Examining the Walmart Effect on Inventory and Profits

David Matsa, Assistant Professor of Finance Northwestern University Kellogg School of Management

When Walmart comes to town, should you cut prices or boost inventory? That's one question a Northwestern University finance professor grapples with in his new research on the long-term impact of supermarkets' inventory strategies. While companies' decisions about acceptable levels of out-of-stock items often center on short-term financial projections, even a slight increase in inventory shortfalls can send some shoppers to a competing store. Over the long term, a retailer’s brand image can be affected, says David Matsa, assistant professor of finance at Northwestern University's Kellogg School of Management.

Some shoppers simply choose another item when their preferred product is out of stock, minimizing the financial impact to the retailer. Yet a 10 percent increase in product availability shortfalls -- or stockouts -- can spur some consumers to shop elsewhere, Matsa suggests. "The short-run cost is lost profits from foregone sales," Matsa says. "But what I think is most interesting on inventory investment is how it can have an impact on the long run."

Declining stockout rates
Matsa discusses the correlation between inventory levels and the customer experience at retail. He illustrates the impact of new Walmart supercenters on service at existing supermarkets in the area.

"When Walmart enters the market, they're entering with a low-price but also a low-quality proposition," he says. Independents who try to compete with Walmart on price often lose sales, while larger chains frequently take the opposite approach by boosting inventory and emphasizing service. "It seems that the supermarkets that survived were the ones trying to differentiate themselves by increasing quality in this dimension," Matsa says.

The research indicates when a new Walmart supercenter opens, the stockout rates at existing supermarkets decline 10 percent on average, while among chains of 1,000 or more stores, stockouts decrease about one-third, Matsa says. Boosting inventory levels can be an effective survival strategy, notes Matsa, whose research was published in the August issue of The Quarterly Journal of Economics.

Investing in inventory
In general, grocers looking for a long-term strategy to keep consumers returning might be wise to spend more on inventory, Matsa says, citing his earlier research published this year in the American Economic Journal: Microeconomics that examined the correlation between financial leverage and stockout rates at grocery retailers.

In that study, Matsa found supermarkets that were highly leveraged ran out of items about 10 percent more often than nonleveraged competitors, as they worked to manage cash flow. During the mid-1980s, Safeway took out several loans and also cut inventory by about $75 million, Matsa says. While the company estimated it saved $19 million in the short run, Matsa calculates the company lost about $68 million in long-term profits because of the strategy. In general, Matsa says, "The business has to trade off its cost of carrying inventory with the benefits of having the products customers need."

In today's economy where credit can be hard to come by, grocers might be tempted to cut inventory to improve cash flow, Matsa says. "Firms are hoarding liquidity more (now) than before the financial crisis," he says. Yet Matsa suggests that holding on to cash at the expense of serving the customer could send shoppers to the nearest well-stocked competitor.