Preventing avoidable stockouts:
the impact of itemlevel RFID in retail
Gary M. Gaukler
Texas A&M University, College Station, Texas, USA
Abstract Purpose – This paper aims to characterize some of the operational beneﬁts of itemlevel radiofrequency identiﬁcation (RFID) in a retail environment. Design/methodology/approach – The paper examines a retail store operation with backroom and shelf stock under the assumption of multiple replenishment and sales periods. Backroom stock is replenished according to a periodicreview orderup to policy and shelf stock is replenished continually from the backroom. Backroom replenishment decisions are made based on demand forecasts that are updated in each sales period based on previous sales. The inﬂuence of itemlevel RFID is twofold: ﬁrst, it directly affects the number of products sold through the efﬁciency and effectiveness of the backroomtoshelf replenishment process. Second, it indirectly affects the retailer’s demand forecast: ceteris paribus, more products sold mean a higher demand forecast, which means a higher orderup to level in the backroom. Findings – This study conﬁrms that the direct effect of more efﬁcient and effective backroomtoshelf replenishment contributes the majority of beneﬁts. On average, this model shows that approximately 8085 percent of the total RFID beneﬁt is directly due to the backroomtoshelf process, and only 1520 percent is due to an improvement in backroom stocking. This ﬁnding suggests that, in general, the operation of the backroom is not as crucial to the overall retail store proﬁtability. Originality/value – The model in this paper delivers further evidence of the importance of the “last several yards” in retail execution. This has important implications for retail RFID projects: most current retail RFID implementations and pilots focus on case and palletlevel RFID to ensure correct backroom stocking. Seeing, however, that this type of beneﬁt accounts for less than 20 percent of total potential RFID beneﬁts, it appears that current case and palletlevel implementations are merely scraping the tip of the iceberg.
Keywords Retailing, Demand forecasting, Stock control, Sales, Product identiﬁcation
Paper type Research paper
An executive summary for managers and executive readers can be found at the end of this issue.
1. Introduction
Radiofrequency identiﬁcation (RFID) is an identiﬁcation method that uses electromagnetic waves to transmit information from a tag to a reader device. In recent years, use of this technology has proliferated in all areas of operations management. Applications of RFID now include retail operations; inventory control and logistics; manufacturing and conﬁguration management; as well as authentication, counterfeit protection and security (Gaukler and Seifert, 2007). RFID can be used at different levels of tagging. Palletlevel tagging refers to the situation where RFID tags are placed on individual pallets, which is typically used in fullpallet storage and logistics. Caselevel tagging has RFID tags attached to cases, which facilitates mixedpallet loads. The ﬁnest granularity of tracking is enabled by item level tagging, where each individual product has its own RFID tag. This is primarily envisoned to assist retail operations withinstore. For an exhaustive treatment of RFID technology, see, for
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Journal of Business & Industrial Marketing 25/8 (2010) 572–581 q Emerald Group Publishing Limited [ISSN 08858624] [DOI 10.1108/08858621011088301]
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example, Clampitt (2007), or Sweeney (2005). Realworld implementations of RFID in retail, including itemlevel RFID implementations, are described for example in Gaukler and Seifert (2007), Wolfe et al. (2003), Abell (2003), Roberti (2003), and Sliwa (2002). In this research, we characterize some of the operational beneﬁts of itemlevel RFID in a retail environment. We examine a retail operation with backroom and shelf stock under the assumption of multiple replenishment and sales periods. Backroom stock is replenished according to a periodicreview orderup to policy and shelf stock is replenished continually from the backroom. Backroom replenishment decisions are made based on demand forecasts that are updated in each sales period based on previous sales. The idea is that retail shelves that are outﬁtted with RFID readers would continually monitor the remaining stock on the shelves and issue lowstock and replenishment alerts to store personnel, so that shelves can be replenished from the store backroom before actual sales are lost at the shelf. This is done, for example, in the Metro FutureStore itemlevel RFID implementation (see Metro Group Future Store Initiative, 2003). In this model, the inﬂuence of itemlevel RFID is twofold:
ﬁrst, it directly affects the amount of products sold by reducing outofstock events. Second, it indirectly affects the retailer’s demand forecast: ceteris paribus, more products sold mean a higher demand forecast, which means a higher order up to level in the backroom. The research questions we try to address here are:
1 Given that the beneﬁts from itemlevel RFID are:
^{.} better demand level prediction and hence a better decision on how much to stock in the backroom; and
Preventing avoidable stockouts
Gary M. Gaukler
^{.} a better restocking process from the backroom to the shelf – what is the relative contribution of each of the two to the potential overall cost savings? This is an important consideration because better demand prediction could also be achieved by utilizing better forecasting techniques rather than RFID.
2 What are properties of products and processes that make a real world setting more conducive to see substantial beneﬁts from itemlevel RFID? This will determine, for example, whether or under which circumstances it is better to implement RFID for high or low margin products.
3 What are rough, ballpark estimates of the minimum level of tag cost necessary to make itemlevel RFID proﬁtable? An answer to this question will help determine when one can expect to see widespread adoption of this technology.
The remainder of this paper is organized as follows: In section
2 we will review the literature related to RFID
implementations in general, and in the retail sector in particular. Section 3 presents the multiperiod model and initial analytical results. Section 4 contains results from a numerical study of the model, and section 5 rounds off the paper with conclusions and managerial insights.
