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Stocking Up Can Build Customer Value
Topics: Markets-Demand and ConsumersResearch-Research and DevelopmentOperations-DistributionA classic business problem from the 1950s illustrates the tension between inventory costs and missed sales. A newspaper vendor must decide how many papers to buy each day based on typical demand. His profit is optimized, the solution says, when he buys just enough to run out a percentage of days matching the ratio between his cost and the price he charges. For example, if he buys the papers for ten cents and sells them for seventy cents, and his records show that demand is typically ten papers or less six days out of every week, he should always buy ten papers. This means he will run out of papers (and miss one or more possible sales) once a week, or one-seventh of the time. What's ignored in this equation, though, according to HBS professor David Bell, is that customers care how often a retailer runs out of stock. "The probability that you'll be in stock affects the customer's willingness to buy," says Bell in his working paper titled "Incorporating the Customer's Perspective into the News Vendor Problem." He continues, "The knowledge that certain stores are bound to have what you want is very important to a consumer."
Reworking the news vendor scenario, Bell incorporated the customer's expected value of a transaction - the difference between the price the customer is willing to pay and the store's price (the magnitude of the perceived "bargain"), multiplied by the likelihood the customer will find the item in stock. The higher this expected value, the more likely the shopper is to visit the store.
Bell's calculations demonstrate that profit is
maximized when "stock-outs" occur a percentage of days
matching the ratio between the vendor's cost and the price
the customer is willing to pay. Compared to the classic solution,
this results in higher recommended inventory and fewer stock-outs,
regardless of item price.
"Retailers are shortsighted if they stock inventory
by thinking only in terms of their own economics," says Bell.
His
findings offer the numbers to back up an intuitive assumption:
stock what the customer wants and she will return.
- Laura Singleton (MBA '88)
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