How to manage supply shortages in the face of unexpected events
Companies that face supply chain disruptions can use a sliding scale purchase limit model to adjust prices while ensuring adequate supply during shortages
From the global COVID-19 pandemic and its ongoing aftershocks through to natural disasters such as record-breaking droughts, catastrophic bushfires and devastating floods, the world has experienced an escalation in crises in recent years. Other unexpected events including the Ukraine-Russia war, US/Australia-China trade disputes as well as other events such as strikes, civil unrest and factory disasters have all shaken economies to a greater or lesser degree around the world.
Regardless of whether they are natural or man-made, significant crises can abruptly disrupt supply, rapidly escalate demand (or both) and many products can suddenly become scarce, including water, petrol, toilet paper, meat, toys, chlorine and computer chips (just to name a few). Such events directly affect production and supply – such as 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 shortages in semiconductors as a result of the pandemic’s impact on manufacturing facilities, and this – coupled with a spike in demand for consumer electronics – has led the car manufacturer to issue significant profit downgrades because of an ability to keep up with demand, coupled with cutting production by up to 40 per cent.
How companies have managed supply shortages
Such events often take companies involved in the production and supply of goods by surprise, according to Dr Jihwan Moon, Senior Lecturer in the School of Marketing at UNSW Business School. “For the past two years, stores suffered from shortages that caused by various reasons including the COVID-19 pandemic, floods, Brexit, and so on,” said Dr Moon, who observed firms have employed a variety of strategies to help manage shortages.
Some strategies are relatively easy to implement. For example, firms can raise prices to decrease demand or simply sell products on a first-come-first-served basis. Other strategies are more complex, such as pulling scarce products from the market to reduce demand. Companies can also limit sales to priority groups such as loyal customers, first responders and backlogged orders, while Dr Moon said another (less popular) option is to allocate supply randomly using lottery-like processes.
Out of the above strategies – and with the benefit of hindsight of the past two-plus years – purchase limits are emerging as a popular tool for managing shortages, according to Dr Moon, who recently co-authored a research paper on the topic: The Profitability of Purchase Limits During Shortages.
Purchase limits set the maximum number of units a consumer can buy in a single transaction. “It seems that imposing purchase limits is a very effective tool,” he observed. “During the COVID-19 pandemic, many major retailing chains implemented purchase limits on scarce products such as meat cuts, paper towels, hand sanitisers, face masks, disinfectant wipes, liquid bleach, disposable gloves, bathroom tissues and rubbing alcohol. Moreover, we can easily see gas stations limit fuel purchases during shortages. Although many stores adopted purchase limits, it was not clear how and when stores should use purchase limit with price changes.”
Unpredictability and supply shortages
While shortages are common problems for stores, Dr Moon said it is very difficult for managers to find a good solution – mostly because of two reasons. “First, it is very difficult to anticipate a shortage. Usually, unexpected events cause shortages. For example, pandemics can close factories or disrupt distribution,” said Dr Moon, who gave the example of how the pandemic disrupted supply chains and unexpectedly reduced the inventory of cleaning and disinfectant products or food products.
“Second, simply increasing inventory is not a solution for an unexpected shortage, because carrying excessive inventory is prohibitively costly and increases the risk of demand decreases resulting from unexpected closures, curfews, harsh weather, regulation, new superior products, and so on,” he said. For example, lawn product demand plunges during hurricanes, while demand at malls (and products such as suitcases and dress clothing) plunges during pandemics like COVID-19.
“Excessive inventory can be as problematic as insufficient inventory. This implies that it is hard to develop an optimal inventory policy that perfectly manages neither shortages nor low demand,” Dr Moon explained.
An altruistic approach to managing shortages
In managing stock shortages, the research paper found stores usually focus on profits while they attempt to look altruistic to customers. When there were natural disasters such as hurricanes, for example, Dr Moon said stores charged outrageous prices. “To prevent this, some states made a pricing gouging law. This implies that fairness and justice concerns seem inadequate to induce firms to sacrifice their profits and take a purely altruistic approach,” he said.
More selfless and altruistic approaches may allow stores to realise some equity-related goals and improve goodwill on the part of consumers. However, altruistic approaches can also create ill-will because Dr Moon explained fairness is always relative. For example, when a store imposes purchase limits to improve distributional fairness, it may cause ill-will from customers who are first in a queue as they may have greater needs and have made more of an effort to source and buy available supplies. “So, ill-will may offset goodwill,” said Dr Moon.
“Some may think that goodwill creates greater future revenue,” he added. However, this is not so clear, as customers may not necessarily reward some stores with future patronage (thereby reducing spend at others) because this may require the adoption of different buying behaviours following shortages.
Moreover, altruistic approaches entail potentially significant administrative, enforcement and opportunity costs. For example, in the days before a hurricane, Dr Moon said petrol stations that take a less altruistic approach by not limiting purchases to quickly sell available fuel inventory and close early in the week, allowing the station and employees to prepare for the hurricane.
How to manage product shortages during future crises
In the research paper, Dr Moon and co-authors developed a model that stores can use to their benefit in properly using purchase limits and adjusting prices during shortages. The model takes a sliding scale approach, with recommendations based on store size and shortage severity.
For moderate shortages, in which means firms can save inventory without purchase limits, Dr Moon said large multiproduct stores with large average shopping baskets should use low prices to increase current customer traffic and impose limits in order to increase future customer traffic. On the other end of the scale, small stores with low customer traffic (and associated profits) should set high prices without limits because purchase limits are unnecessary to save inventory (and only decrease sales at high prices). For example, during a meat shortage, large supermarkets like Coles and Woolworths may impose purchase limits on meat products without price increases. In contrast, small butcher stores may increase prices without purchase limits.
For severe shortages, in which firms cannot save inventory without purchase limits), Dr Moon said large stores should use low prices to leverage limited supplies of scarce products in order to maximise current customer traffic because traffic profits offset lower margins. “Stockouts are inevitable at low prices, so purchase limits are unnecessary administrative costs,” he said. “In contrast, small stores should adopt high prices to enjoy high margins while imposing limits to increase future traffic.”
Another key finding of the research paper is that even when firms purely focus on profits when it comes to setting purchase limit strategies, Dr Moon said purchase limits can improve both profits and consumer welfare because purchase limits can lead large firms, which may want to increase customer traffic, to keep prices low. For example, during a shortage, when Coles imposes purchase limits without price increases, consumers can buy the scarce product at a low price because without purchase limits, Coles would have increased the price. Moreover, Coles will enjoy higher profits because purchase limits combined with the low price will increase both current and future store traffic, which will increase profits from non-scarce products.
“In moderate shortages, without limits, stores might raise prices to save inventory while enjoying high margins. In severe shortages occurring during off-peak demand periods, current purchase limits enable stores to save inventory and later decrease prices to increase traffic in a future peak period,” the research paper concluded.
Dr Jihwan Moon is a Senior Lecturer in the School of Marketing at UNSW Business School. His research examines how firms effectively communicate with consumers and how firms and consumers make decisions in uncertain environments. For more information please contact Dr Moon directly.