The calculation of the size of the safety stock that a company must have is built from the balance between the stock and outage ratio, where the sum of the expected value of the cost of stock and the cost of shortages is minimized. Naturally, for this it is necessary to quantify these two costs. The most commonly used methodology to estimate them is:
- For the cost of inventory: the cost of capital incurred by the company for having the product in stock is calculated, based on the attractiveness rate defined by the company.
- For the cost of shortages: it is considered to be how much the company fails to gain from the margin of that product, which could not be sold because it was out of stock.
However, this methodology is a simplification of reality, since there are several other qualitative impacts both in maintaining a high inventory and in not meeting customer demand when presented.
This post will be focused on the cost of absence and does not intend to quantify the costs of qualitative factors when there is a disruption. The proposal is to help companies to qualify whether in their operation the disruption is very or not very serious from the perspective of 4 of Porter's 5 forces. They are: competition, threat of new entrants, threat of substitute products and bargaining power of buyers. As the rupture in the company's relationship with the customer is being analyzed, the force "bargaining power of the supplier" was disregarded.
Figure 1: Porter forces that aggravate the consequences of rupture. Source: Adapted from PORTER (1979)
- Competitors
The intensity of this force is mainly defined by two factors: the growth speed of the company's sector and the number of competitors it has. In the first, when the sector's growth rate is low, the companies that operate in it need to grow by developing their market-share, so they will have more aggressive customer loyalty policies and convince potential customers to migrate to their product. In the second factor, the greater the number of competitors, the greater the availability of supply to meet customer demand and also the number of marketing actions. As the rupture consists in not meeting the customer's demand, naturally, the cost to resume this demand will be greater and the chances of it becoming loyal to the competitor will also be greater.
- Threat of new entrants
The main factor that affects this strength and consequently the cost of failure is the entry barrier. When a demand is not met by any company in the market or is poorly met, a market failure is created, which, in turn, is an opportunity for new business. If the initial cost to enter this sector is low and there are no competitive advantages for companies that already have scale, other competitors will quickly emerge and capture this demand. Therefore, the lower the entry barriers, the higher the cost of absence.
- Threat of substitute products
The cost of shortages is associated with the risk of the customer trying substitute products and becoming loyal. In this case, the cost of recovering the lost customer may be even higher, as the customer becomes loyal not only to the new product, but also to the new way of meeting their demand. For example, assuming that a customer wants to buy a sunscreen, however, due to unavailability in the store, he decides to buy a shirt with UV protection and is satisfied with the product to the point of loyalty. To get it back, the sunscreen company will have to convince you, not only that their sunscreen is better than the competitor's UV shirt, but also that the way to protect yourself with sunscreen is better than with the UV shirt.
- Bargaining power of buyers
The greater the leverage the buyer has over the company, the greater the relative cost of default. As a fragmented market, the buyer's bargaining power is low, given the company's high possibility of winning over other customers. However, for a concentrated market, as there are few buyer customers, they end up having a high power over the company and failing with that customer can have serious consequences for the company.
By understanding how the 4 forces act in the business, it is possible to understand how severe the impact of the disruption will be. Thus, it is possible to make more assertive safety stock decisions that generate long-term strategic gains for the business. Therefore, it is necessary to go beyond a simple inventory size calculation to a more intensive policy. Such a decision will require more investment in inventory, however, it is strategically consistent with the risks of your business. This could prevent the cost related to attracting new customers or recovering a lost customer from growing considerably over time, remembering that the cost of keeping a loyal customer is significantly lower than that of attracting a new one.
References:
– Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review, May 1979 (Vol. 57, No. 2), pp. 137–145.
