A backorder is an inventory status for a product that is temporarily out of stock but is still available for order. Products designated as “available on backorder” are products that have not yet been completed or are on their way to suppliers that have nevertheless been made available for purchase. The producer agrees to fulfill the sales order, but the products are not ready at the time the order is received.
Many businesses experience times when demand exceeds supply. This can be due to a number of circumstances that cause a sudden increase in demand or a temporary decrease in production capacity. When this occurs, rather than discontinue sales, companies may choose to make temporarily out-of-stock products available on backorder, thus ensuring continued revenue.
partially available orders
Sales orders typically consist of several different products. Some of them may be available while others are out of stock but in restocking process. In these cases, it is common for companies to accept the order and immediately ship the available part, while the out-of-stock products remain available on back orders, to be delivered once production is finished. The key is to communicate the delivery times of the pending products. A portion of a backorder may also be part of a supplier’s consignment inventory.
Let’s see an example. A baker places an order for 500 kg of flour. However, the producer only has 350 kg in stock, while the next batch is still in production, with a delivery time of 10 days. Instead of having to wait for the next batch to finish, the producer can make the order partially deliverable, stating that 350kg is available immediately and the remaining 150kg is available on backorder, ready to ship in 10 days. . This way, the producer can finalize the sale while the baker gets to work with the dough.
Backordered vs Pre-ordered vs Out of Stock
Backorders should not be confused with pre-orders or out-of-stock items. The difference between a backorder and a pre-order is simply that while a backorder is a previously in-stock item that has been temporarily out of stock, a pre-order item does not have any prior in-stock status. In other words, pre-orders are products that a company plans to start manufacturing or supplying in the future, but is already accepting orders for today.
In the case of out-of-stocks, however, the supply of a product is uncertain or a company has stopped manufacturing or supplying it entirely. Either the manufacturer is unclear if the product will be available again in the future, or the product has reached the end of its life cycle.
The decision to designate an item as out of stock or available on backorder will depend on many circumstances. For example, a manufacturer must consider the following: whether the demand for the product is persistent; whether backorder availability would be profitable; how long the customer is willing to wait; when the supply of raw materials will be replenished; how many items need to be available for back order; if production planning is set up to allow order booking in advance; whether the inventory management system and accounting module are equipped to handle backorders properly, etc.
Main causes of pending orders
Backorders are not inherently bad news and can be a reliable means of maintaining sales. It all depends on how they are managed. Let’s look at three different circumstances that may necessitate the use of backorders.
unusual demand
Perhaps the main reason for backorders is the sudden fluctuation in demand. It may be the result of a seasonal event, such as a vacation, an unexpected weather event, such as an unexpectedly long snow storm, or anything else. It can also simply be due to the rise in popularity of a product due to its trending on social media.
Many manufacturers rely on demand planning and forecasting models for large customers, total orders, or for specific product lines. Sudden changes in order patterns can throw manufacturing out of balance and prevent planned production capacity from meeting demand.
low safety stock
Companies have to rigorously manage inventory levels to avoid under- or overstocking of products and components. To prevent stock-outs and account for irregularities in the supply chain, many manufacturers maintain a safety inventory of certain products. Safety stock is an inventory management method intended to mitigate supply interruptions.
However, despite the best planning efforts, safety stock levels or finished goods are also sometimes miscalculated. There is simply no reliable way to anticipate every peak in demand in advance.
Supply Chain Issues
In a global economy where supply chains span continents and often include many intermediaries, there will be supply interruptions from time to time. This can be due to natural disasters, shipping or port strikes, regulatory compliance, poor quality from suppliers, etc. Whatever the reason, the result is understocking and, in most cases, longer lead times.
By adopting a multi-vendor approach, the risks associated with lock-in on a single vendor are alleviated. In any case, there is no guarantee that a shipment lost by one supplier can always be covered by a second source.
Advantages and risks of backorders
As we have seen, in some situations, back orders can be a worthwhile sales technique. Next, we will review the main benefits and risks associated with its use.
Advantages of pending orders
One of the advantages of backorders is that they can reflect a healthy increase in demand for a product. If managed correctly, backorders can be used to anticipate constant demand and mitigate the financial risks of increasing production capacity. This can help companies plan their growth and gain valuable market insights.
Another key benefit is that back orders can help companies keep inventory levels lower, freeing up cash flow for operations and expansion. With Lean Manufacturing practices, backorders can increase profitability by increasing revenue and reducing overhead, labor, and maintenance costs.
