9th International Conference on Industrial Engineering and Industrial Management

XXI International Conference on Industrial Engineering and Operations Management

International IIE Conference 2015
Aveiro, Portugal. July 6-8, 2015

On the on-hand stock estimation in a lost sales

context and periodic review policy
Abstract Traditionally, inventory literature assumes that unfilled demand can be
backordered for the next replenishment cycle. However, there are a lot of practical
situations where, if an item is out of stock, backordering assumption in not applicable and unfilled demand is lost. The main problem of the lost sales case is the
mathematical difficulty of its treatment. This paper focuses on the estimation of on
hand stock levels just after the order arrives, i.e. at the beginning of the cycle. On
one hand, we present a review of the existing literature on the on hand stock estimation in lost sales case. On the other hand, we propose a new close-form approach to compute the probability vector associated to the on hand stock levels at
the beginning of the cycle for periodic review systems and discrete demands. Numerical results show that our approximation presents low deviations and overcomes other estimation methods.

Keywords: on hand stock, lost sales, periodic review, discrete demand

1 Introduction
There are two possible customer's responses when an item is temporarily out of
stock: (i) unfilled demand is backordered and filled as soon as the replenishment
order arrives or (ii) unfilled demand is lost. Although there are many real life
situations where backordering assumption is not applicable, only a handful of inventory papers study optimal policies for systems with lost sales. This is mainly
because backordering models are easier to formulate and simpler to analyze
[(Hadley and Whitin 1963), (Zipkin 2008), (Bijvank and Vis 2012)]. However, the
assumption of excess demand being lost is of practical importance in sectors such
as retailing (Gruen et al. 2002), service sector (Diels and Wiebach 2011) or online commerce (Breugelmans et al. 2006).
Recently, lost sales models have received more attention in inventory research
and there is a proliferation of publications under this context [(Bijvank and Vis
2011), (Bijvank et al. 2014)]. Lost sales problem was formulated long time ago by
(Karlin and Scarf 1958) but it is still very hard to formulate and deal with. In in-

ventory systems the demand is satisfied with the available stock at the beginning
of the cycle, i.e. just after the order arrives. At this point, if we assume backordering, the probability associated to each stock state can be easily computed as the
difference between the inventory position at the replenishment moment (which is
equal to the base stock, S) and the demand during the lead time. However, applying the same reasoning in a lost sales context could lead to negative net stocks, so
that finding the on hand stock probability vector becomes a challenge. Therefore,
the key question in lost sales models is to know accurately the on hand steady
probability vector at the beginning of the cycle ( P ( OH R ) ) because not only service measures but also performance metrics must be computed based on them.
To the best of our knowledge, only (Cards et al. 2006) propose an exact expression to compute P ( OH R ) for lost sales context, periodic review policy and
discrete demand. This expression applies only when there is just one outstanding
replenishment order at every time, however it is not a close formula what complicates its implementation in practical environments. The main goal of this paper is
to propose a new close-form approximation to compute the probability of on hand
stock levels for lost sales context and periodic review (R, S). Furthermore, we present a thorough review of current existing methods and analyze their performance.
The rest of the paper is organized as follows. Section 2 introduces the notation
and basic assumptions of this paper. Section 3 describes current methods to compute the on hand stock probability vector and proposes a new approximation. Numerical results are presented in Section 4. Finally, Section 5 highlights the most
relevant conclusions of this work and presents further researches.

2 Basic Notation and Assumptions

In general, the periodic review, base stock (R, S) system places replenishment orders every R fixed time periods to raise the inventory position to the base stock S.
The replenishment order arrives after a constant lead time L. Figure 1 shows an
example of the evolution of the on hand stock and the inventory position for the
lost sales case. Notation used in it and in the rest of the paper is as follows:
S
= base stock (units),
R
= review period and replenishment cycle corresponding to the time between two consecutive deliveries (time units),
L
= lead time for the replenishment order (time units),
OHt
= on hand stock in time t from the first reception (units),
IPt
= inventory position in time t from the first reception (units),
NSt
= net stock in time t from the first reception (units),
Dt
= accumulated demand during t consecutive periods (units),
ft()
= probability mass function of Dt,
Ft()
= cumulative distribution function of Dt,

X+
E[X]

= maximum {X, 0} for any expression X,

= expected value of expression X.

