The Effect of Product Variety and Inventory Levels on Retail Store

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  • The Effect of Product Variety and Inventory Levels onRetail Store Sales: A Longitudinal Study

    Zeynep Ton and Ananth RamanHarvard Business School, Boston, Massachusetts 02163, USA, zton@hbs.edu, araman@hbs.edu

    We examine the effects of product variety and inventory levels on store sales. Using 4 years of data from stores of a largeretailer, we show that increases in product variety and inventory levels are both associated with higher sales. We alsoshow that increasing product variety and inventory levels has an indirect negative effect on store sales through their impacton phantom productsproducts that are physically present at the store, but only in storage areas where customers cannotfind or purchase them. Our study highlights a consequence of increased product variety and inventory levels that haspreviously been overlooked in studies of retail product variety and inventory management. It also quantifies the impact ofphantom products on store sales. In addition, our study provides empirical evidence to support earlier claims that higherproduct variety and inventory levels lead to an increase in defect rate. We discuss the implications of our findings for retailinventory and assortment planning and for the design of retail stores.

    Key words: retail inventory management; assortment management; product variety; misplaced products; quality managementHistory: Received: January 2007; Accepted: August 2009 by Jayashankar Swaminathan, after 3 revisions.

    1. IntroductionHigher product variety and inventory levels at retailstores are typically associated with higher sales. Hav-ing more products at a store increases the probabilitythat customers will find what they want (Baumol andIde 1956). Having more inventory of a particularproduct increases sales by increasing service levels(Cachon and Terwiesch 2006) and stimulating cus-tomer demand (Dana and Petruzzi 2001, Larson andDeMarais 1990). In this paper, using 4 years of datafrom stores of a large retailer, we empirically confirmthe theories that higher product variety and inventorylevels lead to higher sales. But we also show thathigher product variety and inventory levels have anindirect negative effect on sales through their effect onin-store logistics. Increasing product variety and in-ventory levels increases the complexity and confusionin the operating environment (Hayes and Clark 1986,Skinner 1974), making it more likely that store em-ployees will make errors in performing in-storelogistics activities such as shelving and replenishingmerchandise. Such errors result in phantom prod-uctsproducts that are physically present in the store,but only in storage areas where customers cannot findthem (Ton and Raman 2005).

    Phantom products are a common and expensiveproblem in many retail settings. For example, Ander-sen Consulting (1996) estimates that sales losses dueto products being in storage areas but not on the sell-ing floor amount to $560960 million per year in theUnited States supermarket industry. A study by the

    Grocery Manufacturers of America (2004) estimatesthat 2530% of grocery stockouts are caused by prod-ucts that are placed in areas where customers cannotfind them. In our study, we show that a one-standard-deviation increase in percentage of phantom productsis associated with a 1% decrease in store sales which,assuming a 30% gross margin, translates to a loss ofroughly 7% of the net income generated by an averagestore.

    One contribution of our study is to build on theexisting literature on retail assortment and inventorymanagement by highlighting a consequence of in-creased product variety and inventory levels that hasbeen overlooked. In some extreme cases, increasinginventory for a particular product has been associatedwith lower sales because of a substantial increase inphantom products. This can occur when a retailersemployees are better at shelving newly arrived prod-ucts than at replenishing products from storage areas.For example, inventory planners at a large electronicsspecialty retailer increased inventory levels for a verypopular item at several test stores to estimate howmuch sales would increase if this item were always instock. Several weeks later, the planners observed adecrease in sales for that item. Visits to several storesrevealed that this surprising result could be explainedby problems with inventory replenishment processes.Previously, when the inventory level for the item hadbeen lower, store employees were able to fit most ofthe units on the display shelves and there were veryfew units in storage areas. Consequently, when the

    546

    PRODUCTION AND OPERATIONS MANAGEMENTVol. 19, No. 5, SeptemberOctober 2010, pp. 546560ISSN 1059-1478|EISSN 1937-5956|10|1905|0546

