Negative Externalities of Inefficient Inventory Systems

There Are Costs Associated with Externalities Beyond Just Dealing with Themselves When Retailers Have Inventory They Cannot Sell

Economists use externalities to describe situations where a third party is hurt because someone has done something that has had a negative impact on them. Some examples are pollution and traffic congestion. While economists do mention other forms of externalities, they do not spend much time discussing how inventory management inefficiency is another form of externality that is very damaging on many levels, and one that is becoming increasingly obvious to those who are impacted by it. In 2023, the Federal Reserve Bank of St Louis reported that retailers in the USA were holding inventory valued at $1.84 trillion that has not been sold. The cost associated with the amount of unsold inventory will not only be borne by retailers; but will ripple across supply chains, labour markets, and affect the natural environment.

The underlying economic factor here is information asymmetry where firms do not have visibility into stock levels and hence they over-order to protect themselves against uncertainty. While at the firm level this over-ordering behaviour is rational, at the collective level it leads to inefficiencies in coordination that have long been recognised by economists. As a result of every node in the chain adding safety stock because of their upstream partner's unreliability, we see the amplification of the demand signal up the supply chain as the result of the so-called bullwhip effect which leads to orders being placed that are much larger than what is actually needed due to small changes in consumer demand.

The environmental impact of poor forecasting is concrete: excess production due to inaccurate inventory forecasting has led to a large amount of food being wasted annually, estimated at approximately 1.3 billion tonnes across the world, based on an estimate from the Food and Agriculture Organization (FAO). In the United Kingdom alone, WRAP (Waste and Resources Action Programme) estimated that in 2022 UK households and businesses wasted 9.5 million tonnes of food; while some of this food waste should be attributed to poor decisions by consumers, much of the food waste originated because of errors in ordering or replenishment, as opposed to just consumer behaviour alone. Each tonne of food wasted has embedded carbon emissions from agriculture, refrigeration and transport associated with its production; however, these emissions have no corresponding economic benefit to society and come at a cost to the environment.

The fast-fashion industry has been a prominent example of how this effect plays out over time; Zara's parent company Inditex built a competitive advantage based upon its unique inventory systems and rapid replenishment strategies, thereby creating a lower overall markdown and waste rate compared with its competitors; on the other hand, competing companies that continue to rely on seasonal bulk ordering methods often had to destroy large amounts of unsold merchandise to prevent markdowns from occurring (an action that received increased attention from regulators in France, where it became the first country to ban the destruction of unsold non-food goods in 2020). The external effects of these strategies, such as increasing landfill use, carbon emissions and increasing demand for raw materials, are now politically unacceptable.

Labour market distortions

Beyond its direct costs, inefficient inventory management has a negative impact on workers and their schedules. Labour market distortions from inefficiencies arise through what is referred to as an unstable labour market. Many warehousing companies will employ a manual cycle count for their inventory and respond reactively to restock when they require more product than their estimates suggest. Over time these warehousing companies develop a routine of inconsistent and unpredictable patterns of labour demand, thus creating unsafe and erratic scheduling of their workers. The fulfilment centres of Amazon, which process large quantities of inventory through their warehouses, have been documented as having extremely unpredictable labour demand patterns and poorly scheduled workers. According to incident reports provided to the Occupational Safety and Health Administration (OSHA), workers employed by Amazon experienced injury rates approximately double that of the transportation and warehousing industry average in 2022. Some of the operational pressure placed on Amazon's fulfilment centres comes as a result of the inefficiency created by using an inventory system that does not allow for accurate anticipation of workload to safely and consistently staff workers.

In addition, the technology to resolve many of the costs associated with the inefficiency of Amazon's fulfilment centres already exists in the marketplace. As an example, proper use of modern warehouse management systems and professional wms implementation services will produce a reduction of 20–30% in overstock as well as a dramatic decrease in order fulfilment errors. As previously mentioned, the only reason for the lack of investment in these systems by warehousing companies is that their costs are borne by either the workers, environment, taxpayers or other parties rather than being borne by the company that caused the cost to be carried. Consequently, companies do not have enough of a financial incentive to invest in better equipment and technology until they are held accountable for those costs through either changes to regulations, product liability laws or through the establishment of carbon accounting for CO2 emissions.