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Preventing avoidable stockouts:

the impact of item-level 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 item-level radio-frequency 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 periodic-review order-up 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 item-level RFID is two-fold: first, it directly affects the number of products sold through the efficiency and effectiveness of the backroom-to-shelf 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 order-up to level in the backroom. Findings – This study confirms that the direct effect of more efficient and effective backroom-to-shelf replenishment contributes the majority of benefits. On average, this model shows that approximately 80-85 percent of the total RFID benefit is directly due to the backroom-to-shelf process, and only 15-20 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 pallet-level 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 pallet-level 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

Radio-frequency 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. Pallet-level tagging refers to the situation where RFID tags are placed on individual pallets, which is typically used in full-pallet storage and logistics. Case-level tagging has RFID tags attached to cases, which facilitates mixed-pallet 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 within-store. For an exhaustive treatment of RFID technology, see, for

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journal is available at www.emeraldinsight.com/0885-8624.htm Journal of Business & Industrial Marketing 25/8 (2010)

Journal of Business & Industrial Marketing 25/8 (2010) 572–581 q Emerald Group Publishing Limited [ISSN 0885-8624] [DOI 10.1108/08858621011088301]

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example, Clampitt (2007), or Sweeney (2005). Real-world implementations of RFID in retail, including item-level 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 item-level 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 periodic-review order-up 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 low-stock 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 item-level RFID implementation (see Metro Group Future Store Initiative, 2003). In this model, the influence of item-level RFID is two-fold:

first, it directly affects the amount of products sold by reducing out-of-stock 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 item-level 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 item-level 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 item-level 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 multi-period 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 RFID-related 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 visibility-enabled 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 backroom-to-shelf processes at a retailer who implements item-level 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 item-level 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 item-level RFID to decrease the occurrence of out-of-stock situations at the retail shelf. In that paper, the retail operation is modeled as a one-period, 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 multi-period 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 multi-period 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 multi-period model, considerations of demand forecasts and demand forecast updates become an important issue. If item-level RFID can significantly lower out-of-stock 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 in-store backroom-to-shelf replenishment process. The better the backroom-to-shelf 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 backroom-to-shelf 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 item-level RFID is an increase in u due to continuous monitoring of shelf stock and a decrease in product misplacement, compared to a non-RFID store operation. To quantify the effectiveness and efficiency of the backroom-to- shelf process, GSH define u to be the probability that an arriving customer sees a non-empty 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 backroom-to-shelf 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 90-93 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 non-RFID 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 multi-period model of retail operations

This section gives a general description of the underlying multi-period 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 decision-maker 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 order-up 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 backroom-to-shelf 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 best-possible 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

order-up-to level. The policy followed by the retailer is to use

the optimal fractile solution z given by F ðzÞ ¼

the order-up-to 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 item-level 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 backroom-to-shelf 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 and set

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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 order-up to levels. The exception is the order-up to level for the shelf RFID case, which by definition is independent of the RFID system’s effectiveness. Furthermore, the order-up 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 order-up to levels of the shelf and backroom RFID scenario are higher than those without RFID; the order-up to levels of the shelf RFID scenario is identical to the non-RFID scenario. However, when tags are not free, then the Shelf RFID order-up to levels are lower than without RFID, and the shelf and backroom RFID order-up to levels can be either lower or higher than the non-RFID 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 long-run averages of the simulation output. To compute stable long-run 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

Order-up-to 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 order-up-to-levels using demand forecasts based on RFID sell-through data yields – as expected – larger profit improvements than not updating backroom order-up-to levels. However, the incremental profit increase from updating backroom order-up-to levels appears small. Interestingly, a closer look (see Figure 2) reveals that the incremental benefit from updating the backroom order-up-to levels is fairly minor: the study shows that the portion of benefits that is due to improved backroom stocking is in the range of 10-20 percent of total benefits. Put in a different way, more than 80 percent of benefits are directly due to preventing avoidable out-of-stocks via the improved backroom-to-shelf 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 order-up- to-level decrease. With less safety stock available, it becomes more important to base the order-up-to levels on the best- possible demand forecast, which is the one that utilizes the sell-through data from RFID. Hence the higher the tag cost, the more important it is to update the backroom stocking levels based on RFID sell-through 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 order-up-to 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, item-level 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 backroom-to shelf process. Compared to the study’s assumption of a 92 percent effectiveness of the non-RFID 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 five-year time-period, after fixed costs are accounted for in this manner. It can be observed that even at a per-product fixed cost of $500 and a tag cost of $0.05, there is a positive net present value to an introduction of item-level 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 item-level 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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Marketing Volume 25 · Number 8 · 2010 · 572–581 Figure 2 Profit improvement vs tag

Figure 2 Profit improvement vs tag cost

2010 · 572–581 Figure 2 Profit improvement vs tag cost Figure 4 shows the plot of

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 r2c , 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 order-up-to levels using the best available forecasts, which are based on RFID sell-through 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 backroom-to-shelf process is nearly indifferent

r

576

to changes in CV. However, also taking into account the optimal backroom order-up-to 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 order-up 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 order-up-to 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 (five-year horizon)

vs variable and fixed costs (five-year horizon) Figure 4 Profit improvement vs profit margin Journal of

