THREE ESSAYS ON INVENTORY MANAGEMENT

By

JIANG ZHANG

Submitted in partial fulfillment of the requirements

for the Degree of Doctor of Philosophy

Thesis Advisor: Dr. Matthew J. Sobel

Department of Operations

CASE WESTERN RESERVE UNIVERSITY

August 2004
 CASE WESTERN RESERVE UNIVERSITY

SCHOOL OF GRADUATE STUDIES

We hereby approve the dissertation of

JIANG ZHANG
______________________________________________________

candidate for the Ph.D. degree *.

Matthew J. Sobel
(signed)_______________________________________________
(chair of the committee)

Lisa M. Maillart
________________________________________________

Yunzeng Wang
________________________________________________

Peter H. Ritchken
________________________________________________

________________________________________________

________________________________________________

06/16/2004
(date) _______________________

*We also certify that written approval has been obtained for any
proprietary material contained therein.
I grant to Case Western Reserve University the right to
use this work, irrespective of any copyright, for the
University’s own purposes without cost to the University
or to its students, agents and employees. I further agree
that the University may reproduce and provide single
copies of the work, in any format other than in or from
microforms, to the public for the cost of reproduction.

JIANG ZHANG
To my mother: Huishu Jiang

my father: Shuqing Zhang

my wife: Dr. Yan Cao

Contents

List of Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii

List of Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x

Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xii

1 Inventory Replenishment with a Financial Criterion . . . . . . . . . . . 1

1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.2 Model Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . 7

1.3 Dynamic Programming Analysis . . . . . . . . . . . . . . . . . . . 11

1.4 Optimality of (sn , Sn ) Replenishment Policies . . . . . . . . . . . 14

1.5 Infinite Horizon Convergence . . . . . . . . . . . . . . . . . . . . . 18

1.6 Models with Smoothing Costs . . . . . . . . . . . . . . . . . . . . 19

1.7 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . 23

v
2 Fill Rate of General Review Supply Systems . . . . . . . . . . . . . . . . . . . 25

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

2.2 General Periodic Review System . . . . . . . . . . . . . . . . . . . 29

2.3 Uncapacitated Single-stage Systems . . . . . . . . . . . . . . . . . 32

2.4 Gamma and Normal Demand in Single-stage Systems . . . . . . . 35

2.4.1 Gamma Demand Distribution . . . . . . . . . . . . . . . . 35

2.4.2 Normal Demand Distribution . . . . . . . . . . . . . . . . 36

2.4.3 Fill Rate Approximation for Normal Demand Distribution 39

2.5 Multi-Stage General Review Systems . . . . . . . . . . . . . . . . 40

2.5.1 Fill Rate in Two-Stage Systems . . . . . . . . . . . . . . . 42

2.5.2 Fill Rate in Two-Stage Systems with General Leadtime . . 48

2.5.3 Numerical Example . . . . . . . . . . . . . . . . . . . . . . 51

2.6 Fill Rate in a Three-Stage System . . . . . . . . . . . . . . . . . . 51

2.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

3 Interchangeability of Fill Rate Constraints and Backorder Costs

in Inventory Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

3.2 Model and Problem Formulations . . . . . . . . . . . . . . . . . . 66

3.3 Continuous Demand . . . . . . . . . . . . . . . . . . . . . . . . . 72

3.4 Discrete Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

3.5 Interchangeability . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

vi
 3.6 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

3.6.1 Strictly Positive Demand Density . . . . . . . . . . . . . . 83

3.6.2 Non Strictly Positive Demand Density . . . . . . . . . . . 84

3.6.3 Discrete Demand . . . . . . . . . . . . . . . . . . . . . . . 86

3.7 Generalizations and Summary . . . . . . . . . . . . . . . . . . . . 89

3.8 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

vii
List of Tables

2.1 Fill Rate and its Approximation for Normal Demand . . . . . . . . . 57

2.2 Fill Rate of Two-stage Systems for Normal Demand (a) . . . . . . . 58

2.3 Fill Rate of Two-stage Systems for Normal Demand (b) . . . . . . . 59

3.4 Distribution Function and Expected Number of Backorders . . . . . . 87

3.5 Values of G−1 (·) and B −1 (·) . . . . . . . . . . . . . . . . . . . . . . 88

3.6 S-optimal Base-Stock Levels and Fill Rates at which they are F-optimal 88

3.7 F-optimal Base-Stock Levels and Unit Stockout Costs at which they are

S-optimal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

viii
List of Figures

2.1 The standard N-stage serial inventory system . . . . . . . . . . . 30

2.2 The Fill Rate Integral for a system with Normal Demand . . . . 38

3.3 Dependence of S-Optimal Base-Stock Level on Stockout Cost: Non-

negative Density . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

3.4 Locus of {(b, f)} with the Same Optimal Base-Stock Level: Non-

negative Density . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

ix
 Acknowledgements

I would like to express my sincere gratitude to my mentor, Professor Matthew

J. Sobel, who encouraged and guided me through various phases of my doctoral

studies with patience. I would also like to thank him for his incredible effort and

willingness to help me at any time and any where.

I would specially like to thank my dissertation committee members, Profes-

sors Lisa Maillart, Peter Ritchken, and Yunzeng Wang for their generous insight,

comments, and support on this work. In addition, my thanks are also owed to Pro-

fessors Apostolos Burnetas, Hamilton Emmons, Kamlesh Mathur, Daniel Solow,

and George Vairaktarakis for their help throughout my doctoral studies.

I would like to express my appreciation to the Department of Operations, Case

Western Reserve University, for their generous financial support. Special thanks

to department’s staff, Elaine Iannicelli, Sue Rischar, and Emily Anderson for their

help throughout my study in the department.

I had a fabulous time at Case which would not have been possible without the

company of friends like Junze Lin, Zhiqiang Sun, Yuanjie He, Huichen Chiang,

x
Wei Wei, Xiang Fang, Qiaohai Hu, Will Millhiser, Ant Printezis, Halim Hans, and

Kang-hua Li who have always helped and cheered me up in every possible way.

Finally, I would like to thank my family for their unconditional love, support

and encouragement. My special thanks are for my wife Yan who is always there

for me through everything.

xi
 Three Essays on Inventory Management

Abstract

by

JIANG ZHANG

This dissertation consists of three essays that are related to inventory man-

agement.

The first essay models a single-product equity-owned firm which orders prod-

ucts from an outside supplier, borrows short-term capital for solvency, and issues

dividends to its shareholders while facing financial risks and demand uncertainty.

The firm maximizes the expected present value of the time stream of dividends. If

there is a setup cost in this model, we show that an (s, S) replenishment policy is

optimal by jointly optimizing the firm’s operational and financial decisions. The

analysis is not a straightforward copy of Scarf’s argument. The second part of

this essay studies the same model with a smoothing cost (instead of a setup cost)

and shows that the optimal policy has the same form as the traditional smoothing

xii
cost model. Although operational decisions and financial decisions interact with

each other in these models, the optimal inventory policies have standard forms.

The second essay obtains fill rate formulas for general review inventory models

with base-stock-level policies. Ordering decisions in a general review model are

made every R (R ≥ 1) periods but demand arises every period. We provide

exact fill rate formulas for single-stage model with a general demand distribution.

A simple fill rate expression is derived for the model with normally distributed

demand. For multi-stage models, we first discuss a general review procedure at

each stage and then provide exact fill rate formulas for two-stage and three-stage

models.

There are parallel streams of literature which analyze identical models except

that one stream has backorder costs and the other has fill rate constraints. The

third essay clarifies redundancy in the two streams of dynamic inventory models

with linear purchase costs. We show that optimal policies for either kind of

model can be inferred from the other. That is, inventory fill rate constraints

and backorder costs are interchangeable in dynamic newsvendor models.

xiii
Chapter 1

Inventory Replenishment with a

Financial Criterion

1.1 Introduction

Nearly all the literature on optimal inventory management uses criteria of cost

minimization or profit maximization. An inventory managers’ goal for example,

is modeled as minimizing cost or maximizing profit while satisfying customers’

demands. If inventory decisions do not affect the revenue stream, these two crite-

ria result in the same optimal replenishment policy. Most of this literature treats

firms’ inventory decisions and financial decisions separately. This dichotomy is

perhaps due to the perception that inventory managers in a large firm cannot in-

fluence the firm’s financial policy and that financial officers are usually detached

1
 2

from the inventory decisions. This separate consideration of financial and opera-

tional decisions simplifies management and has its foundation in corporate finance.

The pathbreaking papers, Modigliani and Miller (1958) and Modigliani and Miller

(1963) (hereafter referred to as M-M), show that the firm’s capital structure and

its financial decisions should be independent of the firm’s investment and opera-

tional decisions if capital markets are perfect.

However, when market imperfections such as taxes and transaction fees are in-

troduced, the results characterized from these separate treatments may no longer

hold. “Treating real and financial decisions of the firm as independent may not

be justified.”(Dammon and Senbet 1988). Other sources of market imperfections

include asymmetric information between supplier and retailer, asymmetric infor-

mation between shareholders and managers, and differential access to financial

resources by different firms. For example, many small and medium-sized firms

are cash constrained, and their operational decisions are heavily dependent on

their financial decisions (such as short-term borrowing). Although the assumed

independence of operations and finance has led to the development of intuitively

appealing and insightful results, there remains the question of whether joint opti-

mization of both the operational and financial decisions of a firm will generate new

insights regarding firm behavior and perhaps overturn or modify existing results.

The M-M theorem not only allows separation of operations and finance, but

also establishes that the firm’s optimal decisions are the same no matter if it
 3

optimizes the value of the firm, dividends, or retained earnings. However, when

capital markets are imperfect, the equivalence of different objectives is no longer

valid. The literature on agency theory finds that corporate managers, the agents

of shareholders, have conflicting interests with the shareholders. Those conflicts

are primarily caused by dividends paid to shareholders. “Payouts to shareholders

reduce the resources under managers’ control, thereby reducing managers’ control,

and making it more likely they will incur the monitoring of the capital markets

which occurs when firm must obtain new capital”(Jensen 1986, p. 1). So managers

have to seek external funds to finance their projects. Since the external funds are

usually unavailable for certain firms or available only at high prices, it somewhat

reduces the profitability (or increases the operating costs) of the projects and may

affect the performance evaluation of the managers. This conflict may discourage

managers from disgorging the cash to shareholders and cause organizational inef-

ficiencies.

There is a literature on finance that recognizes the interdependence issues

among a firm’s decisions. Most of this literature focuses on the effects of mar-

ket imperfections on financial structures and decisions. Miller and Rock (1985)

extend the standard finance model of the firm’s dividend/investment/financing

decisions by allowing asymmetric information between the firm’s managers and

outside investors and they show that there exists an equilibrium investment pol-

icy which leads to lower levels of investment than the optimum achievable under
 4

full information. Myers (1974) shows how investment decisions, i.e., acceptance

or rejection of projects, affect the optimal financial structure of a firm and why

investment in turn, should be affected by leverage. Long and Racette (1974)

shows that the cost of capital of a competitive firm facing stochastic demand is

affected by the level of production. Hite (1977) examines the impact of leverage

on the optimal stock of capital by the firm and its capital-to-labor ratio. Datan

and Ravid (1958) analyze the interaction between the optimal level investment

and debt financing. In their model, a firm faces an uncertain price and has to

decide on its optimal level investment and debt simultaneously. They show that

a negative relationship exists between investment and debt. Dammon and Senbet

(1988) extend capital structure model in DeAngelo and Masulis (1980) and study

the effect of corporate and personal taxes on the firm’s optimal investment and

financing decisions under uncertainty. However, this literature does not address

how a firm operates (quantitatively) by considering the interrelationships.

This paper considers interactions between operational and financial decisions

and uses a dividend criterion. The primary purpose of this paper is to study how

operational decisions are affected by jointly considering financial and operational

decisions and using a non-traditional operations objective. We consider a sin-

gle product equity-owned retail firm which periodically reviews its inventory and

retained earnings. Every period the firm faces random demand and replenishes
 5

stocks to satisfy customer demand. In addition, every R (a positive integer) peri-

ods, the firm issues a dividend to its shareholders. The firm seeks to maximize the

expected present value of the time stream of dividends (also called shareholders’

wealth).

Shareholders’ wealth maximization is a widely accepted objective of the firm in

the literature (cf. Hojgaard and Taksar 2000, Milne and Robertson 1996, Moyer,

McGuigan, and Kretlow 1990, Sethi 1996, and Taksar and Zhou 1998). This goal

states that management should seek to maximize the present value of the expected

future returns to the shareholders of the firm. These returns can take the form of

periodic dividend payments or proceeds from the sale of stock.

If the objective of the firm is to minimize the expected present value of or-

dering, holding, and shortage costs and the capital market is perfect, the optimal

replenishment policies have been characterized for a broad range of conditions. See

Porteus (1990), Graves et al. (1993), and Zipkin (2000) for details and references

to the literature.

Some recent research addresses the coordination of financial and operational

decisions. Li, Shubik, and Sobel (2003) examine the relationship between de-

cisions on production, dividends, and short-term loans in dynamic newsvendor

inventory models. They show that there are myopic optimal base-stock policies

associated with production decisions and dividend decisions. The present paper

proceeds directly from Li, Shubik, and Sobel (2003) and augments their model
 6

with a setup cost and smoothing costs. Buzacott and Zhang (1998) look at the

interface of finance and production for small firms with limited borrowing. They

maximize profit over a finite horizon using a mathematical programming model

to optimize inventory and borrowing decisions, and they assume that the demand

for the product is known. Archibald, Thomas, Betts, and Johnston (2002) as-

sert that start-up firms are more concerned with the probability of survival than

with profitability. They present a sequential decision model of a firm which faces

an uncertain bounded demand and whose inventory replenishment decisions are

constrained by working capital.

Buzacott and Zhang (2003) incorporate financial capacity into production de-

cisions using an asset-based constraint on the available working capital in a single-

period newsvendor model. They model the available cash as a function of assets

and liabilities that will be updated according to the dynamics of the production

activities. They analyze a leader-follower game between the bank and the retailer,

and illustrate the importance of jointly considering production and financial deci-

sions. Babich and Sobel (2002) consider capacity expansion and financial decisions

to maximize the expected present value of a firm’s IPO. They treat the IPO event

as a stopping time in an infinite-horizon Markov decision process, characterize an

optimal capacity-expansion policy, and provide sufficient conditions for a mono-

tone threshold rule to yield an optimal IPO decision.

 7

The rest of the paper is organized as follows. Section 1.2 formulates the finan-

cial inventory model and §1.3 analyzes the corresponding dynamic program. The

structure of the finite-horizon optimal replenishment policy is explored in §1.4

and extended to the infinite horizon optimal policy is discussed in §1.5. Section

1.6 studies the financial inventory model with smoothing costs and characterizes

optimal replenishment policies. Section 1.7 concludes the paper.

1.2 Model Formulation

We consider an equity-owned retail firm that sells a single product to meet uncer-

tain periodic demand and orders the product from a supplier with an ample supply.

The firm can make short-term loans, if necessary, to obtain working capital. As

discussed in the introduction, every R periods, dividends are issued to the share-

holders and the objective of the firm is to maximize the expected present value

of the time stream of dividends. Negative dividends are interpreted as capital

subscriptions, a common phenomenon for young firms. The following chronology

occurs in each period. The firm observes the level of retained earnings, wn , and

the current physical inventory level, xn . A default penalty (or bankruptcy) p(wn )

is assessed if wn < 0, but it is convenient to define p(·) as a function on . We

assume that p(·) is convex nonincreasing on . Then the firm chooses the level

of its short-term loan, bn , and the order quantity, zn . The restriction R = 1 sim-

plifies the presentation and Section 6 substantiates that R = 1 is without loss of

 8

generality.

At the beginning of each period, the firm also decides on the amount of divi-

dend to declare, vn . if vn ≥ 0 then it is a dividend issued to the shareholders; if

vn < 0 then it is a capital subscription. Also at the beginning of the period, the

loan interest ρ(bn ) (where we assume ρ(·) is a convex increasing function on + ) is

paid, and the ordering decision is implemented at a cost of Kδ(zn ) + czn , where K

is an ordering setup cost, δ(zn) = 1 if zn > 0, and δ(zn ) = 0 otherwise. Then de-

mand Dn in period n is realized, and sales revenue net of inventory cost, denoted

g(yn , Dn ), is received. For specifity, let g(y, d) = r min{y, d}−h(y−d)+ −π(d−y)+

where yn , r, h and π denote available goods in period n after delivery, unit sale

price, holding cost and shortage penalty cost, respectively. However, we only use

convexity of g(·, d) for each d ≥ 0. Finally, the loan principal bn is repaid. We as-

sume that the demands D1 , D2 , · · · are independent nonnegative random variables

and unmet demands are backlogged.

For convenience but without loss of generality, we assume that the order lead-

time is 0. Therefore, the amount of goods that is available to satisfy demand in

period n is

yn = xn + z n (1.1)

Let In be the internally generated working capital in period n:

In = wn − p(wn ) − vn − czn − ρ(bn ) − Kδ(zn ) (1.2)

 9

That is, In is working capital after the dividend is issued, loan interest and replen-

ishment costs are paid, and before the loan is made and revenue and inventory

costs are realized. The total working capital available at the beginning of period n

is bn + wn and the residual cash left in the firm before sales is bn + In . We assume

that there is an interest rate γ associated with In , that is, if working capital is

positive, the firm will gain γIn if In ≥ 0 or pay a penalty −γIn if In < 0.

