Performance Measurement for Inventory Models with Risk Preferences

Abstract

In financial economics in general the objective function expresses the risk preferences of the decision maker, see for example the mean variance approach in portfolio theory. Only recently in inventory management instead of maximizing expected profit or minimizing expected cost risk-averse objective functions have been used for determining the optimal order quantity. Examples are the exponential utility function and the conditional value at risk criterion. We use the well-known newsvendor model to determine the optimal performance measures for an objective function with two risk parameters, which can describe risk neutral, risk averse as well as risk taking behaviour of the inventory manager. We provide for this approach a complete characterization with respect to the performance measures expected profit and service level. We show that a risk averse inventory manager can not dominate a risk neutral or a risk taking inventory manager. Finally, we provide a managerial guideline for selecting the appropriate risk parameters of the objective function.Performance Measurement, Risk Preferences, Newsvendor Model