2. Literature review
Research on RFIDrelated aspects of operations management has developed into a fairly fertile ﬁeld, over the last couple of years. The research activity has been such that a survey paper on RFID research focused on quantitative analysis was recently published (Lee and Ozer, 2007). In particular, quantitative research aimed at the retail sector includes the work by Atali et al. (2005), who examine the impact of imperfect information on stocking levels, and Kang and Gershwin (2005), who report on the role of RFID in mitigating inventory inaccuracies. In inventory control, Gaukler et al. (2007) model a visibilityenabled emergency ordering policy. In the area of complex assembly processes, Gaukler and Hausman (2008) present a model of process time and quality cost savings due to RFID. On a less quantitative level, Wong and McFarlane (2003) describe the ordering and backroomtoshelf processes at a retailer who implements itemlevel RFID. Karkkainen (2003) examines a grocery application where the advantage of identiﬁcation information is in observing the condition of perishable items. Shefﬁ and McFarlane (2003) offer some general qualitative insights into how identiﬁcation information could impact supply chain operations. Alexander et al. (2002) as well as Berger (2003) give qualitative overviews of the opportunities for itemlevel RFID in a retail application. They see improved product availability at the shelf as the key enabler to enhanced proﬁtability. This current paper is closest in spirit and modeling assumptions to Gaukler et al. (2007), which will be referred to as GSH from here on. GSH consider a retailer that uses itemlevel RFID to decrease the occurrence of outofstock situations at the retail shelf. In that paper, the retail operation is modeled as a oneperiod, newsvendor type setting in which the retailer decides on an optimal stocking level for the backroom at the beginning of the season, and then no further replenishments can take place. A similar model, which is
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based on GSH, is explored numerically, by Szmerekovsky and Zhang (2007). This current research expands GSH in two important directions:
1 It presents a multiperiod model of retail operations.
2 In this paper, backroom stocking decisions are inﬂuenced by improved demand forecasts in the RFID case.
These extensions are important because a multiperiod model is arguably a more realistic depiction of the retail environment, in which typically the same products are offered for sale over multiple time and replenishment periods. Furthermore, in such a multiperiod model, considerations of demand forecasts and demand forecast updates become an important issue. If itemlevel RFID can signiﬁcantly lower outofstock situations at the shelf, the overall number of sales is improved. It stands to reason that the more sales can be observed, the more accurate demand forecasts and forecast updates can be obtained. This in turn would inﬂuence the backroom stocking decision, which in turn would inﬂuence (indirectly) the number of sales in subsequent periods and so on. The main modeling feature that we borrow from GSH is the notion of effective demand at the retail shelf. GSH model an exogenous parameter 0 # u # 1, which describes the effectiveness and efﬁciency of the instore backroomtoshelf replenishment process. The better the backroomtoshelf replenishment process works, the higher u will be. Examples of processes and practices that inﬂuence u are the frequency with which shelf stock is monitored, the frequency with which backroomtoshelf replenishments are performed, and the reaction time between observing an empty shelf and restocking it. Product misplacement (a product that sits on the wrong shelf cannot be considered to be available for sale) is another factor. In general, it is assumed that the effect of itemlevel RFID is an increase in u due to continuous monitoring of shelf stock and a decrease in product misplacement, compared to a nonRFID store operation. To quantify the effectiveness and efﬁciency of the backroomto shelf process, GSH deﬁne u to be the probability that an arriving customer sees a nonempty shelf, given that there is still a positive amount of stock left in the backroom. Conversely, 1 2 u is the probability that an arriving customer sees an empty shelf, but there is product stocked in the backroom. Thus, this describes the situation where the stockout event at the shelf was avoidable, as opposed to the situation where both shelf stock and backroom stock is depleted: in that case, the stockout is unavoidable. Deﬁned in this way, the best possible backroomtoshelf process is given by u ¼ 1; in this case, a stockout only occurs when there are no more products on the shelf and in the backroom. We deﬁne effective demand at the retail shelf to be the demand that remains after those demands that correspond to avoidable stockouts have been removed from the demand process. That is, the difference between real demand and
effective demand is that effective demand reﬂects all those lost sales that occurred at the shelf due to shelf stockouts that were avoidable (those where there was positive stock in the backroom). Under the assumption that customer demand over a time period is approximately normal, it can be shown (see Appendix) that for a given value of u , the resultant
effective demand is distributed as Nð um;
u sÞ, where m and s
correspond to the effective demand when u ¼ 1, i.e. the
p
ﬃﬃﬃ
Preventing avoidable stockouts
Gary M. Gaukler
perfect case where effective demand is equivalent to real demand. It needs to be noted that estimating u in practice is not trivial. GSH assumed values between 0.8 and 1.0 for the non RFID retailer, and normalized the RFID retailer at u ¼ 1. Wong and McFarlane (2003) provide an estimate of the efﬁciency of the replenishment process from backroom to shelf that varies between 9093 percent. Chappell et al. (2003) provide survey results that mention that for the companies surveyed, approximately 30 percent of products that were unavailable on the shelf were available in the backroom. The numerical study in this paper will assume initial values of u ¼ 0:92 in the nonRFID case, and u ¼ 0:97 in the RFID case. The validity of the model development in the subsequent section is independent of any particular choice of u , of course.
3. A multiperiod model of retail operations
This section gives a general description of the underlying multiperiod retail model. The technical details of this model are given in the Appendix. We consider a retailer that sells a variety of products. The retailer purchases the products from a supplier, but in this paper, we will assume that the retailer and the supplier form a centralized system, and for convenience, we shall refer to the decisionmaker in this centralized systems as the retailer. We shall assume that the products can be considered independently of each other and hence we concentrate our analysis on one particular product only. The retail location is divided up into backroom storage and shelf space. Customer demand occurs at the shelf. Customer demand that cannot be satisﬁed instantly is lost. There is no backlogging of demand. The retailer employs a periodic orderup to inventory control policy. Every period, she orders enough of the product to bring the inventory position (backroom stock þ shelf stock) up to S _{i} 1. The values S _{i} are determined endogenously within the model for each period i. Effective demand at the shelf is a function of the effectiveness and efﬁciency of the backroomtoshelf restocking process. The effectiveness and efﬁciency of this process in our model is given by the parameter u, 0 # u # 1. For period i ¼ 1, the retailer is assumed to have bestpossible estimates of the mean and standard deviation of demand, m _{1} and s _{1} . For each period i . 1, the retailer uses a forecasting algorithm that can be described as a function of the amount of product sold in the previous periods. Examples of such forecasting methods are exponential smoothing, moving averages, etc. Every period, the retailer needs to decide on her backroom
orderupto level. The policy followed by the retailer is to use
the optimal fractile solution z given by F ðzÞ ¼
the orderupto level S _{i} ¼ m _{i} þ s _{i} z based on the retailer’s demand forecast (see theorem 1 in the Appendix). Recall that itemlevel RFID in our retail model has two effects:
