Benefits of Risk Pooling

PRODUCTION AND OPERATIONS MANAGEMENT
Vol. 20, No. 1, JanuaryFebruary 2011, pp. 5771

ISSN 1059-1478|EISSN 1937-5956|11|2001|0057
POMS
10.1111/J.1937-5956.2010.01134.x
r 2010 Production and Operations Management Society
DOI
On the Benefits of Risk Pooling in

Inventory Management
Oded Berman, Dmitry Krass
Joseph L. Rotman School of Management, University of Toronto, Toronto, ON M5S 3E6, Canada
berman@rotman.utoronto.ca, krass@rotman.utoronto.ca
M. Mahdi Tajbakhsh
Department of Industrial Engineering, Dalhousie University, Halifax, NS B3J 2X4, Canada, tajbakhsh@dal.ca
e analyze the benefits of inventory pooling in a multi-location newsvendor framework. Using a number of common
demand distributions, as well as the distribution-free approximation, we compare the centralized (pooled) system with
the decentralized (non-pooled) system. We investigate the sensitivity of the absolute and relative reduction in costs to the
variability of demand and to the number of locations (facilities) being pooled. We show that for the distributions considered,
the absolute benefit of risk pooling increases with variability, and the relative benefit stays fairly constant, as long as the
coefficient of variation of demand stays in the low range. However, under high-variability conditions, both measures decrease
to zero as the demand variability is increased. We show, through analytical results and computational experiments, that these
effects are due to the different operating regimes exhibited by the system under different levels of variability: as the
variability is increased, the system switches from the normal operation to the effective and then complete shutdown regimes;
the decrease in the benefits of risk pooling is associated with the two latter stages. The centralization allows the system to
remain in the normal operation regime under higher levels of variability compared to the decentralized system.
Key words: risk pooling; stochastic inventory models; high demand variability; distribution-free approach
History: Received: June 2009; Accepted: December 2009 by Eric Johnson; after 2 revisions.
1. Introduction
When the demands faced by the individual locations are independent and Normally distributed, it is
indeed not hard to show that the benefits of risk
pooling increase with variability (see Example 1 in
section 2). However, the Normal distribution cannot
be a reasonable approximation of the distribution of
demand when the variability is high, since it may lead
to a significant probability of negative demands; for
this reason Silver et al. (1998) present a rule of thumb:
if the coefficient of variation of demand is > 0.5, one
should consider a distribution other than the Normal
distribution. In contrast to the results for the Normal
distribution, Gerchak and He (2003) provide an example where increased variability of the individual
demands reduces the risk pooling benefits. Benjaafar
et al. (2005) show that in the production-inventory
systems (also called make-to-stock queues), inventory
pooling leads to little benefit if the variability of the
location demands is very high. They argue that the
inconsistency between their result and those obtained
for pure inventory systems is partly due to the assumption of independent demands (or lead-time
demands) in the inventory models. However, the
vanishing benefits of inventory pooling are, in fact,
Risk pooling in inventory management, a.k.a. inventory pooling, refers to the consolidation of inventory
across locations into a single (real or virtual) location,
from which the demands at the individual locations
are served. Since one of the primary functions of the
inventory is to protect the system against the variability in demand, one would intuitively expect
inventory pooling to be beneficial, as the centralized
location faces less demand variability (as measured by
the coefficient of variation) than the individual locations. Moreover, since the reduction in variability is
greatest when the demand faced by the individual
locations has high variability, one would expect the
benefits of inventory pooling to increase with the
variability of demand.
It is well known that (in the absence of additional
costs such as transshipment costs and/or increase in
lead times) inventory pooling is indeed beneficial (see
Eppen (1979), Schwarz (1981), Chen and Lin (1989),
and Cherikh (2000) as well as a recent review in Gerchak and He (2003)). However, the behavior of risk
pooling benefits as a function of variability of demand
is less clear-cut.
57
58
Berman, Krass, and Tajbakhsh: On the Benefits of Risk Pooling in Inventory Management
Production and Operations Management 20(1), pp. 5771, r 2010 Production and Operations Management Society
easy to demonstrate for inventory systems with independent demandssee Example 2 in section 2, as well
as results in sections 3 and 4.
Our paper seeks to shed some light on these seemingly counter-intuitive behaviors. Namely, we want to
understand how the benefits of risk pooling behave
under increasing variability of demand and what accounts for this behavior. To this end, we examine a
simple system consisting of n identical locations facing identically distributed, independent demands and
operating as newsvendor systems (no fixed costs). The
centralized system faces combined demands from the
individual locations with no additional transshipment
costs or increases in lead times. We define two measures of inventory pooling savingsthe absolute and
the relative decrease in costsand analyze how the
benefits of pooling change with the increase in the
variability of demand (at each location) and the number of locations. The analysis is carried out under a
variety of common demand distributions at each location, including the Normal, Uniform, Laplace,
Logistic, Lognormal, Gamma, and Weibull (for a comprehensive discussion on the applicability of different
demand distributions to inventory control, the reader
is referred to Burgin (1975), Silver et al. (1998), and the
references therein). We classify these distributions into
two groups depending on whether the negative demand can occur: Category I distributions (comprised
of the first four on our list) that admit negative demands and Category II distributions (the last three)
that do not. Category I distributions can be analyzed
only under the low demand variability (coefficient of
variation under 0.5), while Category II distributions
can be used under any level of variability. Our main
results can be summarized as follows:
We show, both analytically (where possible) and
numerically (through Monte-Carlo simulations),
that while the absolute benefits of pooling do increase with variability of demand under the lowvariability conditions (as suggested by the intuition and by the analysis for the Normal
distribution), the behavior changes drastically at
higher variability levels. Indeed, the benefits of
pooling (both absolute and relative) decrease rapidly once the coefficient of variation of demand
(at each location) exceeds a certain threshold, and
disappear entirely as the variability continues to
grow. This behavior occurs for all Category II
distributions. With respect to the number of locations being pooled, under a given level of
variability the benefits of pooling do increase
with the number of locations. However, under
high-variability conditions, a certain minimum
number of locations may need to be pooled
before any appreciable benefits of pooling can be
realized.
The reasons for this behavior have to do with the

