What are Backorder Costs?
Backorder costs are associated with not being able to fill an order.
How Do Backorder Costs Work?
Company XYZ sells widgets. On Black Friday, it offers 30% off all widgets online, and it receives an unprecedented number of orders: 500,000 units in four hours. It only has 400,000 units in its warehouse and will need three weeks to make the missing 100,000 units. These units are backordered.
Although it's nice to have a product that is so popular that a waiting list forms, there are some real costs associated with not having products on hand when customers want them.
Some of the costs are tangible. For instance, Company XYZ will have to spend a lot more money on expedited shipping to get parts from its suppliers faster in order to fill the order. Then, it may have to pay its laborers a lot of money in overtime in order to hasten production, and when it finally has the 100,000 units ready to ship, it might have to overnight those items to customers who are anxious about having the widgets in time for Christmas.
But many backorder costs are intangible. Customers may get irate and buy from a competitor instead, the media may draw attention to the debacle, and in our example, Company XYZ's customer service department will likely have some long days and nights.
Why Do Backorder Costs Matter?
Most companies (and their shareholders) consider it a nice problem when there is more demand than supply for their goods and services. However, backorder situations can signal poor inventory management or purchasing behavior, and after considering the tangible and intangible costs of backorders, sometimes it's just cheaper in the long run to make more product and carry more inventory. For these reasons, many companies measure the success of their customer service in part by tracking the percentage of orders that are shipped complete.