Figure 4 Profit improvement vs profit margin

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is satisfied. The retailer’s goal is to reduce out-of-stock situations at the shelf to avoid lost sales. The role of item-level 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 two-fold: first, it directly affects efficiency and effectiveness of the backroom-to-shelf 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 order-up to level in the backroom. We derive order-up to levels for backroom stocking for both the RFID and no-RFID cases, and we examine the relative magnitude of the direct (i.e. sales) and indirect (i.e. forecast-driven order-up to levels) effects on expected retailer profit. Our numerical study confirms that the direct effect of more efficient and effective backroom-to-shelf replenishment contributes the majority of benefits. On average, our model shows that approximately 80-85 percent of the total RFID benefit is directly due to the backroom-to-shelf process, and only 15-20 percent is due to an improvement in backroom stocking. This finding suggests that, in general, the operation

This finding suggests that, in general, the operation Figure 5 Profit improvement vs coefficient of variation

Figure 5 Profit improvement vs coefficient of variation

This finding suggests that, in general, the operation Figure 5 Profit improvement vs coefficient of variation

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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 pallet-level 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 pallet-level 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 item-level RFID implementation. Neglecting any fixed costs, the numerical results show that under the very conservative assumption that the backroom-to-shelf 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 backroom-to-shelf 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 wide-spread adoption of item-level 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 item-level RFID on the manufacturer, when manufacturer and retailer are not the same entity? Similar to the situation in the one-period model of Gaukler et al. (2007), the manufacturer needs a monetary incentive to bear the cost of applying the RFID tag. In the multi-period 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 no-RFID 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 no-RFID 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

Abell, P. (2003), “Item tracking: myths and realities”, RFID Journal, available at: www.rfidjournal.com Alexander, K., Birkhofer, G., Gramling, K., Kleinberger, H., Leng, S., Moogimane, D. and Woods, M. (2002), Focus on Retail: Applying Auto-ID to Improve Product Availability at the Retail Shelf, white paper, available at: www.autoidcenter. com Atali, A., Lee, H. and Ozer, O. (2005), “If the inventory manager knew: value of RFID under imperfect inventory information”, working paper, Dept. Management Science and Engineering, Stanford University, Stanford, CA. Berger, R. (2003), “Strategy consultants”, Optimal Shelf Availability. A Survey for ECR Europe, available at: www.

ecrnet.org/05-projects1-1.html

Chappell, G., Durdan, D., Gilbert, G., Ginsburg, L., Smith, J. and Tobolski, J. (2003), Auto-ID in the Box: The Value of Auto-ID 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. 1083-96. 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), “Item-level RFID in the retail supply chain”, Production and Operations Management, Vol. 16 No. 1, pp. 65-76. Kang, Y. and Gershwin, S. (2005), “Information inaccuracy in inventory systems”, IIE Transactions, Vol. 37 No. 9, pp. 843-59. 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. 529-36. Lee, H. and Ozer, O. (2007), “Unlocking the value of RFID”, Production and Operations Management, Vol. 16 No. 1, pp. 40-64. Metro AG (2003), Metro Group Future Store Initiative Web Site, available at: www.future-store.org Nahmias, S. (1994), “Demand estimation in lost sales inventory systems”, Naval Research Logistics, Vol. 41, pp. 739-57. 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 auto-ID on supply chain operations”, International Journal of Logistics Management, Vol. 14 No. 1, pp. 1-17. 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 Auto-ID on Retail Shelf Replenishment Policies, white paper, available at: www.autoidcenter.org

Further reading

Agarwal, V. (2001), Assessing the Benefits of Auto-ID Technology in the Consumer Industry, white paper, available at: www. autoidcenter.com Chappell, G., Ginsburg, L., Schmidt, P., Smith, J. and Tobolski, J. (2002), Auto-ID 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), Auto-ID 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 McGraw-Hill, 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 order-up 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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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 i21 ; V i22 ; :::; m 1 Þ

and s i :¼

g s ðV i21 ; V i22 ; :::; s 1 Þ.

In each period, the timing of events is as follows:

.

Retailer establishes demand forecast D i based on D i21 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 finite-horizon periodic-review, 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.

order-up-to 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 order-up to levels).

Under these assumptions, the one-period 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 x¼0 xf u ðxÞdx þ R x¼S i S i f u ðxÞdx. That is, the one-period 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 one-period profit given by expression 1 is maximized by the order-up-to 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 x¼0 xf u ðxÞdx þ R x¼S i S i f u ðxÞdx

i

1

1

R

0

xf u ðxÞdx þ R x¼S 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 one-period 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 cost-minimizing order-up 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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order-up to level is F um;

concludes the proof.

Thus, the order-up-to 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 order-up-to 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 order-up-to level S i ¼ m i þ s i z, where z is the safety stock factor from above. Due to the non-stantionarity of forecasted demand, these order-up 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 order-up to level is dependent on the retailer’s demand estimate. Since the order-up 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 order-up to level etc., the

order-up to levels cannot be determined prior to observing

the previous periods’ sales.

Lemma. Let {d i } i¼1::N denote the sequence of actual realizations of real demand for each of the N time-periods. That is, d i is a realization of D . For any sequence of actual demand realizations {d i } i¼1::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

order-up

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 2m 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 } i¼1::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

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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

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.