fact that the optimal order-up-to level of the
newsvendor system operating under Category II
distributions tends to decrease with variability
once a certain threshold value of the coefficient of
variation is exceeded. This results in the following
three-state regime for an optimally operating
newsvendor system. At low levels of variability,
both overage and underage costs increase with
variability; we call this the normal operation regime. Above a certain level of the coefficient of
variation, the overage costs begin to decrease,
while the underage costs continue to increase with
variability. Essentially, the system refuses to accept overage risk; we call this the effective shutdown
regime. At still higher levels of variability, the order-up-to levels as well as the overage costs are
essentially equal to 0the system holds no inventory and accepts the full costs of unmet
demand. We call this the complete shutdown regime. While both the decentralized and the
centralized systems go through all three regimes
as the variability is increased, the decentralized
system enters them at lower levels of the variance
of demand. Our results indicate that the absolute
savings due to pooling grow (and the relative
savings stay approximately constant) while both
systems are in the normal operation regime. The
absolute savings peak when the decentralized
system enters the effective shutdown regime
while the centralized system is still in the normal
operation regime. The benefits of pooling decrease
once both systems are in the effective shutdown
regime, and approach 0 once both systems enter
the complete shutdown regime. Note that Category I systems only operate under low-variability
conditions and thus are always in the normal operation regime. This accounts for the difference in
behavior between the two types of distributions.
These results suggest that an inventory system
facing a certain distribution of demand has a certain variability threshold above which normal
operations are not possible. Since, managerially, it
probably does not make sense to operate a system
under the effective or complete shutdown regime,
the benefits of pooling do behave as intuitively
expected in the range where the system operates
normally. Moreover, inventory pooling allows the
system to continue to operate normally under
higher levels of variability by delaying the onset
of the effective shutdown regime. Under very
high levels of variability at the individual locations, a number of locations may need to be
pooled before the variability of the centralized
system is reduced sufficiently to allow normal
operations.
59
We note that while it is possible to analyze the