Since excess demand is backlogged, the dynamics are as follows:

xn+1 = xn + zn − Dn

wn+1 = (1 + γ)[wn − p(wn ) − vn − czn − ρ(bn ) − Kδ(zn )] + g(yn , Dn )

The first equation balances the flow of physical goods and the second equation

balances the cash flow. Using (1.1) and (1.2), the balance equations become

xn+1 = yn − Dn (1.3)

wn+1 = (1 + γ)In + g(yn , Dn ) (1.4)

We assume that the loan and replenishment quantities are nonnegative:

bn ≥ 0 and zn ≥ 0 (1.5)

The following liquidity constraint prevents the expenditures in period n from

exceeding the sum of retained earnings and the loan proceeds:

wn + bn − ρ(bn ) ≥ p(wn ) + vn + czn + Kδ(zn ) (1.6)

 10

Given xn and wn , from (1.1) and (1.2) the decision variables in period n can be

specified as yn , In and bn instead of zn , vn and bn .

Let B denote the present value of the time stream of dividends and let β

denote the single period discount factor :

∞


B= β n−1vn (1.7)
n=1

Remark Discount factor β can be regarded as the risk neutral discount rate for

the shareholders and need not to be a constant every period. Letting β(xn , wn )

be an endogenous random variable which depends on the levels of inventory and

retained earnings will not alter the results.

For n = 1, 2, · · ·, let Hn denote the history up to the beginning of period n,

namely,

Hn = (x1 , w1, b1 , I1, y1, D1 , · · · , xn−1 , wn−1 , bn−1 , In−1 , yn−1 , Dn−1 , xn , wn )

Let Ωn be the set of all possible Hn sequences. A policy is a nonanticipative rule for

choosing y1, I1 , b1, y2, I2, b2 , . . . . That is, a policy is a rule that, for each n, chooses

yn , In , and bn as a function of Hn . An optimal policy maximizes E(B|Hn = η)

for each η ∈ Ωn , for all n = 1, 2, . . .. Since a policy specifies the three decisions

each period (the amount of supply level, yn , the amount of internally generated

working capital, In , and the short-term loan, bn ), the firm can easily determine

the order size and the amount of dividends to issue to shareholders by using (1.1)
 11

and (1.2). The theme of §3 and §4 is the characterization of an optimal policy,

i.e., one that maximizes the expected value of (1.7) subject to (1.3)-(1.6).

1.3 Dynamic Programming Analysis

This section gives the dynamic programming equations which correspond to the

dynamics in §2. We then give a proposition that reduces the dimensionality of

the decision space from three to two. From (1.2) and (1.3), vn = wn − p(wn ) −

In − cyn + cxn − ρ(bn ) − Kδ(yn − xn ) and xn = yn−1 − Dn−1 (n > 1), and using

standard procedures (Veinott and Wagner 1965), substituting vn and xn in (1.7),

then inserting (1.4) and rearranging terms yields

∞


B = cx1 − β ncDn
n=1
∞

 
+ β n−1 wn − p(wn ) − In − (1 − β)cyn − ρ(bn ) − Kδ(yn − xn )
n=1
∞

∞


= cx1 + w1 − p(w1 ) − β n cDn − β n−1Kδ(yn − xn )
n=1 n=1
∞

  
n−1
+ β −(1 − β)cyn − In + β (1 + γ)In + g(yn , Dn )
n=1 
 
−βp (1 + γ)In + g(yn , Dn ) − ρ(bn )

For (b, I, y) ∈ 3 let

  
L(b, I, y) = −(1 − β)(I + cy) + βγI + βE g(y, D) − p (1 + γ)I + g(y, D) − ρ(b)

(1.8)
 12

Then the expected present value of the dividends can be stated as



∞  

∞  
E(B) = cx1 +w1−p(w1 )−E β n cDn +E β n−1 L(bn , In , yn )−Kδ(yn −xn )
n=1 n=1

(1.9)

As in Veinott and Wagner (1965) and in many other references since then, we

interpret L(·, ·, ·) as a generalized inventory reward function (revenue minus costs

and penalties). Because the first four terms in (1.9) do not depend on the decision

variables, a policy maximizes (1.9) if and only if it maximizes the last term of (1.9).

So we utilize (1.8) and (1.9) and pursue the following objective:



∞
sup EH1 β n−1 [L(bn , In, yn ) − Kδ(yn − xn )]
n=1

subject to yn ≥ xn , bn + In ≥ 0, and bn ≥ 0. (1.10)

where the supremum is over the set of all policies, H1 = (x1, w1 ) is the initial

state, and the constraints in (1.10) follow from (1.1), (1.2), (1.5), and (1.6).

It is convenient to analyze the following finite horizon counterpart of (1.10)

and then let N → ∞:



N
sup EH1 β n−1 [L(bn , In , yn ) − Kδ(yn − xn )]
n=1

subject to yn ≥ xn , bn + In ≥ 0, and bn ≥ 0 (1.11)

A dynamic recursion that corresponds to (1.11) is ϕ0(·) ≡ 0 and for each x ∈ 

and n = 1, 2, . . .,

ϕn (x) = sup{Jn (b, I, y) − Kδ(y − x) : y ≥ x, I + b ≥ 0, b ≥ 0} (1.12)

 13

Jn (b, I, y) = L(b, I, y) + βE[ϕn−1 (y − D)]. (1.13)

This dynamic program has one state variable, x, and three decision variables (b,

I, y), but the original problem has two state variables, x and w. This reduction

occurs because equation (1.4) allows embedding state variable w into the decision

variable I, which is also a surrogate decision variable for v.

Let bn (x), In (x) and yn (x) be optimal values of b, I and y in (1.12). The

following proposition states that borrowing should not exceed the amount needed

to cover current expenses. That is, bn (x) = [−In(x)]+ . The proof is similar to

that of Proposition 3.2 in (Li, Shubik, and Sobel 2003).

Proposition 1.3.1 For all n = 1, 2, · · · and x ∈ , if the supremum in (1.12) is

achieved, then b = (−I)+ without loss of optimality in (1.12).

Proof From (1.8), (1.12) and (1.13),


ϕn (x) = sup −(1 − β)(I + cy) + βγI + βE g(y, D) − p[(1 + γ)I + g(y, D)]
b,I,y

−ρ(b) + βE[ϕn−1 (y − D)] − Kδ(y − x) : y ≥ x, I + b ≥ 0, b ≥ 0

= sup −c(1 − β)y + βE[g(y, D)] + βE[ϕn−1(y − D)] − Kδ(y − x)

y
 
+ sup −(1 − β)I + βγI − E p[(1 + γ)I + g(y, D)]
I
 

+ sup −ρ(b) : I + b ≥ 0, b ≥ 0 : I ∈  : y ≥ x
b

The last supremum is achieved by b = 0 if I ≥ 0 and by b = −I if I < 0 because

 14

ρ(·) is monotone increasing. Therefore,

   
ϕn (x) = sup − c(1 − β)y + βE g(y, D) + βE ϕn−1 (y − D) − Kδ(y − x)
y
  
+ sup −(1 − β)I + βγI − βE p((1 + γ)I + g(y, D))
I 

+
−ρ[(−I) ] : I ∈  : y ≥ x .

The next section uses Proposition 1.3.1, (1.12), and (1.13) to analyze the

dynamic problem and establish conditions that guarantee the optimality of (s, S)

policies.

1.4 Optimality of (sn , Sn ) Replenishment Poli-

cies

This section establishes conditions under which the optimal ordering policy turns

out to be an (s, S)-type policy for the dividend criterion inventory model. An (s,

S) policy brings the level of inventory after ordering up to S if the initial inventory

level x is below s (where s ≤ S), and orders nothing otherwise. For a finite horizon

dynamic inventory problem in which the ordering cost is linear plus a fixed setup

cost and the other one-period costs are convex, Scarf (1959) and Zabel (1962)

show that the optimal ordering policy is (sn , Sn ). Iglehart (1963) shows that

the limiting (s, S) policy characterizes the optimal policy for the infinite horizon

problem. Scarf’s proof uses the important concept of K-convexity. In this paper,

we use K-concavity.
 15

Definition A real-valued function f(·) on  is K − concave (K ≥ 0) if for all

x ∈ , λ ≥ 0, and θ > 0,

λ
f(x + λ) − f(x) ≤ K + [f(x) − f(x − θ)] (1.14)
θ

Properties of K-concave functions are analogous to those of K-convex func-

tions.

Lemma 1.4.1 (a) f(·) is 0-concave ⇔ f(·) is concave on ;

(b) fi (·) is K-concave, i=1,2,. . . ⇒ α1 f1 + α2 f2 is α1 K1 + α2 K2 concave (α1 >

0, α2 > 0);

(c) f(·) is K-concave ⇒ f(·) is V -concave for all V ≥ K;

(d) f(·) is K-concave ⇒ f(·) is continuous on .

Proof f(·) is K-concave if and only if −f(·) is K − convex. So (a) through (d)

follow from properties of K-convex functions (Scarf 1959).

For dynamic program (1.12) and (1.13), we use the following results to show

that there is an optimal (s, S) policy.

Let µ and Q(·) be the mean and distribution function of D. Let G(y) =

E[g(y, D)].

Lemma 1.4.2 (a) p[(1 + γ)I + g(y, d)] is convex with respect to (I, y) ∈ 2 (for

each d ≥ 0);

(b) L(·, ·, ·) is a concave function on its domain 3 .

 16

Proof (a) Since g(·, d) is a convex on  for each d ≥ 0, (1 + γ)I + g(y, d) is jointly

convex in (I, d). The conclusion in (a) follows from monotonicity and convexity

of p(·). p[(1 + γ)I + g(y, d)] is convex on I ∈ , so is E{p[(1 + γ)I + g(y, D)]}.

(b) Concavity of L(·, ·, ·) follows from definition (1.8) and (a).

Theorem 1.4.3 If L(b, I, y) → −∞ as |y| → ∞ for all b ≥ 0, and b + I ≥ 0,

then there is an optimal (s, S) policy.

Note that the hypothesis uses concavity of L(·, ·, ·) and ensures the existence of

maxima of L(b, I, ·). The proof of this theorem is not a paraphrasing of Scarf

(1959). Indeed, it exploits Proposition 1.3.1 to reduce the decision space from 3

to 2, and establishes the K-concave properties of embedded functions.

Proof The concavity of ϕ0(·) ≡ 0 initiates an inductive proof of K-concavity for

each n.

For any n ≥ 1, if ϕn−1 (·) is K-concave, then

Jn (b, I, y) = L(b, I, y) + βE[ϕn−1(y − D)]

is βK-concave ( 0 < β < 1 ) in y because L(·, ·, ·) is concave and E[ϕn−1 (y − D)]

is βK-concave due to Lemma 1.4.1 (b).

To prove that ϕn (·) is K-concave, we show that Tn (·) is βK-concave where

Tn (y) = sup{Jn (b, I, y) : b ≥ 0, b+I ≥ 0}; Proposition 1.3.1 asserts that b = (−I)+

is optimal. So

Tn (y) = sup{L(b, I, y) + βE[ϕn−1 (y − D)] : b ≥ 0, b + I ≥ 0}

 17

= sup{L(0, I, y) + βE[ϕn−1(y − D)] − ρ(b) : b ≥ 0, b + I ≥ 0}

= βE[ϕn−1 (y − D)] + sup{L(0, I, y) − ρ[(−I)+] : I ∈ }.

Let ζ(y) = supI∈ {L(0, I, y) − ρ[(−I)+]}. Since ζ(·) : C →  and C = {(I, y) :

I ∈ , y ≥ x} is a convex set, a slight modification of Heyman and Sobel (1984)

(Proposition B-4) shows that ζ(·) is concave on  by proving that supI∈ {L(0, I, y)−

ρ[(−I)+]} is concave in y.

So Tn (·) is βK-concave because βE[ϕn−1(y − D)] is βK-concave by applying

Lemma 1.4.1 (b).

Therefore, ϕn (·) is βK-concave; hence it is K-concave.

The proof that an (s, S) policy is optimal for period n follows the next lemma

which is proved in lemma 7-3 (Heyman and Sobel 1984) (p.314).

Lemma 1.4.4 Suppose T (·) is K-concave, attains its global maximum at S, and

there is a smallest number s ≤ S such that

T (s) ≥ −V + T (S) (1.15)

where V ≥ K. Then ϕ(·) is V -concave where

ϕ(x) = sup{T (y) − V δ(y − x) : y ≥ x} x ∈  (1.16)

Since Tn (y) → −∞ as |y| → ∞ and Tn (·) is continuous due to βK-concavity,

the global maximum of Tn (·) is attained, say at Sn . Also, let sn be the smallest

number x such that x ≤ Sn and Tn (x) ≥ −βK + Tn (Sn ); so sn is well defined.

 18

Finally, K > βK implies K-concavity of

ϕn (x) = sup{Tn(y) − Kδ(y − x) : y ≥ x} x ∈  (1.17)

Therefore, a policy that utilizes (sn , Sn ) policy for each n = 1, 2, · · · , N is

optimal.

1.5 Infinite Horizon Convergence

The analysis in §1.3 replaces the infinite planning horizon in (1.10) with a finite

planning horizon (n < ∞) in (1.11). This section shows that the earlier conclu-

sions regarding the qualitative properties of an optimal policy remain valid for

(1.10). We draw on Iglehart (1963) and Heyman and Sobel (1984, sections 8-5,

8-6), and proves that (a) there are upper and lower bounds for the sequences

{sn } and {Sn } of the finite horizon optimal policy, (b) the value function of the

finite horizon dynamic program converges as n → ∞, (c) the limit value function

satisfies the functional equation of dynamic programming, (d) as n → ∞, the fi-

nite horizon optimal policy converges to a policy that is optimal in the functional

equation, and (e) the limit policy inherits the qualitative properties of the finite

optimal policies.

We rewrite function Tn (·):

Tn (y) = βE[ϕn−1 (y − D)] + ζ(y). (1.18)

 19

Assuming that sup(I,b)∈2 {L(b, I, y)} ≥ 0 leads to ζ(·) > 0 on . Then the

dynamic program in (1.17) and (1.18) with ϕ0 (·) ≡ 0 is analogous to (1) in

Iglehart (1963). We modify (1.17) as follows:

ϕn (x) = inf{−Tn(y) + Kδ(y − x) : y ≥ x} x ∈ . (1.19)

Then −Tn(·) and −ϕ(·) are K-convex, and −ζ(·) is convex. The dynamic program

in (1.19) and (1.18) preserves all the properties (convex one-step cost function and

K-convex value functions ) of the one in Iglehart (1963). So Theorems 1 and 2

(Iglehart 1963) hold in our infinite horizon model. Therefore, an (s, S) policy is

optimal in (1.10).

1.6 Models with Smoothing Costs

In this section, we replace the setup cost in previous sections with smoothing

costs and provide another test of the following conjecture. For a broad class of

cost structures in inventory models, replacing traditional criteria with the dividend

criterion does not change the form of the optimal replenishment policy. Smoothing

costs discourage intertemporal volatility of replenishment quantities and have a

literature dating at least from Beckmann (1961).

Let e+ be the unit cost of increasing replenishment and e− be the unit cost of

decreasing replenishment. So the smoothing cost in period n is

e+ · (zn − zn−1 )+ + e− · (zn−1 − zn )+ .

 20

The present value of the time stream of dividends can be expressed as

∞

∞


B = cx1 − β n cDn + β n−1[wn − p(wn ) − In − (1 − β)cyn
n=1 n=1

− ρ(bn ) − e (zn − zn−1 )+ − e− (zn−1 − zn )+ ]

+
(1.20)

Define e = (e+ + e− )/2 and observe that

e+ − e−
e+ · (zn − zn−1 )+ + e− · (zn−1 − zn )+ = e|zn − zn−1 | + (zn − zn−1 )
2

Proceeding as in Sobel (1969), rearranging and collecting terms in (1.20) yields

∞


B = β n−1 −(1 − β)(In + cyn ) + βγIn + βg(yn, Dn )
n=1
  
e+ − e−
− βp (1 + γ)In + g(yn , Dn ) − ρ(bn ) − e|zn − zn−1 | − (1 − β)2yn
2
 ∞


+ cx1 + w1 − p(w1 ) − β ncDn
n=1

e+ − e− 
∞ 
+ (1 − β)x1 − β n (1 − β)Dn − z0
2 n=1

Let


M(b, I, y) = −(1 − β)(I + cy) + βγI + βE g(y, D) − p[(1 + γ)I + g(y, D)]
e+ − e−
−ρ(b) − (1 − β)2y
2

Therefore,

∞


E(B) = β n−1 E M(bn , In , yn ) − e|zn − zn−1 |
n=1
 ∞


+E cx1 + w1 − p(w1 ) − β n cDn (1.21)
n=1

e+ − e−  N


+ (1 − β)x1 − β n (1 − β)Dn − z0
2 n=1
 21

Since the last two rows of (1.21) depend only on the distribution of demand and

the initial state, we proceed to optimize the first row of (1.21).

As in §1.4, we analyze a finite-horizon counterpart of the infinite-horizon prob-

lem and the former converges to the latter. Henceforth, we optimize the following

objective:

N


sup EH1 { β n−1 [M(bn , In , yn ) − e|zn − zn−1 |]}
n=1

subject to yn ≥ xn , bn + In ≥ 0, and bn ≥ 0 (1.22)

where the supremum is over the set of all policies.

A dynamic programming recursion that corresponds to (1.22) is φ0 (·, ·) ≡ 0

and for each n = 1, 2, · · · , N, x ∈ , and z ≥ 0,

φn (x, z) = sup[Jn (b, I, y) − e|y − x − z| : y ≥ x, I + b ≥ 0, b ≥ 0] (1.23)

Jn (b, I, y) = M(b, I, y) + βE[φn−1(y − D, y − x)] (1.24)

Let bn (x), In (x) and yn (x) be optimal values of b, I and y, respectively, in

(1.23). It can be shown that bn (x) = [−In(x)]+ is optimal as in Proposition 1 in

the setup cost model.

Corollary 1.6.1 For all n = 1, 2, · · · and x ∈ , if the supremum in (1.23) is

achieved, then b = (−I)+ is without loss of optimality.

Using Corollary 1.6.1, (1.23) and (1.24) can be written as follows:


φn (x, z) = sup −e|y − x − z| + sup{Jn (b, I, y) : I + b ≥ 0, b ≥ 0}
y≥x
 22


= sup −e|y − x − z| + hn (y) (1.25)
y≥x

where hn (y) = sup{Jn (b, I, y) : I + b ≥ 0, b ≥ 0}.

