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 benets of item-level radio-frequency identication (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 inuence of item-level RFID is two-fold: rst, it directly affects the number of products sold through the efciency and effectiveness of the backroom-to-shelf replenishment process. Second, it indirectly affects the retailers 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 conrms that the direct effect of more efcient and effective backroom-to-shelf replenishment contributes the majority of benets. On average, this model shows that approximately 80-85 percent of the total RFID benet is directly due to the backroom-to-shelf process, and only 15-20 percent is due to an improvement in backroom stocking. This nding suggests that, in general, the operation of the backroom is not as crucial to the overall retail store protability. 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 benet accounts for less than 20 percent of total potential RFID benets, 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 identication 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 identication (RFID) is an identication 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 conguration 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 nest 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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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 benets 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 outtted 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 inuence of item-level RFID is two-fold: rst, it directly affects the amount of products sold by reducing out-of-stock events. Second, it indirectly affects the retailers demand forecast: ceteris paribus, more products sold mean a higher demand forecast, which means a higher orderup to level in the backroom. The research questions we try to address here are: 1 Given that the benets from item-level RFID are: . better demand level prediction and hence a better decision on how much to stock in the backroom; and 572

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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. What are properties of products and processes that make a real world setting more conducive to see substantial benets 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. What are rough, ballpark estimates of the minimum level of tag cost necessary to make item-level RFID protable? An answer to this question will help determine when one can expect to see widespread adoption of this technology.
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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 inuenced 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 signicantly 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 inuence the backroom stocking decision, which in turn would inuence (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 efciency 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 inuence 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 efciency of the backroom-toshelf process, GSH dene 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. Dened in this way, the best possible backroom-to-shelf process is given by u 1; in this case, a stockout only occurs when there are no more products on the shelf and in the backroom. We dene 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 reects 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 valuepof u , the resultant effective demand is distributed as Num; us, where m and s correspond to the effective demand when u 1, i.e. the 573

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 eld, 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 identication information is in observing the condition of perishable items. Shef and McFarlane (2003) offer some general qualitative insights into how identication 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 protability. 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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Journal of Business & Industrial Marketing Volume 25 Number 8 2010 572 581

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 nonRFID retailer, and normalized the RFID retailer at u 1. Wong and McFarlane (2003) provide an estimate of the efciency 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 0:92 in the non-RFID case, and u 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 satised 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 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 efciency of the backroom-to-shelf restocking process. The effectiveness and efciency of this process in our model is given by the parameter u, 0 # u # 1. For period i 1, the retailer is assumed to have best-possible estimates of the mean and standard deviation of demand, m1 and s1 . 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 r2c2t the optimal fractile solution z given by Fz rh2c2t and set the order-up-to level S i mi si z based on the retailers 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 574

the way RFID is used by the retailer. In the rst scenario, there is no RFID. Effective demand at the retailers shelf is given by the random variable DuN , where 0 # uN , 1. In the i second scenario, there is RFID, and RFID improves only shelf availability, but not backroom stocking. Effective demand at the retailers shelf is DuR , where uN # uR # 1. In i the third scenario, there is RFID, and RFID improves both shelf availability and backroom stocking. Effective demand at the retailers shelf is DuR , where uN , uR # 1. Note that the i second scenario is a somewhat articial scenario that is only added to allow for an exploration of the incremental benet of adjustments to the backroom stocking based on RFID sellthrough data. In practice, one would only expect to see either the rst or the third scenario. Table I summarizes the three cases. We remark that the limiting case of perfect RFID is given by uR 1. In that case, effective demand is the same as real demand: DuR Di . i It is easy to show mathematically (see lemma 1 in the Appendix) that an increase in effectiveness of either the nonRFID 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 denition is independent of the RFID systems 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 (uR ).

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 signicantly 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.