exact behavior of the decentralized system under
all of the distributions listed earlier (we supply
the closed-form expressions for optimal order-upto levels and costs for the distributions not previously analyzed in the literature), the exact
analysis is generally not available for the centralized system since, in most cases, the distribution
of demand cannot be derived in closed form. To
overcome this difficulty, we employ the distribution-free approximation (e.g., see Gallego and
Moon (1993)). We observe that the behavior of
savings due to pooling is similar to the behavior
observed for other distributions in our numerical
tests.
The remainder of this paper is organized as follows.
In section 2, we present the general model and the
preliminary results based on the Normal and Gamma
distributions. In section 3, we conduct numerical
analysis of the effects of centralization. In section 4,
we follow the distribution-free approach and derive
several theoretical results on the benefits of risk pooling. In section 5, we present the different operating
regimes described above and present further computational results. Finally, section 6 presents conclusions
and problems for further research.
2. The Model and Preliminary Results

We consider a multi-location newsvendor problem
with n locations having identical cost structure. We
assume that the per-period demands at all locations
are independent and identically distributed (i.i.d.).
There are no transshipment costs between locations.
The two alternative system designs are the decentralized (non-pooled) system, where each location services
its own demand, and the centralized (pooled) system,
where all demand is served from a single location.
One should note that both systems are centrally
owned, i.e., under a single decision maker.
2.1. Decentralized (Single-Location) Newsvendor
System
Let y (the decision variable) be the stock level after
ordering at the beginning of the period, which is also
known as the order-up-to level. We will use D to represent the per-period demand, which has cumulative
distribution function (c.d.f.) F, mean m, and standard
deviation s; we also assume that a probability density
function (p.d.f.) f of D is well defined. Letting co and cu
represent the unit overage and underage costs, respectively, the expected cost per period is given by
(e.g., see Porteus (2002))
Ly co Ey D cu ED y
co y m co cu ED y :
To avoid trivial cases, we will assume that s, co, cu40.

The optimal order-up-to level y that minimizes (1) is
given by
cu
Fy
a;
co cu
where a is known as the critical ratio or the Type I
service level. Using (1), we can express the minimum
expected cost per period as follows:
Z y
Ly cu m co cu
xfxdx:
2
1
The system above describes the inventory operation at

each of the n locations. The total expected cost for the
disaggregated system is given by nLy .
2.2. Centralized (Pooled) System and Efficiency
Measures
Let Di be the per-period demand at location i, for
i 5 1, . . ., n, and DT 5 D11 1Dn the total pooled demand in the system, where the demands at each
location are assumed to be i.i.d. random variables. As
before, we will use mT, sT, fT, FT, yT , and LT to represent the mean, the standard deviation, p.d.f., c.d.f.,
the optimal order-up-to level, and the total expected
cost of
p the centralized system. Note that mT 5 nm,
sT ns, and yT satisfies FT yT a.
We define two efficiency measures allowing us to
compare the decentralized and the centralized systems: the absolute savings of the centralized system
D nLy LT yT ;
and the relative savings in percent (or the percentage
savings) of the centralized system

LT yT
C 100 1
:
nLy
It is easy to show that the total expected cost of the
centralized system is lower than that of a decentralized system (see, e.g., Chen and Lin (1989), Eppen
(1979)) LT yT onLy , and thus, both measures
above are positive and well defined. We are primarily
interested in how the absolute and relative savings
behave with respect to the variability of demand s
and the number of inventory locations n. In the case of
Normally distributed demand, this analysis is
straightforward, as shown below.
EXAMPLE 1: Normally distributed demand. Assume the
demand DiN(m, s) at each location i. Let f and F
denote, respectively, the p.d.f. and the c.d.f. of the
standard normal random variable. Then the optimal
order-up-to level is given by y m z s, where
z F1 a, with the optimal expected cost of
Ly co cu sfz . Since the convolution of
Normal random variables is also Normal,
60
p
D
ns, and
pT Nnm;
nsfz , implying that
thus
LT yT co cu
D co cu fz n

