Lecture 6: The Loss Function

We define the expected value (also called the expectation or the mean) of a discrete random
variable X, with probability distribution function P (x) , by
X
E[X] = xP (x)
all x

Example 1: Consider two independent fair coin tosses. Let X be the number of heads obtained.
Then X has probability distribution

X=x P(X=x)
0 1/4
1 1/2
2 1/4

So the mean of X is E[X] = (0)(1/4) + (1)(1/2) + (2)(1/4) = 1.

Given random variable X, the loss function L(q) of X is the expected amount X is greater than q.
In other words, the expected loss is the expected amount a random variable X exceeds a chosen
threshold q. For example, if the random variable X is demand and q is the inventory on hand,
then L(q) is the expected lost sales per cycle, which is defined as ESC in the textbook. Consider
Example 1, suppose X is the demand and you have 1 unit product on hand. To calculate L(1), we
set up the following table:

X=x P(X=x) Amount lost column 2 times column 3

0 1/4 0 0
1 1/2 0 0
2 1/4 1 1/4

So, L(1) = 0 + 0 + 1/4 = 1/4. You can verify that L(0) = 1, and L(2) = 0.
At this point you hopefully understand that the loss function is not conceptually difficult, but it is
a ”pain in the neck” to evaluate. More work than should be done by hand. In other words, either
you have a spreadsheet to help you evaluate the loss function, or you should have a table that
has already been evaluated for you. Fortunately, for continuous random variable, we only consider
normal distribution in this course. We have a table similar to the standard normal distribution
table learned in Stats I. However, you should know following theorems.
Theorem 1. For the standard normal distribution, if z > 0, then
L(−z) = L(z) + z
Theorem 2. Suppose X is normally distributed with mean µ and standard deviation σ, then
ROP − µ
LX (ROP ) = σL( ),
σ

1
 ROP − µ
where L( ) can be found either using the table below directly or jointly using the table and
σ
Theorem 1.

Example 2: Weekly demand for Palms at B&M is normally distributed, with a mean of 2,500 and a
standard deviation of 500. The replenishment lead time is two weeks. Assume that the demand is
independent from one week to the next. Calculate the expected lost sales from a policy of ordering
10,000 Palms when there are 6,000 Palms in inventory (so this is a continuous review policy).
Because demand across time is independent, demand during the lead time to be normally distributed
with a mean DL and a standard deviation of σL , where
√ √
DL = DL = 2 × 2500 = 5000 σL = Lσ = 2 × 500 = 707

A shortage occurs in a replenishment cycle only if the demand during the lead time exceeds the
reorder point (ROP=6,000). Therefore, the expected lost sales is

6000 − 5000
L(6000) = 707 × L( ) = 707 × L(1.41) = 707 × 0.0359 = 25
707

If ROP = 4,000, then L(4000) is

4000 − 5000
707 × L( ) = 707 × L(−1.41) = 707(L(1.41) + 1.41) = 25 + 707 × 1.41
707

Now we prove the above two Theorems. You can skip the proof.
Proof of Theorem 1: Begin with the density function of the standard normal distribution,

1 2
f (x) = √ e−x /2
2π
Rz
Let F (z) = P (X ≤ z) = −∞ f (x)dx. Let L(z) be the expected loss function:
Z ∞ Z ∞ Z ∞
L(z) = E[max{x − z, 0}] = (x − z)f (x)dx = xf (x)dx − zf (x)dx
z z z

The first integral is Z ∞

xf (x)dx = −f (x)|∞
z = f (z),
z

because f 0 (x) = −xf (x) and the second integral is

Z ∞
zf (x)dx = z(1 − F (z))
z

Thus, L(z) = f (z) − z(1 − F (z)). L(−z) = f (−z) − (−z)(1 − F (−z)) = f (z) + zF (z) = f (z) −
z(1 − F (z)) + z = L(z) + z.

2
Proof of Theorem 2: If X ∼ N (µ, σ 2 ) with density function

1 (x−µ)2
f (x) = √ e− 2σ2 ,
2πσ

then

L(Q) =E[max{X − Q, 0}]

Z ∞
= (x − Q)f (x)dx
Q

Substitute x = µ + σz, we obtain

Q−µ
L(Q) = σL( ).
σ

Exercises

1. Weekly demand for Motorola cell phones at a Best Buy store is normally distributed, with
a mean of 300 and a standard deviation of 200. Motorola takes two weeks to supply a Best
Buy order. Best Buy is targeting a CSL of 95% and monitors its inventory continuously. How
much safety inventory of cell phones should Best Buy carry? What should its ROP be?

2. Assume that the Best Buy store in Exercise 1 has a policy of ordering cell phones from
Motorola in lots of 500. If the store manager is targeting a fill rate of 99%, what safety
inventory should the store carry? What should its ROP be?

