The Distinction between Inventory Holding and Stockout Costs: Implications for Target Inventories, Asymmetric Adjustment, and the Effect of Aggregation on Production Smoothing

This paper shows that differences between the costs of holding inventories and the costs of incurring stockouts provide a convenient theoretical distinction between production-to-stock and production-to-order industries. Furthermore, differences in holding and stockout costs can cause a firm to replenish inventories following a positive demand surprise at a different speed than it reduces stocks following unexpectedly low sales. This asymmetric adjustment lessens the tendency for firm-specific production shocks to cancel out in aggregation and can cause industry output to be more variable than industry sales even when representative firms exhibit production smoothing behavior. Copyright 1994 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.