Backorders are orders for goods that a company cannot fill at present because demand has outpaced supply.
There are a lot of complex terms used to describe how companies keep goods flowing to consumers. From ERP and MRP to FIFO and LIFO to Supply Chain and Demand Forecasting, there seems to be an endless list of terms. But one key term often overlooked and misunderstood is that of backorders.
High demand is sought after by all companies, but there are times when circumstances may push demand to a level that cannot be filled. Backorders are orders for goods that a company cannot fill at present because demand has outpaced supply. It may represent a good that is currently in production or it may represent one that has not yet begun production. In assemble to order environments, it may represent orders partially built and waiting on a component to arrive.
Backorders should not be confused with “out of stock”. In the case of “out of stock”, supply or production may be uncertain. It may also be the end of a product’s lifecycle and slated for discontinuance. Backorders, on the other hand, are in-process or planned production that has encountered a lag due to several factors. The product will be made, it is simply not ready at the time the sales order is received.
How Does a Backorder Work?
Backorders can be an order for units of a specific part number or one of many parts ordered. In many cases, orders consist of more than one part number and those available are shipped as requested. It may also mean shipping a part of an order.
For Example: If someone orders 500 kg of flower, the producer may have enough to fill 350 kg but have another 2000 kg in production. Depending on quoted lead times, the producer may be able to wait until an additional 150 kg are produced and ship the order complete. However, if the expected production will not be ready until after the quoted lead time, the producer may ship the 350 kg and notify the customer that the balance of 150 will ship on a later date.
The key is communication. By communicating the presence of a backorder, the supplier lets the customer know what is inbound, and when the balance will be there. This allows both the supplier and the customer to continue operations uninterrupted.
What Causes Backorders?
Backorders are not inherently bad. It all depends on how they are managed. They can occur for many reasons including:
Unusual Demand – A common reason for backorders is an unusual demand. This may be the result of a seasonal event such as a holiday. It may also be the result of natural events such as hurricanes and disasters where people order more of an item than usual. And it may simply be the result of a very popular product or one that was noticed in the media leading to a rush.
Low Safety Stock – Companies manage their supply chain tightly to keep from having too much or too little stock in inventory. Regardless of whether that supply chain management is automated or manual, there will be a time when safety stock levels are miscalculated.
Supplier Issues – Let’s face it, in a global economy with supply chains stretched across the globe, there will occasionally be supplier issues. This may be the result of acts of nature, shipping or dock strikes, or regulatory compliance. It may also be the result of bad quality on the suppliers’ end.
Use of Multiple Suppliers – Another reason for backorders related to the supply chain is the use of multiple vendors. By ordering components from multiple sources, a buyer reduces the risk of placing all hopes in one segment of the supply chain. However, a missed shipment or problem by one supplier may not be able to immediately be addressed by the secondary source.
Variation in Order Patterns – Holiday seasons, weather events and natural disasters can cause variations in order patterns. Companies may rely on forecasts and demand planning models for large customers, total orders, or for specific product lines. But sudden variations in order pattern can throw manufacturing off balance and result in backorders.
Accounting for Backorders
Backorders are usually expressed as a dollar figure. However, there is an impact on how backorders are accounted for. Most companies that allow backorders record them as backorders on their financials rather than as a completed sale. The reason for this is simple, if the customer cancels, the backorder can be removed without having to reconcile accounting records. This keeps a backorder from impacting the bottom line while the transaction is in flux.
There are other accounting considerations as well. Backorders may impact inventory and other holding costs. If the backorder is due to a specific part or raw material that is part of a process or assembly, then the other parts that go into that assembly are subject to regular inventory procedure and valuation. The same goes for holding costs. Even though the product isn’t yet recorded as a completed sale, rent, utilities, and labor must still be paid for holding components that go with the material being awaited.
Other accounting concerns include expedited shipping costs which must be rolled in at some point into the financials. It may also include both tangible and intangible costs, both of which must have some accounting to track backorder progress.
Advantages and Disadvantages of Backorders
Whether a backorder is a good thing or a bad thing, depends on several factors. One advantage of backorders is that it can show a healthy increase in demand for a product. If kept at a minimum and managed correctly, this can help companies plan for growth to deal with consistent increases in demand.
Another advantage is that backorders can help companies maintain lower inventory levels, freeing up cash flow for operations and expansion. By running leaner, backorders can drive more profitability by impacting everything from improved cash flow, taxes that would have been levied on inventory, and reduced labor and holding costs.
As for disadvantages, backorders can indicate that a company is too lean. It is also a disadvantage for manufacturers whose lead times on production are long based on process realities. If lead times are too long and backorders drag on, customers may cancel orders and look elsewhere. Canceled orders could also lead to overstocks in inventory and finished goods as long lead times on production means that manufacturers must purchase raw materials and components over a long time frame. If the customer cancels the orders during that time, producers are left with high inventory costs.
Tips for Minimizing Backorders
While backorders can be managed to be beneficial for a company, the key is to make sure the production system is balanced. Here are five tips to minimize backorders in a way that will balance the system and keep customers happy:
- Regularly Review Popular Items – It’s always great to have a product that takes off. But product lifecycles vary by tastes, season, and other factors. Reviewing the history of popular items will help manufacturers develop strategies for balancing the system. In advanced ERP and MRP systems, these histories will be available, accurate, and sortable in a way that allows for the best analysis of the data.
- Give Manageable ETAs – Customers may be willing to wait for a reasonable backorder, but communication is critical to ensure that they do not cancel the order. Manageable, accurate ETAs can provide customers with a reliable arrival time for their product.
- Calculate and Set Re-order Points – Often, products require a complex blend of raw materials or components to produce a final unit. These raw materials and components may have different inbound lead times from vendors. Calculating realistic reorder points based on consumption history will reduce the risk of running out of a component and causing the need for a backorder.
- Set Safety Stock – Related to reasonable reorder points, setting a safety stock to address increases in demand, waste, spoilage, etc. can reduce the need for backorders as well.
- Integrate Systems – Small and medium-sized manufacturers often use disparate systems of different vintages. This causes information silos and the need to reconcile data from department to department, introducing the chance of error. By integrating systems under one umbrella, systemic causes of backorder can be further reduced.
While backorders are always a possibility under the right circumstances, balancing the production system, managing the strategies to address backorders, and reducing human error will go a long way toward making sure that backorders, when they happen, do not hurt a company. The best way to this is through an integrated, cloud-based ERP/MRP system to tie these components together. The five tips listed above are sound advice regardless of the system.
However, a unified system with advanced analytics, and accurate history, and built-in production, scheduling, inventory and shipping functionality such as found in an ERP/MRP system will make the process seamless and allow manufacturing companies to operate with a minimum of backorders and to properly balance and manage the ones they do incur to their financial advantage.