Statistical measurement of the inventory shortage cost

In searching for the optimal inventory control policy, the objective is to minimize the expected total costs related, of which the shortage cost is an important element. Due to the difficulty in calculating the indirect cost of the loss of goodwill resulted from the shortage, practitioners and researchers often simply assume a fixed penalty cost on the inventory shortage or switch to the alternative method by assigning a specific customer service level. The development of an appropriate tool for measuring the shortage cost can help a business control the total costs and improve the productivity more effectively. This paper proposes probabilistic measurements of the shortage cost, based on mathematical relationship between the cost and the shortage amount. The derived closed-form estimates of the expected shortage cost value can then be applied to support the determination of the optimal inventory control policy.