A Comparison of the Optimal Costs of Two Canonical Inventory Systems

We compare two inventory systems, one in which excess demand is lost and the other in which excess demand is backordered. Both systems are reviewed periodically. They experience the same sequence of identically and independently distributed random demands. Holding and shortage costs are considered. The holding cost parameter is identical, however the cost of a lost sale could be different from the per period cost of backlogging a unit sale. When these costs are equal, we prove that the optimal expected cost for managing the system with lost sales is lower. When the cost of a lost sale is greater, we establish a relationship between these parameters that ensures that the reverse inequality is true. These results are useful for designing inventory systems. We also introduce a new stochastic comparison technique in this paper. IOMS-OM Group, Stern School of Business, New York University, 44 W. 4th Street, Room 8-71, New York, NY 10012-1126. IOMS-OM Group, Stern School of Business, New York University, 44 W. 4th Street, Room 8-73, New York, NY 10012-1126. 4129 Etcheverry Hall, Department of Industrial Engineering and Operations Research, University of California, Berkeley, CA 94720.