Demand fulfilment: a key to supply chain management sustainability
Location and lead time affect inventory management and stock levels, and can even lead to overproduction and extreme waste in supply chain operations
It’s no secret that inefficiencies in global supply chains have led to stockouts and shortages during COVID-19, which have hiked up the cost of some goods. But what is less reported is how these inefficiencies also lead to overproduction, resulting in an incredible amount of waste. In the food industry, for example, food overproduction and surplus have led to vast amounts of waste globally in economically developed countries. This isn’t good from a sustainability point of view or economic growth. Issues in demand forecasting come into play here. While many businesses are ordering extra safety stock, an additional quantity of a product is stored in the warehouse to prevent shortages; this practice can be wasteful if consumers don’t purchase orders. Indeed, experts now warn that holding as much stock as possible can create liquidity risks and drives up e-commerce expenses.
With the rising cost of living, it’s important for businesses to minimise waste in time, money and resources. Yet every year, billions are lost in discarded inventory as many businesses continue to overproduce and improperly forecast customer demand. One study of supply chain waste found that, on average, 8 per cent of stock perishes or is discarded annually, adding up to US$163 billion (A$240 billion) worth of inventory being wasted, totaling more than the GDP of Croatia, Costa Rica and Iceland combined. Yet the most recent estimates put the total amount of lost revenue opportunities worldwide due to inventory distortion at around US$1.1 trillion (A$1.6 trillion).
So why is so much inventory going to waste?
Inventory management process: making sense of disruptions
The fashion industry, another big waste culprit, has notoriously unsustainable production lines and inventory management systems. This is especially true of growth-obsessed fast fashion brands like H&M, which promote disposable fashion. These business models are inherently unsustainable and unethical, and many have been called out for greenwashing. But even before products are sold, poor warehouse management processes can lead to missing stocks or even damage during the warehousing itself.
Overproducing stock from raw materials creates a lot of waste. Some luxury brands then go and burn leftover stock, which is said to be the most “cost-effective” way for luxury designers to protect exclusivity and avoid devaluing their brand image. Estimates suggest that every second, the equivalent of a rubbish truckload of clothes are burnt or buried in a landfill. This seems to be a systemic issue and one that, in part, relates to poor supply chain management and inventory management.
There have also been significant disruptions to supply chains. COVID-19, for example, has significantly impacted supply chain management, resulting in global procurement issues, and affecting businesses’ bottom lines. Customer satisfaction took a hit as the flow of goods slowed. Many businesses had to find better or new inventory management techniques.
According to the findings of a new study, For the future and from afar: Psychological distance and inventory decision-making, complicating all these inventory issues even further are psychological factors that affect how inventory managers perceive their suppliers. Sam Kirshner, Associate Professor in the School of Information Systems and Technology Management at UNSW Business School, recently co-authored a study that examines how global supply chains and long-lead times can increase production, which he said can also lead to more waste.
Location and lead time are two types of psychological distances: spatial and temporal, which significantly impact global supply chains, said A/Prof. Kirshner. These factors affect the number of products that are made and inventory costs. And overproduction in the amount of inventory can lead to waste.
In the study, A/Prof. Kirshner and his co-author Brent Moritz, Associate Professor of supply chain management in the Penn State Smeal College of Business, tested the effects of a classic decision-making paradigm called the ‘newsvendor problem’. This problem, named after the newsboys from the 1800s who had to purchase newspapers daily and could not return any unsold newspapers, is based on the idea that decision-makers must determine the supply (i.e., inventory) of a seasonal or perishable product ahead of knowing the exact demand.
Across four experiments with 663 participants acting as inventory managers, the researchers looked at two standard measures of psychological distance – spatial distance (suppliers that are geographically near or far) and temporal distance (short or long lead time from order to receipt). They found that a far psychological distance, both spatial and temporal, increased order quantities.
“This problem has a critical trade-off between undersupplying the market, in which ordering more inventory would allow for more sales and profits and oversupplying the market, leading to excess inventory that must be heavily discounted or otherwise expires,” explained A/Prof. Kirshner.
“The optimal inventory level typically balances the relative costs of missing out on sales with the cost of holding additional inventory. This means holding lower stock for products with low margins is better since excessive inventory is more costly than missing out on sales. Similarly, holding more inventory for products with high margins is better, where missing out on sales is more costly than being left with excess inventory,” he said.
