Optimal inventory policies under service-sensitive demand

The service level provided by a retailer influences demand and sales in several ways. In the short run, sales can fall short of demand when customers experience stockouts and choose not to backorder. In the long 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 cost attributable to each stockout occasion. In practice, stockout costs are difficult to determine, at least in part because they reflect the 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 retailer, and determine optimal order-up-to inventory policies in the presence of service-sensitive demand. We show under what conditions inventory policy is sensitive to both the mean and the variance of long-run demand.