What is Backorder Cost

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Backorder Cost is a Cost which is incurred by a business when it is unable to fill an order and must complete it later. It is a real and perceived cost of the inability to fulfill an order. The costs can include negative customer relations, interest expenses, etc. Backorder costs are usually computed and displayed on a per-unit basis. Sometimes it is also considered as Penalty cost.

Backorder costs are important for the company to track, as the relationship between holding cost of inventory and backorder costs will determine whether a company should over or under produce.

For example: Company ABC sells different type of bags online. On some day, it offers 25% off all bags online, and it receives an unprecedented number of orders: 5000 bags in four hours. It only has 4000 bags in its warehouse and will need three weeks to make the missing 1000 bags. 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 ABC 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.

But many backorder costs are intangible. Customers may get irate and buy from a competitor instead. Backorder situations can signal poor inventory management or purchasing behavior.

Backorder Inventory Model

In this model, we assume that stock outs (and backordering) are allowed. In addition to previous assumptions, we assume that sales will not be lost due to stock out because we will back order any demand that cannot be fulfilled.

1

B: Backordering cost per unit per year
b: the amount backordered at the time the next order arrives
Q-b: Remaining units after the backorder is satisfied.

Total Annual Cost = Annual Setup Cost + Annual Holding Cost + Annual Backordering  Cost

Annual Setup (Ordering) Cost = (D/Q).S

Annual Holding Cost = (Average Inventory Level).H
By using the graphical ratios, we know that: T1/T= (Q-b)/Q
Therefore if we replace T1/T in the above equation, we get
Average Inventory Level as per Backorder Investntory Model = (Q-b)2/2Q

A Personal Finance enthusiast, Karan is the founder of charteredclub.com and loves to discuss about Money related matters.