For the newsvendor model if the inventory holding cost incre

For the newsvendor model, if the inventory holding cost increases, with the other parameters fixed, A. the optimal service level increases but the profit decreases B. the optimal service level decreases but the profit increases C. both the optimal service level and the profit increases D. both the optimal service level and the profit decreases E. the optimal service level does not change but the profit decreases

Solution

When devising an inventory management policy, it is important to choose a service level target. Service level target basically means the level of service the firm wish to provide. It is usually in terms of the number of customers that the firm wants to effectively serve. When a firm chooses a service level target, it becomes easier for them to determine the inventory requirements and the costs associated in order to provide that level of service. When the service level target of the firm is higher, they cannot afford to stock-out as it may lead to missed sales in the form of lost opportunities and also intangible losses such as customer dissatisfaction, frustration and reduced loyalty.

With a higher service level, more inventory will be held as safety stock, thereby, increasing the inventory holding cost for the organisation. But because of higher inventory levels as safety stock, firm has the opportunity to serve more customers as the missed sales will be considerably reduced, which can have positive impact on their profitability. Thus, if the inventory holding cost increases, both the optimal service level and the profit increases.

Answer - Option (C)