The assumption that M(·, ·, ·) is a concave function on its domain 3 leads to the

concavity of hn (·) on y.

Theorem 1.6.2 If M(b, I, y) → −∞ as |y| → ∞ for all (b, y) such that b ≥ 0,

and b + I ≥ 0, then for each n and x, there are numbers un (x) and Un (x) with

un (x) ≤ Un (x) for each x ∈ , such that an optimal policy in (1.25) is

⎧
⎪
⎪ un (x) if x + z < un (x)
⎪
⎪
⎪
⎪
⎪
⎪
⎪
⎪ if un (x) ≤ x + z < Un (x)
⎨x + z
y= (1.26)
⎪
⎪
⎪
⎪ Un (x) if x ≤ Un (x) ≤ x + z
⎪
⎪
⎪
⎪
⎪
⎪
⎩
x if Un (x) < x.

Proof Sketch: It is straightforward to prove inductively that φn (·, ·), Jn (·, ·)

and hn (·) are concave functions on their respective domains because M(·, ·, ·) is

concave. Since concave functions have one-sided derivatives (except possibly at

their boundaries), let hn (·) denote the left-hand derivative of hn (·). Concavity

and a modification of Sobel (1969) leads to the structural result in Theorem 1.6.2.

Moreover,

un (x) = sup{y : hn (y) ≤ e}

Un (x) = sup{y : hn (y) ≤ −e}

 23

and (1.26) corresponds to the following optimal replenishment quantity

⎧
⎪ un (xn ) − xn ,
⎪
⎪
if xn + zn−1 < un (xn )
⎪
⎪
⎪
⎪
⎪
⎪
⎪
⎨ zn−1 , if un (xn ) ≤ xn + zn−1 < Un (xn )
zn =
⎪
⎪
⎪
⎪ U (x ) − xn , if xn ≤ Un (xn ) ≤ xn + zn−1
⎪ n n
⎪
⎪
⎪
⎪
⎪
⎩
0, if Un (xn ) < xn .
Sobel (1971) shows in great detail that finite horizon nonstationary policies

converges to infinite horizon stationary policies in the smoothing costs model.

His method is based on the convexity of the value functions, and can be directly

applied in our model. So the infinite horizon counterparts of (1.22), (1.23), (1.24),

and (1.26) are valid and the following stationary policy is optimal:
⎧
⎪
⎪ u(x) if x + z < u(x)
⎪
⎪
⎪
⎪
⎪
⎪
⎪
⎪ if u(x) ≤ x + z < U(x)
⎨x + z
y= (1.27)
⎪
⎪
⎪
⎪ U(x) if x ≤ U(x) ≤ x + z
⎪
⎪
⎪
⎪
⎪
⎪
⎩
x if U(x) < x
where u(x) = sup{y : h (y) ≤ e}, U(x) = sup{y : h (y) ≤ −e}, and h(y) is the

limit of hn (y) as n → ∞.

1.7 Concluding Remarks

In this paper, we consider periodic review inventory systems where the objective

is to maximize the expected present value of the time stream of dividends. We

consider joint financial and replenishment decisions and examine models with a

setup cost and with smoothing costs by embedding the state variable for working
 24

capital in the replenishment decision variable. This embedding simplifies the

analysis and allows the use of existing stochastic optimization techniques to obtain

qualitative results. In the setup cost case, the proof is not straightforward. In

both cases, the same form of replenishment policy is optimal as when the criterion

is cost minimization.

A generalization that permits dividends to be issued every R periods, where

R is a positive integer, would lead to similar results. The only change would be to

constrain vn = 0 for non-dividend-paying periods n. With these constraints added

to the model, Proposition 1.3.1 and Corollary 1.6.1 remain valid. So Theorems

1.4.3 and 1.6.2 remain essentially unchanged with only minor changes in their

proofs.
Chapter 2

Fill Rate of General Review

Supply Systems

2.1 Introduction

All inventory systems face a difficult tradeoff between inventory costs and cus-

tomer service. The fill rate, the long-run average fraction of demand which is sat-

isfied immediately from on-hand inventory, is perhaps the most important measure

of customer service in professional practice.

There is a literature on formulas for the fill rate under different inventory re-

plenishment policies. Most of it concerns the fill rate in a single-stage system with

a demand process consisting of independent and identically distributed normal

random variables. Johnson et al. (1995) review the literature on approximations

25
 26

for the item fill rate in an uncapacitated single-stage system with normally dis-

tributed demand, develop a new approximation, and evaluate the accuracy via

simulations of several approximations to estimate the exact fill rate.

Sobel (2004), Glasserman and Tayur (1994), and Glasserman and Liu (1997)

consider the fill rate of capacitated periodic review multi-stage supply systems

in which each stage reviews its inventory periodically, and there is a constant

transportation leadtime between stages. Glasserman et al. develop asymptotic

bound and approximations, including diffusion approximations with higher order

correction terms, for fill rate and optimal base-stock levels of multi-stage systems,

whereas the fill rate formulas in Sobel (2004) are exact and the bounds are valid

without asymptotics.

Research on fill rate of periodic review inventory systems usually assumes that

the system reviews its inventory every period. In practice, although customer

demand may arise every period, a firm may not review its inventory and make

ordering (replenishment) decisions every period. For example, consider a retailer

who is supplied by a wholesaler who ships products to the retailer by truck once

a week. Although the retailer might prefer to replenish her inventory daily, she

should reorder goods only shortly before the truck leaves. One may argue that in

this situation, if we define the unit period as one week, the system becomes the

usual periodic review system. Indeed, this is a widely held perception. However,

our results show that the fill rate computed via a rescaled periodic review system
 27

differs from the actual fill rate of the system.

Fill rate expressions are sometimes used to optimize the parameters of an

inventory policy subject to a lower bound on the fill rate induced by the policy.

Many authors consider optimization problems with service level constraints and

most of this literature consists of heuristics and approximations.

Tijms and Groenevelt (1984) consider both periodic review and continuous re-

view (s, S) inventory systems and present a practical approximation for the reorder

point s subject to a fill rate constraint and find that the normal approximation

gives good results for required service levels when the coefficient of variation of

the demand during lead time and review periods does not exceed 0.5.

Silver (1970), Yano (1985), and Platt, Robinson, and Freund (1997) propose

heuristic solutions to fill-rate constrained models using (R, Q) policies. Axsäter

(2003) considers a continuous-review fill-rate constrained serial system with batch

ordering. The system faces a discrete compound Poisson demand process in which

the leadtime demand has a negative binomial distribution. He shows that an

optimal policy consists of a mixed multistage echelon stock (R, nQ) policy with

one of the reorder points varying over time.

Schneider (1978) and Schneider and Ringuest (1990) study service-constrained

models with setup costs, focus on (s, S) policies where the order quantities are

predetermined, and present several approximations to estimate the reorder point

s such that the required service level is achieved. Schneider and Ringuest consider
 28

a periodic review system with a fixed leadtime.

Boyaci and Gallego (2001) and Shang and Song (2003) study a periodic re-

view service-constrained serial inventory system where the leadtime demand for

the end product is Poisson distributed. Their service measure, the limiting prob-

ability of having positive on-hand inventory at the last stage, differs from the fill

rate. Boyaci and Gallego focus on base-stock policies, develop heuristic solutions,

and discuss the relationship between stockout cost and service-constrained models.

Shang and Song study the same model, and develop closed-form heuristics to ap-

proximate optimal base-stock policies for serial service-constrained systems. Our

paper concerns exactly optimal policies for periodic review single-stage models

with general demand distributions.

An important purpose of modeling is to analyze the sensitivity of system per-

formance to various parameters. So fill rate equations are used to analyze the

sensitivity of inventory levels to alternative fill rate goals. In this sense, the role

of fill rate targets is similar to that of stockout costs, but practitioners seem to

prefer fill rate targets. Van Houtum and Zijm (2000) discuss the possible relations

between backorder cost and several types of service contraints. In particular, they

establish the one to one correspondence between backorder cost and modified fill

rate (one minus the ratio of the average backlog at the end of a period and the

mean demand per period) constraint. Chapter 3 of this dissertation show that fill

rate constraints and backorder costs are interchangeable in dynamic newsvendor

 29

models and establish monotone mappings between the set of optimal polices with

backorder costs and the set of optimal policies with fill rate constraints.

The rest of this paper is organized as follows. Section 2.2 introduces the general

review inventory model. A single-stage general review model is considered in §2.3

and §2.4. Section 2.3 provides fill rate formulas for general demand distribution.

Specific fill rate formulas are developed for Gamma and Normal distributions

of demand in §2.4. Section 2.5 discusses the review mechanisms of a multi-stage

system and has the fill rate formulas for general review two-stage systems. Section

2.6 has a formula for the fill rate of a three-stage system. We conclude the paper

in §2.7.

2.2 General Periodic Review System

The following model describes a periodic review N-stage serial system which is

displayed in Figure 2.1. Materials, parts or products can be ordered from any

stage and are then shipped to the next downstream stage. The inventory level

at each stage n is reviewed every Rn periods at which time an order is placed

for additional items, if any. An order for material placed at the beginning of a

review period t with destination stage n arrives at that stage at the beginning of

period t+Ln (Ln and Rn are positive integers.), if sufficient materials are available

at stage n + 1. The outside supplier preceding stage N has ample supplies and

can deliver any order that is placed by stage N. Customer demand for the end
 30

Figure 2.1: The standard N-stage serial inventory system

product arises solely at stage 1 and any excess demand is backlogged. If Rn = 1

(1 ≤ n ≤ N), this general review model is a standard serial multi-stage model.

At the beginning of period t, let xnt denote the number of items that are in

storage at stage n (n = 2, · · · , N; t = 1, 2, · · ·). Let x1t be the analogous quantity

at stage 1 minus the number of items backlogged, if any, at the beginning of period

t. That is, x1t is the on-hand physical inventory if x1t ≥ 0, and −x1t is the amount

of backordered demand if x1t < 0. Let zN t be the number of items purchased from

an outside supplier in period t, and for n < N, let znt be the number of items

that are ordered by stage n and removed from stage n + 1 in period t.

Let Dt be the demand in period t, and let D1 , D2 , · · · be independent, identi-

cally distributed, and nonnegative random variables with distribution function G

and finite mean µ. To avoid trivialities, it is assumed that G(0) < 1. Let G(k) (·)
k
denote the k-fold convolution of G(·), i.e., the distribution function of j=1 Dj ,

and let G0 (a) = 1 (0) if a ≥ (<)0.

The following chronology of events occurs during each time period t:

• The inventory vector (x1t, · · · , xN t) is observed;

• The previously ordered items (z1,t−L1 , · · · , zN,t−LN ) arrive at their respective

 31

stages;

• The order size vector (z1t, · · · , zN t) is chosen;

• Finally, demand at stage 1 occurs.

Let ynt be the inventory at stage n in period t after deliveries of previously ordered

goods but before demand occurs:

y1t = x1t + zt−L1 ; ynt = xnt + zn,t−Ln if n > 1. (2.28)

Because an order cannot exceed the upstream inventory,

0 ≤ znt ≤ yn+1,t if 1 ≤ n ≤ N; 0 ≤ zN t. (2.29)

Notice that znt = 0 if period t is not a review period for stage n. For expository

convenience, let period t with t|R = 0 (where a|b denotes a modulo b when a and

b are integers) be a review period at stage 1. Then an order decision is made at

stage 1 with order size zt units which will be delivered at period t + L1. If t|R
= 0,

z1t = 0. The on-hand inventory that is available to satisfy demand in period t is

(y1t)+ . Because excess demand (if any) is backlogged, the inventory dynamic are

as follows:

x1,t+1 = y1t − Dt ; xn,t+1 = ynt − zn−1,t (1 < n ≤ N). (2.30)

The fill rate, β, is the long run average fraction of demand that can be satisfied

immediately from on-hand inventory. So,

 T 
+
t=1 min{(y1t ) , Dt }
β = lim E T (2.31)
T →∞
t=1 Dt
 32

where (u)+ denote max{u, 0}. The expectation and limit exist in (2.31) for the

base-stock policies that are analyzed in subsequent sections.

2.3 Uncapacitated Single-stage Systems

This section considers an uncapacitated single stage general review system in

which products are ordered from an outside supplier every fixed R periods and

are available to satisfy demand in period t + L (where both R and L are positive

integers). We assume that the system uses a base-stock-level policy. Base-stock

policies have been proved to be optimal for periodic review single-stage system

under general conditions and are very easy to implement in practice (cf. Zipkin

2000 and Porteus 2002). Let τ be the base-stock level, so

z1t = (τ − y1t )+ if t|R = 0 and z1t = 0 otherwise for t = 1, 2, · · ·.

It follows from Lemma 1 in Sobel (2004) that there is no loss of generality

in assuming that initial inventory is never higher than τ , i.e., x11 ≤ τ . As a

consequence, for every t ≥ L,

L+[(t−L)|R]


y1t = τ − Dt−k , for (t − L)|R = 0, 1, · · · , R − 1 (2.32)
k=1

In Sobel (2004), there is an inconsistency between the fill rate definition and

the proof of Theorem 1 . He uses y1t in the fill rate definition [(3) on page 43], but

uses x1t to derive the fill rate formula in the proof of Theorem 1 (line 9, page 44).

However, because of the chronology differences between his model and the present
 33

model, substituting x1t in the proof by y1t of our model results in the same fill

rate formulas. Formulas (4) and (5) in Sobel (2004) remain valid here if R = 1.

The following theorem gives an exact fill rate formula for a general review

single-stage inventory system.

Theorem 2.3.1
 τ
1
β= [G(L)(b) − G(L+R) (b)]db (2.33)
Rµ 0

Proof From (2.31), the fill rate is the long run average fraction of demand that

is met directly from on-hand inventory. So,



T T


+
β = lim E min{(y1t) , Dt }/ Dt
T →∞
t=1 t=1


T T


= lim E [ min{(y1t)+ , Dt }/T ]/[ Dt /T ]
T →∞
t=1 t=1
1 
T 
= lim E min{(y1t)+ , Dt } /T
µ T →∞ t=1
1 
T 
= lim E min{(y1t )+ , Dt } /(T /R)
Rµ T →∞ t=1

R−1 
1


= lim E min{(y1t)+ , Dt } /(T /R)
Rµ T →∞ i=0 t∈{t:(t−L)|R=i}


1

R−1

= lim E min{(y1t)+ , Dt }/(T /R)
Rµ T →∞ i=0 t∈{t:(t−L)|R=i}

 +
Let Hj = t∈{t:(t−L)|R=j} min{(y1t ) , Dt }, j = 0, 1, · · · , R − 1. Using (2.32), for all

j ∈ {0, 1, · · · , R − 1}, it can be shown that

  L+j


lim E[Hj /(T /R)] = E min (τ − Dk )+ , DL+j+1
T →∞
k=1
 L+j


= E DL+j+1 − [DL+j+1 − (τ − Dk )+ ]+
k=1
 34

 L+j


= µ − E [DL+j+1 − (τ − Dk )+ ]+
k=1

Let β(τ ) make explicit the dependence of β on τ . Then

  L+j 
1 R−1

1 R−1



β(τ ) = Hj = µ − E [DL+j+1 − (τ − Dk )+ ]+
Rµ j=0 Rµ j=0 k=1
 
L+j 
1 R−1



= 1− E [DL+j+1 − (τ − Dk )+ ]+
Rµ j=0 k=1

and let K(τ ) = µ[1 − β(τ, L, R)]. So,

  L+j 
1 R−1


+
K(τ ) = E [DL+j+1 − (τ − Dk )+ ]
R j=0 k=1
 ∞ τ
1 R−1


= (a + b − τ )dG(L+j) (b)dG(a)
R j=0 0 τ −a
 ∞  ∞ 
+ a dG(L+j) (b)dG(a)
0 τ
   ∞ τ 
1 R−1


= µ 1 − G(L+j) (τ ) + (a + b − τ )dG(L+j) (b)dG(a)
R j=0 0 τ −a

Leibnitz’ Rule yields

  ∞ τ 
1 R−1
K  (τ ) = − dG(L+j) (b)dG(a)
R j=0 0 τ −a


R−1  τ ∞ 
1
= − dG(a)dG(L+j) (b)
R j=0 0 τ −b
R−1

  τ   
1 (L+j)
= G(τ − b) − 1 dG (b)
R j=0 0

1

R−1 
= G(L+j+1) (τ ) − G(L+j) (τ )
R j=0
1  (L+R) 
= G (τ ) − G(L) (τ )
R

Since β(0) = 0, K(0) = µ[1 − β(0)]. Therefore,

β(τ ) = 1 − K(τ )/µ

 35

 τ
= 1 − [K(0) + K (a)da]/µ
0
 τ
1
= [G(L) (b) − G(L+R) (b)]db.
Rµ 0

Theorem 2.3.1 characterizes the dependence of the system fill rate on the base-

stock level (τ ), demand distribution (G), review period (R), and leadtime (L).

2.4 Gamma and Normal Demand in Single-stage

Systems

This subsection specializes (2.33) for the gamma distribution and the normal

distribution.