1
C 100 1 p
n
p
ns;
Observe that D is increasing in the standard deviation

s and that C is independent of s. Thus, the absolute
savings of the centralized system grow without bound
at the linear rate as s increases, while the relative
savings do not depend on the demand variability.
Also note that D increases approximately linearly
with the number of locations n, while C rapidly approaches 100% as n increases.
The fact that the benefits of risk pooling are increasing in the number of locations has also been
observed in other settings. Hanany and Gerchak
(2008) study inventory pooling in cooperative, decentralized systems (with multiple decision makers)
facing the symmetric multivariate Normal demand.
Under transferable utility games, they show that the
expected profit per location is increasing in the number of locations. Dong and Rudi (2004) study
transshipmentwhich is considered to be a special
form of risk poolingin a distribution system, where
a single manufacturer sells to multiple locations (retailers) owned by a single decision maker. They again
show that under the symmetric multivariate Normal
distribution, the expected profit per location is increasing in the number of locations. Therefore, the
results suggest that when the location demands follow identical and Normal distributions, the benefits of
risk pooling increase with the number of participating
locations.
The case of the Normally distributed demand suggests that the centralized system should outperform
the decentralized system by a wide margin as the demand variability increases. This is quite intuitive,
since we expect the inventory cost to increase with the
variability of the demand, and the coefficient of variation of the
ptotal demand CVT 5 sT/mT is smaller (by a
factor of n) than the coefficient of variation of the
demand at each location CV 5 s/m. Note, however,
that the derivations in Example 1 are somewhat misleading, as (given that the demand should be nonnegative) once s4m/2, it is no longer reasonable to
assume that the demand is Normal.
In fact, the results (and the intuition) above clearly
do not hold for the case when the demand has a
Gamma distribution, as discussed below.
EXAMPLE 2: Gamma distributed demand. Assume that for
each location i, the demand DiGamma(k, y) where the
parameters of the Gamma distribution are related to
the mean m and the standard deviation s by m 5 k/y

and s2 5 k/y2. The centralized demand DT also follows the Gamma distribution with parameters y and
nk. The formulas for the optimal order-up-to level and
the optimal expected cost are derived in the Online
Supplement and are summarized in Table 1. It can be
shown that

Ly co cu s2 y fy =m:
Unfortunately, y depends on both s and m in a rather
complex way, and thus, no closed-form expressions
for D and C are available. However, it is not hard to
show (see Gallego et al. (2007)) that lims!1 y
lims!1 yT 0. Therefore, since for non-negative Dis
we can write
Z y

Z y
T
D co cu
xfT xdx n
xfxdx ;
0
0
!
R y
ncu m co cu 0 T xfT xdx
C 100 1
;
R y
ncu m nco cu 0 xfxdx
it can be seen that lims!1 D lims!1 C 0. Thus,
the benefits of risk pooling vanish as the variability of
demand grows. The numerical results presented in
the next section confirm the asymptotic results above:
while both D and C initially grow with s, at some
point they start decreasing and eventually asymptotically approach 0.
The two examples above present two very different
pictures of the benefits of centralization. Further investigations of this effect will be presented in
subsequent sections.
3. Effects of Centralization:
Computational Results
In this section, we investigate the behavior of D and C
measures for a number of common distributions of
demand. The distributions we investigate are divided
into two groups: Category I includes distributions that
allow both positive and negative values of demand,
while Category II distributions allow only positive
values of demand. The specific distributions we examine are listed below:
Category I (distributions allowing negative demand):
Normal, Uniform, Laplace, and Logistic.
Category II (non-negative distributions): Lognormal,
Gamma, and Weibull.
Table 1 provides closed-form expressions for calculating the minimum expected cost and the optimal
order-up-to level for all the distributions listed above.
These expressions can be used to evaluate the optimal
costs of the corresponding decentralized systems. To
the best of our knowledge, the expressions for the
Laplace, Logistic, Gamma, and Weibull distributions
have not appeared previously in the literaturethe
1=u l
f (x)
otherwise
if l x u
x 0; y40; k 40
k x k 1 x =yk
e
y y
x 0; y40; k 40
Weibull (Online Supplement)
yk x k 1 eyx
Gk
x 0; 1ono 1; B40

p
px m
px m 2
p exp
p
p
1 exp
s 3
s 3
s 3
1oxo 1
"
#
1
lnx n2
p exp
2B2
xB 2p
p
1
2jx mj
p exp
s
s 2
1oxo 1
Gamma (Online Supplement)
Lognormal (Gallego
et al. 2007)
Logistic (Online Supplement)
Laplace (Online Supplement)
Uniform (Lau 1997)
Demand distribution
p.d.f.
Table 1 Expressions for Optimal Order-up-to-Level and Minimum Expected Cost
yG(111/k)
k/y
exp (n1B2/2)
y2G(112/k) m2
k/y2
exp2n B2
expB2 1