    POMSDOI 10.3401/poms.1080.01120

    r 2010 Production and Operations Management Society

    mailto:zton@hbs.edumailto:araman@hbs.edu

  • units on the shelves were sold, the low inventory levelfor the item would trigger a replenishment order andthe store would receive a new shipment from the dis-tribution center. Now, with increased inventory levels,store employees had to keep many more units of thatitem in storage locations, intending to move them tothe display shelves once the units on the shelves weresold. But when the planners visited the stores, theyfound the display shelves empty and the inventorystill in various storage locations. Apparently, once theunits on the display shelves were sold, the remainingunits were never replenished. Failure to replenishfrom storage locations limited total sales for the itemto the number of units that were placed on the displayshelves when the large shipment arrived at the store.

    In our study, the direct positive effect on sales ofincreasing inventory levels and product variety ismuch greater than its indirect negative effect on salesthrough phantom products. Nevertheless, with a bet-ter understanding of the mechanisms by whichinventory levels and product variety affect store sales,researchers and retail managers can make the appro-priate trade-offs in determining a stores optimalproduct variety and inventory levels.

    This paper differs from our earlier work (Ton andRaman 2005), in which we examined phantom prod-ucts and their drivers but not their impact on storesales. Our previous analysis was limited to cross-sec-tional data and hence focused on inter-storevariationwhy some stores had a higher percentageof phantom products than others. In this paper we usepanel datadata from multiple stores over timewhich allow us to capture within-store changes overtime and permits a more sophisticated research de-sign controlling for store-specific fixed effects. Forexample, linear shelf space in the selling and storageareas could affect inventory levels, product variety,phantom products, and sales. However, since our re-search site does not track its stores linear shelf space,we could not include this measure in our earlier cross-sectional study. In the present study, the inclusion ofstore fixed effects controls for linear shelf space. Andbecause panel data allow researchers to explainchanges within a unit over time, they are an improve-ment over cross-sectional data for making causalstatements.

    Our study also makes two contributions to the lit-erature on quality management. First, by showing theeffect of phantom products on store sales, we provideempirical support for studies that demonstrate thebeneficial impact of increased quality on firm perfor-mance. Second, we provide empirical evidence tosupport earlier assertions that higher product varietyand inventory levels increase defect rates. Althoughseveral researchers have hypothesized a negative re-lationship between product variety and quality,

    empirical evidence for this assertion has been lim-ited, Fisher and Ittner (1999) being the exception.Moreover, as stated in a recent literature overview(Ramdas 2003), studies of product variety in opera-tions management literature have generally focusedon manufacturing environments, particularly on therelationship between product variety and manufac-turing costs (e.g., Anderson 1995, Banker et al. 1990,Datar et al. 1993, Kekre and Srinivasan 1990). Ramdas(2003) notes that the effect of product variety ondownstream processes such as distribution and retailoperations has not been empirically examined.

    The rest of the paper is organized as follows: Insection 2, we review the relevant literature and high-light the contributions of this study. In section 3, wedescribe our research methodology and econometricmodel. In section 4, we present our results and insection 5, we conclude.

    2. Theoretical MotivationOur study builds on earlier work on retail inventoryand assortment management and on the literature onquality management. The relationship between in-ventory levels, product variety, and sales has beenstudied extensively in the operations managementand marketing literatures. Numerous studies examinethe effect of inventory on sales. In stochastic inventorytheory, increase in inventory levels leads to an in-crease in expected sales by improving service levels(Cachon and Terwiesch 2006, Silver et al. 1998). Be-cause customers may be more willing to visit a storewhen they expect a high service level (Dana and Pet-ruzzi 2001), increasing inventory is also associatedwith an increase in sales through stimulating cus-tomer demand (Larson and DeMarais 1990). Severalshelf-allocation models in marketing literature there-fore consider the consumer demand rate as a functionof shelf space allocated to the product (e.g., Corstjensand Doyle 1981, Zufryden 1986).

    The relationship between a stores product varietyand its sales is also considered to be positive. Increas-ing the number of products at a store increases thechoice set for the customer and is assumed to increasethe likelihood that the customer will buy something(e.g., Baumol and Ide 1956, Smith and Agra

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