Estimating Stockout Costs and Optimal Stockout Rates: A Case on the Management of Ugly Produce Inventory

Efficiently managing inventories requires an accurate estimation of stockout costs. This estimation is complicated by challenges in determining how to compensate consumers monetarily to ensure they will maintain the same level of utility they would have obtained had stockouts not occurred. This paper presents an analysis of these compensation costs as applied to the design of optimal stockout rates by an online retailer marketing to consumers aesthetically substandard fruits and vegetables rejected by mainstream grocery chains. Because growers face high uncertainty in their harvesting conditions and in the aesthetic quality of their crops and there are little data on hand to predict the value consumers attach to the availability of subpar produce, it is difficult to optimally match the supply of these products with consumers’ demand. Our analysis draws from a multiple discrete-continuous extreme value (MDCEV) choice model to calculate consumer compensations that the retailer can use to estimate the opportunity costs of stockouts to manage its inventory. We show that not taking into account these compensation costs could unduly inflate the optimal stockout rates for these products. Armed with these compensation cost estimates, we show how these costs can serve as incentives for retailers to source greater inventory amounts of imperfect produce from growers and how this will ultimately translate into less waste in the supply chain.