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Table I Three RFID scenarios

Scenario 1 (N) 2 (S) 3 (BS) Effects of RFID on . . . Shelf availability Backroom stocking No Yes Yes No No Yes Using u to determine . . . Eff. demand at shelf Order-up-to level

uN uR uR

uN uN uR

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 5. . .40 for the standard deviation of real 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: . coefcient of variation of demand (via parameter s), . effectiveness of RFID relative to the effectiveness without RFID (via parameter uR ), . product prot margin (via parameter c), and . RFID tag cost (parameter t). With respect to the behavior of prots versus tag price t and RFID effectiveness uR , the numerical study conrms intuition as well as the analytical ndings from section 3. Figure 1 shows a graph of prot improvement versus t and uR . Prot 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 prot improvements than not updating backroom order-up-to levels. However, the incremental prot increase from updating backroom order-up-to levels appears small. Interestingly, a closer look (see Figure 2) reveals that the incremental benet from updating the backroom order-up-to levels is fairly minor: the study shows that the portion of benets that is due to improved backroom stocking is in the range of 10-20 percent of total benets. Put in a different way, more than 80 percent of benets 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 Real demand mean Real demand stddev Initial forecasted demand mean Initial forecasted demand stddev Effectiveness RFID Effectiveness no RFID Sales price Purchase price Tag cost Holding cost Time horizon Initial value 100 units 30 100 units 30 0.97 0.92 $10 $5 $0.10 5 percent per month 12 months Range 5. . .40 0.9. . .1.0 1. . .8 0. . .0.5

m s m1 s1 uR uN
r c t I N

Figure 2 that the portion of benets 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-upto-level decrease. With less safety stock available, it becomes more important to base the order-up-to levels on the bestpossible 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 protable 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 benets. 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 benets. 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 prot 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 studys 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 prot improvements do not include the additional xed 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 rst insight into the effect of the xed cost of readers and IT infrastructure, we calculate the net present value of prot improvements due to RFID, and deduct xed costs in the rst year. These xed costs represent the portion of overall storewide xed costs, which are attributable to the one product that is studied here. To make this comparison more insightful, we use a range of xed 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 prot improvements over a ve-year time-period, after xed costs are accounted for in this manner. It can be observed that even at a per-product xed 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 protability as it is often assumed. Indeed, our simulations predict a positive return on investment after ve years at these current price points. 575

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Figure 1 Prot improvement vs tag cost t and RFID effectiveness uR

Figure 2 Prot improvement vs tag cost

Figure 4 shows the plot of prot improvement relative to the unit prot margin of the product. The prot margin is here dened as p : r2c, that is, p% of sales revenue is prot2. The r graph shows that prot improvements are highest for high prot margin products, which is an intuitively expected result. It is also observable that the portion of prot improvement that is due to improved backroom stocking is highest for lowmargin products. The explanation for this behavior is that, ceteris paribus, lower prot 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 prot improvement as a function of the coefcient of variation (CV). It can be observed that prot improvement is slightly decreasing in the coefcient of variation. In fact, the prot improvement that is due only to the backroom-to-shelf process is nearly indifferent 576

to changes in CV. However, also taking into account the optimal backroom order-up-to level changes, prot improvement is decreasing in CV. That is, as demand becomes more variable, the prot 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 coefcient 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 retailers 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

Journal of Business & Industrial Marketing Volume 25 Number 8 2010 572 581

Figure 3 Prot improvement vs variable and xed costs (ve-year horizon)

is satised. The retailers 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 inuence of RFID is two-fold: rst, it directly affects efciency and effectiveness of the backroom-to-shelf replenishment process and hence the amount of product sold. Second, it indirectly affects the retailers 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 prot. Our numerical study conrms that the direct effect of more efcient and effective backroom-to-shelf replenishment contributes the majority of benets. On average, our model shows that approximately 80-85 percent of the total RFID benet is directly due to the backroom-to-shelf process, and only 15-20 percent is due to an improvement in backroom stocking. This nding suggests that, in general, the operation