2.4.1 Gamma Demand Distribution

Let Γ(j, λ) denote the sum of j independent, identically distributed random vari-

ables, each one exponential with parameter λ, i.e., Γ(j, λ) is a gamma random

variable with parameters j and λ. If D is Γ(γ, λ) where γ is a positive integer,

then µ = E(D) = γ/λ, V ar(D) = γ/λ2 , the probability density function of D is

λe−λa (λa)γ−1
Γ(γ)

and the distribution function of D is

γ−1


G(a) = P (D ≤ a) = 1 − e−λa (λa)j /j!
j=0
 36

Consequently, G(L) and G(L+R) are Γ(Lγ, λ) and Γ[(L + R)γ, λ], respectively. So,

Lγ−1


G(L) (a) = 1 − e−λa (λa)j /j!
j=0

(L+R)γ−1


G(L+R) (a) = 1 − e−λa (λa)j /j!
j=0

It follows from (2.33) that

 τ (L+R)γ−1

Lγ−1


1
β = e−λa(λa)j /j! − e−λa(λa)j /j! da
Rµ 0 j=0 j=0
 τ (L+R)γ−1


λ
= e−λa (λa)j /j! da
Rγ 0 j=Lγ
(L+R)γ−1  τ  
1

= λe−λa (λa)j /j! da
Rγ j=Lγ 0

Therefore,
(L+R)γ
1

β= P {Γ(j, λ) ≤ τ } (2.34)
Rγ j=Lγ+1

2.4.2 Normal Demand Distribution

Many researchers investigate the fill rate of an inventory system with normally

distributed demands. In order to compare our results with others, we analyze the

general review inventory systems when demand (D) is normally distributed with

mean µ and variance σ 2 > 0.

Let Φ(·) and φ(·) denote the distribution and density function, respectively,

of a standard normal random variable (with mean 0 and variance 1), and let
√
b(a, j) = (a − jµ)/(σ j). The normality and independence of demand imply
 37

that sums of demands are normally distributed; that is, G(S) (a) = Φ[b(a, S)] for

S ∈ I + . So, formula (2.33) yields

1  τ
β = Φ[b(a, L)] − Φ[b(a, L + R)] da
Rµ 0
 √  b(τ,L) √  b(τ,L+R) 
1
= σ L Φ(x)dx − σ L + R Φ(x)dx (2.35)
Rµ b(0,L) b(0,L+R)

The evaluation of the integral in (2.35) exploits the following equation (Hadley

and Whitin 1963; Sobel 2004; Zipkin 2000).

 ∞
[1 − Φ(x)]dx = φ(t) + tΦ(t) − t
t

This equation implies

 s
Φ(x)dx = φ(s) − φ(t) + sΦ(s) − tΦ(t). (2.36)
t

Using (2.36) in (2.35) yields the following equation for the fill rate that uses only

the standard normal density and tabulated standard normal distribution function:

 
1 √
β = σ L φ[b(τ, L)] − φ[b(0, L)] + b(τ, L)Φ[b(τ, L)] − b(0, L)Φ[b(0, L)]
Rµ 
√
− σ L + R φ[b(τ, L + R)] − φ[b(0, L + R)]

+ b(τ, L + R)Φ[b(τ, L + R)] − b(0, L + R)Φ[b(0, L + R)]
√  
1 √
= σ L φ[b(τ, L)] − Φ[b(0, L)] − σ L + R φ[b(τ, L + R)] − φ[b(0, L + R)]
Rµ

+ (τ − Lµ) Φ[b(τ, L)] − Φ[b(τ, L + R)]
  
+ R Φ[b(τ, L + R)] + L Φ[b(0, L)] − (L + R)Φ[b(0, L + R)] . (2.37)

Another deviation of 2.37 uses the following formula:

 b
xφ(x)dx = φ(a) − φ(b). (2.38)
a
 38

Figure 2.2: The Fill Rate Integral for a system with Normal Demand

Write the integral in (2.35) as

 τ  b(a,L)  b(a,L+R) 
1
β= φ(x)dx − φ(x)dx da
Rµ 0 −∞ −∞

whose integrand in the a − x plane covers the area in the northeast and southeast

quadrants depicted in Figure 2.2 and bounded by the lines a = 0, a = τ , x =

b(a, L), and x = b(a, L + R). As shown in Figure 2.2 , this area is the union of

three sets in the a − x plane. Interchanging the order of integrations, employing

formula (2.38), and integrating A1, A2, and A3 individually leads to the same fill

rate expression as (2.37).

 39

2.4.3 Fill Rate Approximation for Normal Demand Dis-

tribution

Although (2.37) can be calculated easily, the following simple approximation yields

valuable insights:

√
1
βA = − σ L + Rφ[b(τ, L + R)]
Rµ
 
+ (τ − Lµ) 1 − Φ[b(τ, L + R)] + RΦ[b(τ, L + R)] (2.39)

Approximation (2.39) is derived from (2.37) by observing from Figure 2.2 that

φ[b(0, L)]  0, φ[b(τ, L)]  0, φ[b(0, L+R)]  0, Φ[b(τ, L)]  1, Φ[b(0, L+R)]  0,

and Φ[b(0, L)]  0. Our numerical results show that the fill rate approximation

(2.39) is very accurate when τ ≥ (L + R)µ. The numerical comparisons are shown

in Table 2.1.

Table 2.1 use the same normal demand distribution as Table 1 in Sobel (2004),

compute the exact value and approximation of the fill rate in a general review

single-stage system with µ = 2000 and L + R = 5. The last columns of the tables

report the absolute error (100%) of fill rate and its approximation.

In summary, we have the following observations:

• The fill rate increases as the variance (σ 2) goes down or base-stock level (τ )

goes up.

• In general, shorter leadtime yields higher fill rate if L + R is fixed.

 40

• The approximation performs better when the demand coefficient of variation

(σ/µ) decreases. There are three cases (with high variance, long leadtime) in

our example that cause large errors, but the errors diminish when base-stock

level increases.

2.5 Multi-Stage General Review Systems

An echelon base-stock policy is optimal for a periodic-review multi-stage systems

with linear inventory holding costs at all stages and linear backorder costs at stage

one (Clark and Scarf 1960, Federgruen and Zipkin 1984). It is quite natural to use

echelon base-stock policies in our general review systems. To clearly understand an

echelon base-stock policy, it is useful to define the following echelon variables(cf.

Clark and Scarf 1960):

• echelon inventory level of a stage is the inventory on hand at this stage plus

inventories at or in transit to all its downstream successor stages minus total

customer backorder at the lowest stage.

• echelon inventory position of stage is the sum of echelon inventory level at

this stage and inventory in transit to the stage.

sbnt = the (beginning) echelon inventory level at stage n before any order is

received
 41

abnt = the (beginning) echelon inventory position at stage n before any order

is placed

snt = echelon inventory level at stage n

snt = the echelon inventory position at stage n before demand occurs.

The evolution of the system and dynamics of these echelon variables can be

specified as:

Ln


abnt = sbnt + zn,t−k ant = abnt + znt snt = sbn,t + zn,t−Ln (2.40)
k=1

and

abn,t+1 = ant − Dt sbn,t+1 = snt − Dt (2.41)

The first expression in (2.40) can be written

L

n −1

ant = snt + zn,t−k

k=0

The formulation in installation variables xnt , ynt , and znt is equivalent to a

formulation in echelon variables because xnt = ynt − znt, ynt = snt − an−1,t (let
Ln −1
s0t = a0t = 0), and znt = ant − k=1 zn,t−k − snt . Because s1t = y1t, (2.31) can

be written
 T 
t=1 min{(s1t)+ , Dt }
β = lim E T (2.42)
T →∞
t=1 Dt

The constraints on the order quantities (2.29) correspond to

s1t ≤ a1t ≤ s2t ≤ · · · ≤ sN t ≤ aN t. (2.43)

 42

An echelon base-stock policy depends on echelon base-stock levels τ1 , · · · , τN

and can be expressed as: If period t is a review period, aN t = max{abN t, τN } and

for n < N, ⎧
b
⎪
⎨ ant if τn ≤ abnt
ant = (2.44)
⎪
⎩
min{τn , sn+1,t } otherwise,
and ant = abnt if period t is not a review period for all n ≤ N. The order quantity

specified by (2.44) is znt = min{(τn − abnt )+ , (sn+1,t − abnt)+ } if t is a review period,

and znt = 0 otherwise.

The subsequent sections discuss the fill rate of general review two-stage and

three-stage supply systems.

2.5.1 Fill Rate in Two-Stage Systems

This subsection considers a two-stage general review system in which both stages

have the same review intervals (R1 = R2 = R) and order leadtimes are L1 = L

and L2 = 1. Based on the review procedure, if t is a review period, then t − 1 is a

review period for stage two. Both stages have the same length of review intervals.

We are interested in this system because it is very similar to the single-stage

system; in essence, the only difference is that the order quantity in stage one at

a review period is constrained by the inventory at stage two. We shall explicitly

characterize the relationship between the echelon inventory level at stage one and

base-stock levels τ1 and τ2 for stage one and 2, respectively. It is without loss

of generality to assume that the initial echelon inventory positions are no higher
 43

than the echelon base-stock levels (cf. Sobel 2004, page 47):

At the beginning of each period t, abnt , sbnt for n = 1, 2, z2,t−1, and z1,t−k for

k = 1, · · · , L are known. In fact, there are at most Ln /R ( a/b is the minimum

integer that is greater than or equal to a/b ) outstanding orders that in transit to

stage n for any period t.

Suppose t is a review period at stage two and R > 1. Since R > 1, stage

one does not place an order in period t. Then a2t = τ2 , s2t = sb2t, a1t = ab1t, and

s1t = sb1t + zt−L. When demand Dt occurs at stage one, period t + 1 is not a review

period for stage two, so ab2,t+1 = sb2,t+1 = τ2 −Dt = s2,t+1 (order has been received).

Period t + 1 is a review period for stage one, ab1,t+1 = ab1,t − Dt , sb1,t+1 = s1t − Dt ,

and because of ordering, a1,t+1 = min{τ1 , s2,t+1}. Order quantity will be delivered

L period later, until then the changes of echelon inventory level (s1t) depend only

on the period demand and the orders in transit to stage one.

The following result is consistent with comments in several papers [e.g. Cheng

and Zheng (1994, §3.1), Federgruen and Zipkin (1984)]

Lemma 2.5.1

L


s1t = a1,t−L − Dt−k
k=1

Proof

L−1


s1t = a1t − zt−k
k=0
L−1


= a1t − (a1,t−k − ab1,t−k−1 )
k=0
 44


L−1 
= a1t − a1,t−k − (a1,t−k−1 − Dt−k−1 )
k=0
L


= a1,t−L − Dt−k
k=1

Lemma 2.5.1 states that the echelon inventory level at stage one in period t is

equal to its echelon inventory position in period t − L minus the preceding L

periods’ demands.

As a consequence [similar to the derivation of (2.32)], s1t for any period t can

be expressed explicitly. It is without loss of generality to assume that stage one

reviews its inventory at period t when t|R = 0. Let ∆ = τ2 − τ1 .

Lemma 2.5.2 For any t ≥ L,

L+(t−L)|R


s1t = τ1 + min{0, ∆ − Dt−[L+(t−L)|R]−1 } − Dt−k (2.45)
k=1

Proof At t = L, then (t − L)|R = 0, and a2,L−1 = τ2 because stage two reviews

its inventory one period ahead of stage one. Lemma 2.5.1 assures

L


s1L = a1,L − Dt−k
k=1
L


= min{τ1 , τ2 − DL−1 } − Dt−k
k=1
L+0


= τ1 + min{0, ∆ − DL−0−1 } − Dt−k
k=1

So (2.45) is valid at t = L and initiates an inductive proof of (2.45).

Assume that (2.45) is valid at t and note that

s1,t+1 = s1,t − Dt + zt+1−L

 45

If (t + 1 − L)|R = 0, then an order placed at period t + 1 − L is delivered to

stage one at period t + 1, applying Lemma 2.5.1 again,

L


s1,t+1 = a1,t+1−L − Dt+1−k
k=1
L


= min{τ1 , τ2 − Dt+1−L−1 } − Dt+1−L−k
k=1
L+(t+1−R)|R


= τ1 + min{0, ∆ − Dt+1−[L+(t+1−L)|R]−1 } − Dt+1−k
k=1

If (t + 1 − L)|R
= 0, then zt+1−L = 0, (t + 1 − L)|R = (t − L)|R + 1, so

s1,t+1 = s1,t − Dt
L+(t−L)|R


= τ1 + min{0, ∆ − Dt−[L+(t−L)|R]−1 } − Dt−k − Dt
k=1
L+(t+1−R)|R−1


= τ1 + min{0, ∆ − Dt−[L+(t+1−L)|R−1]−1 } − Dt−k − Dt
k=1
L+(t+1−R)|R


= τ1 + min{0, ∆ − Dt+1−[L+(t+1−L)|R]−1 } − Dt+1−k
k=1

Lemma 2.5.2 leads to a relatively simple fill rate formula. Notice that expres-

sion (2.32) is a special case of (2.45) by letting ∆ = ∞.

Theorem 2.5.3

1  τ1  
β = G(∆) G(L)(a) − G(L+R) (a)
Rµ 0
 ∞  
+ G(L) (a + ∆ − c) − G(L+R) (a + ∆ − c) dG(c) da (2.46)
∆

Proof From (2.31), the fill rate is the long run average fraction of demand that

is met directly from on-hand inventory. So,



T T


+
β = lim E min{(s1t) , Dt }/ Dt
T →∞
t=1 t=1
 46



T T


= lim E [ min{(s1t )+ , Dt }/T ]/[ Dt /T ]
T →∞
t=1 t=1
1 
T 
= lim E min{(s1t )+ , Dt } /T
µ T →∞ t=1
1 
T 
= lim E min{(s1t)+ , Dt } /(T /R)
Rµ T →∞ t=1

R−1 
1


= lim E min{(s1t)+ , Dt } /(T /R)
Rµ T →∞ i=0 t∈{t:(t−L)|R=i}


1

R−1

= lim E min{(s1t)+ , Dt }/(T /R)
Rµ T →∞ i=0 t∈{t:(t−L)|R=i}

 +
Let Hj = t∈{t:(t−L)|R=j} min{(s1t ) , Dt }, j = 0, 1, · · · , R− 1. Using (2.45) and

noticing that the demand variables are independent,

  L+j+1

+ 
lim E[Hj /(T /R)] = E min τ1 + min{0, ∆ − D1 } − Dk , DL+j+2
T →∞
k=2

For all j ∈ {0, 1, · · · , R − 1}, it can be shown that

  L+j+1

+ 
β(Hj ) = E min τ1 + min{0, ∆ − D1 } − Dk , DL+j+2
k=2
  L+j+1


+ +
= E DL+j+1 − DL+j+2 − [τ1 + min{0, ∆ − D1 } − Dk ]
k=2
 L+j+1


+ + +
= 1−E DL+j+2 − [τ1 − (D1 − ∆) − Dk ]
k=2

Let β(τ1 , ∆) make explicit the dependence of β on τ1 and ∆. Then


1 R−1 
β(τ1, ∆) = β(Hj )
Rµ j=0
 L+j+1 + 
1 R−1



= 1 − E DL+j+2 − [τ1 − (D1 − ∆)+ − Dk ]+
Rµ j=0 k=2

Let K(τ1 , ∆) = µ[1 − β(τ1, ∆)]. So,

 L+j+1 + 
1 R−1



K(τ1 , ∆) = E DL+j+2 − [τ1 − (D1 − ∆)+ − Dk ]+
R j=0 k=2
 47

  τ1 +∆−c  ∞
1 R−1

∞
=
R j=0 ∆ 0 τ1 +∆−b−c

(a + b + c − τ1 − ∆)dG(L+j+2) (a)dG(L+j) (b)dG(c)

 ∞ ∞  ∞
+ a dG(L+j+2) (a)dG(L+j) (b)dG(c)
∆ τ1 +∆−c 0
 ∆  τ1  ∞
+ (a + b − τ1 ) dG(L+j+2) (a)dG(L+j) (b)dG(c)
0 0 τ1 −b 
 ∆ ∞ ∞
+ a dG(L+j+2) (a)dG(L+j) (b)dG(c)
0 τ1 0

Leibnitz’ Rule yields

  τ1 +∆−c  ∞
∂K(τ1 , ∆) 1 R−1

∞
= − dG(L+j+2) (a)dG(L+j) (b)dG(c)
∂τ1 R j=0 ∆ 0 τ1 +∆−b−c
 ∞ ∞
+ a dG(L+j+2) (a)g (L+j) (τ1 + ∆ − c)dG(c)
∆ 0
 ∞ ∞
+ −a dG(L+j+2) (a)g (L+j) (τ1 + ∆ − c)dG(c)
∆ 0
 ∆  τ1  ∞
+ − dG(L+j+2) (a)dG(L+j) (b)dG(c)
0 0 τ1 −b
 ∆ ∞
+ a dG(L+j+2) (a)g (L+j) (τ1 )dG(c)
0 0 
 ∆ ∞
(L+j)
+ −a dG(L+j+2) (a)g (τ1 )dG(c) (2.47)
0 0

Notice that the sum of the second and third lines in (2.47) is zero and the sum of

the fifth and sixth lines is zero. Further simplifying (2.47),

  τ1 +∆−c  ∞
∂K(τ1, ∆) 1 R−1

∞
= −dG(L+j+2) (a)dG(L+j) (b)dG(c)
∂τ1 R j=0 ∆ 0 τ1 +∆−b−c
 ∆  τ1  ∞
+ − dG(L+j+2) (a)dG(L+j) (b)dG(c)
0 0 τ1 −b

1
 ∞  τ1 +∆−c 
R−1 
= G(L+j+2) (τ1 + ∆ − b − c) − 1 dG(L+j) (b)dG(c)
R j=0 ∆ 0
 ∆  τ1  
+ G(L+j+2) (τ1 − b) − 1 dG(L+j) (b)dG(c)
0
0 
1 R−1

∞  
= G(L+j+1) (τ1 + ∆ − c) − G(L+j) (τ1 + ∆ − c) dG(c)
R j=0 ∆
 48

 ∆ 

(L+j+1) (L+j)
+ G (τ1) − G (τ1 ) dG(c)
0

1
 ∞
R−1  
= G(L+j+1) (τ1 + ∆ − c) − G(L+j) (τ1 + ∆ − c) dG(c)
R j=0 ∆

 
(L+j+1) (L+j)
+G (τ1 ) − G (τ1 ) G(∆)


1 ∞ 
= G(L+R) (τ1 + ∆ − c) − G(L) (τ1 + ∆ − c) dG(c)
R ∆

 
(L+R) (L)
+G (τ1) − G (τ1 ) G(∆) (2.48)

Similarly, it is straightforward to show that for all ∆ ≥ 0, K(0, ∆) = µ.

