How to manage supply shortages in the face of unexpected events
From the global COVID-19 pandemic and its ongoing aftershocks to natural disasters such as record-breaking droughts, catastrophic bushfires and devastating floods, the world has seen an escalation of crises in recent years. Other unexpected events, including the Ukraine-Russia war, the US/Australia-China trade disputes, and other events such as strikes, civil unrest and factory disasters, have more or less shaken economies around the world.
Whether natural or man-made, major crises can abruptly disrupt supplies, rapidly escalate demand (or both), and suddenly run out of many products, including water, gasoline, toilet paper, meat, toys, chlorine, and computer chips (just to name a few). Such events have a direct impact on production and supply – like the recent lettuce shortages in Australia due to flooding, or coffee bean price spikes due to droughts in Brazil, the world’s largest coffee producer. Unexpected events can also have a domino effect on supply chains. Toyota, for example, is currently experiencing unprecedented semiconductor shortages as a result of the pandemic’s impact on manufacturing facilities, and this — coupled with a surge in demand for consumer electronics — has prompted the automaker to take significant earnings downgrades on an ability to keep up with demand , combined with a reduction in production of up to 40 percent.
How companies have dealt with supply bottlenecks
according to dr Jihwan Moon, Senior Lecturer at UNSW Business School’s School of Marketing, says such events often surprise companies involved in the production and delivery of goods. “Over the past two years, businesses have suffered from bottlenecks caused by a variety of reasons including the COVID-19 pandemic, flooding, Brexit and so on,” said Moon, who observed that companies have employed a variety of strategies, to overcome bottlenecks.
Some strategies are relatively easy to implement. For example, companies can raise prices to reduce demand, or simply sell products on a first-come, first-served basis. Other strategies are more complex, such as B. withdrawing scarce products from the market to reduce demand. Businesses can also limit sales to priority groups like loyal customers, first responders and backorders, while Moon said another (less popular) option is to randomly allocate supplies using lottery-like processes.
From the above strategies – and looking back over the past two years – buy limits are proving to be a popular tool for dealing with congestion, according to Moon, who recently co-authored a research paper on “The Profitability of Buy Limits During Congestion”.
“It seems that imposing buy limits is a very effective tool,” he noted. “During the COVID-19 pandemic, many major retail chains have implemented purchase restrictions on scarce items such as cuts of meat, paper towels, hand sanitizer, face masks, disinfectant wipes, liquid bleach, disposable gloves, toilet paper and rubbing alcohol. In addition, we can easily see that gas stations limit fuel purchases during shortages. Although many stores have implemented buy limits, it has not been clear how and when stores should use buy limits on price changes.”
Unpredictability and delivery bottlenecks
While bottlenecks are common problems for businesses, Moon said finding a good solution is very difficult for managers – for two main reasons. “Firstly, it is very difficult to foresee a shortage. Normally, unexpected events lead to bottlenecks. For example, pandemics can shut down factories or disrupt distribution,” he said, citing the example of how the pandemic has disrupted supply chains and unexpectedly reduced inventory of cleaning and disinfecting products or food.
“Second, simply increasing inventory is not a solution to an unexpected shortage because storing excess inventory is prohibitively expensive and increases the risk of demand falls due to unexpected closures, lockdowns, inclement weather, regulations, new superior products, etc.,” he said. For example, demand for turf products falls during hurricanes, while demand in malls (and products like suitcases and formalwear) falls during pandemics like COVID-19.
“Excess inventory can be just as problematic as insufficient inventory. This implies that it is difficult to develop an optimal inventory policy that does not perfectly cope with either shortages or low demand,” Moon explained.
An altruistic approach to congestion management
When dealing with inventory shortages, the research paper typically focuses on profits while trying to appear altruistic to customers. For example, when there were natural disasters like hurricanes, Moon said the stores charged outrageous prices. “To prevent this from happening, some states have enacted price-cutting laws. This implies that fairness and equity concerns seem inappropriate to induce companies to sacrifice their profits and take a purely altruistic approach,” he said.
More unselfish and altruistic approaches may allow businesses to achieve some equality-related goals and improve consumer goodwill. However, altruistic approaches can also lead to resentment, because fairness is always relative, Moon explained. For example, if a store imposes purchasing restrictions to improve distributional equity, this may result in resentment from customers who are first in line, as they may have greater needs and have put more effort into sourcing available supplies and to buy. “So bad faith can offset goodwill,” he said.
“Some may think that goodwill will lead to greater future earnings,” he added. However, this is not so clear as customers may not necessarily reward some stores with future customer retention (thereby reducing spending at others) as this may require adopting different buying behavior after bottlenecks.
In addition, altruistic approaches come with potentially significant administrative, enforcement and opportunity costs. For example, Moon said gas stations that take a less altruistic approach in the days before a hurricane by not restricting purchases to sell available fuel inventories quickly and close early in the week allow the station and employees to prepare for the hurricane can prepare.
How to manage product shortages in future crises
In the research, Moon and his co-authors developed a model that stores can use to their advantage by properly utilizing purchase limits and adjusting prices in the event of shortages. The model takes a sliding approach with recommendations based on store size and defect severity.
Under moderate congestion, meaning businesses can conserve inventory without purchasing restrictions, large multi-product stores with large average shopping baskets should use low prices to increase current customer traffic and impose restrictions to increase future customer traffic. At the other end of the scale, small stores with low footfall (and associated profits) should set high prices without limits, since purchasing restrictions are unnecessary to save on inventory (and only reduce sales when prices are high). For example, during a meat shortage, large supermarkets such as Coles and Woolworths may impose purchase restrictions on meat products without raising prices. In contrast, small butchers are allowed to increase prices without purchase limits.
In the event of severe shortages, where companies cannot save on inventory without purchasing restrictions, large stores should, according to Dr. Moon leverage low prices to take advantage of limited supplies of scarce product to maximize current customer traffic as traffic gains offset lower margins. “When prices are low, stock levels are inevitable, so buying limits are unnecessary administrative costs,” he said. “By contrast, small stores should accept high prices to achieve high margins while setting limits to increase future traffic.”
Another key finding of the research is that even when companies focus solely on profit when setting buy limit strategies, according to Moon, buy limits can improve both profits and consumer welfare, as buy limits can lead large businesses who may want to attract more customers traffic to keep prices down. For example, if Coles sets purchasing restrictions without price increases during a shortage, consumers can buy the scarce product at a low price because without purchasing restrictions, Coles would have increased the price. Additionally, Coles will see higher profits as the shopping limits combined with the low price will increase both current and future store traffic, which will increase profits from non-scarce products.
“In the case of moderate shortages without borders, stores could increase prices to save on inventory while maintaining high margins. During severe shortages that occur during periods of low demand, current purchase limits allow stores to conserve inventory and later lower prices to increase traffic at a future peak period,” the research paper concluded.
This article is republished with permission from UNSW BusinessThink, the knowledge platform of the University of New South Wales Business School. You can access the original article here.