1 Better backroom stocking decision due to better demand forecasts.
2 Fewer shelf stockouts due to better backroomtoshelf replenishment process.
We would like to know more about the magnitude of these two effects. Hence, we examine three scenarios that differ in
r2c2t
rþh2c2t ^{a}^{n}^{d} ^{s}^{e}^{t}
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the way RFID is used by the retailer. In the ﬁrst scenario,
there is no RFID. Effective demand at the retailer’s shelf is
given by the random variable D
second scenario, there is RFID, and RFID improves only shelf availability, but not backroom stocking. Effective
, where u _{N} # u _{R} # 1. In
the third scenario, there is RFID, and RFID improves both
shelf availability and backroom stocking. Effective demand at
the retailer’s shelf is D
second scenario is a somewhat artiﬁcial scenario that is only added to allow for an exploration of the incremental beneﬁt of
adjustments to the backroom stocking based on RFID sell through data. In practice, one would only expect to see either the ﬁrst or the third scenario. Table I summarizes the three
cases. We remark that the limiting case of “perfect RFID” is given by u _{R} ¼ 1. In that case, effective demand is the same as real
demand: D
It is easy to show mathematically (see lemma 1 in the Appendix) that an increase in effectiveness of either the non RFID system or the RFID system leads to higher sales and higher orderup to levels. The exception is the orderup to level for the shelf RFID case, which by deﬁnition is independent of the RFID system’s effectiveness. Furthermore, the orderup to levels in the RFID scenarios decrease as the tag price increases. This is expected, because the tag price makes the product more costly to hold in inventory. If tags are free, then the orderup to levels of the shelf and backroom RFID scenario are higher than those without RFID; the orderup to levels of the shelf RFID scenario is identical to the nonRFID scenario. However, when tags are not free, then the Shelf RFID orderup to levels are lower than without RFID, and the shelf and backroom RFID orderup to levels can be either lower or higher than the nonRFID levels, dependent on the tag price and the effectiveness of the system ( u _{R} ).
u N
i
, where 0 # u _{N} , 1. In the
demand at the retailer’s shelf is D
u R
i
u R
i
, where u _{N} , u _{R} # 1. Note that the
u
R
i
¼
D _{i} .
4. Numerical exploration
To explore the model constructed in the previous section, we analyze several scenarios via numerical simulation. The simulation experiments are performed in Microsoft Excel, using Visual Basic code to generate samples from a demand distribution and to compute longrun averages of the simulation output. To compute stable longrun averages, 1,000 independent replications of each scenario have been run; this number of replications yields stable results to within plus/minus one percent precision. The Excel spreadsheet and the code are available on request from the author. Demand forecasting is done via Nahmias’ (1994) exponential smoothing model. This forecasting method is a signiﬁcantly more sophisticated version of the exponential smoothing method. The basic exponential smoothing method is not able to deal correctly with censored demand observations (that is, instances where demand was higher than what was in stock: exponential smoothing would conclude that the demand in that period was equal to what was in stock, when in fact this should be an indicator that demand was larger). The Nahmias method correctly accounts for censored demand observations by basing forecasts only on those sales observations that are not censored by the available inventory.
Preventing avoidable stockouts
Gary M. Gaukler
Table I Three RFID scenarios
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Scenario
Effects of RFID on
Shelf availability
Backroom stocking
Using u to determine Eff. demand at shelf
Orderupto level
1 (“N”) 
No 
No 
2 (“S”) 
Yes 
No 
3 (“BS”) 
Yes 
Yes 
_{u} _{N} 
_{u} _{N} 
u _{R} 
u _{N} 
u _{R} 
u _{R} 
4.1 Basic exploration and sensitivity results The basic dataset for the numerical study is displayed in Table
II. Table II also lists the range for each of the parameters for which sensitivity analysis has been performed. For example,
the range of
demand ( s) means that separate numerical experiments have been performed for values of s within that range. As can be seen from the table, the numerical analysis covers the sensitivity of results to changes in:
for the standard deviation of real
“5
40”
^{.}
^{.}
^{.}
^{.}
coefﬁcient of variation of demand (via parameter s),
effectiveness of RFID relative to the effectiveness without RFID (via parameter u _{R} ),
product proﬁt margin (via parameter c), and
RFID tag cost (parameter t).
