OPTIMAL INVENTORY POLICIES UNDER SERVICE-SENSITIVE DEMAND

The service level provided by a retailer influences demand and safes i n several ways. In the short run, sales can fall short of demand when customers experience stockouts and choose not to backorder. In the lon g run, demand itself may decline as customers who experience excessive stockouts shift permanently to more reliable sources. The traditional approach to determining inventory policies assumes a fixed stockout c ost attributable to each stockout occasion. In practice, stockout cost s are difficult to determine, at least in part because they reflect th e long-term loss of demand due to inadequate service. In this paper we model the response of long-run demand to the service level of the ret ailer, and determine optimal order-up-to inventory policies in the pre sence of service-sensitive demand. We show under what conditions inven tory policy is sensitive to both the mean and the variance of long-run demand.