Therefore,

β(τ1, ∆) = 1 − K(τ1 , ∆)/µ

  τ1
∂K(a, ∆) 
= 1 − K(0, ∆) + da /µ
0 ∂a
 τ1
∂K(a, ∆)
= − da/µ
0 ∂a
  τ1  
1
= G(∆) G(L) (a) − G(L+R) (a) da
Rµ 0
 τ1  ∞   
+ G(L) (a + ∆ − c) − G(L+R) (a + ∆ − c) dG(c)da
0 ∆

2.5.2 Fill Rate in Two-Stage Systems with General Lead-

time

The formula for a two-stage general review system with a single period leadtime

in stage two can be easily extended to a two-stage general review system in which

the review intervals are R1 = R2 = R and order leadtimes are L1 and L2 . We use

the following review procedure which is bases on complete information-sharing

between stages 1 and 2: if t is a review period, then t − L2 is a review period for

 49

stage two. Both stages have the same length of review intervals.

Lemma 2.5.1 still holds for this general two-stage system. We give the following

lemma to express the echelon inventory level at stage one.

Lemma 2.5.4 For any t ≥ L1 + L2,

 L2 L1 +(t−L1 )|R



s1t = τ1 + min 0, ∆ − Dt−[L ]−k − Dt−k (2.49)
1 +(t−L1 )|R
k=1 k=1

The proof of Lemma 2.5.4 is similar to that of Lemma 2.5.2 except that the order

placed by stage two has L2 delay before it can be used to satisfy stage one’s order.
L2
Replacing D1 and G(c) by k=1 Dk and G(L2 ) (c), respectively, in the proof of

Theorem 2.5.3 yields the next result.

Theorem 2.5.5

 τ1   
1
β = G(L2 )(∆) G(L1 ) (a) − G(L1 +R) (a)
Rµ 0
 ∞  
+ G(L1 )(a + ∆ − c) − G(L1 +R) (a + ∆ − c) dG(L2 ) (c) da (2.50)
∆

In what follows, we present an alterative formula for (2.50) using the single

stage fill rate formulas. Let β1(τ, L) be the fill rate of a single stage system

with review period R, base-stock level τ , and order leadtime L. We introduce

incomplete convolutions (cf. van Houtum et al. 1996). Let G(k) be the distribution
k
functions of j=1 . Let δ > 0 and define
⎧
(k)
⎪
⎨ G (x + δ) if x ≥ 0
(k)
Gδ (x) =
⎪
⎩
0 if x < 0,
 50

[m,n]
The incomplete convolution, denoted Gδ , is

 δ
[m,n]
Gδ (x) = G(m) (δ + x − u)dG(n) (u).
0

[m,n]
note that G0 (x) = G(m+n) (x)

Corollary 2.5.6


1
β = G(L2 ) (∆)β1(τ1 , L1 ) + β1(τ1 + ∆, L1 + L2 ) − β1 (∆, L1 + L2 )
Rµ
 τ1  
[L1 ,L2 ] [L +R,L2 ]
− G∆ (a) − G∆ 1 (a) da (2.51)
0

Proof Rewriting (2.50) and using (2.33),

  τ1  ∞  
1
β = G(L1 ) (a + ∆ − c) − G(L1 +R) (a + ∆ − c) dG(L2 ) (c)da
Rµ 0 ∆
 τ1   
(L2 ) (L1 ) (L1 +R)
+G (∆) G (a) − G (a) da
0
  τ1  a+∆  
1
= G(L1 )(a + ∆ − c) − G(L1 +R) (a + ∆ − c) dG(L2 )(c)da
Rµ 0 ∆

+G(L2 ) (∆)β1(τ1 , L1 )

1  τ1  a+∆  (L1 ) 
= G (a + ∆ − c) − G(L1 +R) (a + ∆ − c) dG(L2 )(c)da
Rµ 0 0
 τ1  ∆  
− G(L1 ) (a + ∆ − c) − G(L1 +R) (a + ∆ − c) dG(L2 ) (c)da
0 0

(L2 )
+G (∆)β1(τ1 , L1 )
  τ1  
1
= G(L1 +L2 ) (a + ∆) − G(L1 +L2 +R) (a + ∆) da
Rµ 0
 τ1  
[L ,L ] [L +R,L2 ] (L2 )
− [G∆ 1 2 (a) − G∆ 1 (a) da + G (∆)β1(τ1 , L1 )
0
  τ +∆  
1 1
= G(L1 +L2 ) (u) − G(L1 +L2 +R) (u) du
Rµ ∆
 τ1  
[L ,L ] [L +R,L2 ] (L2 )
− [G∆ 1 2 (a) − G∆ 1 (a) da + G (∆)β1(τ1 , L1 )
0
  τ1 +∆  
1
= G(L1 +L2 ) (u) − G(L1 +L2 +R) (u) du
Rµ 0
 51

 ∆  
− G(L1 +L2 ) (u) − G(L1 +L2 +R) (u) du
0
 τ1  
[L ,L2 ] [L +R,L2 ]
− [G∆ 1 (a) − G∆ 1 (a) da + G(L2 )(∆)β1(τ1 , L1 )
0

1
= G(L2 ) (∆)β1(τ1 , L1 ) + β1(τ1 + ∆, L1 + L2 ) − β1(∆, L1 + L2 )
Rµ
 τ1  
[L1 ,L2 ] [L +R,L2 ]
− G∆ (a) − G∆ 1 (a) da (2.52)
0

2.5.3 Numerical Example

It is clear from (2.50) that the fill rate of a two-stage general review system depends

on R, L, τ1 , ∆ (τ2 ), and G(·). However, it is not easy to reveal the dependences.

Therefore, we perform another set of numerical study on (2.50) to illustrate their

relationships. In this study, demand is normally distributed with µ = 10.

We make the following observations from Tables 2.2 and 2.3:

• The fill rate increases as variance goes down, and as echelon base-stock level

at stage one goes up.

• The fill rate decreases as leadtime at stage one and stage two increase.

• The fill rate increases as echelon base-stock level at stage two increases.

2.6 Fill Rate in a Three-Stage System

This section considers a three-stage general review system in which the review

interval is the same at each stage (R1 = R2 = R3 = R) and order leadtimes are
 52

L1 , L2 , and L3 . Based on the review procedure, if t is a review period at stage

one, then t − L2 is a review period at stage two, and t − L2 − L3 is a review

period at stage three. We assume that an echelon base-stock policy with echelon

base-stock levels τ1 , τ2 , and τ3 is used. Let ∆1 = τ2 − τ1 and ∆2 = τ3 − τ2 .

Lemma 2.6.1 For any t ≥ L1 + L2 + L3 ,

  L3


s1t = τ1 + min 0, ∆1 + min 0, ∆2 − Dt−[L ]−L2 −k
1 +(t−L1 )|R
k=1
L2

 L1 +(t−L1 )|R


− Dt−[L ]−k − Dt−k (2.53)
1 +(t−L1 )|R
k=1 k=1

Proof sketch: Suppose t is a review period at stage one. Then the echelon

position is

L2


a1t = min{τ1 , s2t } = min{τ1 , a2,t−L2 − Dt−k }
k=1
 L2


= min τ1 , min{τ2 , s3,t−L2 } − Dt−k
k=1

L3 L2


= min τ1 , min{τ2 , a3,t−L2 −L3 − Dt−L2 −k } − Dt−k
k=1 k=1
 L3

L2


= min τ1 , min{τ2 , τ3 − Dt−L2 −k } − Dt−k
k=1 k=1
 L3

L2


= min τ1 , τ2 + min{0, ∆2 − Dt−L2 −k } − Dt−k
k=1 k=1
 L3

L2


= τ1 + min 0, ∆1 + min{0, ∆2 − Dt−L2 −k } − Dt−k .
k=1 k=1

Lemma 2.5.1 yields,

L1


s1t = a1,t−L1 − Dt−k .
k=1

An inductive proof similar to that of Lemma 2.5.2 results in (2.53).

 53

Theorem 2.6.2

 τ1
 ∞  ∞ 
1
β = G(L1 )(a + ∆1 + ∆2 − c − e)
Rµ 0 ∆2 ∆1 +∆2 −e

−G(L1 +R) (a + ∆1 + ∆2 − c − e) dG(L2 ) (c)dG(L3 )(e)
  ∞
(L1 ) (L1 +R)
+G (a) − G (a) G(L2 ) (∆1 + ∆2 − e)dG(L3 ) (e)
∆2
 ∞ 
(L3 )
+G (∆2) G(L1 )(a + ∆1 − c) − G(L1 +R) (a + ∆1 − c) dG(L2 ) (c)
∆1 
 
(L1 ) (L1 +R) (L2 ) (L3 )
+G (a) − G (a) G (∆1)G (∆2 ) da. (2.54)

Proof From (2.31),



T T


β = lim E min{(s1t)+ , Dt }/ Dt
T →∞
t=1
t=1 
1

R−1

= lim E min{(s1t)+ , Dt }/(T /R)
Rµ T →∞ i=0 t∈{t:(t−L)|R=i}

 +
Let Hj = t∈{t:(t−L)|R=j} min{(s1t ) , Dt }, j = 0, 1, · · · , R − 1, use (2.53), and

notice that the demand random variables are independent. Let D(j) have the
j
distribution of k=1 Dk . Then limT →∞ E[Hj /(T /R)] is equal to

 
 
(L3 ) (L2 ) (L1 +j) +
E min τ1 + min 0, ∆1 + min {0, ∆2 − D }−D −D ,D

For all j ∈ {0, 1, · · · , R − 1}, it can be shown that

 + 
  + 
(L3 ) + (L2 ) (L1 +j) +
β(Hj ) = 1 − E D − τ1 − [D − ∆2 ] + D − ∆1 −D

Let β(τ1 , ∆1, ∆2) make explicit the dependence of β on τ1 , ∆1, and ∆2. Then


1 R−1 
β(τ1, ∆1, ∆2) = β(Hj )
Rµ j=0
 54

Let K(τ1 , ∆1 , ∆2) = µ[1 − β(τ1 , ∆1, ∆2)]. So,

K(τ1 , ∆1 , ∆2)

 
1 R−1

  + + +
(L3 ) + (L2 ) (L1 +j)
= E D − τ1 − [D − ∆2 ] + D − ∆1 −D
R j=0


1 R−1

∞ ∞  τ1 +∆1 +∆2 −e−c  ∞
=
R j=0 ∆2 ∆1 +∆2 −e 0 τ1 +∆1 +∆2 −e−c−b

(a + b + c + e − τ1 − ∆1 − ∆2 )dG(a)dG(L+j)(b)dG(L2) (c)dG(L3)(e)
 ∞ ∞  ∞  ∞
= adG(a)dG(L1+j) (b)dG(L2) (c)dG(L3)(e)
 ∆∞2  ∆∆11+∆2 −e τ1 +∆1 +∆2 −e−c 0
+∆2 −e  τ1  ∞
+ (a + b − τ1 )dG(a)dG(L1+j) (b)dG(L2) (c)dG(L3) (e)
∆∞
2
0 ∆1 +∆2 −e  0 τ1 −b
∞ ∞
+ adG(a)dG(L1+j) (b)dG(L2)(c)dG(L3) (e)
∆∆2 2 0 ∞  τ1 +∆1τ−c
1
 0∞
+
0 ∆1 0 τ1 +∆1 −c−b

(a + b + c − τ1 − ∆1 )dG(a)dG(L1+j) (b)dG(L2) (c)dG(L3) (e)

 ∆2  ∞  ∞  ∞
+ adG(a)dG(L1+j) (b)dG(L2) (c)dG(L3) (e)
0 ∆1 τ1 +∆1 −c 0
 ∆2  ∆1  τ1  ∞
+ (a + b − τ1 )dG(a)dG(L1+j) (b)dG(L2) (c)dG(L3) (e)
0 0 0 τ1 −b 
 ∆2  ∆1  ∞ ∞
(L1+j) (L2) (L3)
+ adG(a)dG (b)dG (c)dG (e)
0 0 τ1 0

Leibnitz’ Rule yields

∂K(τ1 , ∆1, ∆2)

∂τ1

 ∞ ∞  τ1 +∆1 +∆2 −e−c  ∞

1 R−1


= −
R j=0 ∆2 ∆1 +∆2 −e 0 τ1+∆1 +∆2 −e−c−b

dG(a)dG(L+j) (b)dG(L2 ) (c)dG(L3 )(e)

 ∞  ∆1 +∆2 −e  τ1  ∞
− dG(a)dG(L1 +j) (b)dG(L2 ) (c)dG(L3 ) (e)
∆2 0 0 τ1 −b
 ∆2  ∞  τ1 +∆1 −c  ∞
− dG(a)dG(L1 +j) (b)dG(L2 ) (c)dG(L3 ) (e)
0 ∆1 0 τ1 +∆1 −c−b 
 ∆2  ∆1  τ1  ∞
(L1 +j) (L2 ) (L3 )
− dG(a)dG (b)dG (c)dG (e)

0 0
 ∞
0 τ1 −b
1 ∞ 
= G(L1 +R) (τ1 + ∆1 + ∆2 − c − e)
R ∆2 ∆1 +∆2 −e
 55


−G(L1 ) (τ1 + ∆1 + ∆2 − c − e) dG(L2 ) (c)dG(L3 ) (e)
 ∞
+[G(L1 +R) (τ1 ) − G(L1 ) (τ1 )] G(L2 ) (∆1 + ∆2 − e)dG(L3 ) (e)
∆2
 ∞ 
+G(L3 ) (∆2) G(L1 +R) (τ1 + ∆1 − c) − G(L1 ) (τ1 + ∆1 − c) dG(L2 ) (c)
∆1 
 
G(L1 +R) (τ1 ) − G(L1 ) (τ1 ) G(L2 ) (∆1)G(L3 ) (∆2 ) (2.55)

It is straightforward to show that K(0, ∆1 , ∆2) = µ. Therefore,

β(τ1, ∆1, ∆2) = 1 − K(τ1 , ∆1 , ∆2)/µ

  τ1
∂K(a, ∆1, ∆2) 
= 1 − K(0, ∆1 , ∆2) + da /µ
0 ∂a
 τ1
1 ∂K(a, ∆1, ∆2)
= − da.
R 0 ∂a

Using (2.55), yields (2.54)

[m,n,q] [m,n,q]
An alternate to (2.54) uses (2.33) and (2.50). Let Gδ1 ,δ1+δ2 and Gδ1 ,δ2 be the

following three-fold incomplete convolutions:

 δ1  δ1 +δ2 −v
[m,n,q]
Gδ1 +δ2 ,δ1 (x) = G(m) (δ1 + δ2 + x − v − u)dG(n) (u)dG(q) (v);
0 0
 δ1  δ2
[m,n,q]
Gδ2 ,δ1 (x) = G(m) (δ1 + δ2 + x − v − u)dG(n) (u)dG(q) (v).
0 0

Corollary 2.6.3

1
β = G(L3 )(∆2 )β2(τ1 , ∆1, L1 , L2 )
Rµ
 
[L ,L3
+β1(τ1 , L1 ) G(L2 +L3 ) (∆1 + ∆2) − G∆22 (∆1)

+β1(τ1 + ∆1 + ∆2, L1 + L2 + L3 ) − β1(∆1 + ∆2 , L1 + L2 + L3 )

 τ1 
[L1 +L2 ,L3 ] [L +L2 +R,L3 ]
− G∆2 (a + ∆1) − G∆21 (a + ∆1)
0

[L ,L ,L ] [L +R,L ,L ] [L ,L ,L ] [L +R,L ,L ]
−Gδ1 1+δ23,δ1 2 (a) + Gδ1 1+δ2 ,δ1 3 2 (a) − Gδ2 ,δ1 1 3 2 (a) + Gδ2 ,δ1 1 3 2 (a) da

The proof of Corollary 2.6.3 is similar to that of Corollary 2.5.6 and is omitted.
 56

2.7 Conclusion

This paper develops formulas for the fill rates of single-stage and multi-stage

supply systems that use base-stock-level policies and have general review intervals.