Units
S

IPR-L

OH0

IP2R-L

On hand stock (OH)

Inventory position (IP)

OHR
OHR-L

R-L

OH2R-L

2R-L

time

Fig. 1 On hand stock and inventory position evolution in a periodic review and lost sales system

This paper considers the following assumptions: (i) time is discrete and is organized in a numerable and infinite succession of equi-spaced instants; (ii) the
lead time, L, is known and constant; (iii) the replenishment order is added to the
inventory at the end of the period in which it is received, hence these products are
available for the next period; (iv) demand during a period is fulfilled with the on
hand stock at the beginning of that period; (v) only one outstanding replenishment
order is launched within any period, which means that L<R, (vi) backordering is
not allowed and (vii) demand process is stationary with a known, discrete, and
i.i.d. distribution function.

3 Methods to compute the on hand state probability vector at

the beginning of the cycle
As known, the on hand stock varies from 0 to S so that if the probability of each
stock level were known we could easily compute the fill rate or the cycle service
level for that probability. However in a lost sales context, finding the probability
associated to each stock value becomes a challenge. In the literature, there are
only several papers that deal with it. This section presents these methods and proposes a new approximation.

2.1 Exact calculation

(Cards, Miralles, & Ros 2006) derive and inductive expression to compute

P ( OH R ) , based on modelling the on hand inventory as an ergodic Markov chain

with a set of states {0, 1,..., S}. This probability vector is computed by means of
calculating the probability transition matrixes of the on hand stock levels between:
(i) the beginning of the cycle and the review moment (times 0 and R-L),
M R L = m ji , and (ii) the review and the beginning of the next replenishment cycle (times R-L and R), M L = skj .
Hence, M R = M R L M L is the transition matrix between two consecutive replenishment cycles. Considering the case where the Markov chain is regular,
n

lim M R = M where all rows of M are the same vector v , which is the principal

left eigenvector and their components are positive, add up to one, and represents
the state probabilities of every feasible value of the on hand stock at the beginning
of any cycle, i.e. v = P ( OH R ) .
Note that the convergence process required to find M requires a huge computational effort and may be time consuming, mainly for large values of S, which
complicates its implementation in practical environments. However it is very useful for reference purposes.

2.2 Non Stock Out Approximation

A close form approximation to compute P ( OH R ) can be derived based on the assumption that there is not stockout during the lead time. In this case, the stock balance at R can be easily computed as
+

OH R = [OH R L DL ] + S OH R L OH R L DL + S OH R L = S DL
Then, we can define

f ( S i )
P ( OH R = i ) L
1 FL ( S 1)

0<iS

so that the vector of on hand stock probabilities is

i=0

(1)

P (OH R ) (1 FL ( S 1))

f L ( S 1)

f L (0)

(2)

Expression (2) is quite similar to the backlog case, obviously except for the
zero stock probability.

2.3 Bijvank and Johansen Approach

(Bijvank and Johansen 2012) study optimal replenishment policies and suggest a
close-form expression to approximate the average on hand stock level when demand follows a pure and compound Poisson distribution. To that end, authors develop an approximation to compute P ( OH R ) as in backordering case but correcting the demand distribution with a factor Cs in order to avoid negative net stocks.

C f ( S i )
P ( OH R = i ) S L
1 CS FL ( S )

0<iS
i=0

(3)

In its derivation, authors assume that L can be any value, but following the assumption of L<R, the computation of Cs can be simplified by
Cs =

S
+
+
E ( S DL ) E ( S DL + R ) + E ( S DR )

(4)

2.4 Proposed Approximation

The Non Stock Out Approximation (Section 2.2) considers an extreme situation in
inventory system, which is precisely the most favourable: there are not stock out
situations during L, i.e. OHR-LDL. On the contrary, the most unfavourable situation is being always out of stock during the replenishment period, which implies
that OHR-L<DL. In this case, the stock balance just after the order arrives is
+

OH R _ OOS = [OH RL DL ] + S OH R L = S OH R L

(5)

where
+

OH RL = [OH 0 DR L ]

