks of demand” is not
appropriate for both products
• The higher variance of item A means that it should have an
overall higher inventory level that item B
• Another consideration should be the relative product
profitability.
• Suppose items C & D both cost $10, but item C sells for $100
and item D sells for $20
• It would be wise to have a higher service level on item C than
item D
 Multiple Products and Shelf Space Limitations
• Similar problem occurs in repair businesses like computer and
copier repair
• Companies usually send out a technician with a van full of
equipment for repair work, but a van cannot hold all the spare
parts that may be needed.
• A customer is equally disappointed if a repair is not made
because an expensive part or a cheap part is not on hand
• Consequently, the parts to load on the van are the cheap
ones. While this may sound trivial for a single van, firms like
IBM and Xerox have thousands of mobile units servicing the
customers
• The basic point is that there are substantial gains to be made
by managing product inventories individually, considering
differences like demand variance and product profitability
 Inventory Tracking System
• One of the most difficult tasks in retail store operation is keeping up with
the stock.
• A lot of time is spent in tracking inventory particularly if the product mix is
very wide.
• Though it requires hard work and discipline to maintain, a good inventory
system will make it easier to meet the needs of the customers.
• Some advantages of a good inventory tracking system are:
• Theft Control
• A good inventory system will enable the store to know in time and to
control the theft of items by customers or employees.
• Customer Service
• It is possible to avoid running out of stock and determine if an item is
available in stock and locate it easily if you have a good tracking system.
 Inventory Tracking System
• Financial Management
• Inventory system enables one to keep track of performance and provide
timely information about the status of stock.
• Product Tracking
• We can track specific items and weed out slow moving items with sales or
markdowns.
• Many computer software programs are available for tracking
inventory and some of these are relatively inexpensive too.
• They also have the capability to print and read bar code
labels, print invoices, and provide several types of reports and
statistics.
• One disadvantage of using a package inventory system is the
inability to use stock numbers that relate an item to a specific
product and vendor.
 Inventory Tracking System
• One can always look up this information in the system but it is
not transparent from the stock number and there may not be
enough time to chase it down when one is waiting on
customers.
• A Database program such as Microsoft Access can also be
used to manage inventory.
• Such programs can handle any kind of descriptive product
code but will require more skills to develop than a package
system.
• Also, we will need to develop own reports and statistical
analyses.
 Inventory Tracking System
• If you are not comfortable with inventory software, you can begin with a
simple card system.
• Pre-printed inventory cards can be procured with spaces for item code,
description, supplier, cost, selling price, opening stock, sales and current
balance.
• When a new item arrives, it will be assigned a unique code and description
will be entered.
• Other details will also be entered in the card.
• A simple alpha-numeric system can be used to describe the item
• When an item is sold, the inventory code will be put on the sales ticket
and at the end of the day, inventory cards will be updated from the sales
tickets. inventory cards will be updated from the sales tickets.
• Even when using a computer system, the sales tickets, merchandise
coding, daily posting, and pricing systems can be used.
 Inventory Tracking System
• The only difference is that the daily sales and receipts will be entered on a
computer generated print-out, which will then be input into the computer
on a weekly or monthly basis.
• Every month the inventory will be updated and a new print-out will be
generated for the succeeding month.
• Inventory Policies for Managing Inventory
• For managing inventory and improving the sales and
profitability, one needs to consider the following points:
• 1. Items that are selling well and have low stock balances
• For these types of items it will be helpful to establish and indicate a
desirable reorder point on the inventory card or computer sheet.
 Inventory Tracking System
• Slow moving items that have been in inventory for a long time
• If these are not seasonal items which can be sold later, then, we should
consider putting them on sale and move them out so that the money can be
invested in fast-moving items.
• Hot selling items for which sales have increased
• For these items, we should increase the order quantities or put in special
order to take advantage of the surge in sales.
• Annual Physical Inventory
• This is the final inventory activity. It is essential for prudent financial
management and should not be skipped.
• This must be done at the end of the financial year. This stock verification
should be used to compute the stock values for all items to get the total
inventory value. This should be compared with the computerized report of
inventory value the differences in these values would give an idea of the
extent of loss of goods through theft or disappearance. This should be
compared with the computerized report of inventory value the differences in
these values would give an idea of the extent of loss of goods through theft or
disappearance.
 Methods to Reduce Stock outs
• Revenue Sharing
• A major cause of stock outs at the retail level is the low and uncertain
margin that retailers get from the product compared to the high price they
must pay for the product
• In the past, a movie video would cost a video rental store about $60 which
is a clear outgo.