We provide fill rate formulas for a single-stage general review system and general

distributions of demand. When demand is normally distributed, an exact fill

rate expression uses only the standard normal distribution function and density

function. For the general review multi-stage systems, we first discuss how each

stage reviews its inventory and provide a general approach to compute the system

fill rate.
 57

σ σ/µ τ R L β βA %Error
200 0.1 11000 1 4 0.999014 0.999014 0
200 0.1 11000 2 3 0.999507 0.999507 0
200 0.1 11000 3 2 0.999671 0.999671 0
200 0.1 11000 4 1 0.999754 0.999754 0
1000 0.5 11000 1 4 0.789395 0.760095 2.93
1000 0.5 11000 2 3 0.880264 0.880047 0.0217
1000 0.5 11000 3 2 0.919869 0.920032 0.0163
1000 0.5 11000 4 1 0.938963 0.940024 0.1061
2000 1 11000 1 4 0.590938 0.335729 25.5209
2000 1 11000 2 3 0.686992 0.667864 1.9128
2000 1 11000 3 2 0.766131 0.778576 1.2445
2000 1 11000 4 1 0.815568 0.833932 1.8364
200 0.1 12000 1 4 1 1 0
200 0.1 12000 2 3 1 1 0
200 0.1 12000 3 2 1 1 0
200 0.1 12000 4 1 1 1 0
1000 0.5 12000 1 4 0.895048 0.886563 0.8485
1000 0.5 12000 2 3 0.943282 0.943282 0
1000 0.5 12000 3 2 0.962025 0.962188 0.0163
1000 0.5 12000 4 1 0.97058 0.971641 0.1061
2000 1 12000 1 4 0.679695 0.520189 15.9506
2000 1 12000 2 3 0.765023 0.760095 0.4928
2000 1 12000 3 2 0.826923 0.840063 1.314
2000 1 12000 4 1 0.861683 0.880047 1.8364
200 0.1 13000 1 4 1 1 0
200 0.1 13000 2 3 1 1 0
200 0.1 13000 3 2 1 1 0
200 0.1 13000 4 1 1 1 0
1000 0.5 13000 1 4 0.95544 0.953442 0.1998
1000 0.5 13000 2 3 0.976695 0.976721 0.0026
1000 0.5 13000 3 2 0.984318 0.984481 0.0163
1000 0.5 13000 4 1 0.987299 0.98836 0.1061
2000 1 13000 1 4 0.758474 0.664425 9.4049
2000 1 13000 2 3 0.829454 0.832213 0.2759
2000 1 13000 3 2 0.874769 0.888142 1.3373
2000 1 13000 4 1 0.897742 0.916106 1.8364

Table 2.1: Fill Rate and its Approximation for Normal Demand
 58

σ σ/µ τ1 ∆1 R L1 L2 β σ σ/µ τ1 ∆1 R L1 L2 β
2 0.2 50 0 1 4 1 0.1747 2 0.2 80 0 1 4 1 1
2 0.2 50 0 1 4 2 0.0037 2 0.2 80 0 1 4 2 0.9940
2 0.2 50 0 2 3 1 0.4985 2 0.2 80 0 2 3 1 1
2 0.2 50 0 2 3 2 0.0892 2 0.2 80 0 2 3 2 0.9970
2 0.2 50 0 3 2 1 0.6654 2 0.2 80 0 3 2 1 1
2 0.2 50 0 3 2 2 0.3336 2 0.2 80 0 3 2 2 0.9980
2 0.2 50 0 4 1 1 0.7491 2 0.2 80 0 4 1 1 1
2 0.2 50 0 4 1 2 0.5 2 0.2 80 0 4 1 2 0.9985
5 0.5 50 0 1 4 1 0.3030 5 0.5 80 0 1 4 1 0.9749
5 0.5 50 0 1 4 2 0.1052 5 0.5 80 0 1 4 2 0.8546
5 0.5 50 0 2 3 1 0.4702 5 0.5 80 0 2 3 1 0.9868
5 0.5 50 0 2 3 2 0.2041 5 0.5 80 0 2 3 2 0.9147
5 0.5 50 0 3 2 1 0.6200 5 0.5 80 0 3 2 1 0.9912
5 0.5 50 0 3 2 2 0.3485 5 0.5 80 0 3 2 2 0.9427
5 0.5 50 0 4 1 1 0.7141 5 0.5 80 0 4 1 1 0.9933
5 0.5 50 0 4 1 2 0.4932 5 0.5 80 0 4 1 2 0.9571
5 0.5 50 20 1 4 1 0.6357 5 0.5 80 20 1 4 1 0.9987
5 0.5 50 20 1 4 2 0.5395 5 0.5 80 20 1 4 2 0.9944
5 0.5 50 20 2 3 1 0.7773 5 0.5 80 20 2 3 1 0.9993
5 0.5 50 20 2 3 2 0.6948 5 0.5 80 20 2 3 2 0.9971
5 0.5 50 20 3 2 1 0.8503 5 0.5 80 20 3 2 1 0.9994
5 0.5 50 20 3 2 2 0.7906 5 0.5 80 20 3 2 2 0.9979
5 0.5 50 20 4 1 1 0.8868 5 0.5 80 20 4 1 1 0.9986
5 0.5 50 20 4 1 2 0.8419 5 0.5 80 20 4 1 2 0.9975

Table 2.2: Fill Rate of Two-stage Systems for Normal Demand (a)
 59

σ σ/µ τ1 ∆1 R L1 L2 β σ σ/µ τ1 ∆1 R L1 L2 β
5 0.5 50 30 1 4 1 0.6373 5 0.5 50 50 1 4 1 0.6373
5 0.5 50 30 1 4 2 0.6284 5 0.5 50 50 1 4 2 0.6373
5 0.5 50 30 2 3 1 0.7785 5 0.5 50 50 2 3 1 0.7785
5 0.5 50 30 2 3 2 0.7714 5 0.5 50 50 2 3 2 0.7785
5 0.5 50 30 3 2 1 0.8512 5 0.5 50 50 3 2 1 0.8512
5 0.5 50 30 3 2 2 0.8462 5 0.5 50 50 3 2 2 0.8512
5 0.5 50 30 4 1 1 0.8874 5 0.5 50 50 4 1 1 0.8874
5 0.5 50 30 4 1 2 0.8837 5 0.5 50 50 4 1 2 0.8874
5 0.5 80 30 1 4 1 0.9987 5 0.5 80 50 1 4 1 0.9987
5 0.5 80 30 1 4 2 0.9985 5 0.5 80 50 1 4 2 0.9987
5 0.5 80 30 2 3 1 0.9993 5 0.5 80 50 2 3 1 0.9993
5 0.5 80 30 2 3 2 0.9991 5 0.5 80 50 2 3 2 0.9993
5 0.5 80 30 3 2 1 0.9994 5 0.5 80 50 3 2 1 0.9994
5 0.5 80 30 3 2 2 0.9993 5 0.5 80 50 3 2 2 0.9994
5 0.5 80 30 4 1 1 0.9986 5 0.5 80 50 4 1 1 0.9986
5 0.5 80 30 4 1 2 0.9985 5 0.5 80 50 4 1 2 0.9986

Table 2.3: Fill Rate of Two-stage Systems for Normal Demand (b)
Chapter 3

Interchangeability of Fill Rate

Constraints and Backorder Costs

in Inventory Models

3.1 Introduction

Inventories which encounter uncertain demand lead to risks of both excess sup-

ply and unsatisfied demand. The associated research on inventory models with

stochastic demand studies how best to balance these risks. Initially, the rela-

tive importance of the two risks was often parameterized with holding costs and

stockout costs. For the past twenty years, research has paid much attention to

the service role of inventories and focused on a service system’s fill rate, namely

60
 61

the fraction of demand which is immediately met from on-hand inventory. During

this latter period, the relative importance of the two risks has often been param-

eterized with holdings costs and a lower bound on the fill rate. As a result, there

are parallel streams of literature which analyze identical models except that one

stream has stockout costs and the other has fill rate constraints.

These streams of literature correspond in mathematical programming to op-

timization subject to constraints and to optimization of an unconstrained La-

grangean. As in nonlinear deterministic optimization, in stochastic optimization

the two approaches do not always yield the same results. This paper investigates

whether there is redundancy in the two streams of dynamic inventory models with

linear purchase costs, namely dynamic newsvendor models. We show the extent

to which optimal policies for either kind of model can be inferred from the other.

Here, an inventory replenishment policy is called Stockout-optimal, or S-

optimal for short, if it minimizes the long-run average sum of holding and stockout

costs per unit time. So, S-optimality corresponds to an unconstrained Lagrangean

formulation. A policy is called Fill-Rate-Optimal, or F-optimal for short, if it

minimizes the long-run average holding cost per unit time subject to a fill-rate

constraint. If demand is continuous, i.e., if the distribution function of demand

has a density function, then S-optimality and F-optimality are shown to be equiv-

alent in the following sense:

(a) Corresponding to any unit stockout cost b, there is a base-stock level y and a
 62

fill-rate f such that a base-stock policy with parameter y is both S-optimal with

stockout cost b and F-optimal with constraint parameter f.

(b) Corresponding to any fill-rate constraint parameter f, there is a base-stock

level y and a stockout cost b such that a base-stock policy with parameter y is

both S-optimal with stockout cost b and F-optimal with constraint parameter f.

If demand is an integer-valued random variable, the situation is more com-

plicated. Although a deterministic base-stock level policy is S-optimal for every

stockout cost b, a randomized base-stock level policy is F-optimal for most con-

straint parameters f. Nevertheless, a parametric analysis of either kind of opti-

mality can be accomplished via the other kind in the following sense:

(c) Corresponding to any unit stockout cost b, there is a base-stock level y and a

fill-rate f such that a base-stock policy with parameter y is both S-optimal with

stockout cost b and F-optimal with constraint parameter f.

(d) There are sequences of fill-rate constraint parameters 0 < f1 < f2 < · · · < 1,

base-stock level parameters y1 < y2 < · · ·, and stockout cost parameters b1 <

b2 < · · ·, with the following property. For any fill-rate constraint parameter f, say

fk ≤ f < fk+1 . Then the base-stock policy with parameter yk is both S-optimal

with stockout cost bk and F-optimal with constraint parameter fk .

If demand is continuous, the consequence of (a) and (b) is that the struc-

ture and parametric analysis of F-optimal inventory policies are implicit in the
 63

structure and parametric analysis of S-optimal policies, and conversely. There-

fore, it is redundant to analyze one if the other has been solved. If demand is

discrete, the consequence of (c) and (d) is that there are discrete sets of fill-rate

constraint parameters and stockout costs at which F-optimality and S-optimality

are interchangeable.

Our methods apply to the interchangeability of pairs of constraints and costs

other than fill rate and stockout cost. For example, in §3.7 we sketch results for

balancing (i) inventory turnover ratios versus fill rates, and (ii) inventory costs

versus stockout frequency.

We provide a few portals to the large literature that is relevant to these issues.

Porteus (2002) and Zipkin (2000) are treatises on stochastic inventory models.

Also, see Porteus (1990) for a review of dynamic newsvendor models. Most of the

literature on fill-rate constrained models consists of heuristics and approximations.

For example, Silver (1970), Yano (1985), and Platt, Robinson, and Freund (1997)

propose heuristic solutions to fill-rate constrained models using (R, Q) policies.

Axsäter (2003) considers a continuous-review fill-rate constrained serial system

with batch ordering. The system faces a discrete compound Poisson demand

process in which the leadtime demand has a negative binomial distribution. He

shows that an optimal policy consists of a mixed multistage echelon stock (R, nQ)

policy with one of the reorder points varying over time.

Schneider (1978) and Schneider and Ringuest (1990) study service-constrained

 64

models with setup costs, focus on (s, S) policies where the order quantities are

predetermined, and present several approximations to estimate the reorder point

s such that the required service level is achieved. Schneider and Ringuest consider

a periodic review system with a fixed leadtime.

Boyaci and Gallego (2001) and Shang and Song (2003) study a periodic re-

view service-constrained serial inventory system where the leadtime demand for

the end product is Poisson distributed. Their service measure, the limiting prob-

ability of having positive on-hand inventory at the last stage, differs from the fill

rate. Boyaci and Gallego focus on base-stock policies, develop heuristic solutions,

and discuss the relationship between stockout cost and service-constrained models.

Shang and Song study the same model, and develop closed-form heuristics to ap-

proximate optimal base-stock policies for serial service-constrained systems. Our

paper concerns exactly optimal policies for periodic review single-stage models

with general demand distributions.

Van Houtum and Zijm (2000) discuss the extent to which a cost-optimal policy

in the dynamic newsvendor model is also optimal for a service-constrained model.

They consider several types of service contraints. When the demand distribution

function is strictly increasing on R+ , they assert that an S-optimal policy is also F-

optimal for an appropriate fill rate lower bound. We confirm their assertion under

more general conditions and examine when an F-optimal policy is also S-optimal.

We also show that the fill rate converges to their modified fill rate, characterize
 65

the F-optimal policies with continuous and discrete demand distributions, and

establish the correspondences between backorder costs and fill rate contraints.

Chen and Zheng (1993) present nonlinear backorder costs in the setup cost in-

ventory model and shows that certain demand distributions guarantee the quasi-

convexity of cost rate function. Therefore, results derived from quasi-convex cost

functions remain valid. Rosling (2002a, 2002b) extends this inventory model

(Chen and Zheng 1993). Rosling (2002a) gives more general conditions than

that of Chen and Zheng (1993) on the demand process for which the cost func-

tion is quasi-convex on the inventory position. Rosling (2002b) has square-root

algorithm to find the optimal inventory policy. It also investigates the inventory

problem with various service-contraints and discusses the relationship between

shortage costs and service constraints. Our paper focus on the dynamic newsven-

dor model and assumes one linear shortage cost which is the case in nearly all of

the literature with backorder costs.

The ability to calculate the fill rate is a prerequisite to finding an F-optimal

policy. Johnson et al. (1995) review fill rate approximations in periodic-review

single-stage models with base-stock level policies. Glasserman and Tayur (1994),

Glasserman and Liu (1997), Glasserman (1997), Sobel (2004), and Chapter 2 of

this dissertation have other approximations and exact expressions for fill rates of

single-stage and multi-stage systems with base-stock level policies.

 66

The paper has the following organization. §3.2 introduces the model and nota-

tion and §3.3 characterizes F-optimal policies when demand has a density function.

§3.4 has the corresponding characterization when demand is an integer-valued ran-

dom variable. §3.5 relates F-optimality to S-optimality with characterizations and

algorithms. §3.6 contains numerical examples and §3.7 generalizes and summa-

rizes the results.

3.2 Model and Problem Formulations

We consider a periodic-review inventory model in which an inventory manager

has a single product that faces independent and identically distributed nonneg-

ative demands D1 , D2 , · · · in successive periods. For any positive integer j let

j
Dj = n=1 Dn , let D have the same distribution as D1 , and let µ = E(D) with

0 < µ < ∞. Ordering decisions are made at the beginning of each period, and

each order takes L periods to deliver, i.e., items ordered in period n are deliv-

ered at the beginning of period n + L (where L is a scalar integer). If a is the

order-up-to level in period n, then the expected excess inventory and excess back-
L
ordered demand in period n + L are E[(a − j=0 Dn+j )+ ] (define u+ = max{u, 0})
L L
and E[( j=0 Dn+j − a)+ ], respectively. Let Bn+L (a) = ( j=0 Dn+j − a)+ and
L
Hn+L (a) = (a− j=0 Dn+j )+ , and let B(a) = E[Bn+L (a)] and H(a) = E[Hn+L (a)].

Given an inventory replenishment policy, initial inventory level, and inbound

shipments due in periods 1, ..., L, let F N , KIN , and KSN denote, respectively, the
 67

fill rate, the average end-of-period inventory level, and the average end-of-period

stockout level, all during periods L + 1, · · · , L + N.

Let yn denote the inventory position after placing an order in period n, namely

the physical inventory (net of backlog) at the beginning of the period plus the sum

of shipments which will arrive at the beginning of periods n, n+1, · · · , n+L. Since
L−1
yn − j=0 Dn+j is the amount of goods that will be available to satisfy Dn+L ,



N L−1



N 
FN = E min {Dn+L , yn − Dn+j } Dn+L
n=1 j=0 n=1


N 
KIN = E Hn+L (yn ) /N
n=1

N 
KSN = E Bn+L (yn ) /N
n=1

We assume that excess demand is backordered and order quantities are non-

negative. Let xn denote the inventory position net of backlog at the start of period

n, so xn+1 = yn − Dn and let π be an inventory replenishment policy, namely, a

nonanticipative decision rule that yields nonnegative order quantities, i.e., yn ≥ xn

for all n. We assume that there are no planned backorders, so, yn ≥ max{xn , 0}.

Let c, h, and b be the respective unit costs of replenishment, end-of-period

inventory, and end-of-period backorders. Let F denote the infinite-horizon fill

rate, namely, F = lim infN →∞ F N .

These problems are considered in subsequent sections:


inf π lim inf Eπ|x1 (hKIN ) : F ≥ f (3.56)
N →∞

inf π lim inf Eπ|x1 (hKIN + bKSN ) (3.57)
N →∞
 68


inf π lim inf Eπ|x1 (hKIN − λF N ) (3.58)
N →∞

Problem (3.56) minimizes the average inventory cost subject to a fill rate con-

straint. Problem (3.57) minimizes the average sum of inventory and stockout

costs. Problem (3.58) is a Lagrangean with terms for the average inventory cost

and the fill rate. In (3.56) - (3.58) there is no loss of generality in the assumption,

henceforth made, that h = 1. In each problem, the primary issues are the form

of an optimal policy and the set of optimal policies as a parameter is varied: f in

(3.56), b in (3.57), and λ in (3.58). However, The agenda is reduced by showing

that (3.58) is a special case of (3.57). The identity z = (z)+ − (−z)+ implies

L


Bn (a) = Hn (a) − a + Dn+j and B(a) = H(a) − a + (L + 1)µ
j=0

Therefore, for N < ∞, the criterion in (3.57) is

lim inf Eπ|x1 (KIN + bKSN )

N →∞


N   
= lim inf Eπ|x1 E Hn+L (yn ) + bBn+L (yn ) /N
N →∞
n=1

N  L

 
= lim inf Eπ|x1 E Bn+L (yn ) + yn − Dn+j + bBn+L (yn ) /N
N →∞
n=1 j=0

N   
= lim inf Eπ|x1 B(yn)(1 + b) + yn /N − (L + 1)µ
N →∞
n=1

Rewriting F N as



N 

N 
FN = E [Dn+L − Bn+L (yn )] Dn+L
n=1 n=1

the criterion in (3.58) is

 69

KIN − λF N


N L


=E [Bn+L (yn ) + yn − Dn+j ]/N
n=1 j=0


N 

N
− λE [Dn+L − Bn+L (yn )] Dn+L
n=1 n=1


N L


=E [Bn+L (yn ) + yn − Dn+j ]/N
n=1 j=0


N N



N
− λE Dn+L − Bn+L (yn ) Dn+L
n=1 n=1 n=1


N L


=E [Bn+L (yn ) + yn − Dn+j ]/N
n=1 j=0
 N



N
− λE 1 − Bn+L (yn ) Dn+L
n=1 n=1

N
The law of large numbers implies that n=1 Dn+L /N → µ with probability one

as N → ∞. Since 0 < µ < ∞, Slutsky’s theorem (Cramér 1946, p. 255) yields

N N
n=1 Bn+L (yn )/N D limN →∞ inf n=1 Bn+L (yn )/N
lim inf N −→
N →∞ µ
n=1 Dn+L /N

D
where −→ denotes convergence in distribution.

