Backorder Costs

What Are Backorder Costs?

Backorder costs include costs incurred by a business when it is unable to immediately fill an order and promises the customer that it will be completed with a later delivery date. Backorder costs can be direct, indirect, or ambiguously estimated. As such, backorder costs usually involve friction cost analysis. Backorder sales generally reduce a company’s operating efficiency, though there can be times when backorder sales may be effective.

Understanding Backorder Costs

Backorders and backorder costs can add an additional element to inventory management and financial accounting. Companies that allow for backorder sales will take a sales order for a product that is not in their readily available inventory and provide a notification to the customer that delivery of the order will take longer than the standard time for delivery.

Usually, a backorder arises when a potential customer tries to place an order for a product but the order cannot be fulfilled immediately because the merchant doesn't have the product available for sale at that particular point in time. In this instance, the customer is told the product is "back-ordered." Here, the customer may decide to continue the transaction, pay, and wait for the new product. The customer could also simply say no and not complete the order or go ahead with the order but cancel if they find a substitute that can deliver more quickly.

Companies weigh backorder costs against other product costs when determining if backorders are allowed and how they will be managed. Backordering is not necessarily a supply chain best practice. As such, many companies do not take backorders, opting only to alert customers when inventory has been rebuilt.

Backorder cost analysis can involve a multitude of considerations.

Backorder Cost Analysis

In general, companies may add some additional inventory metrics to understand and analyze backorders and backorder costs in their supply chain. Two of these additional metrics include backorder rates and backorder costs. The backorder rate is the rate at which a specific product is unable to be immediately fulfilled through standard inventory processes.

The backorder rate is a calculation that identifies the number of backorders as a percentage of total orders during a period overall. For example, if a company had to backorder 10 orders during a week’s time when 100 total orders were received then their weekly backorder rate would be 10%.

Companies also look at the total cost of a backorder for supply chain optimization. Friction analysis is often used in backorder cost calculations because it provides a full breakdown of all direct, indirect, and ambiguous costs. Companies usually run a high risk of cancellation when products are back-ordered. Other costs can include additional customer service requirements, special shipping terms, and lost business.

Companies may also need to use alternative accounting methods to record backorders. In accrual accounting, all revenue and expenses are recorded when recognized. However, since backorders are delayed and have a higher risk of cancellation, companies may potentially account for these orders differently which can also be added costs.

Overall, a multitude of considerations can be included when calculating backorder costs. Furthermore, backorder costs will certainly vary depending on each product. Companies often look at the relationship between holding costs of inventory and backorder costs to determine how much inventory to hold. Inventory that can be held for long periods of time without spoilage or obsolescence will have lower costs.

Alternatively, inventory that must be sold in a short amount of time will have a higher cost because of the obsolescence risk. If the carrying cost of an inventory unit is less than the backorder cost per unit then a company should choose to hold a higher amount of inventory on average than demanded to mitigate backorders. If a company determines that it has relatively low backorder costs, it could potentially be beneficial for the company to implement a back order system.

Special Considerations: Inventory Management and Metrics

In cases where inventory management is required, most companies have rigorously developed inventory management processes in place to optimize the supply and sales delivery process. Financial accounting includes several important inventory metrics that inventory managers are usually required to monitor and report. Some of these key metrics include the following.

Inventory Turnover

Inventory turnover is a financial analysis metric calculated by dividing the cost of goods sold over average inventory. This calculation provides a replacement metric that shows how often inventory is being replaced or turned over. The higher the inventory turnover the better since this means there is a high demand for a product and inventory is being actively restocked to meet the demand.

Day Sales of Inventory (DSI)

This metric is used to analyze the number of days a unit of inventory is held before being sold. It is calculated by dividing the average inventory over the cost of goods sold and then multiplying by the number of days in the period. This results in the number of days inventory is held. Typically the lower this metric the better. However, in cases where inventory is being depleted to quickly it can be important to increase the average inventory in order to mitigate the issue of backorders.

Companies also rely on operational strategies as well as their own processes for inventory management to avoid backorder issues. Some of these key concepts and considerations include the following.

Manufacturing Quantity

Companies that produce their own inventory may link their inventory management metrics with their manufacturing output production to optimize their supply. Companies may lower manufacturing when DSI is increasing and increase manufacturing when DSI is low. Companies may also have the option to vary the goods they produce depending on the inventory management metrics of each type of good.

Economic Quantity

Companies can use a very basic inventory management process that always keeps a specific amount of inventory in stock. Inventory is tracked and ordered on a regular basis to ensure that a specific economic quantity is steadily held.

Just-in-Time

Just in time inventory management is a popular inventory processing method. This method can vary depending on the inventory. Usually, it seeks to solicit inventory in real-time with orders. For example, a car manufacturer can order the parts it needs for a car after the order has been placed. It has a relatively specific amount of time for producing the car which allows for parts to be received and used in production without being held in inventory.

In another example, Walmart has perfected the just in time inventory model for retail by using advanced technology. Its advanced technology allows for real-time and automated alerts to suppliers and transporters who can then move goods to stores as needed to meet immediate demand.

The ability of inventory management systems and the increased use of online retailing along with real-time inventory management systems have greatly reduced the issue of backorder costs. Modern-day inventory management systems have technology that can allow for rapid replenishment of products so there is often minimal need to alert a customer or create a backorder.

However, backorder costs can be a real consideration for some companies, specifically traditional brick-and-mortar businesses who may have storage limitations or potentially for manufacturers who can produce their own goods with their own manufacturing schedules.