Direct Marketing Magazine - March 1997

• Measuring the Shadow Demand
• Dealing With Shadow Demand: Damage Control
  • Inventory-Oriented Approaches
  • Approaches to Induce Customers Not to Go Elsewhere

When you ask DM inventory managers what harm occurs when they’re out of stock, nine out of ten can’t give you an answer. They can tell you initial fill and final fill rates, but they can only guess at what lies beyond, in the area sometimes called ‘shadow demand’, or ‘lost phone demand’, or ‘skip-its’.

The unfortunate fact is that the vast majority of order entry systems in use today simply don’t gather information about what happens when customers learn the products they’ve requested are out of stock. Most systems just record actual orders or backorders. For example, if a customer asks for an item, learns it is unavailable, and orders a substitute item, most order entry systems merely record the order, with none of its history. Re-cently-released systems have begun to capture partial information, but a complete picture appears to be years away.

Even the initial fill and final fill numbers reported by such systems leave important gaps. The next time someone quotes you such a number, probe to see whether it meas-ured early in the mailing’s life or if it is a true overall average. Does it include soldouts? What about substitutions? Does it include items the company canceled, for example, due to vendor failures or unacceptable quality? You will probably find that a true “clinical” measure of stockouts is worse than what your systems report.

Stockouts are surprisingly common. When you consider that the average cus-tomer order often includes 2 or 3 items, the likelihood of encountering a stockout mounts quickly, as the following table shows.

Chances that a customer will encounter a stockout

Many direct marketers consider an initial fill rate of 80 percent acceptable and a rate in the mid-80’s as pretty good. Yet, when soldouts, canceled items, and substitutes are considered, an 85 percent initial fill rate probably translates into an 80 percent in-stock rate, or worse. As the shaded area in the table shows, this “pretty good” performance still leaves 30 to 40 percent of customers hearing the dreaded words, “I’m sorry, but we’re out of that item...”

Let’s look closer into the shadowy world of shadow demand. From occasional surveys and from the few companies whose systems capture relevant information, we can piece together some educated guesses of what happens when customers hear their items are unavailable. Typically they make one of three choices: 1) accept a backorder, 2) substitute another item, or 3) give up and skip the item altogether.

What happens next? Surprisingly little seems to be known, and the possibilities multiply quickly as you involve more stages in the process. Figure 1 below outlines some of the more common outcomes, depending on which path is chosen. The bolded entries in the right column indicate the least desirable outcomes.

This is a simplified picture, for example, it makes no adjustments for returned mer-chandise. Nor do the example percentages capture the escalation that occurs as initial fill rates get worse. Typically, as initial fill rates sink below 70 percent, the portion of cus-tomers who cancel or say “skip it” rises rapidly.

The path that people take through this range of options will depend on many fac-tors such as:

· Whether they need the item by a certain day, for example, for a trip.

· Whether it is an impulse purchase.

· Whether they are a first-time or repeat customer.

· How often they’ve encountered backorders with you before.

· How competitive the market is for the item they selected.

The good news in this picture is that roughly two-thirds of customers encountering a stockout will get what they wanted, with only a delay. The bad news is that about a quarter of them end up with a distinctly bad outcome, such as going to a competitor or owning a product they’re unhappy with. Translated into overall terms, at an 85 percent “initial fill” rate, about 9 percent of the demand a company generates will end up with its competitors, or distinctly unhappy with its service, or both.

Dealing with Shadow Demand – Measuring the Extent of the Problem

In developing a strategy to reduce the effects of shadow demand, the top priority is to make it more visible, so top management knows the true economics of its business. As the old quality control saying goes, “You can’t fix what you can’t measure.” The goal, therefore, should be to develop estimates of the lost demand, then apply normal margins, lost shipping revenue, backorder costs, and the like, to compute a “cost of lost demand” number for reporting to management.

Some ideas for estimating the amount and costs of lost demand include:

· Ask your order entry software suppliers if they offer any ways to capture sub-stitutions, soldouts, or lost telephone demand. Some do, now, and your ques-tion might spur them to add more such capability in the future.

· Conduct a spot survey, for one week, say, among the telephone salespeople.

· Phone a sample of stockout customers and ask what they did upon learning their item was unavailable. Did they do without it, get it elsewhere, or buy a substitute (and if so, where)?

· Similarly, phone a sample of customers who bought substitute items (logged manually by the telephone sales reps). Ask how happy they are with their choice. If they had it to do over, would they make the same choice?

Dealing with Shadow Demand – Damage Control

Even if you cannot fix the problem of shadow demand, there are ways to mitigate the effects. Most of these approaches rely on two basic ideas: 1) without increasing overall inventory levels, re-balance the inventory to focus stockouts on products where they will do the least harm, and 2) induce customers to accept substitutes and backorders, rather than going elsewhere.

Inventory-Oriented Approaches

· Shift stockouts toward less competitive items. In other words, carry greater stocks on highly competitive items (oxford shirts, for example) and lower stocks on items which are unique to your firm (hand-painted Italian vases).

· Learn more about why your customers buy each item. If you can identify ones whose timing is urgent, you can increase coverage for those items and reduce coverage on less urgent ones.

· If you are using an inventory coverage model (a formula-based approach for deciding how much to buy), increase the assumed backorder cost to allow for replacing customers lost due to stockouts. For example, if your cost of a new customer is $65, and there is a 10 percent chance that stocked-out customers never come back, add another $6.50 to your backorder cost.

Approaches to Induce Customers Not to Go Elsewhere

· Increase your capability for suggesting substitute products. A few companies have actually built this capability into their order entry systems. When an item is out of stock, the system presents a list of alternatives to the telephone sales-person. (Be careful that the substitutions are good ones, or as the chart above shows, the customers may become doubly unhappy.)

· Use Federal Express, drop shipping, and other similar devices for fast delivery once the item becomes available. In other words, look for ways to minimize the customer’s inconvenience. Many companies do just the opposite, using low-cost slow methods for shipping backorders.

· Adopt a strong ‘Truth in Backordering” policy. Over-optimism on delivery dates just adds insult to the injury of a stockout. Think of your own reactions, for example, when airlines post a new departure time for a delayed flight. Don’t you tend to add a cushion for over-optimism? And, don’t you resent their apparent lack of truthfulness?

· For long delays, take the initiative in shifting to a posture of, “We’ll call you as soon as it comes in”.

· Some people have suggested compensating customers to induce them to ac-cept backorders, such as by promising a bonus gift together with the delayed shipment. How well this approach would work is an open question. (Any readers with experience in this practice are invited to comment.)

· Consider making an arrangement with a non head-on competitor for backup supplies when you are out of stock. Many industrial distributors have long used this practice with good results.

Much more needs to be learned about what people actually do when they discover the products they want are unavailable. Once this behavior is better understood it will be-come easier to choose the right corrective actions. Enough is known, however, to say one thing. By ignoring the problem, as most do, direct marketers are costing themselves a great amount of needless customer frustration and missed opportunities. Just shining a light on shadow demand would make a considerable improvement.