Therefore,

 N B   N
Bn+L (yn ) 
n=1 n+L (yn ) 1 n=1
lim inf Eπ|x1  N = lim inf Eπ|x1 (3.59)
N →∞ Dn+L µ N →∞ N
n=1

if the right-side expectation in (3.59) exists. Henceforth, we restrict attention to

policies for which the expectation exists.

Suppose policy π induces yn ≥ 0, for all n. The Helly-Bray Theorem (Loève

1963, p. 182) implies that the right-side expectation in (3.59) exists if demand
 70

is a bounded random variable. A less restrictive justification begins with the

observation
N

N n+L



0≤ Bn+L (yn )]/N ≤ Dj /N
n=1 n=1 j=n

whose right side has expectation (L + 1)µ to which it converges in probabil-

ity (by the strong law of large numbers). Since 0 < µ < ∞, it follows that
N
E{ n=1 Bn+L (yn )]/N} exists and is finite for every N and has a convergent sub-

sequence. That is, the right-side expectation in (3.59) exists.

Employing (3.59),

lim inf Eπ|x1 (KIN − λF N )

N →∞
 

N L


= lim inf Eπ|x1 E [Bn+L (yn ) + yn − Dn+j ]/N
N →∞
n=1 j=0
 N

 
−λE 1 − Bn+L (yn ) (Nµ)
n=1
 

N 
= lim inf Eπ|x1 E Bn+L (yn ) + yn
N →∞
n=1
L

 
− Dn+j + (λ/µ)Bn+L (yn ) N −λ
j=0


N   
= lim inf Eπ|x1 B(yn )(1 + λ/µ) + yn N − (L + 1)µ − λ
N →∞
n=1

Therefore, varying b in (3.57) is the same as varying λ in (3.58). The remainder

of the paper concerns only (3.56) and (3.57).

This argument results in the following property.

Proposition 3.2.1

1 
N 
F = 1− lim sup Eπ|x1 B(yn)/N (3.60)
µ N →∞ n=1
 71

Proof
 N   N 
N n=1 [Dn+L − Bn+L (yn )] n=1 Bn+L (yn )/N
F =E N = 1−E N
n=1 Dn+L n=1 Dn+L /N

which implies (3.60).

We note that Proposition 3.2.1 shows that the modified fill rate of Van Houtum

and Zijm (2000) converges to the fill rate.

Let G(·) be the distribution function of DL+1 and let m = sup{a : G(a) = 0}

and M = inf{a : G(a) = 1} be the smallest interval for which P {m ≤ DL+1 ≤

M} = 1. Let G−1 (θ) = inf{a : G(a) ≥ θ}, 0 ≤ θ ≤ 1. We denote ν as the mean of

L + 1 periods demand, so ν = (L + 1)µ. It is well known (cf. Porteus 1990, 2002

and Zipkin 2000) that yn = max{xn , y∗} for all n is an S-optimal policy with

b
y ∗ = G−1 ( ) (3.61)
b+1

So the parametric analysis of (3.57) consists of solving (3.61) as b spans positive

real numbers.

In (3.56), the fill-rate constrained minimization of inventory cost, Proposition

3.2.1 permits replacement of the fill rate constraint with a constraint on the aver-

age backorder level. Therefore, an F-optimal policy solves the following problem:
 

N 
inf lim inf Eπ|x1 H(yn )/N :
π N →∞
n=1


N 
lim sup Eπ|x1 B(yn )/N ≤ µ(1 − f) (3.62)
N →∞
n=1

The following properties of H(·) and B(·) are useful in section §3.3. The

straightforward proof is omitted.

 72

Lemma 3.2.2 H(·) is convex on + and is strictly increasing on (m, ∞), and

B(·) is convex on + and is strictly decreasing on (0, M). If m ≥ 0 and M < ∞,

then H(a) = 0 for a ≤ m, H(a) = a − ν for a ≥ M, B(a) = ν − a for a ≤ m, and

B(a) = 0 for a ≥ M.

Definition A function is injective (or an injection) if it maps at most one point

in the domain to each possible value in the range.

Let B −1 (θ) = sup{y : B(y) ≥ θ}, 0 ≤ θ ≤ ν, and H −1 (η) = sup{y : H(y) ≤

η}, 0 ≤ η ≤ M − ν. Since H(·) and B(·) are strictly monotone and continuous

(due to convexity) on (m, ∞) and (0, M), respectively, they are injections; i.e.,

B[B −1(θ)] = θ and H[H −1 (η)] = η. In subsequent sections we analyze problem

(3.62) for continuous demand and discrete demand.

3.3 Continuous Demand

First we analyze the following N-period version of (3.62) and then let N → ∞:

 

N  

N 
inf
π
Eπ|x1 H(yn ) : Eπ|x1 B(yn ) ≤ Nµ(1 − f) (3.63)
n=1 n=1

The single-period newsvendor model with a fill rate constraint is the special

case of N = 1 in (3.63):


inf
π
Eπ|x1 [H(y1 )] : Eπ|x1 [B(y1)] ≤ µ(1 − f) (3.64)

The following result states that a base-stock policy is F-optimal for (3.64).
 73

Proposition 3.3.1 If demand has a density function, then y = max{y ∗, x} is

F-optimal in (3.64) with

y ∗ = B −1 [µ(1 − f)]. (3.65)

Proof Since H(·) is convex and increasing and B(·) is covex and decreasing,

the smallest y that satisfies the constraint achieves the constrained minimum of

H(·).

If x1 ≤ y ∗, then the base-stock policy in (3.65) is optimal in (3.63) regardless

of the value of N.

Lemma 3.3.2 If demand has a density and x1 ≤ y ∗, then yn = y ∗, n = 1, 2, · · · , N,

is F-optimal in (3.63) for all finite horizons N ∈ I + .

Proof The claim is valid for N = 1 (Proposition 3.3.1). For any N > 1, rewrite

(3.63) as
 

N  

N 
inf Eπ H(yn ) : Eπ B(yn ) ≤ Nµ(1 − f) (3.66)
π
n=1 n=1

For any N > 1, yn ≥ 0 for n = 1, · · · , N. Then (3.66) is a convex nonlinear

program for which the following Karush-Kuhn-Tucker conditions are necessary

and sufficient when demand has a density:

E[H (yn )] + γ · E[B (yn )] − ρn = 0 for n = 1, 2, · · · , N (3.67)



N
γ· E[B(yn)] − Nµ(1 − f) = ρn yn = 0 for n = 1, 2, · · · , N (3.68)
n=1
N


E[B(yn )] ≤ Nµ(1 − f), yn ≥ 0, γ ≥ 0, and ρn ≥ 0. for n = 1, 2, · · · , N (3.69)
n=1
 74

Since H (·) > 0 and B (·) < 0 on (m, M), if γ = 0, then (3.67) implies that

ρn = E[H  (yn )] > 0 for n = 1, · · · , N. Consequently, from (3.68), yn = 0 for

n = 1, · · · , N. But then,

N


E[B(yn )] = Nν = N(L + 1)µ > Nµ(1 − f) for all f > 0
n=1

which contradicts (3.69).

So γ
= 0, and (3.68) yields

N


E[B(yn )] = Nµ(1 − f). (3.70)
n=1

Also, from (3.67),

E[H (y1 )] E[H (y2 )] E[H (yN )]

= = · · · =
E[B (y1 )] E[B (y2 )] E[B (yN )]

So, y1 = y2 = · · · = yN because H(·) and B(·) are convex and monotone. There-

fore, with (3.70),

E[B(y1)] = E[B(y2)] = · · · = E[B(yN )] = µ(1 − f)

Since B(·) is an injection, it follows that

y1 = y2 = · · · = yN = y ∗ = B −1[µ(1 − f)]

Since x1 ≤ y ∗, xn+1 = yn − Dn and P {Dn ≥ 0} = 1 ensure that yn = y ∗ ≥ xn for

all n. Therefore, adding the constraints yn ≥ xn for all n reduces the feasibility set

of (3.66), but does not affect the optimality of yn = y ∗ for all n (given x1 ≤ y ∗).
 75

The transition from (3.63) to (3.62) is consistent with the large literature which

connects finite horizon and infinite horizon inventory models. We exploit the fact

that eventually the inventory level is at least as low as the back-stock level y ∗

(regardless of the initial inventory level). The proof is brief, straightforward, and

omitted.

Lemma 3.3.3 With probability one there is a period n∗ < ∞, such that xn ≤ y ∗

for all n ≥ n∗ .

Proposition 3.3.4 If demand has a density, then the base stock policy yn =

max{y ∗, xn } for all n, with y ∗ specified in (3.65), is F-optimal for (3.62), the

infinite horizon problem with a fill rate constraint.

N
Proof For all N and for all π such that Eπ|x1 [ n=1 B(yn )] ≤ Nµ(1 − f), if

x1 ≤ y ∗ ,


N 
NH(y ∗ ) ≤ Eπ|x1 H(yn ) (Lemma 3.3.2)
n=1

 1
N 
∗
H(y ) ≤ Eπ|x1 H(yn )
N n=1

Therefore, if π is feasible in (3.62),

∗ 1
N 
H(y ) ≤ lim inf Eπ|x1 H(yn )
N →∞ N n=1

Therefore, π ∗ is optimal in (3.62) because it is feasible due to Lemma 3.3.3 and

∗


N  1  n

−1 N


lim inf Eπ∗ |x1 H(yn ) = lim inf Eπ∗ |x1 H(xn ) + H(y ∗ )
N →∞ N →∞ N n=1
n=1 n=n∗
 76

1

N 
= lim inf Eπ∗ |x1 H(y ∗)
N →∞ N n=n∗
= H(y ∗)

Proposition 3.3.4 states that a nonrandomized base-stock policy, with target

base-stock level B −1 [µ(1 − f)], is F-optimal when demand has a density. The

optimal policy is randomized when demand is discrete.

3.4 Discrete Demand

Demand and order quantities are integer-valued in this section. Let ξj = P {DL+1 =

j}, j = 0, 1, ..., M. For a target fill rate f < 1, identify k < M such that

B(k + 1) < µ(1 − f) ≤ B(k). If B(k) = µ(1 − f), it is clear from §3 that

yn = k for all n = 1, 2, ... is F-optimal. The remainder of this section concerns

the typical situation in which B(k + 1) < µ(1 − f) < B(k). Then yn = k for all

n is infeasible because the resulting fill rate is lower than f. If yn = k + 1 for all

n, then the fill rate is strictly higher than f and there is an opportunity to lower

the long-run average holding cost per period and still meet the fill rate constraint.

That is, a randomized policy dominates the best unrandomized policy. We note

that yn = k + 1 for all n is F-optimal among unrandomized policies.

Recall that xn denotes the inventory level at the beginning of period n. We

prove that the following policy, labeled π ∗, is F-optimal among randomized poli-

cies. For all n, if xn = k + 1, then yn = k + 1. If xn ≤ k then yn = k + 1 with

 77

probability β and yn = k with probability 1 − β where

γ(1 − ξ0 ) B(k) − µ(1 − f)

β= , γ= (3.71)
1 − γξ0 B(k) − B(k + 1)

We confirm that π ∗ is feasible and then prove that it is optimal.

Lemma 3.4.1 The fill rate of π ∗ with parameters in (3.71) is f.

Proof Without loss of generality let x1 ≤ k. Then {yn } is a Markov chain with

states k and k + 1, transition probabilities pkk = 1 − β, pk,k+1 = β, pk+1,k =

(1 − β)(1 − ξ0 ), and pk+1,k+1 = 1 − (1 − β)(1 − ξ0 ), and stationary probabilities

(1 − β)(1 − ξ0 ) β
λ∗k = λ∗k+1 =
1 − (1 − β)ξ0 1 − (1 − β)ξ0

Using (3.71),

µ(1 − f) − B(k + 1) B(k) − µ(1 − f)

λ∗k = λ∗k+1 = (3.72)
B(k) − B(k + 1) B(k) − B(k + 1)

Therefore, the fill rate, using (3.60) and (3.72), is

1 ∗
F = 1− [λ B(k) + λ∗k+1 B(k + 1)]
µ k
1  [µ(1 − f) − B(k + 1)]B(k) + [B(k) − µ(1 − f)]B(k + 1)
= 1− =f
µ B(k) − B(k + 1)

Let Π(f) be the set of all randomized stationary policies which result in F ≥ f,

for π ∈ Π(f) let {λπj } be the stationary distribution of {yn } from initial state 0,

and write Hλπ for j H(j)λπj .

Proposition 3.4.2 Policy π ∗ is F-optimal among randomized stationary policies.

 78

∗
Proof Since π ∗ ∈ Π(f) from Lemma 3.4.1, we show that Hλπ = min{Hλπ : π ∈

Π(f)}.

Since there are no planned backorders and P {0 ≤ DL+1 ≤ M} = 1, with

probability one max{0, xn} ≤ yn ≤ M and −M ≤ xn ≤ M for all n. Under

any stationary policy π, the inventory position {yn } is a Markov chain with states

{0, · · · , M}. Since ξ0 < 1, state 0 is recurrent. Therefore, let {λa : a = 0, · · · , M}

be the stationary distribution.

The following linear program minimizes the average holding cost subject to a

fill rate constraint. Find {λa : a = 0, · · · , M} in order to

M


minimize H(a) λa
a=0

M
subject to B(a) λa ≤ µ(1 − f) (3.73)
a=0

M
λa = 1
a=0

λa ≥ 0, a = 0, · · · , M

The proof is completed with the following lemma which is proved in the Appendix.

Lemma 3.4.3 The optimal solution of (3.73) is λk = λ∗k , λk+1 = λ∗k+1 , and

λa = 0 for a
= k and a
= k + 1.

Let wja be the probability of ordering a − j units when the inventory level

is j; j = −M, · · · , M; a = 0, · · · , M. Policy π ∗ induces wjk = (1 − β)(λ∗k ξk−j +

λ∗k+1 ξk+1−j ), wj,k+1 = β(λ∗k ξk−j + λ∗k+1 ξk+1−j ) if j ≤ k wk+1,k+1 = λ∗k+1 ξ0 , and

wja = 0, otherwise.
 79

We note that π ∗ is not uniquely optimal because other policies can induce the

same stationary distribution of the inventory position.

3.5 Interchangeability

For b ≥ 0 and f ∈ [0, 1], let y S (b) = G−1 [b/(b + 1)] and y F (f) = B −1 [µ(1 − f)].

If b is the unit stockout cost, then y S (b) = G−1 [b/(b + 1)] is an S-optimal base-

stock level. If f constrains the fill rate and demand is continuous, then y F (f) =

B −1 [µ(1 − f)] is an F-optimal base-stock level. If demand is integer-valued, there

is a randomization among y F (f) and y F (f) + 1 that is F-optimal. This section

focuses on two questions. First, for a unit stockout cost b, is there an f such

that y F (f) is an S-optimal base stock level? Second, if f constrains the fill rate,

is there a b such y S (b) is an F-optimal base stock level (randomization among

y S (b) and y S (b) + 1 if demand is discrete)? Both questions have positive answers

and if demand is continuous, there is a formula for b in terms of f and conversely.

Although the relation between b and f is more complicated with discrete demand,

if B[y F (f)] = µ(1 − f), then an F-optimal policy employs base stock level y F (f)

(with probability one). We say that demand has a strictly positive density g(·) if

g(a) > 0, m < a < M.

Let F (y) be the fill rate induced by the base-stock policy with base-stock level

y. Then F (M) = 1. Let bU = inf {b ≥ 0 : G−1 [b/(b + 1)] = M}.

 80

Proposition 3.5.1 If demand is continuous:

y F (f) = y S (b) if (3.74) (equivalently (3.75)) is valid


G B −1 [µ(1 − f)]
b=  (3.74)
1 − G B −1[µ(1 − f)]

B G−1 [b/(b + 1)]
f =1− (3.75)
µ

Also, y F (·) is an injection on [0, 1],


y F F [y S (b)] = y S (b) = G−1 [b/(b + 1)] (3.76)


y S G[y F (f)]/{1 − G[y F (f)]} ≥ y F (f) (3.77)

and, if the density is strictly positive, the inequality in (3.77) is satisfied as an

equality and y S (·) is an injection on [0, bU ].

Proof When the distribution of demand has a density, y F (·) is an injection on

[0, 1] because both B(·) and B −1 (·) are continuous and strictly monotone. There-

fore, equating y S (b) = G−1 [b/(b + 1)] with y F (f) = B −1 [µ(1 − f)] and applying

B(·) to both sides yields (3.74) and (3.75). Similarly, Proposition 3.2.1 implies

F [y S (b)] = 1 − B{y S (b)}/µ. With the definitions of y F (·) and y S (·), this implies

(3.76). For (3.77), let a = y F (f) in y S {G(a)/[1 − G(a)]} = G−1 [G(a)] ≥ a with

equality if G has a strictly positive density. Finally, if demand has a strictly posi-

tive density, then y S (·) is an injection because both G(·) and G−1 (·) are continuous

and strictly monotone.

 81

If demand has a strictly positive density function, Proposition 3.5.1 states that

S-optimality and F-optimality are equivalent in the following sense:

(a) Corresponding to any unit stockout cost b, a base-stock policy with base-

stock level y S (b) is F-optimal if f = 1 − B[y S (b)]/µ.

(b) Corresponding to any fill-rate constraint parameter f, a base-stock policy


with base-stock level y F (f) is S-optimal if b = G[y F (f)] 1 − G[y F (f)] .

The properties are weaker if demand is discrete or if it is continuous with

a density that is not strictly positive. In both instances, G(·) is not strictly

monotone which causes discontinuities in G−1 (·). If demand is discrete, recall the

notation ξj = P {DL+1 = j}, j = 0, 1, ..., M. For expository convenience, in the

next result we assume ξj > 0, j = 0, 1, · · · , M. Only minor modifications are

needed if ξj = 0 for some j.