“It shouldn’t influence the order quantity at all,” explained Moritz said. “While an inventory manager might place an order earlier from a supplier with a longer lead time, there’s no reason to order more from that same supplier.”
How space and time affect customer demand forecasting and order management
The newsvendor problem serves as a workhorse of inventory issues because it illustrates the challenge of balancing the cost of excess inventory with the cost of a shortage, explained A/Prof. Moritz. “There’s a cost of having too much – because the value of a day-old newspaper is zero – and a cost of not having enough – because you don’t want to run out when you could have sold more,” he said.
This means that the way inventory managers process information and evaluate trade-offs can differ substantially, especially when making decisions for the here and now versus far away in time or space.
“Many businesses have to place orders for inventory ahead of knowing the demand,” explained Moritz, whose area of research is behavioural operations management. “If a business knows the costs of too much or too little inventory and can estimate expected demand, it’s possible to select an optimal order quantity. However, our study found that individual decision makers are not especially good at doing this, even if they have all the information they need.”
One example of how distance affects decisions is in the trade-offs between the desirability and feasibility of options. Profit, for example, is a desirable outcome, and feasibility is the probability of selling all the inventory. Higher inventory levels generate the potential for more sales and profits, explained A/Prof. Kirshner. “However, achieving the desired outcomes becomes increasingly difficult because selling each additional inventory unit requires higher demand,” he explained.
Another substantial bias that impacts decision-makers is a concept called demand chasing. A/Prof. Kirshner explained that customer orders and demand levels change from week-to-week, season to season. There is an element of randomness even at the point of sale. “Yet, we tend to treat this randomness as trend information for the next period. This even occurs for decision-makers making forecasts for stationary demand levels (i.e., demand levels that do not vary from period to period),” he said.
“As a result, when demand in the previous period was higher than expected, let’s say for a specific item of clothing, we tend to order more of that item in the next period, which can lead to tremendous waste in the next period, as demand levels tend back towards the mean. Also, decision-makers may use these random high periods as evidence for a popular trend and make more of those products in the following period, even though the high demand was partly random.”
Inventory control and better supply chain management
“Key factors that relate to temporal and spatial distance, i.e., lead times and supplier locations, can influence how people order, even though decision-makers should not factor in these decisions. And this is particularly important given firms’ supply chain responses following COVID-19,” reiterated A/Prof. Kirshner.
The study also found that increasing or decreasing perceptions of psychological distance can encourage more optimal ordering in real-time. For example, inventory managers can make suppliers seem psychologically closer by contrasting them against alternative suppliers farther away in the supply chain, creating a closer sense of distance.
And these findings apply to all types of inventories that are, in a sense, ‘perishable’,” he added. What kinds of products are perishable? Fashion and tech industries are often perishable because new styles and technological advances make the demand for older products (particularly at the original price points) obsolete.
And it is important that businesses address these issues. Higher inventory levels are also more likely to rely on sweatshops since they need to reach a higher production level, which may be too tricky under fair labour practices, added A/Prof. Kirshner, referring to one study on psychological distance and modern slavery in supply chains found larger psychological distances promote a far from mind attitude regarding modern slavery.
“As supply chain managers navigate the new normal, they must prioritise geography and logistics, including transport distance and supplier location. As firms continue to make structural changes to their supply chains, our work advances our understanding of how individuals perceive and act on distance in managing inventory,” recommend the authors in the study.
“Our results reveal that extraneous and readily available information regarding suppliers’ lead time and location can inadvertently affect inventory order quantity decisions.”
Effective inventory management starts by understanding the key drivers of decision-making in supply chain operations, and from there, businesses have the groundwork necessary to build strong supplier relationships.
“Establishing closer relationships with your suppliers can also decrease psychological distance through social distance. Thus, if the social distance between partners is close, even if the supplier is geographically far, they may be psychologically more comparable to the decision-makers, promoting lower orders,” explained A/Prof. Kirshner.
“Given that spatial and temporal distances occur naturally in supply chains, these results show us that psychological distance is one driver of decisions, and distance framing could be used to decrease biased inventory ordering,” said A/Prof. Moritz. “Applying theory from cognitive psychology to show the intersection of human nature and supply chain and operations decisions, as we did in this study, can lead to improved performance in inventory ordering.”
Sam Kirshner is a Senior Lecturer in the School of Information Systems and Technology Management at UNSW Business School. His research interests include analysing behavioural decision-making in operations and technology management and studying how algorithms and artificial intelligence impact decision-making.