Leveraging uncertainty through backorder

Business models based on postponement are being increasingly adopted by firms in categories ranging from consumer electronics and information technology to automobiles. Backorder is one example of this system wherein firm produces the product after receiving an order from the customer and they represent a stark contrast to the traditional Make-to-stock (MTS) system where firm anticipates demand and satisfies it from finished inventory. The popularity of postponement is primarily attributed to the operational efficiencies that it can generate for a firm in dealing with highly uncertain and dynamic demand environments. Our focus in this paper is on understanding the implications of the interaction of demand uncertainty and consumer heterogeneity for the optimality of these different systems. We show that the combination of these two forces requires the firm to use both backorder and MTS simultaneously. The optimality of backorder depends on the extent of demand uncertainty-products that exhibit relatively higher demand volatility are better candidates for backorder. Importantly, the combination of the two systems has significant implications for the firm's product line decision (in terms of product qualities) and pricing.