The determination of optimal base-stock inventory policy when the costs of under- and oversupply are uncertain

This article considers the determination of the optimal base-stock inventory policy for the newsboy inventory model when there is uncertainty about either or both of its basic cost inputs: either C_u, the marginal cost of an undersupply mistake, or C_o, the marginal cost of an oversupply mistake. Such uncertainties often arise in implementing the newsboy model, especially with respect to C_u, whose value depends mostly on the often-imponderable economic consequences of a lost sale or backorder. Given this uncertainty, we use decision theory to propose and analyze two measures of policy “goodness” and two base-stock selection criteria, which in combination provide four alternative “optimal” base-stock policies. Formulas and/or conditions defining each alternative policy are provided. Our empirical study indicates that the recommended policy can be quite sensitive to the measure/criterion chosen, and that the consequences of the wrong choice can be quite considerable.