Figure 4 Prot improvement vs prot margin

Figure 5 Prot improvement vs coefcient of variation

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of the backroom is not as crucial to the overall retail protability. 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 benets of these implementations are mainly in improving logistics and receiving operations, reducing order inaccuracy, etc. From the retailers perspective, these benets almost exclusively pertain to ensuring correct backroom stocking. Seeing, however, that this type of benet accounts for less than 20 percent of total potential RFID benets, it appears that current case- and pallet-level implementations are merely scraping the tip of the iceberg. The study also quanties the impact of RFID tag cost and the xed cost of readers and IT investment on the protability of an item-level RFID implementation. Neglecting any xed 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 protable implementation. Accounting for xed costs of readers etc., the study still shows protability of itemlevel RFID at realistic tag prices of up to 10 cents and xed 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 ndings, it is the authors 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 manufacturers quantity sold is closely related to the retailers 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 retailers prot by much, but may severely affect the manufacturers of the different brands of products.

3 This can also be derived more directly from the innite 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.rdjournal.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:// rdhandbook.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 mixedmodel 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 efciency 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.rdjournal.com 578

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 benet, 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 prot margin measure p0 : p t=r if so desired. Note that t/r is a constant, hence this does not change the nature of our observations.

Preventing avoidable stockouts Gary M. Gaukler

Journal of Business & Industrial Marketing Volume 25 Number 8 2010 572 581

Shef, 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 benets 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 Benets 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 AutoID 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 Efciency and Prot, 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.

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 satised (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, bestpossible estimate of customer demand in the rst period, m1 and s1 . 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 mi and si , making use of actual sales data. Let Vi 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 mi : g m V i21 ; V i22 ; :::; m1 and si : g s V i21 ; V i22 ; :::; s1 . In each period, the timing of events is as follows: . Retailer establishes demand forecast Di based on Di21 and previous sales. . Retailer calculates backroom stocking level S i and orders quantity S i 2 onhand inventory from outside supplier. Product arrives instantaneously. . Real demand over the demand period is D and effective demand at retailers shelf over the demand period is Du . . Retailer sells V i over the whole demand period. . Retailer calculates prot for demand period i. The retailer operates a nite-horizon periodic-review, orderup to inventory system with lost sales and stationary cost data. For this inventory control policy, dene the following: r: c: t: h : Ic t: Si : f u x and F u x: 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 (Du , EDu um, VarDu us2 ). Note that this demand is stationary.

Appendix. Model formulation

Recall that with a probability of 1 2 u , an individual customer demand that occurs at the shelf will not be satised 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 ofp the resultant effective u, demand is distributed as Num; us, where m and s correspond to the effective demand when u 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 579

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 prot 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 prot function for period i is:

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Journal of Business & Industrial Marketing Volume 25 Number 8 2010 572 581

pi r 2 c 2 tEVi 2 hS i 2 EVi 1 R Si R1 where EVi x0 xf u xdx xSi S i f u xdx. That is, the one-period prot is equal to the prot 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 retailers one-period prot given by expression 1 is maximized by the order-up-to level: p y um usz

meff seff z

where Fz r 2 c 2 t=r h 2 c 2 t. Proof. Dene D to be effective demand in a time period, and x : max0; x: First, we will show that maximizing 1 with respect to S i is equivalent to minimizing r 2 c 2 tED 2 y hEy 2 D with respect to y. To do this, observe that: R Si R1 u u EVi x0 xf xdx xS i S i f xdx R1 R1 u R1 u u 0 xf xdx xS i S i f xdx 2 S i xf xdx R1 ED 2 S i x 2 S i f u xdx ED 2 ED 2 S i 2

