Stockout Cost Decision

How this works

A stockout risk by itself is not a decision. It becomes one only once priced against the working capital cost of carrying enough extra safety stock to avoid it. This engine prices expected annual stockout cost from the entered risk, cycle frequency, and shortage size, then compares it against the real annual cost of holding a proposed amount of extra stock, the annual holding cost, not the one-time working capital it ties up, since those are two different numbers and comparing against the wrong one changes the answer.

Key terms

• Stockout risk: the chance a stockout occurs during a given replenishment cycle.
• Working capital tied up: the one-time dollar value of the extra units held in stock.
• Annual holding cost: the yearly cost of carrying those extra units (storage, insurance, obsolescence risk, cost of capital), the figure that actually competes against stockout cost.
• Service penalty: any additional per-unit cost of a shortage beyond lost margin, such as expediting fees or contractual penalties.

Assumptions

• Stockout risk and average shortage size are stable across replenishment cycles
• Holding cost rate is constant regardless of how much extra stock is added

Limitations

• Single SKU or SKU family, not a portfolio-level view, see Multi-Item Working Capital Prioritizer
• Does not compute the safety stock level itself, that belongs to Service Level Cost Tradeoff

Sources

Standard inventory-economics stockout-cost and holding-cost-rate treatment (Silver, Pyke, and Peterson, Inventory Management and Production Planning and Scheduling).

Worked example

At a 15% stockout risk, 12 replenishment cycles/year, an average 30-unit shortage, $25/unit contribution margin, and a $5/unit service penalty, expected annual stockout cost comes to about $1,620. Carrying 200 extra units at $500/unit ties up $100,000 in working capital, but only costs $800/year to actually hold at a $4/unit/year holding rate, so carrying the stock still wins by about $820/year, even though the working-capital figure looks enormous next to the stockout cost. Comparing against the $100,000 figure instead of the $800 figure would give the wrong verdict.

Common use cases

• Deciding whether a proposed safety-stock increase is actually worth its carrying cost
• Making an existing stockout risk's real annual cost visible before deciding whether to fix it
• Separating working capital exposure from the annual cost that should drive the decision
• Feeding stockout cost and working capital into Multi-Item Working Capital Prioritizer