Stockout Cost

Stockout cost refers to the loss incurred by a business when there is a shortage of a specific inventory item to meet its consumer demand in the market. These consequences can be both direct and indirect, including missed sales opportunities, potential customer dissatisfaction, or poor brand reputation.

Moreover, there are certain associated expenses related to rapid shipping, back ordering, or other stock replenishment measures to meet current customer demand. Thus, businesses need to maintain a balanced inventory or stock level to enhance customer satisfaction. Hence, such expenses can be curtailed through effective cost management and inventory management practices.

• Stockout cost refers to the costs incurred by a business when it runs out of inventory or fails to meet customer demand for a particular product.
• Meanwhile, the lost sales opportunity, productivity loss, diminished profit margins, increased supply chain expenses, and high shipping costs are direct stockout expenses. 
• The negative reviews, discounts to prevent churn, expedited shipping expenses, and lower product rankings are indirect consequences of inventory shortage.
• Some of the ways to avoid stockout costs include effective inventory management and robust supply chain strategies for maintaining optimal stock levels.

Stockout cost refers to the costs associated with running out of inventory or not having enough stock to meet customer demand for a particular product. Therefore, these costs can be an outcome of poor inventory management, and paying attention to these expenses can significantly impact a business. Companies commonly face direct and indirect expenses when they run out of stock. Hence, it can't meet the existing market demand for a specific product or service. Let us understand these costs one by one:

1. Direct Stockout Costs: Such scenarios comprise all those losses that can be immediately evaluated in financial terms. These include loss of sales, productivity loss, diminished profit margins, increased supply chain expenses, and high shipping costs.
2. Indirect Stockout Costs: These include factors like excess inventory afterward, storage outlays, piled backorders, customer complaints, replenishment order costs, refunds on canceled orders, difficulty attracting new customers, change of supplier, and increased administrative costs. 

Irrespective of a business's financial health, the cumulative actual and opportunity cost of stockouts is often massive and unexpected. Hence, it is essential to find out the reasons behind such inventory shortages and implement effective strategies to avoid them. 

Therefore, these costs can lead to customer dissatisfaction and damage the reputation of the business. However, when customers experience stockouts, they may lose trust in the business's ability to meet their needs. This can result in a long-term loss of customer loyalty and repeat business.

Thus, to mitigate such costs, businesses often employ inventory management techniques, such as safety stock levels, demand forecasting, and efficient supply chain management. Furthermore, accounting for stockout costs involves recognizing and tracking the various expenses. Which are associated with running out of inventory and the subsequent impacts on sales and operations.

A business should identify the root causes of stockout and the associated costs. Hence,  to avoid significant ramifications pertaining to loss of brand reputation and customer confidence. Some of the possible factors of inventory shortage are discussed below:

• Supply Chain Disruptions: The companies may face issues such as delays from suppliers, transportation challenges, or production interruptions resulting in stockout of a particular item.
• Demand Forecasting Inaccuracy: Another reason can be the inability to predict accurate customer demand, which can disturb the stock levels.
• Supplier Challenges: Most often, small businesses depend upon a single supplier or a limited number of suppliers for stocks, which increases the susceptibility to inventory shortage if the supplier encounters some issues.
• Human Errors: Wrong inventory counting by the store staff can result in false order placement and even lower stock levels.
• Insufficient Cash Flow: Companies that fail to manage their cash flows well may not be able to reorder goods due to previously outstanding bills with the suppliers.
• Inefficient Communication: Sometimes, delays in placing orders with the suppliers or replenishing inventory can leave a business susceptible to stockouts.
• Production Challenges: Also, disruptions in the manufacturing process, such as equipment malfunctions or quality control issues, can cause product shortages.
• Inventory Mismanagement: Ineffective inventory control or management, including insufficient safety stock levels, can increase the potential stockout risk.
• Unanticipated Events: Some factors like natural disasters, economic downturns, or unforeseen events that are not in management’s control can impact the supply chain adversely.

Stockout cost in inventory management is the loss that a business may incur when it is unable to process customer orders due to a shortage of inventory. Such direct financial consequences can be determined by evaluating the lost sales opportunity during the period an item was out of stock. The following equation can be used for its calculation:

Stockout Cost = (Number of days out of stock × Price per unit × Average units sold per day) + Cost of Consequences

However, the cost of consequences is the other indirect financial expenses borne by the company due to insufficient material stock for production. 

Let us understand the concept better with the help of examples.

Example #1

The large clothing company GAP warned in November 2021 that problems with the supply chain have increased expenses while hurting revenue.

Following an earnings report that revealed the company's top line dropped by 1% to $3.9 billion and that inventory was still a problem, GAP shares were down 22% as of this writing. The corporation calculated that inventory stockouts cost it $300 million during the quarter. A shortage of inventories might cost the business $500 million annually.

The fact that Vietnam, which has been hit hard by the epidemic, is a necessary component of GAP's supply chain accounts for a large portion of the burden. The management of the company mentioned on the earnings call that manufacturing closures and longer transit times related to Vietnam affected gross margin (and, of course, harmed inventory availability).

Example #2

Suppose a bookseller sells 12 coursebooks in a day at $7 each. If, due to the strike of trucks, he is unable to replenish stock for the last five days, determine his stockout costs. Also, he placed an order with a local competitor (who has overstocked the item) for 1000 coursebooks by paying $0.5 more than the regular cost.

Solution:

Stockout Cost = (Number of days out of stock × Price per unit × Average units sold per day) + Cost of Consequences

Stockout Cost = (5 × $7 × 12) + (1000 × $0.5) = $920

Hence, we can clearly see that the shortage cost faced by the bookseller is considerable, amounting to a total loss of $920.

Addressing the factors causing stockouts can help mitigate the impact of stockouts on businesses. To prevent high subsequent costs, let us consider the following inventory management strategies:

1. Economic Order Quantity (EOQ): Accurately determine the optimal order quantity for cost efficiency and maintaining sufficient stock levels.
2. Safety Stock: Maintain a buffer stock level to safeguard against unexpected demand spikes or supply chain disruptions.
3. Accurate Demand Forecasting: Utilize accurate forecasting methods to predict demand patterns and make inventory adjustments accordingly.
4. Adhere to Ordering Policies: Optimize order quantities and reorder points to minimize the risk of stockouts without overstocking.
5. Strengthen Supplier Relationships: Build strong ties with suppliers to ensure reliable and timely deliveries, reducing the likelihood of stockouts.
6. Continuous Monitoring: Regularly monitor inventory levels and sales trends to identify potential stockouts early on.
7. Lead Time Reduction: Work towards reducing lead times in the supply chain to minimize the time between placing an order and receiving goods.
8. Strong Collaboration Across Departments: Facilitate clear communication among sales, marketing, and supply chain teams to share information and enhance coordination.

This article has been a guide to what is Stockout cost. Here, we explain in detail its formula, examples, how to avoid it, and factors. You may also take a look at the useful articles below –

• Cost Reduction
• Stock Level
• Order Fulfillment