Hence, 1 is equivalent to r 2 c 2 tED 2 r 2 c 2 tED 2 S i 2 hS i hED 2 hED 2 S i . Note that S i ED 2 S i 2 ED ES i 2 D . Therefore, 1 is equivalent to r 2 c 2 tED 2 r 2 c 2 tED 2 S i 2hES i 2 D . Dropping the rst term (which is not a function of S i ) and substituting y S i , this is equivalent to minimizing: r 2 c 2 tED 2 y hEy 2 D . Next, we will use a result from Porteus (2002) to show the remaining step: Porteus (2002, p. 96), considers a periodicreview problem under the conditions of: . free returns; . an arbitrary fraction of unsatised demand being lost (1 2 bB ); and . an arbitrary fraction of leftover stock remaining usable (bR ), and an arbitrary discount factor (a). The one-period problem that he considers is: miny gy cy Ry Ey chR 2 D cp ED 2 y a 0 2 cbR y 2 xfxdx 1 a y cbB x 2 yfxdx. Note that D is the realization of demand that is distributed according to Nm; s. Porteus shows that for this problem, the cost-minimizing order-up to level is Fm;s S cp 2 c1 2 abB =cp ch acbB 2 bR . This problem can be transformed into our problem by setting: a 1, bR 1, bB 0. Then, R1 gy ch Ey 2 D cp ED 2 y cED 2 c y x 2 yfxdx ch Ey 2 D cp 2 cED 2 y cED

order-up to level is Fum;ps S r 2 c 2 t=r 2 c 2 t h. This u concludes the proof. Thus, the order-up-to level of the preceding Theorem solves the retailers prot 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 u), then the optimal order-up to level would be p S* S i um usz, for all i, where z is dened as above. This choice of stocking level maximizes expected prots. 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 retailers demand forecast Di is a forecast of effective demand, not of real demand. Therefore, using his forecasted demand parameters mi and si , the retailer would select the order-up-to level S i mi si 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 retailers 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 periods order-up to level etc., the order-up to levels cannot be determined prior to observing the previous periods sales. Lemma. Let {d i }i1::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 }i1::N , the following is true: . As uN (uR ) increases, V N (V S and V B ) increase for all i. i i i . As uN (uR ) increases, S i (S B ) increases for all i. S S is i i invariant in uR . . If t 0, then S B $ S i for all i, with equality holding iff i i 1; and S S S i for all i. If t . 0, then S B $ S S for all i, i i i with equality holding iff i 1, and S S , S i for all i. i . As t increases, S S and S B decrease. i i Proof 1 Note that if d i is the realization of a Nm; s random variable, then d i 2m is the corresponding realization of a s N0; 1 random variable. Hence, the corresponding p realization of effective demand, which is Num; us, is p p d u mu 2 u ud i . It is easy to see that d u increases i i as u increases. Therefore, V N mind uN ; S 1 increases as uN increases, 1 1 because S 1 F 21 : also increases as uN increases uN (because effective demand is stochastically increasing in uN ). Therefore, the forecasted demand distribution for the next period, D2 increases because forecasted demand is stochastically increasing in V N . Therefore, S 2 increases i as uN increases. Then V N mind uN ; S 2 increases as uN 2 2 increases, and so on. The proofs for uR and V S and V B are analogous. i i 2 From the preceding part of this Lemma, we have that V N i increase as uN increases, for any {d i }i1::N . Hence forecasted demand Di becomes stochastically larger as uN increases. Therefore, S i increases as uN increases. The proofs for the other cases are analogous. 580

Noting that cED does not affect the minimization, and setting ch h and cp r, we obtain (2). Hence the optimal

Preventing avoidable stockouts Gary M. Gaukler

Journal of Business & Industrial Marketing Volume 25 Number 8 2010 572 581

t 0: Note that S B is calculated from V B , which is based i i on DuR . S i is calculated from V N , which is based on DuN . i i i Then, because of the rst part of this Lemma, it follows B B that S i . S i . S 1 S 1 by denition of the retailers rstperiod demand estimate. S i and S S are both based on i forecasted demand DuN . Therefore when t 0, S S S i . i i t . 0: Note that S B is based on DuR and S S is based on i i i

DiuN . Since DuR stochastically larger than DuN , it follows i i that S B $ S S . S S , S i because t c.p. decreases S S . i i i i Follows directly from the denition of S i , S S . i

Corresponding author
Gary M. Gaukler can be contacted at: gaukler@tamu.edu

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