Liquidating Cancelled Inventory

My long-time readers know that I revisit and reanalyze certain firms (e.g., Starbucks, Amazon, and McDonald’s), given their outsized impact on the economy, and their operational importance. 

But writing twice about Kanye West-related topics was not on my roadmap (who am I kidding…I have no roadmap).

I’ve already devoted an entire article to Kanye West, his decision to buy Parler, and how one should aim to combat echo chambers.

In direct relation to this came Adidas’ decision to discontinue the collab with Kanye, given his anti-semitic rhetoric. But discontinuing a product, has certain implications, and this past week, the new CEO of Adidas acknowledged the magnitude of the problem: 

“The new chief executive of Adidas has $1.3 billion in Yeezy sneakers he doesn’t know what to do with. Stored in warehouses around the world, the sneakers are a reminder of the once-fruitful tie between Adidas and Kanye West, the rapper now known as Ye. Since the first Yeezy Boost 750 shoe dropped in February 2015, his Yeezy brand became a defining force in the sportswear industry and an incredibly lucrative cornerstone for Adidas.”

This raises many questions.

The first one is: Do firms need to prepare for similar situations in the future (i.e., the possibility that products associated with a celebrity or a concept are canceled or banned)?

Second, assuming this phenomenon is not going away, how should firms prepare for the day a product has no value? And this isn’t limited only to cases where products are canceled, but can refer to any situation in which, either by design or an exogenous shock, the product is rendered invaluable.

Finally, assuming that firms have different methods to deal with these situations, how should these methods affect their initial inventory and stocking decisions, if at all?

Cancellation Risk

While not typical, in a polarized society, this kind of risk will most likely grow.

In supply chain theory, we focus on demand risk, which is continuous as demand is usually assumed to be normally distributed. There’s an average, and a high likelihood that the risk is either above or below. But there’s a low probability that it’s well above or well below, making stocking decisions somewhat simple.

We also tend to account for supply risk, either yield (meaning we don’t get all the units we ordered) or lead time risk (we don’t get them on time). Both supply and demand risks are continuous.

Cancellation risks, on the other hand, are usually more binary —closer to what we call event risks, such as a pandemic or a hurricane. 

Netflix being stuck with House of Cards, which has been “cancelled” due to the sexual harassment allegations against Kevin Spacey, is one example. 

But while we have some understanding of event risks and can forecast them based on weather reports, there’s no simple way to forecast cancellation events and put a probability distribution on them. But given the amount of money involved with such products, firms will have to take these risks into account.

 The question is, how?

How do Firms Deal with “Toxic” Excess Inventory?

While firms don’t have a playbook to deal with products that have to be “discarded” because of a canceled celebrity, firms know what to do when a product doesn’t have any value or the firm doesn’t want to release the excess inventory to the market given the negative impact on the market’s dynamics.

This question of what to do with unsold products is quite interesting and much more sensitive than you might imagine. Note that I’m not talking about products that were returned —an issue I have devoted quite a bit of time and space to— I’m talking about products that a firm knows, in advance, that they either won’t be able to, or won’t want to sell. 

For example, at the Super Bowl, as soon as the game ends, players change into gear (hats and shirts) with the insignia of the specific event (the name of their team along with the Super Bowl series), and the same merchandise becomes immediately available on the NFL and team stores. 

As you can imagine, there’s no way to print this merchandise on demand at the volume needed.

Shirts can be printed, but hats, mugs, and the many other items, just cannot be manufactured on demand, and the willingness to pay diminishes as time passes from the moment of victory.

So what does the NFL do? They actually print inventory for both teams in the two weeks leading to the game. Here’s an image from a few years ago leading to the game between the Colts and the Bears:

What happens to the losing team’s shirts? They are donated. 

In fact, here is a photo of kids in Nicaragua wearing the famous 19-0 Patriots shirt:

As a Boston sports hater, very few things give me joy more than this photo. 

For those not following, the Patriots almost won that Super Bowl, which would have given them the first 19-0 perfect season in NFL history (the only perfect season to date was 17-0, by the Miami Dolphins). And it all ended in the legendary catch depicted below (also known as the helmet catch):

At that very second, these shirts were transformed from a hot commodity to a toxic asset.

But I digress.

Why donate these shirts?

Beyond, of course, the notion of doing good (which I’m not even sure about), you’re subjecting these kids to ridicule (if they ever come to the US with these shirts), or even worse, you’re making them Patriots fans, which is beyond “cruel and unusual punishment.”

The real reason for donating them is that you can use charitable giving to defray some of the costs. 

But this brings us to the third question, assuming you know in an advance that you may have to donate some of your merch, how does it impact your stocking decisions?