• The store could rent it out as many times as possible, the number of
rentals is guesswork
• “Out-of-stocks” were the single biggest problem in this industry
• Between 20% to 25% of people coming to rent a video would leave
without their intended title
• While some of them found another video to rent, but some proportion
would leave disgruntled
 Methods to Reduce Stock outs
• Revenue Sharing
• Under revenue sharing only about 5% of video rental customers leave
without their intended title
• “Revenue Sharing” refers to charging a lower up-front price to the retailer,
but taking a share in the retailer’s revenue
• For the movie rental industry, this change meant the price for getting
videos from dropped from $60 to about $8, but their rental revenue
dropped from about $5/rental to $2.50/rental.
• The net effect of revenue sharing was that stores stocked more copies of
each movie and more customers got what they wanted
• In terms of newsvendor model, the cost of overage is reduced severely,
while the cost of stock out is reduced relatively mildly
• Consequently, the optimal amount to stock increases
 Markdown Money
• Another type of incentive to retailers is “markdown money”
or sometimes called protection money
• If a product is not selling well, retailers often severely
markdown the price on the remaining items to get some
return for the money spent
• Marking down the price even below its cost, still makes sense
– it is better to lose 80% of your money than 100%
• Markdown money helps alleviate the downside of ordering
too much of the product
• The manufacturer agrees to pay a percentage of the
markdown amount for units that have price cuts
• With this protection, retailers are willing to order more
product
• Again, as per newsvendor model, cost of overage is reduced
 Phantom Stock outs
• “Phantom Stock outs” are situations where customers cannot
locate the products they want, even though they are available
in a store
• For supermarkets, the sales lost due to this is quite high
• Phantom stock outs hurt a business in several ways
• In addition to the loss of immediate sale, labor requirements
are increased, as the customers ask employees for help
• Forecasting accuracy and reordering policies are weakened,
since the computer assumes the product is sitting on the shelf
and no one wants it
• Customers walk away believing the employees are
incompetent – the computer tells them the product is in the
store but they can’t find it
 Phantom Stock outs
• It is found that phantom stock outs are associated with having
too much stuff
• If there are more product variety in a store, and more number
of units of each product, more phantom stock outs would
occur
• Highlighting the problem and recognizing that it is a factor to
be managed, can help to reduce it
• In the grocery industry, it is common for manufacturers to hire
full-time personnel to do retail audits
• These persons travel from store to store to make sure the
manufacturer’s product is actually on the shelf, rather than
rotting in a back room
 Inventory Inaccuracy
• The inventory records of service firms are highly inaccurate
• Even large public retailers with highly modern operations, had
inventory inaccuracies (difference between actual stock and
the stock shown by the computer) for nearly 65% products
• Inventory inaccuracy isn’t caused just by customers. Even in a
store where customers never entered, the inventory system
had wrong quantities for about 29% of the SKUs
• The costs associated with inventory inaccuracy are:
• Increased labor cost; the stores pay employees to wander the aisles and
manually order products rather than rely on the inventory system
• Other costs are same as those associated with phantom stock outs, such
as inability to properly forecast demand
 Inventory Inaccuracy
• Many systems approaches such as ERP systems, CFPR systems,
and DRP systems rely on accurate inventory information to work
• If inventory records are not accurate, the recommendations and
orders these systems place can be destructive.
• The most important aspect of inventory inaccuracy is to get
managers to understand that it exists
• For example, it was found that one store sold enormous quantities of hard-
boiled eggs, according to the computer
• On investigation, it was found that since hard-boiled eggs were priced at
exactly 50 cents, when a cashier came upon an item for which he didn’t
know the inventory code, he simply rang up equivalent number of eggs to
get close to the right price.
• So, a $4 mystery vegetable became eight eggs on the computer system
• Once the problem was known, all it took was informing the cashiers they
were causing problems elsewhere in order to get them to stop
 Shrinkage
• “Shrinkage” refers to lost, stolen, or damaged goods
• It is necessary for service firms to see that goods are available
to see and touch for customers to make purchase decisions,
but this also provides customers with opportunity to steal or
damage products
• Most of the methods for reducing shrinkage are quite clear
and need no discussion. Instead we focus on a cautionary tale
of focusing too much shrinkage
• The incentive for managers to reduce shrinkage was powerful
• Every dollar of shrinkage was recovered from their pay
cheques. Hence, management took reducing shrinkage very
seriously – too seriously
 Shrinkage
• The focus on preventing theft and miscounts led to an
atmosphere of “sales prevention”
• All small items that could be easily stolen were put under lock
and key
• If insufficient employees were around to safeguard the store,
the manager simply closed the store down.
• Instead of helping and informing customers, managers
personally counted shipments in the back room to make sure
they were getting exactly what was on the invoice
 Shrinkage
• When a new system was introduced, the performance
changed dramatically
• The new incentive system based manager’s pay on store
profitability
• Since the focus was no longer on solely on shrinkage, the
amount of shrinkage rose from a monthly average of $123 to
$676
• But the incentive system got managers out of the back room
and helping the customers, so sales jumped from $156000 to
$190000 per month, and the overall per store profit increased
$5000 per month