The Washington State tree fruit industry loses 5% to 12% of potential revenue because of costs associated with inventory shrinkage and 1% of revenue because of costs associated with stock-outs.

How to reduce shrinkage and stock-out costs in tree fruit
James Foreman
Guest Columnist

Each year, $2 billion worth of apples, pears and cherries, some 125 million to 150 million boxes, move through the Washington tree fruit supply chain. 

Because of the perishable nature of fruit, good inventory management practices are essential. 
 
The two biggest sources of inventory inefficiency are shrinkage and stock-out costs.

When inventory levels are high, firms discount prices to avoid the physical deterioration, or shrinkage, of the fruit. 

When inventory levels are low, firms incur stock-outs. Each firm faces a unique tradeoff between shrinkage and stock-out costs, given their network design, customer base and product offerings.
 
Excess inventory, shrinkage

Tree-fruit companies maintain on-hand inventory because fruit is not usually sorted by stock-keeping units when it is in raw material storage, so packing managers are forced to pack a range of SKUs to meet a single order, even when there is no demand for many of those SKUs at the time of packing. 

When firms have high levels of on-hand inventory, they lose revenue in three ways:

  • Sales managers discount the price of inventory as it gets older because they know it is deteriorating.
  • When several pieces of fruit in a box have deteriorated, the entire box must be resorted and re-packed, a process which incurs labor and material costs as well as lost volume.
  • If boxes are shipped containing fruit that has already deteriorated, they may be rejected upon receipt by the buyer.

Firms can avoid these problems by:

  • Improving visibility of production by pre-sizing fruit or reducing the number of SKUs offered.
  • Improving visibility of demand by using point-of-sale (POS) data to improve forecasting and establishing vendor-managed inventory relationships to reduce demand variability.
  • Improving visibility of on-hand inventory to potential buyers by setting up an e-commerce platform and posting on-hand inventory by SKU.
  • Shape customer demand through pricing decisions.

 
Consolidate or buy outside

When a buyer places an order for an SKU that is not in stock, the sales manager can move, buy, make or cancel the order.

Most sales managers do not cancel orders because it is counter to their sales mentality, and packing managers do not like to conduct emergency production cycles because their compensation metrics are based on packing line efficiency. 
 
Thus, in reality, sales managers have two choices: to consolidate fruit within their network of warehouses or to buy it from an outside firm.

To make this move-or-buy decision, sales managers need a tool to quickly calculate the costs of each option in a dynamic environment. Several software programs exist to help make this decision, although most need to be customized to fit the network design of a specific company. 
 
Management insights

Firms in the tree fruit industry systematically maintain high levels of on-hand inventory, resulting in shrinkage costs of 5% to 12% of potential revenue.

Despite having high levels of on-hand inventory, stock-outs occur during 5% to 7% of all incoming orders, resulting in sourcing costs of 1% of revenue.

Both the packing and sales managers have the power to implement new policies designed to reduce levels of on-hand inventory, including pre-sizing fruit, reducing available SKUs, establishing vendor-managed inventory relationships, and shaping demand through pricing.

If firms implement policies to reduce the average level of on-hand inventory, the likelihood of stock-outs may increase. To minimize any increase in sourcing costs, managers should implement optimization software to identify the lowest-cost way to move inventory during an intra-shed transfer. 

By comparing this cost to the premium paid for fruit from an external organization, sales managers can make a clear cost comparison and make the most efficient move or buy decision.

James Foreman’s master’s thesis from the Massachusetts Institute of Technology measured the costs associated with inventory shrinkage and stock-outs in the Washington State tree fruit industry using multivariate regression and optimization techniques. In addition to his 2009 master’s degree in engineering from MIT, he has as master’s degree in agriculture from Washington State University and a bachelor’s degree in economics from Harvard University. E-mail him at james.s.foreman@gmail.com.

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