With respect to the behavior of proﬁts versus tag price t and RFID effectiveness u _{R} , the numerical study conﬁrms intuition as well as the analytical ﬁndings from section 3. Figure 1 shows a graph of proﬁt improvement versus t and u _{R} . Proﬁt improvements drop sharply as the tag price increases, but are increasing in the effectiveness of RFID. Furthermore, updating the backroom orderuptolevels using demand forecasts based on RFID sellthrough data yields – as expected – larger proﬁt improvements than not updating backroom orderupto levels. However, the incremental proﬁt increase from updating backroom orderupto levels appears small. Interestingly, a closer look (see Figure 2) reveals that the incremental beneﬁt from updating the backroom orderupto levels is fairly minor: the study shows that the portion of beneﬁts that is due to improved backroom stocking is in the range of 1020 percent of total beneﬁts. Put in a different way, more than 80 percent of beneﬁts are directly due to preventing avoidable outofstocks via the improved backroomtoshelf process. It can also be observed from
Table II Basic dataset for numerical study
Parameter Description 
Initial value 
Range 

m 
Real demand mean 
100 units 
– 

s 
Real demand stddev 
30 
5 
40 
m _{1} 
Initial forecasted demand mean 

100 units 
– 

s _{1} 
Initial forecasted demand stddev 

30 
– 

u _{R} 
Effectiveness RFID 
0.97 
0.9 
1.0 
u _{N} 
Effectiveness no RFID 
0.92 
– 

r 
Sales price 
$10 
– 

c 
Purchase price 
$5 
1 
8 
t 
Tag cost 
$0.10 
0 
0.5 
I 
Holding cost 
5 percent per month 
– 

N 
Time horizon 
12 months 
– 
575
Figure 2 that the portion of beneﬁts that is due to improved backroom stocking increases with the tag cost. This is because with the addition of the tag cost, each product becomes slightly more expensive. Therefore, the holding cost increases and the optimal safety stock along with the optimal orderup tolevel decrease. With less safety stock available, it becomes more important to base the orderupto levels on the best possible demand forecast, which is the one that utilizes the sellthrough data from RFID. Hence the higher the tag cost, the more important it is to update the backroom stocking levels based on RFID sellthrough data. However, from the standpoint of potentially proﬁtable RFID implementations, we are mostly concerned with analyzing those cases where RFID tag costs are fairly low. For these low tag cost cases, our results indicate that simply setting the backroom orderupto levels “approximately right” yields about 90 percent of total beneﬁts. This observation clearly highlights the crucial importance of preventing avoidable stockouts (those stockouts where the shelf is empty, but the backroom is not), for this alone accounts for those 90 percent of beneﬁts. Returning to Figure 1, it is interesting to observe that for the (not unrealistic) set of parameters of this study, itemlevel RFID yields positive proﬁt improvements at a tag cost as high as $0.05, if the RFID implementation can yield a 94 percent effectiveness of the backroomto shelf process. Compared to the study’s assumption of a 92 percent effectiveness of the nonRFID case, this appears to be a reasonable, and most likely conservative, expectation. Recall though that these proﬁt improvements do not include the additional ﬁxed costs of RFID readers, IT infrastructure etc. that an RFID implementation entails. The actual business case for RFID will have to include these costs. To enable a ﬁrst insight into the effect of the ﬁxed cost of readers and IT infrastructure, we calculate the net present value of proﬁt improvements due to RFID, and deduct ﬁxed costs in the ﬁrst year. These ﬁxed costs represent the portion of overall storewide ﬁxed costs, which are attributable to the one product that is studied here. To make this comparison more insightful, we use a range of ﬁxed costs, from a low of $100 to a high of $1,000. Figure 3 shows the net present value (at an 8 percent discount rate) of proﬁt improvements over a ﬁveyear timeperiod, after ﬁxed costs are accounted for in this manner. It can be observed that even at a perproduct ﬁxed cost of $500 and a tag cost of $0.05, there is a positive net present value to an introduction of itemlevel RFID. Given the prices for passive UHF tags at the time of this writing, which hover typically between $0.05 and $0.10 if purchased in large quantities, and the prices of smart shelves or reader/antenna assemblies, which are in the $500 range, it appears that an itemlevel RFID implementation is not as far out of the reach of proﬁtability as it is often assumed. Indeed, our simulations predict a positive return on investment after ﬁve years at these current price points.
Preventing avoidable stockouts
Gary M. Gaukler
Figure 1 Proﬁt improvement vs tag cost t and RFID effectiveness _{u} _{R}
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Figure 2 Proﬁt improvement vs tag cost
Figure 4 shows the plot of proﬁt improvement relative to the unit proﬁt margin of the product. The proﬁt margin is here deﬁned as p :¼ ^{r}^{2}^{c} , that is, p% of sales revenue is proﬁt2. The graph shows that proﬁt improvements are highest for high proﬁt margin products, which is an intuitively expected result. It is also observable that the portion of proﬁt improvement that is due to improved backroom stocking is highest for low margin products. The explanation for this behavior is that, ceteris paribus, lower proﬁt margin products have a lower optimal safety stock. Hence, given this lower safety stock, it becomes more important to update the backroom orderupto levels using the best available forecasts, which are based on RFID sellthrough data. Finally, Figure 5 shows the plot of proﬁt improvement as a function of the coefﬁcient of variation (CV). It can be observed that proﬁt improvement is slightly decreasing in the coefﬁcient of variation. In fact, the proﬁt improvement that is due only to the backroomtoshelf process is nearly indifferent
r
576
to changes in CV. However, also taking into account the optimal backroom orderupto level changes, proﬁt improvement is decreasing in CV. That is, as demand becomes more variable, the proﬁt improvements decrease. This goes hand in hand with the observation that the part of the overall improvement that is attributable to adjusting the backroom orderup to level decreases as the coefﬁcient of variation increases. Again, this is essentially a consequence of safety stock: the optimal safety stock increases as CV increases, hence there is less opportunity for improvement by changing the backroom orderupto levels.