(6)

then, we need to know the value of OH0. We assume that: (i) we initialize the
system with an stock equal to the base stock, i.e. OH0=S and (ii) the on hand stock
at the review period is always positive, i.e. OHR-L>0. Under this assumptions
OH R _ OOS S ( S DR L ) = DR L

(7)

and therefore the probability vector in an out of stock situation is expressed as

P (OH R )OOS f RL (0)

f RL (i )

(1 FRL ( S 1))

(8)

We propose a new close-form approximation which combines both extreme

situations, taking into account that the probability of an stock out occurs during L
can be computed as FR(S). Then, the proposed approach to compute P ( OH R ) is

P (OH R ) FR ( S ) P (OH R )NOOS + (1 FR ( S )) P (OH R )OOS

(9)

where P ( OH R ) NOOS represents the probability vector when there is not an

stock out situation (expression (2)) and P ( OH R )OOS the probability vector when
always there is an stock out during L (expression (8)).

3 Numerical results
This section illustrates deviations which arise from using approximations instead
of the exact expression for P ( OH R ) calculation. We assume that demand follows
a Poisson distribution with = 0.01, 0.1, 0.5, 1, 2, 5 and 10. The inventory policy
values considered are: L = 1, 2, 3, 4, 5; R = 5, 7 and S = 5, 7, 9. The total feasible
combinations result in 189 cases. We quantify the deviations computing the module of the error vector with the following expression:

 
e ap
Deviation =

e

(10)



where e is the exact P ( OH R ) vector and ap is the approximate vector obtained
with the Non Stock Out Approximation vector (NSO), Bijvank&Johansen approach (B&J) and the new approach we propose in this paper (Prop.Appr.). Table

1 presents the average and the standard deviation of each approximation for different values of DR+L.
Table 1 Deviation between exact and approximate methods to compute P ( OH R )
Average

Standard deviation

NSO

B&J

Prop.Appr.

NSO

B&J

Prop.Appr.

[0-0.1]

0.000

0.000

0.000

0.000

0.000

0.000

]0.1-1]

0.000

0.000

0.000

0.000

0.000

0.000

]1-5]

0.059

0.068

0.101

0.084

0.102

0.177

]5-10]

0.421

0.653

0.406

0.273

0.545

0.235

]10-20]

1.098

2.874

0.474

0.352

1.995

0.377

]20-50]

1.485

9.160

0.159

0.371

7.720

0.268

>50

1.420

21.469

0.006

0.094

11.801

0.021

Total

0.678

5.401

0.166

0.667

9.609

0.276

As can be observed, the B&J estimation presents the highest average and standard deviations whereas the new approach presented in this paper shows the lowest. If we analyze the results for categories of DR+L we observe that, when demand
is low, all the approximations present a good performance. However, for high values of DR+L both the average and the standard deviations of NSO and B&J are increasingly high.

4 Conclusions
We propose a new perspective to deal with lost sales systems. Most of the papers
on inventory control focus on proposing cost models or service metrics in lost
sales context, for which they need to know the on hand stock at the beginning of
the cycle. However, this work focuses directly on the calculation of the on hand
stock and proposes a close formula which can be applied to compute any other inventory metric. We consider periodic review, (R, S) system, and discrete demands.
We observe that when DR+L is low, all approximations present low average and
standard deviations corresponding to cases which most of the demand has been
fulfilled. However, as numerical results point out, the proposed approximation
presents the best performance even for high values of DR+L.
Further researches should focus on analyzing the impact of these approximations when they are used to compute service measures. Furthermore, there is only
one exact expression which assumes that L<R. One possible extension of this
work is to assess the suitability of this proposed approach even when LR.

Acknowledgements
We gratefully acknowledge the help of Dr. Marco Bijvank, University of Calgary,
for providing useful comments to improve this work. All errors remain ours. This
research is part of a project supported by the Generalitat Valenciana, Ref.
GV/2014/006.

5 References
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Bijvank, M. & Vis, I.F.A. 2011. Lost-sales inventory theory: A review. European Journal of Operational Research, 215, (1) 1-13
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