Maintaining sales even when products are out of stock is especially beneficial for small manufacturers who are highly dependent on steady revenue and cannot afford to lose customers. What’s more, a backorder can even send a signal to consumers that a product is in high demand, increasing its popularity.
Backorder risks
As for the risks and downsides, relying too heavily on backorders may indicate that a business has become too lean in an effort to save costs, has failed to anticipate demand, or may be experiencing productivity issues. If lead times are too long and backorders lengthen, customers may leave for competitors and orders may be cancelled, with raw materials ordered to meet demand automatically becoming overstocked upon arrival.
The risk of cancellation is usually greater the longer the customer has to wait to receive the product. You may find a better deal or your circumstances or preferences may change while you wait. If a customer ends up canceling the order, it is almost always added waste, a missed opportunity, and a blow to the company’s reputation.
If the order was already paid for, the money must be returned and production plans rescheduled. Even if you weren’t, additional operational costs from customer support are virtually guaranteed.
Accounting Considerations on Backorders
In accounting, backorders—sometimes also called a company’s backlog—are often expressed as a dollar figure denoting the value of the sale. However, there is an impact on how they are accounted for. Specifically, paid pending orders are recorded as liabilities in the financial statements rather than as sales made. These are future obligations to customers. The reason is simple: if the customer cancels, the pending order can be deleted without affecting the sales revenue of the previous period. This prevents a pending order from affecting the bottom line while the transaction is in progress.
There are other accounting considerations as well. On the one hand, backorders can affect inventory and other carrying costs. If they are related to a specific component or raw material that is part of a process, the other parts that go into that set are subject to the usual inventory and valuation procedures. The same goes for maintenance costs. Even if the item has not yet been registered as a completed sale, rent, utilities, and labor for backordered items still need to be paid.
Other accounting aspects are immediate shipping costs, which must be included at some point in the financial statements. It can also include tangible and intangible costs, which must be accounted for to track the progress of back orders.
Tips for managing pending orders
While the use of back orders can be beneficial to a business in many circumstances, the key is to make sure that the production system is set up to handle them properly and that customers are informed. Here are six tips to more effectively manage backorders:
- Periodically check the popularity of the articles . When an item is taking the shelves by storm, be sure to look at the product’s life cycle. Determine key indicators of your popularity, such as market trends, seasonality, and other factors. It pays to make informed decisions about whether or not to backorder items before they’re out of stock.
- Communicate with customers. Customers are more willing to place backorders if they can trust that production is running smoothly and their order is given priority. Communication is key to minimizing the risk of cancellations. Accurate delivery times and regular status updates give customers the reassurance that their business is valued.
- Double down on production planning. Anticipating production planning and scheduling considerations for quick-sell items is crucial to ensuring a balanced supply. Spend more time analyzing production capacities and resource allocation for the most popular SKUs. Advanced MRP systems allow accurate and comprehensive analysis of production histories, capacities, stock levels, etc.
- Calculate and set reorder points. Products often require a complex mix of raw materials and components to manufacture. The delivery times of the suppliers can be very different. Calculating and setting realistic reorder points based on consumption history will reduce the risk of running out of a component. In this case, too, inventory management software can be a game changer.
- Maintain healthy safety stock levels. As we have seen, having sufficient safety stock is a good way to cope with increases in demand and can reduce the need for backorders. However, safety stocks must be kept at a balanced level, as overstocking brings added overhead and introduces risks of waste.
- Integrate production systems. Small and medium manufacturers often use different systems for different functions. This leads to information silos and the need to reconcile data from one department to another, which increases the chances of error and introduces delays. By integrating production systems into a unified solution, such as manufacturing ERP software, backorders can be managed much better.
If managed properly, backorders can be an effective means of addressing potential problems resulting from inconsistent demand or fluctuating delivery times. A unified manufacturing system with advanced production tracking, reporting and analysis capabilities, such as MRPeasy , can go a long way to ensuring that backlogs end up working for you instead of hurting your business.
Simplify the management of your pending orders
Main aspects to take into account
- A backorder is out-of-stock production that is in progress or planned, but has not been made available for order.
- Backorders differ from out-of-stock orders in that they are still open for sales orders, while out-of-orders are not.
- The main causes of back orders are sudden fluctuations in demand, problems in the supply chain, and inadequate management of safety stocks.
- If managed correctly, backorders can help maintain sales amid unresolved supply issues, as long as sufficient customer support prevents cancellations.
- Tips for managing backorders include reviewing safety stock levels, establishing optimal reorder points, and implementing a unified production planning system.