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Bounds and Heuristics for Optimal Bayesian Inventory Control with Unobserved Lost Sales

Fuqua School of Business, Duke University, Durham, North Carolina 27708
li.chen{at}duke.edu

In most retail environments, when inventory runs out, the unmet demand is lost and not observed. The sales data are effectively censored by the inventory level. Factoring this censored data effect into demand estimation and inventory control decision makes the problem difficult to solve. In this paper, we focus on developing bounds and heuristics for this problem. Specifically, we consider a finite-horizon inventory control problem for a nonperishable product with unobserved lost sales and a demand distribution having an unknown parameter. The parameter is estimated sequentially by the Bayesian updating method. We first derive a set of solution upper bounds that work for all prior and demand distributions. For a fairly general monotone likelihood-ratio distribution family, we derive relaxed but easily computable lower and upper bounds along an arbitrary sample path. We then propose two heuristics. The first heuristic is derived from the solution bound results. Computing this heuristic solution only requires the evaluation of the objective function in the observed lost-sales case. The second heuristic is based on the approximation of the first-order condition. We combine the first-order derivatives of the simpler observed lost-sales and perishable-inventory models to obtain the approximation. For the latter case, we obtain a recursive formula that simplifies the computation. Finally, we conduct an extensive numerical study to evaluate and compare the bounds and heuristics. The numerical results indicate that both heuristics perform very well. They outperform the myopic policies by a wide margin.

Subject classifications: inventory/production; heuristics; unknown demand distribution; Bayesian updating; unobserved lost sales; dynamic programming/optimal control; bounds.
History: Received January 2007; revision received January 2009; accepted April 2009.