Everything in life is a newsvendor problem. The NFL needs to balance the cost of underage (a willing fan that can’t buy a shirt) and the overage (the cost of having a shirt produced, yet not demanded). For those who don’t remember the newsvendor formula, the service level of a product should be the solution of the following equation: Cu/Cu+Co.

Where Cu is the price of a customer willing to buy minus the cost (very high in the case of these shirts), and Co is the cost of overage (cost of production - resale value). 

These products have no resale value. Who wants a 19-0 Patriots shirt? It’s not even ironic. To be honest, who wants any Patriots shirts? 

So how do donations help? Firms get a tax deduction from the non-donation. So, if the corporate tax rate is 21% and the Fair Market Value of the product is $30 (and it costs $6 to make the shirt), you can bring the Co to nearly zero, resulting in a very high optimal service level.

Paat Rusmevichientong and his colleagues wrote a paper analyzing such situations, concluding, for example, that:

“While the value of the deduction is tied to the FMV (and the price) of the product, surprisingly, the firm may find it more profitable to charge a lower price, when the lower price scales up the demand uncertainty and increases the expected tax subsidy under the enhanced tax deduction.”

So firms that know they may donate products, are willing to make bolder bets, either by stocking more or reducing the price as a way of inducing higher, but also potentially more volatile, demand.

Burn Baby Burn

While you can find kids in Africa and Latin America thinking that the Giants just can’t win a Super Bowl against Tom Brady (ok, I’ll stop), you won’t see any kids in Africa with a slightly defective Louis Vuitton bag. 

Why would they, you may ask? Because Louis Vuitton doesn’t sell defective bags. And it has a policy of never discounting them. Donating them means that they will find their way to the second-hand market, thus diluting the brand.

So what do they do? 

They burn them…

And t’s not only Louis Vuitton. According to the BBC, Burberry burns bags, clothes, and perfume worth millions:

“Burberry, the upmarket British fashion label, destroyed unsold clothes, accessories and perfume worth £28.6m last year to protect its brand. It takes the total value of goods it has destroyed over the past five years to more than £90m.”

But don’t worry... It’s wasteful, but not harmful:

“Burberry said that the energy generated from burning its products was captured, making it environmentally friendly. ‘Burberry has careful processes in place to minimise the amount of excess stock we produce. On the occasions when disposal of products is necessary, we do so in a responsible manner and we continue to seek ways to reduce and revalue our waste,’ a spokesperson for the company said.”

And Burberry isn’t shy about it either:

“‘The reason they are doing this is so that the market is not flooded with discounts. They don't want Burberry products to get into the hands of anyone who can sell them at a discount and devalue the brand,’ Ms. Malone said.”

What is the implication for the stocking levels of these products, destined to be burned? Newsvendor-wise, the burning process increases the Co, which is the cost of a unit that was stocked but not sold. Burning these units is going to be costly. The higher the overage cost, the less interested the firm is in taking the risk of having too many units unsold, which, in turn, means lower service level (i.e., the probability that the firm has enough units to cover demand). So even a firm with very high Cu will have a relatively low service level to ensure they don’t have to burn too many bags. 

Like Burberry, Louis Vuitton has a similar policy. A few years ago, in class, I hosted several senior people from Louis Vuitton’s US retail operations who stated that the firm’s policy was to maintain a service level of 90%. At the time, this meant that on one out of every 10 days, each store had to run out of products. Besides creating the impression of scarcity, the main point was to account for the fact that blemished and defective products cannot be discounted and have to be burned.

Back to Adidas

It seems Adidas is in a bind:

“- Burning or trashing the gear would be unsustainable.

- Donating the shoes could create a boom in the resale market.

- Even if Adidas rebrands the items and sells them, Ye is still promised a cut of the profits.”

It’s hard to do a newsvendor analysis at this point, given the fact that this is the first time the firm has encountered such a situation, so I can’t imagine they were prepared for it. Yet, let's try.

You may ask, how much money does Adidas make from Yeezy each year?

“Jonathan Komp, a Baird analyst, estimated the Yeezy partnership brings in $1.8 billion in annual revenue for Adidas, according to New York Post. In their statement, Adidas also said that their decision to end the partnership with Ye would have a “short-term negative impact” of up to €250 million on the company’s net income in 2022.”

The Yeezy 950 was first released on October 29, 2015, so we are talking about seven years of $1.8B in revenues. If the losses indeed amount to $250M in one year, it seems like a pretty good balance of overage and underage. 

The main point, however, is that firms will have to start thinking about the liquidation channels for such products, which may differ from the common methods when dealing with returned and/or defective products.

So, in a world where even Big Bird can be banned, firms with products that can become polarized should start preparing for anything to happen.