Online Appendix for "Running on Empty? Financial Leverage and Product Quality in the Supermarket Industry"

The empirical analysis in the paper finds that, on average, taking on high leverage increases stockouts by about 8 to 9 percent. To put this magnitude in perspective, I construct an estimate of the profit impact of an 8 percent increase in stockouts for the average supermarket firm. The calculation, which is presented in Panel A of Table A1, trades off the benefit of reduced inventory investment for the lost profits from forgone current and future sales. The value of reduced inventory investment equals the decrease in inventories times the cost of carrying inventory, which includes storage, utilities, handling, insurance, taxes, obsolescence, and the cost of capital. On the other hand, more frequent stockouts reduce current sales when customers substitute to lowervalue products or cancel their intended purchase of the out-of-stock item. The profit impact of this substitution equals the value of forgone sales (which others have estimated based on surveys of customer substitution patterns) times the gross margin on these products. More frequent stockouts also have a longer-run impact on sales in that the firm is likely to lose customers when its reputation for service deteriorates. Assuming the firm forgoes sales to a lost customer in perpetuity, the profit impact of customer switching equals the value of forgone annual sales times the gross margin divided by the appropriate discount rate for the firm’s assets.1 The calculation is calibrated using estimates from various industry studies and financial data from the U.S. Internal Revenue Service for a representative sample of public and private supermarket firms. However, the calculation requires two key assumptions for which estimates are not available: (1) the percentage decrease in inventory associated with the increase in stockouts, and (2) the impact of the higher stockout rate on future sales. I proceed by making relatively conservative assumptions for these variables and then examining the sensitivity of the profitimpact estimate to these assumptions. Based on the inventory reductions achieved by Safeway (Magowan 1989, p.12), I assume that firms reduce inventories by 5 percent. I have less basis on which to estimate lost future sales due to the increase in stockouts. I assume that the 8 percent increase in stockouts leads to a 0.1 percent reduction in the customer base; that is, 1 in 1,000 customers are frustrated enough by the extra stockouts that they start shopping elsewhere. These calculations imply that an 8 percent increase in stockouts would decrease the average