5. Conclusion
This paper presents a study of retail operations where the retailer’s stocking problem is characterized by two separate stocking locations: in the backroom where the bulk of the product is located, and at the shelf, where customer demand
Preventing avoidable stockouts
Gary M. Gaukler
Figure 3 Proﬁt improvement vs variable and ﬁxed costs (ﬁveyear horizon)
Figure 4 Proﬁt improvement vs proﬁt margin
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is satisﬁed. The retailer’s goal is to reduce outofstock situations at the shelf to avoid lost sales. The role of itemlevel RFID is to alert the retailer to impending stockouts at the shelf so that product can be replenished in time from the backroom to the shelf. In our model, the inﬂuence of RFID is twofold: ﬁrst, it directly affects efﬁciency and effectiveness of the backroomtoshelf replenishment process and hence the amount of product sold. Second, it indirectly affects the retailer’s demand forecast: more products sold mean a higher demand forecast, which means a higher orderup to level in the backroom. We derive orderup to levels for backroom stocking for both the RFID and noRFID cases, and we examine the relative magnitude of the direct (i.e. sales) and indirect (i.e. forecastdriven orderup to levels) effects on expected retailer proﬁt. Our numerical study conﬁrms that the direct effect of more efﬁcient and effective backroomtoshelf replenishment contributes the majority of beneﬁts. On average, our model shows that approximately 8085 percent of the total RFID beneﬁt is directly due to the backroomtoshelf process, and only 1520 percent is due to an improvement in backroom stocking. This ﬁnding suggests that, in general, the operation
Figure 5 Proﬁt improvement vs coefﬁcient of variation
577
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Gary M. Gaukler
of the backroom is not as crucial to the overall retail proﬁtability. Our model therefore delivers further evidence of the importance of the “last several yards” in retail execution. This has important implications for retail RFID projects: the majority of current RFID implementations and pilots focus on case and palletlevel RFID. The beneﬁts of these implementations are mainly in improving logistics and receiving operations, reducing order inaccuracy, etc. From the retailer’s perspective, these beneﬁts almost exclusively pertain to ensuring correct backroom stocking. Seeing, however, that this type of beneﬁt accounts for less than 20 percent of total potential RFID beneﬁts, it appears that current case and palletlevel implementations are merely scraping the tip of the iceberg. The study also quantiﬁes the impact of RFID tag cost and the ﬁxed cost of readers and IT investment on the proﬁtability of an itemlevel RFID implementation. Neglecting any ﬁxed costs, the numerical results show that under the very conservative assumption that the backroomtoshelf replenishment process under RFID is two percentage points more effective than without RFID, a tag cost as high as $0.05 can yield a proﬁtable implementation. Accounting for ﬁxed costs of readers etc., the study still shows proﬁtability of item level RFID at realistic tag prices of up to 10 cents and ﬁxed costs up to $500 per product, if the backroomtoshelf process can be guaranteed to be 5 percentage points more effective under RFID. Based on these ﬁndings, it is the author’s personal opinion that a widespread adoption of itemlevel RFID in retail may not be as far in the distant future as is commonly believed. For future research consideration, two aspects stand out:
First, what is the impact of itemlevel RFID on the manufacturer, when manufacturer and retailer are not the same entity? Similar to the situation in the oneperiod model of Gaukler et al. (2007), the manufacturer needs a monetary incentive to bear the cost of applying the RFID tag. In the multiperiod model, however, the manufacturer’s quantity sold is closely related to the retailer’s quantity sold. Hence, one would expect very different results from those presented in Gaukler et al. (2007). Second, consider the inclusion of consumer substitution behavior in the model. This is of interest because when consumers substitute by buying a different brand when their favorite brand is out of stock, the retailer does not incur a lost sale. Hence an introduction of RFID would appear to lower the frequency of these substitutions, which may not affect the retailer’s proﬁt by much, but may severely affect the manufacturers of the different brands of products.
Notes
1 We assume that she has exact records of how much is in inventory. This assumption overstates the performance of the noRFID case and understates the RFID beneﬁt, and is thus a conservative assumption. A future research extension could be to add some uncertainty here in the noRFID case. 2 This does not include the tag cost t, which could be included in a proﬁt margin measure p ^{0} :¼ p – t=r if so desired. Note that t/r is a constant, hence this does not change the nature of our observations.
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3 This can also be derived more directly from the inﬁnite divisibility property of the normal distribution (see Gaukler et al., 2007).