Proposition 3.5.2 If demand is discrete:

1. If G[y F (f) − 1]/{1 − G[y F (f) − 1]} < b ≤ G[y F (f)]/{1 − G[y F (f)]}, then

y F (f) is S-optimal with parameter b.

2. If f = 1 − B[y S (b)]/µ, then y S (b) is F-optimal with parameter f. If 1 −

B[y S (b)]/µ ≤ f < 1 − B[y S (b) + 1]/µ, then a randomized policy that employs

base-stock level y S (b) with probability 1 − β and y S (b) + 1 with probability β

is F-optimal; β is specified by (3.71).

Proof For part 1, let b1 = G[y F (f)−1]/{1−G[y F (f)−1]} and b2 = G[y F (f)]/{1−
 82

G[y F (f)]}. Since G(·) is nondecreasing on [0, M], b1 < b2 and

b1
G−1 ( ) = G−1 {G[y F (f) − 1]} = y F (f) − 1
b1 + 1
b2
G−1 ( ) = G−1 {G[y F (f)]} = y F (f)
b2 + 1

Since b1 < b ≤ b2, G−1 [b/(b + 1)] = y F (f). Part 2 follows from Proposition

3.4.2.

The relationship between S-optimality and F-optimality is more complicated

when demand is discrete than when it is continuous because F-optimal policies

are random only in the former case. Nevertheless, a parametric analysis of either

kind of optimality can be accomplished via the other kind in the following sense:

(c) Corresponding to any unit stockout cost b, base-stock level y S (b) is F-

optimal with constraint parameter f = 1 − B[y S (b)]/µ. Also, if 1 − B[y S (b)]/µ <

f < 1 − B[y S (b) + 1]/µ, then a policy which randomizes between base-stock levels

y S (b) and y S (b) + 1 is F-optimal with parameter f.

(d) Corresponding to any fill-rate constraint parameter f, base-stock level

y F (f) is S-optimal for any stockout cost b in the interval G[y F (f) − 1]/{1 −

G[y F (f) − 1]} < b ≤ G[y F (f)]/{1 − G[y F (f)]}.

3.6 Examples

This section illustrates the results with numerical examples having continuous

demand with a strictly positive density, continuous demand lacking a strictly

 83

positive density, and discrete demand. We shall clarify that qualitative results

obtained in the previous sections do not depend on leadtime L. For expository

convenience, the following numerical examples use L = 0.

3.6.1 Strictly Positive Demand Density

In this subsection, the density function is g(a) = 1/10 and G(a) = a/10, a ∈

[0, 10]; so µ = 5. Therefore, G−1 (θ) = 10θ, B(y) = E[(D − y)+ ] = (10 − y)2/20,
√
and B −1(θ) = 10 − 20θ. Using (3.61), an S-optimal policy employs base-stock

level
b 10b
y S (b) = G−1 ( )=
b+1 b+1

In this example, y S (·) is concave and increasing. Using (3.65), an F-optimal policy

has base-stock level

 
y F (f) = B −1[µ(1 − f)] = 10 − 20µ(1 − f) = 10 − 10 1 − f

In this example, y F (·) is convex and increasing. Simplifying y S (b) = y F (f) yields

(3.74) and (3.75):

√
1− 1−f b2 + 2b
b= √ f = (3.78)
1−f (b + 1)2

Each equation in (3.78) uniquely defines the one-to-one mapping between b and

f. Considering b as a function of f, in this example b(·) is convex and increasing.

Considering f as a function of b, in this example f(·) is concave and increasing.

 84

3.6.2 Non Strictly Positive Demand Density

In this subsection, g(a) = 1/10 for a ∈ [0, 5] and a ∈ [6, 11], and otherwise

g(a) = 0. Therefore, µ = 5.5 and G(a) = a/10 if a ∈ [0, 5], G(a) = 1/2 if

a ∈ (5, 6], and G(a) = (a − 1)/10 if a ∈ (6, 11]. So G−1 (θ) = 10θ if 0 ≤ θ ≤ 1/2

and G−1 (θ) = 10θ + 1 if 1/2 < θ ≤ 1. That is, G−1 (·) is strictly increasing but

discontinuous at θ = 1/2. Using (3.61) an S-optimal policy employs base-stock

level ⎧
⎪
⎨ 10b/(b + 1), if 0 ≤ b ≤ 1
S −1b
y (b) = G ( )=
b+1 ⎪
⎩
(11b + 1)/(b + 1), if b > 1.
Although y S (·) is strictly increasing as in Section 3.6.1, it is neither concave nor

continuous due to the discontinuity of G−1 (·). As Figure 3.3 shows, no stockout

cost b induces y S (b) ∈ (5, 6]. However, y S (b) = G−1 [b/(b + 1)] is not necessarily

uniquely optimal. In this case, if b = 1, any base-stock level in [5, 6] is optimal.

Figure 3.3: Dependence of S-Optimal Base-Stock Level on Stockout Cost: Non-

negative Density
 85

Continuing,
⎧ 2
⎪
⎪ (y − 20y + 110)/20 if 0 ≤ y ≤ 5
⎪
⎪
 ∞ ⎪
⎨
B(y) = (a − y)g(a)da = (17 − 2y)/4 if 5 < y ≤ 6
y ⎪
⎪
⎪
⎪
⎪
⎩
(11 − y)2/20 if 6 < y ≤ 11
Using (3.65), an F-optimal policy has base-stock level
⎧ √
⎪ 10 − 100 − 110f if 0 ≤ f ≤ 15/22
⎪
⎪
⎪
⎪
⎨
y F (f) = B −1 [µ(1 − f)] = ⎪ 11f − 5/2 if 15/22 < f ≤ 17/22
⎪
⎪
⎪
⎪
⎩ √
11 − 110 − 110f if 17/22 < f ≤ 1
As in Section 3.6.1, y F (·) is convex and increasing on [0, 1].

Let P = {x : 0 ≤ x ≤ 11} and Q = {x : 5 < x ≤ 6}. Therefore, P =

{y F (f) : 0 ≤ f ≤ 1} and P − Q = {y S (b) : 0 ≤ b}. For y ∈ P − Q, the one-to-one

correspondence between b and f given in (3.74) and (3.75) is the following:

10b 
= 10 − 100 − 110f for y ∈ [0, 5]
b+1
11b + 1 
= 11 − 110 − 110f for y ∈ (6, 11]
b+1

Thus, for each b, y F (f) is uniquely S-optimal with

f = 10(b2 + 2b)/[11(b + 1)2 ] ∈ [0, 15/22].

Conversely, y S (b) is uniquely F-optimal using

 
b = [10 − 100 − 110f ]/ 100 − 11f ∈ [0, 1].

There are similar relationships for b ∈ (0, ∞] and f ∈ (17/22, 1], where

 
f = [11(b2 + 2b) + 1]/[11(b + 1)2 and b = [10 − 110 − 110f ]/ 110 − 110f .
 86

In this example, there is no one-to-one mapping between b and f. If f ∈

(15/22, 17/22], y F (f) = 11f − 5/2 is an F-optimal base-stock level but there is no

b for which y S (b) = 11f − 5/2; cf. Figure 3.4.

Figure 3.4: Locus of {(b, f)} with the Same Optimal Base-Stock Level: Nonneg-
ative Density

3.6.3 Discrete Demand

a
In this subsection, ξk = 1/10, k = 0, 1, · · · , 9; so µ = 4.5, G(a) = a=0 1/10

(0 ≤ a ≤ 9), and G−1 (θ) = inf{a : G(a) ≥ θ}(0 ≤ θ ≤ 1). Define G−1 (0) = 0

to avoid a triviality. Discrete demand causes G(·) to be piece-wise constant, so

(3.61) specifies a many-to-one correspondence between unit stockout costs and

S-optimal base stock levels. That is, y S (·) is piece-wise constant. Here, using

(3.65),

B(y) = E[(D − y)+ ] = (9 − y)(10 − 2y + y)/20

 87

9


y F (f) = B −1[µ(1 − f)] = sup{y : (a − y) ≥ 45(1 − f)}
a=
y

That is, y F (·) is piece-wise constant (and discontinuous) although B(·) is con-

tinuous. Table 3.4 specifies G(·) and B(·) and Table 3.5 tabulates G−1 (·) and

B −1 (·). Tables 3.6 and 3.7 illustrate Proposition 3.5.2. Table 3.6 gives y S (b) as

b varies, together with the values of f for which y S (b) = y F (f). Table 3.7 gives

y F (f) as f varies, together with the values of b which cause y S (b) = y F (f). It is

apparent from Tables 3.6 and 3.7 that the parametric analysis of optimal policies

can be accomplished either with b or f.

y G(y) B(y) = E[(D − y)+ ]

[0, 1) 0.1 4.5-0.9y
[1, 2) 0.2 4.4-0.8y
[2, 3) 0.3 4.2-0.7y
[3, 4) 0.4 3.6-0.6y
[4, 5) 0.5 3.5-0.5y
[5, 6) 0.6 3.0-0.4y
[6, 7) 0.7 2.4-0.3y
[7, 8) 0.8 1.7-0.2y
[8, 9) 0.9 0.9-0.1y
[9, ∞) 1 0

Table 3.4: Distribution Function and Expected Number of Backorders

For example, when 7/3 < b ≤ 4, Table 3.6 shows that the S-optimal policy

has base-stock level 7 and induces a fill rate of 0.933. Table 3.7 confirms that

the F-optimal base-stock level is indeed 7 when f = 0.933. However, if 0.933 <

f < 0.977, y F (f) remains 7 which is infeasible! Although y F (f) + 1 = 8 is

 88

θ G−1 (θ) θ B −1 (θ)

[0, 0.1] 0 (3.6, 4.5] 0
(0.1, 0.2 ] 1 (2.8, 3.6] 1
(0.2, 0.3 ] 2 (2.1, 2.8] 2
(0.3, 0.4 ] 3 (1.5, 2.1] 3
(0.4, 0.5 ] 4 (1.0, 1.5] 4
(0.5, 0.6 ] 5 (0.6, 1.0] 5
(0.6, 0.7 ] 6 (0.3, 0.6] 6
(0.7, 0.8 ] 7 (0.1, 0.3] 7
(0.8, 0.9 ] 8 (0, 0.1] 8
(0.9, 1.0 ] 9 0 9

Table 3.5: Values of G−1 (·) and B −1 (·)

S B[yS (b)] S
b y S (b) 1 − B[yµ (b)] [1 − µ
− B[y µ(b)+1] )
,1
[0, 1/9] 0 0 [0, 0.2)
(1/9, 1/4] 1 0.2 [0.2, 0.377)
(1/4, 3/7] 2 0.377 [0.377, 0.533)
(3/7, 2/3] 3 0.533 [0.533, 0.667)
(2/3, 1] 4 0.667 [0.667, 0.778)
(1, 3/2] 5 0.778 [0.778, 0.867)
(3/2, 7/3] 6 0.867 [0.867, 0.933)
(7/3, 4] 7 0.933 [0.933, 0.978)
(4, 9] 8 0.978 [0.978, 1)
(9, ∞) 9 1 1

Table 3.6: S-optimal Base-Stock Levels and Fill Rates at which they are F-optimal

optimal among deterministic policies, a randomized policy is better. For example,

if f = 0.95, then (cf. Proposition 3.5.2), the following randomized policy strictly

dominates all deterministic policies. Order nothing when the inventory level is at

least 8, and otherwise order up to 7 and 8 with respective probabilities 1 − β and

β. Using (3.71) and Table 3.4, γ = [B(7) − 4.5(1 − 0.95)]/[B(7) − B(8)] = 0.375

and β = [0.375(1 − 0.1)]/[1 − 0.375(0.1)] = 0.35.

 89

F
G[y (f )−1] F
G[y (f )]
f y F (f) ( 1−G[y F (f )−1] , 1−G[yF (f )] ]

[0, 0.2) 0 [0, 1/9]

[0.2, 0.378) 1 (1/9, 1/4]
[0.378, 0.533) 2 (1/4, 3/7]
[0.533, 0.667) 3 (3/7, 2/3]
[0.667, 0.778) 4 (2/3, 1]
[0.778, 0.867) 5 (1, 3/2]
[0.867, 0.933) 6 (3/2, 7/3]
[0.933, 0.978) 7 (7/3, 4]
[0.978, 1.0) 8 (4, 9]
1.0 9 (9, ∞)

Table 3.7: F-optimal Base-Stock Levels and Unit Stockout Costs at which they are
S-optimal

3.7 Generalizations and Summary

Numerous pairs of constraints and costs - not only fill rate constraints and stockout

costs - are interchangeable in the sense of §3.5. The key prerequisite is convexity

and monotonicity as in Lemma 3.2.2. As a first example, consider balancing

inventory turnover ratio versus fill rate. We model the turnover ratio as the ratio

of the demand to the average of the inventory levels at the beginning and ending

of the period. Accordingly, if τ denotes the constraining upper bound on turnover

ratio, then the argument that leads to Proposition 1 shows that the constraint

corresponds to

N


lim sup E{ [yn + H(yn )]/N}/µ ≤ 2µ/τ
N →∞
n=1

We consider (i) maximization of the fill rate subject to this constraint, and (ii)

minimization of the long-run average value of h[H(yn ) + yn ]/2+ bB(yn ). Let h = 1

 90

without loss of generality, and let Q(y) = H(y) + y. Obvious analogues of the

results in Sections 3 through 5 are valid for these problems because Q(·) is convex

and strictly increasing on (m, M). For example, if demand has a density, then the

following base-stock policy is optimal for problem (i): yn = max{y H , xn } for all n,

with y H = Q−1 (2µ/τ ). The following base-stock policy is optimal for problem (ii):

yn = max{y T , xn } for all n, with y T = G−1 [(b − 1)/(b + 1)]. Interchangeability

follows from the fact that y H and y T span the same set as τ and b span the

nonnegative numbers.

A second example of the broader applicability of the methods used in earlier

sections is the task of balancing inventory costs and stockout frequency. The task

can be formalized in several ways including (iii) minimizing the long-run average

inventory cost subject to an upper bound on the long-run relative frequency of

stockout, and (iv) minimizing a weighted linear combination of inventory cost

and probability of stockout. If demand is continuous with a concave distribution

function and m is the upper bound on stockout probability, then the following

base-stock policy is optimal for problem (iii): yn = max{y u, xn } for all n, with

y u = G−1 (1 − m). In problem (iv), if the weight on inventory cost is normalized

to unity and c is the weight on stockout probability, then the following base-stock

policy is optimal for problem (iv): yn = max{y c, xn } for all n, where y c minimizes

H(y) + c[1 − G(y)]. Interchangeability follows from the fact that y u and y c span

the same set as m spans [0, 1] and c spans the nonnegative numbers.
 91

Generally, in this paper we make precise the extent to which Stockout-optimality

(S-optimality) and Fill-rate-optimality (F-optimality) are interchangeable in dy-

namic newsvendor models. We also show that F-optimality is achieved by a base-

stock policy that is unrandomized if demand is continuous. If demand is discrete,

it is achieved by a stationary policy that randomizes between two adjacent base-

stock levels. Also, there is a weakly monotone mapping from the set of S-optimal

policies to the set of F-optimal policies. For practical purposes, the parametric

analysis of either kind of problem can be performed via an algorithm directed at

the other case. So it is unnecessary to study both cases separately.

3.8 Appendix

Proof of Lemma 3.4.3

Proof Expression (3.72) is feasible in (3.73). In order to prove optimality, let δa

be the reduced cost of λa in the simplex algorithm; if δa ≥ 0 for all a

= k, k + 1,

then (3.73) is optimal. The corresponding basis matrix of (3.73) is

 
B(k) B(k + 1)
B=
1 1

Since det(B) = B(k) − B(k + 1) > 0, for each λa the reduced cost is

H(a)[B(k) − B(k + 1)] − H(k)[B(a) − B(k + 1)] + H(k + 1)[B(a) − B(k)]

δa =
B(k) − B(k + 1)
(3.79)
 92

Let ∆a be the numerator of (3.79); since B(k) − B(k + 1) > 0, δa and ∆a have

the same signs.

If a < k,

∆a = H(a)[B(k) − B(k + 1)] − H(k)[B(a) − B(k + 1)] + H(k + 1)[B(a) − B(k)]

= H(a)[B(k) − B(k + 1)] − H(k)[B(a) − B(k) + B(k) − B(k + 1)]

+H(k + 1)[B(a) − B(k)]

= [H(k + 1) − H(k)][B(a) − B(k)] − [H(k) − H(a)][B(k) − B(k + 1)]

We use an induction starting with ∆k = 0 to show that ∆a ≥ 0. If ∆k−n ≥ 0, for

a = k − n − 1 and n = 0, · · · , k − 2

∆k−n−1 = [H(k + 1) − H(k)][B(k − n − 1) − B(k)]

−[H(k) − H(k − n − 1)][B(k) − B(k + 1)]

= [H(k + 1) − H(k)][B(k − n − 1) − B(k − n) + B(k − n) − B(k)]

−[H(k) − H(k − n) + H(k − n) − H(k − n − 1)][B(k) − B(k + 1)]

= [H(k + 1) − H(k)][B(k − n − 1) − B(k − n)]

−[H(k − n) − H(k − n − 1)][B(k) − B(k + 1)] + ∆k−n . (3.80)

Since H(·) and B(·) are convex and monotone, ∆k−n−1 ≥ 0 because

H(k + 1) − H(k) ≥ H(k − n) − H(k − n − 1) ≥ 0

B(k − n − 1) − B(k − n) ≥ B(k) − B(k + 1) ≥ 0.

If a > k + 1,

∆a = H(a)[B(k) − B(k + 1)] − H(k)[B(a) − B(k + 1)]

 93

+H(k + 1)[B(a) − B(k + 1) + B(k + 1) − B(k)]

= [H(a) − H(k + 1)][B(k) − B(k + 1)] − [H(k + 1) − H(k)][B(k + 1) − B(a)]

Another induction concludes that ∆a ≥ 0 for all a > k + 1.

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