3. The Gap has started selling through its online channel along with its retail stores. Manage-
ment has to decide which products to carry at the retail stores and which products to carry at
a central warehouse to be sold only via the online channel. The Gap currently has 900 retail
stores in the United States. Weekly demand for large Khaki pants at each store is normally
distributed with a mean of 800 and a standard deviation of 100. Each pant costs $30. Weekly
demand for purple Cashmere sweaters at each store is normally distributed with a mean of
50 and a standard deviation of 50. Each sweater costs $100. The Gap has a holding cost of
25 percent. The Gap manages all inventories using a continuous review policy and the supply
lead-time for both products is 4 weeks. The targeted cycle service level is 95 percent. How
much reduction in holding cost per unit sold can The Gap expect on moving each of the two
products from the stores to the online channel? Assume demand from one week to the next
to be independent?

4. Reconsider the Best Buy store in Exercise 1. The store manager has decided to follow a
periodic review policy to manage inventory of cell phones. They plan to order every three
weeks. Given a desired cycle service level of 95 percent, how much safety inventory should
the store carry? What should their order up to level be?

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 Standard Normal Loss Function Table, L(z)
z 0.0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.3989 0.3940 0.3890 0.3841 0.3793 0.3744 0.3697 0.3649 0.3602 0.3556
0.1 0.3509 0.3464 0.3418 0.3373 0.3328 0.3284 0.3240 0.3197 0.3154 0.3111
0.2 0.3069 0.3027 0.2986 0.2944 0.2904 0.2863 0.2824 0.2784 0.2745 0.2706
0.3 0.2668 0.2630 0.2592 0.2555 0.2518 0.2481 0.2445 0.2409 0.2374 0.2339
0.4 0.2304 0.2270 0.2236 0.2203 0.2169 0.2137 0.2104 0.2072 0.2040 0.2009
0.5 0.1978 0.1947 0.1917 0.1887 0.1857 0.1828 0.1799 0.1771 0.1742 0.1714
0.6 0.1687 0.1659 0.1633 0.1606 0.1580 0.1554 0.1528 0.1503 0.1478 0.1453
0.7 0.1429 0.1405 0.1381 0.1358 0.1334 0.1312 0.1289 0.1267 0.1245 0.1223
0.8 0.1202 0.1181 0.1160 0.1140 0.1120 0.1100 0.1080 0.1061 0.1042 0.1023
0.9 0.1004 0.0986 0.0968 0.0950 0.0933 0.0916 0.0899 0.0882 0.0865 0.0849
1.0 0.0833 0.0817 0.0802 0.0787 0.0772 0.0757 0.0742 0.0728 0.0714 0.0700
1.1 0.0686 0.0673 0.0659 0.0646 0.0634 0.0621 0.0609 0.0596 0.0584 0.0573
1.2 0.0561 0.0550 0.0538 0.0527 0.0517 0.0506 0.0495 0.0485 0.0475 0.0465
1.3 0.0455 0.0446 0.0436 0.0427 0.0418 0.0409 0.0400 0.0392 0.0383 0.0375
1.4 0.0367 0.0359 0.0351 0.0343 0.0336 0.0328 0.0321 0.0314 0.0307 0.0300
1.5 0.0293 0.0286 0.0280 0.0274 0.0267 0.0261 0.0255 0.0249 0.0244 0.0238
1.6 0.0232 0.0227 0.0222 0.0216 0.0211 0.0206 0.0201 0.0197 0.0192 0.0187
1.7 0.0183 0.0178 0.0174 0.0170 0.0166 0.0162 0.0158 0.0154 0.0150 0.0146
1.8 0.0143 0.0139 0.0136 0.0132 0.0129 0.0126 0.0123 0.0119 0.0116 0.0113
1.9 0.0111 0.0108 0.0105 0.0102 0.0100 0.0097 0.0094 0.0092 0.0090 0.0087
2.0 0.0085 0.0083 0.0080 0.0078 0.0076 0.0074 0.0072 0.0070 0.0068 0.0066
2.1 0.0065 0.0063 0.0061 0.0060 0.0058 0.0056 0.0055 0.0053 0.0052 0.0050
2.2 0.0049 0.0047 0.0046 0.0045 0.0044 0.0042 0.0041 0.0040 0.0039 0.0038
2.3 0.0037 0.0036 0.0035 0.0034 0.0033 0.0032 0.0031 0.0030 0.0029 0.0028
2.4 0.0027 0.0026 0.0026 0.0025 0.0024 0.0023 0.0023 0.0022 0.0021 0.0021
2.5 0.0020 0.0019 0.0019 0.0018 0.0018 0.0017 0.0017 0.0016 0.0016 0.0015
2.6 0.0015 0.0014 0.0014 0.0013 0.0013 0.0012 0.0012 0.0012 0.0011 0.0011
2.7 0.0011 0.0010 0.0010 0.0010 0.0009 0.0009 0.0009 0.0008 0.0008 0.0008
2.8 0.0008 0.0007 0.0007 0.0007 0.0007 0.0006 0.0006 0.0006 0.0006 0.0006
2.9 0.0005 0.0005 0.0005 0.0005 0.0005 0.0005 0.0004 0.0004 0.0004 0.0004
3.0 0.0004 0.0004 0.0004 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003
3.1 0.0003 0.0003 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002
3.2 0.0002 0.0002 0.0002 0.0002 0.0002 0.0002 0.0001 0.0001 0.0001 0.0001
3.3 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
3.4 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
3.5 0.0001 0.0001 0.0001 0.0001 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000