4 A future research area would be to modify the model to accommodate positive lead times.
References
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ecrnet.org/05projects11.html
Chappell, G., Durdan, D., Gilbert, G., Ginsburg, L., Smith, J. and Tobolski, J. (2003), AutoID in the Box: The Value of AutoID Technology in Retail Stores, white paper, available at:
www.autoidcenter.com Clampitt, H. (2007), The RFID Handbook, available at: http:// rﬁdhandbook.blogspot.com Gaukler, G. (2005), “RFID in supply chain management”, PhD thesis, Dept. Management Science and Engineering, Stanford University, Stanford, CA. Gaukler, G. and Hausman, W. (2008), “RFID in mixed model automotive assembly operations: process and quality cost savings”, IIE Transactions, Vol. 40 No. 11, pp. 108396. Gaukler, G. and Seifert, R. (2007), “Applications of RFID in supply chains”, in Jung, H., Chen, F. and Jeong, B. (Eds), Trends in Supply Chain Design and Management: Technologies and Methodologies, Springer, Berlin. Gaukler, G., Seifert, R. and Hausman, W. (2007), “Itemlevel RFID in the retail supply chain”, Production and Operations Management, Vol. 16 No. 1, pp. 6576. Kang, Y. and Gershwin, S. (2005), “Information inaccuracy in inventory systems”, IIE Transactions, Vol. 37 No. 9, pp. 84359. Karkkainen, M. (2003), “Increasing efﬁciency in the supply chain for short shelf life goods using RFID tagging”, International Journal of Retail & Distribution Management, Vol. 31 No. 10, pp. 52936. Lee, H. and Ozer, O. (2007), “Unlocking the value of RFID”, Production and Operations Management, Vol. 16 No. 1, pp. 4064. Metro AG (2003), Metro Group Future Store Initiative Web Site, available at: www.futurestore.org Nahmias, S. (1994), “Demand estimation in lost sales inventory systems”, Naval Research Logistics, Vol. 41, pp. 73957. Porteus, E. (2002), Foundations of Stochastic Inventory Theory, Stanford University Press, Stanford, CA. Roberti, M. (2003), “Metro opens store of the future”, RFID Journal, available at: www.rﬁdjournal.com
Preventing avoidable stockouts
Gary M. Gaukler
Shefﬁ, Y. and McFarlane, D. (2003), “The impact of autoID on supply chain operations”, International Journal of Logistics Management, Vol. 14 No. 1, pp. 117. Sliwa, C. (2002), “Retailers buzz about potential of radio tags in supply chain”, Computerworld, July. Sweeney, P. (2005), RFID for Dummies , Wiley, New York, NY. Szmerekovsky, J. and Zhang, J. (2007), “The effect of supply chain contracts on supplier and retailer costs and beneﬁts in an RFID system”, working paper, North Dakota State University, Fargo, ND. Wolfe, E., Alling, P., Schwefel, H. and Brown, S. (2003), Supply Chain Technology  Track(ing) to the Future, Bear Stearns, New York, NY. Wong, H. and McFarlane, D. (2003), The Impact of AutoID on Retail Shelf Replenishment Policies, white paper, available at: www.autoidcenter.org
Further reading
Agarwal, V. (2001), Assessing the Beneﬁts of AutoID Technology in the Consumer Industry, white paper, available at: www. autoidcenter.com Chappell, G., Ginsburg, L., Schmidt, P., Smith, J. and Tobolski, J. (2002), AutoID on Demand: The Value of Auto ID Technology in Consumer Packaged Goods Demand Planning, white paper, available at: www.autoidcenter.com Gaukler, G., Ozer, O. and Hausman, W. (2008), “Order progress information: improved emergency ordering policies”, Production and Operations Management. Kambil, A. and Brooks, J. (2002), AutoID Across the Value Chain: From Dramatic Potential to Greater Efﬁciency and Proﬁt, white paper, available at: www.autoidcenter.com Nahmias, S. (2001), Production and Operations Analysis, Irwin McGrawHill, Boston, MA. Woods, J., Peterson, K. and Hirst, C. (2003), “Maturing open RFID applications will reshape SCM”, research note, The Gartner Group, Stamford, CT, January.
Appendix. Model formulation
Recall that with a probability of 1 2 u , an individual customer demand that occurs at the shelf will not be satisﬁed because the shelf is empty (but the backroom stocking location is not). If individual demands follow a compound Poisson distribution, then we can obtain the effective demand that the shelf can satisfy by applying Bernoulli trials with thinning parameter u to the compound Poisson demand process. The resulting thinned demand process can be approximated by a central limit theorem and expressed as a normal distribution. We call this thinned demand process approximation the effective demand at the shelf. It can be shown (Gaukler, 2005,
chapter 2) that for a given value of u ﬃﬃﬃ , the resultant effective
u sÞ, where m and s
demand is distributed as Nð um;
p
correspond to the effective demand when u ¼ 1, i.e. the perfect case where effective demand is equivalent to real
demand3.
We assume that the time horizon under consideration is divided into N periods. In each period, the retailer replenishes her backroom stock by using an orderup to policy with order up to level S _{i} . For simplicity, we assume that replenishment to the backroom from some outside supplier is instantaneous after the retailer places an order. This assumption is made
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Journal of Business & Industrial Marketing
Volume 25 · Number 8 · 2010 · 572–581
without loss of generality; any positive deterministic lead time could be used by changing the timing of inventory accounting4. Customer demands that cannot be immediately satisﬁed (due to lacking shelf stock) are lost and not backlogged. Thus, under the assumption of instantaneous external replenishment, inventory position is equal to on hand inventory. Each period starts with a backroom stock replenishment event. The demand forecast is updated at the end of each period. Demand is stationary from period to period and can be expressed as a normal random variable with mean m and standard deviation s (for each period). We assume that the retailer has an exogenous, best possible estimate of customer demand in the ﬁrst period, m _{1} and s _{1} . This estimate may or may not be equal to real demand m, s. That is, we allow for the cases where the retailer initially underestimates or overestimates demand. The only constraint we put on the initial demand estimate is that it must be the same across the three scenarios that we consider:
“no RFID”, “shelf RFID”, and “backroom and shelf RFID”. In subsequent periods i . 1, the retailer forecasts the values
m _{i} and s _{i} , making use of actual sales data. Let V _{i} be the random variable that denotes the amount of product sold in period i, and V _{i} denote the realization of this random variable. The demand forecast (mean and standard deviation) for period i . 1 is then given as m _{i} :¼ g _{m} ðV _{i}_{2}_{1} ; V _{i}_{2}_{2} ; :::; m _{1} Þ
and s _{i} :¼
g _{s} ðV _{i}_{2}_{1} ; V _{i}_{2}_{2} ; :::; s _{1} Þ.
In each period, the timing of events is as follows:
^{.}
Retailer establishes demand forecast D _{i} based on D _{i}_{2}_{1} and
previous sales.
Retailer calculates backroom stocking level S _{i} and orders quantity ½S _{i} 2 onhand inventory ^{þ} from outside supplier. Product arrives instantaneously.
Real demand over the demand period is D and effective demand at retailer’s shelf over the demand period is D ^{u} .
Retailer sells V _{i} over the whole demand period.
Retailer calculates proﬁt for demand period i.
The retailer operates a ﬁnitehorizon periodicreview, order up to inventory system with lost sales and stationary cost data. For this inventory control policy, deﬁne the following:
r:
c:
t:
h :¼ Iðc þ tÞ:
S _{i} :
^{.}
^{.}
^{.}
^{.}
selling price of product. purchase price of product. cost of RFID tag.
holding cost per period.
orderupto level for period i.
pdf and cdf of effective demand over a time period ( D ^{u} , E½ D ^{u} ¼ um, Var½ D ^{u} ¼ us ^{2} ). Note that this demand is stationary.
f ^{u} ðxÞ and F ^{u} ðxÞ:
The lead time for replenishment to the backroom is assumed to be zero. The cost of a stockout is the cost of the loss of proﬁt margin, r 2 c 2 t. The holding cost is assessed on that portion of inventory that is carried over from one period to the next. To develop the mathematical model and to motivate the structure of the inventory control policy, we assume temporarily that:
^{.}
any amount of leftover product at the end of the time horizon can be returned for a refund of the purchase price (“free returns”); and
m and s are known to the retailer (hence no forecasting is necessary to determine the orderup to levels).
Under these assumptions, the oneperiod proﬁt function for period i is:
^{.}
Preventing avoidable stockouts
Gary M. Gaukler
p _{i} ¼ ðr 2 c 2 tÞE½ V _{i} 2 hðS _{i} 2 E½ V _{i} Þ ð1Þ
where E½ V _{i} ¼ ^{R} _{x}_{¼}_{0} xf ^{u} ðxÞdx þ ^{R} _{x}_{¼}_{S} _{i} S _{i} f ^{u} ðxÞdx. That is, the oneperiod proﬁt is equal to the proﬁt on expected units sold, less the holding cost on expected stock carried over to the next period. Note that due to the assumption of free returns at the end of the time horizon, it is not necessary to account for product purchased but not sold. The following can be shown:
Theorem. If the retailer knows the real demand distribution parameters m,s, then the retailer’s oneperiod proﬁt given by expression 1 is maximized by the orderupto level:
S i
1
y
¼ um þ
p
ﬃﬃﬃﬃﬃﬃﬃﬃ
usz
_{¼} _{m} eff _{þ} _{s} eff _{z}
where F ðzÞ ¼ r 2 c 2 t=r þ h 2 c 2 t. Proof. Deﬁne D to be effective demand in a time period, and ½x ^{þ} :¼ maxð0; xÞ: First, we will show that maximizing 1 with respect to S _{i} is equivalent to minimizing
ðr 2 c 2 tÞE½D 2 y ^{þ} þ hE½y 2 D ^{þ}
with respect to y. To do this, observe that:
E½ V _{i}
S
1
¼
¼
¼
¼ E½D 2 E½D 2 S _{i} ^{þ}
^{R} _{x}_{¼}_{0} xf ^{u} ðxÞdx þ ^{R} _{x}_{¼}_{S} _{i} S _{i} f ^{u} ðxÞdx
i
1
1
^{R}
0
xf ^{u} ðxÞdx þ ^{R} _{x}_{¼}_{S} _{i} S _{i} f ^{u} ðxÞdx 2 ^{R} _{i} xf ^{u} ðxÞdx
S
1
E½D 2 ^{R} _{i} ðx 2 S _{i} Þf ^{u} ðxÞdx
S
1
ð2Þ
Hence, 1 is equivalent to ðr 2 c 2 tÞE½D 2
ðr 2 c 2 tÞE½D 2 S _{i} ^{þ} 2 hS _{i} þ hE½D 2 hE½D 2 S _{i} ^{þ} . Note
is
equivalent to ðr 2 c 2 tÞE½D 2 ðr 2 c 2 tÞE½D 2 S _{i} ^{þ} 2hE½S _{i} 2 D ^{þ} . Dropping the ﬁrst term (which is not a function of S _{i} ) and substituting y ¼ S _{i} , this is equivalent to minimizing: ðr 2 c 2 tÞE½D 2 y ^{þ} þ hE½y 2 D ^{þ} . Next, we will use a result from Porteus (2002) to show the remaining step: Porteus (2002, p. 96), considers a periodic review problem under the conditions of:
that S _{i} þ E½D 2 S _{i} ^{þ} 2 E½D ¼ E½S _{i} 2 D ^{þ} . Therefore,
1
^{.}
free returns; an arbitrary fraction of unsatisﬁed demand being lost (1 2 b _{B} ); and an arbitrary fraction of leftover stock remaining usable ( b _{R} ), and an arbitrary discount factor (a).
The oneperiod problem that he considers is: min _{y} gðyÞ ¼ cyþ
^{.}
^{.}
c _{h} E½y 2 D ^{þ} þ c _{p} E½D 2 y ^{þ} þ a ^{R} _{0} ^{y} 2 c b _{R} ðy 2 xÞ fðxÞdxþ
c b _{B} ðx 2 yÞ fðxÞdx. Note that D is the realization of
demand that is distributed according to Nðm; sÞ. Porteus shows that for this problem, the costminimizing orderup to level is F _{m}_{;} _{s} ðSÞ ¼ c _{p} 2 cð1 2 ab _{B} Þ=c _{p} þ c _{h} þ acð b _{B} 2 b _{R} Þ. This problem can be transformed into our problem by
setting: a ¼ 1, b _{R} ¼ 1, b _{B} ¼ 0. Then,
a
1
^{R}
y
gðyÞ
¼
¼ c _{h} E½y 2 D ^{þ} þðc _{p} 2 cÞE½D 2 y ^{þ} þ cE½D
c _{h} E½y 2 D ^{þ} þ c _{p} E½D 2 y ^{þ} þ cE½D 2 c ^{R}
1
y
ðx 2 yÞfðxÞdx
Noting that cE½D does not affect the minimization, and setting c _{h} ¼ h and c _{p} ¼ r, we obtain (2). Hence the optimal
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Journal of Business & Industrial Marketing
Volume 25 · Number 8 · 2010 · 572–581
orderup to level is F _{u}_{m}_{;}
concludes the proof.
Thus, the orderupto level of the preceding Theorem solves the retailer’s proﬁt maximization problem. Hence, if assumptions (1) and (2) were to hold, we would be able to determine the optimal orderupto levels a priori. If the
retailer had perfect knowledge of demand (i.e. if he knew m, s,
and
S ^{*} ¼ S _{i} ¼ um þ
This choice of stocking level maximizes expected proﬁts. While assumption (1) can be made without further problems, assumption (2) cannot hold because the retailer does not know m and s and instead uses his forecasted demand (which
is nonstationary from period to period). However, prior sales are governed not by real demand, but by effective demand. Hence the retailer’s demand forecast D _{i} is a forecast of
effective demand, not of real demand. Therefore, using his forecasted demand parameters m _{i} and s _{i} , the retailer would select the orderupto level S _{i} ¼ m _{i} þ s _{i} z, where z is the safety stock factor from above. Due to the nonstantionarity of forecasted demand, these orderup to levels may technically not be optimal, but they are likely the best the retailer can do. Henceforth we will assume that this is the policy that the retailer follows. Note that for each period i, the orderup to level is dependent on the retailer’s demand estimate. Since the orderup to levels depend on the demand estimate, which in
turn depends on the sales in the previous period, which
depend on the previous period’s orderup to level etc., the
orderup to levels cannot be determined prior to observing
the previous periods’ sales.
Lemma. Let {d _{i} } _{i}_{¼}_{1}_{:}_{:}_{N} denote the sequence of actual realizations of real demand for each of the N timeperiods. That is, d _{i} is a realization of D . For any sequence of actual demand realizations {d _{i} } _{i}_{¼}_{1}_{:}_{:}_{N} , the following is true:
_{s} ðSÞ ¼ r 2 c 2 t=r 2 c 2 t þ h. This
p ﬃﬃ
u
u),
then
the
p
ﬃﬃﬃ
optimal
orderup
to
level
would
be
u sz, for all i, where z is deﬁned as above.
^{.}
^{.}
^{.}
^{.}
As u _{N} ( u _{R} ) increases, V ^{N}
As u _{N}
invariant in u _{R} . If t ¼ 0, then S ^{B} $ S _{i} for all i, with equality holding iff i ¼ 1; and S ^{S} ¼ S _{i} for all i. If t . 0, then S ^{B} $ S ^{S} for all i, with equality holding iff i ¼ 1, and S ^{S} , S _{i} for all i. As t increases, S ^{S} and S ^{B} decrease.
i
(V ^{S} and V ^{B} ) increase for all i.
i
i
is
( u _{R} ) increases, S _{i} (S ^{B} ) increases for all i. S ^{S}
i
i
i
i
i
i
i
i
i
Proof Note that if d _{i}
1
s
is the realization of a Nð m; sÞ random
variable, then ^{d} ^{i} ^{2}^{m} is the corresponding realization of a
Nð0; 1Þ random variable.
realization of effective demand, which is Nð um;
d
as u increases. Therefore, V ^{N} ¼ minðd ^{u} ^{N} ; S _{1} Þ increases as u _{N} increases,
corresponding ﬃﬃﬃ
u sÞ, is
increases
Hence,
the
u
p
u
i
¼ mð u 2
p
ﬃﬃﬃ
Þ þ
u
1
p
ﬃﬃﬃ
d _{i} . It is easy to see that d
u
1
i
because S _{1} ¼ F
ð:Þ also increases as u _{N} increases
(because effective demand is stochastically increasing in u _{N} ). Therefore, the forecasted demand distribution for the next period, D _{2} increases because forecasted demand is stochastically increasing in V ^{N} . Therefore, S _{2} increases
S _{2} Þ increases as u _{N}
as u _{N} increases. Then V ^{N} ¼ minðd
increases, and so on.
The proofs for u _{R} and V ^{S} and V ^{B} are analogous.
21
u
N
i
i
u
N
2
;
2
i
2 From the preceding part of this Lemma, we have that V ^{N} increase as u _{N} increases, for any {d _{i} } _{i}_{¼}_{1}_{:}_{:}_{N} . Hence forecasted demand D _{i} becomes stochastically larger as u _{N} increases. Therefore, S _{i} increases as u _{N} increases. The proofs for the other cases are analogous.
i
Preventing avoidable stockouts
3
Gary M. Gaukler
t ¼ 0: Note that S ^{B} is calculated from V ^{B} , which is based
^{.}
on D
Then, because of the ﬁrst part of this Lemma, it follows
that S ^{B} . S _{i} . S ^{B} ¼ S _{1} by deﬁnition of the retailer’s ﬁrst
are both based on
forecasted demand D
period demand estimate. S _{i} and S ^{S}
i
R
i
. S _{i} is calculated from V ^{N} , which is based on D
i
i
N
1
u N
i
i
. Therefore when t ¼ 0,
u
i
R
and S ^{S}
i
S ^{S} ¼ S _{i} .
i
is based on
u
i
i
u
t . 0: Note that S ^{B} is based on D
i
Journal of Business & Industrial Marketing
Volume 25 · Number 8 · 2010 · 572–581
D
that S ^{B} $ S ^{S} . S ^{S} , S _{i} because t c.p. decreases S ^{S}
i
. Since D
i
uN
i
i
R
i
stochastically larger than D
i
N
u
u
, it follows
i
^{.}
4 Follows directly from the deﬁnition of S _{i} , S ^{S}
i
^{.}
Corresponding author
Gary M. Gaukler can be contacted at: gaukler@tamu.edu
To purchase reprints of this article please email: reprints@emeraldinsight.com Or visit our web site for further details: www.emeraldinsight.com/reprints
581
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