s2
s2
(u l)2/12
m
if co cu
if co 4cu
h
i1=k
u
y lnco cc
u
Satisfies Iy =s; k 1 co cc
u
expn z B;

u
where z F1 co cc
u
p
m s p 3 lnccuo
8

>
< m ps ln c 2ccu
o
u
2

>
: m ps ln co2ccu
o
2
p
3cu co s
co cu
y
s2
(l1u)/2
OPT level
Variance
Mean
ln1 ccuo cu ln1 ccuo
if co cu
if co 4cu
cu m co y co cu
co cu s2 y f y
m
R y
ex =y dx
r

2
cu m co cu mF z ln 1 sm2
p
s 3
p co
8 h
i
>
< cpu s 1 lnco2ccu
u
2
h
i
>
: cpo s 1 lnco2ccu
o
2
p
3co cu s
co cu
Ly
MIN cost
61
62
relevant derivations can be found in the Online

Supplement. It is interesting to note that for Category
I distributions, the optimal cost Ly depends only
on the standard deviation of demand s, while for
Category II distributions it depends on both the mean
and the standard deviation of demand.
Since in most applications, demand must be nonnegative, Category I distributions can only be used to
approximate the distribution of demand when the
likelihood of negative values is low. We thus restrict
our investigation of these distributions to the range
s m/2. For Category II distributions, we can examine the effect of centralization for any value of s.
The distribution of the centralized demand is a
convolution of demands at individual locations, and
for the distributions listed above the closed-form expressions for the convolutions are available in only
three cases: Normal, Gamma, and Uniform (see Renyi
(1970), Feller (1966) for the convolution of the Uniform
distribution). Therefore, we use computational experiments to evaluate the impact of s and n on D and C,
as described in the following subsections. In section 4,
we investigate the distribution-free system where
closed-form expressions are available.
As noted earlier, for the Normal, Gamma, and Uniform distributions, the form of fT is known, and thus,
we are able to solve Equation (5) directly. For all other
distributions, we applied the bisection method, implemented in the Mathematica 6 package, to solve
Equation (5). This allows us to determine LT yT and
subsequently to compute D and C. While, in principle,
the same technique could be applied to n42 locations,
the search for yT becomes multi-dimensional and
leads to numerical difficulties. We thus restricted our
experiments in this section to the n 5 2 case.
In our experiments, we set co $1 and m 5 100
units. We tested a wide range of service level values,
from low to high: a 5 0.15, 0.35, 0.55, 0.75, 0.95 (note
that since a cu =co cu
, fixing a implicitly fixes cu
as well).
Tables 2 and 3 contain the results for the service
level value of 0.35 (the results for a 5 0.75 are presented in the Online Supplement, and the results for
a 5 0.15, 0.55, 0.95 are similar and are available on request from the authors). The columns labeled as N
Cost represent the cost of the Normal approximation.
In this approximation, the optimal order-up-to level is
approximated by that of the Normal distribution and
then, the expected cost is evaluated using the actual
demand distribution. Figure 1 depicts the behavior of
D and C as functions of s for the service level 0.35.
The plots in the right side of the figures are for Category II distributions only since CV40.5.
We make the following observations:
For low levels of variability (i.e., when s 50,
which is equivalent to the coefficient of variation
CV 0.5), it can be observed that the Normal
distribution provides an excellent approximation
for all other distributions with respect to the op-
3.1. The Impact of the Variability of Demand

For the case of n 5 2 locations, fT is obtained as
Z 1
fxfx xdx:
fT x
1
Thus, yT can be determined by solving the following

equation:
Z y Z 1
T
cu
fxfx xdxdx
: 5
FT yT :
co cu
1 1
Table 2
Service Level = 0.35 (Category I)

Before pooling
Demand distribution
Normal
Uniform
Laplace
Logistic
Standard deviation
N cost
OPT level
After pooling
OPT cost
N cost
OPT level
OPT cost
10
96.15
5.70
194.55
8.06
30
88.44
17.10
183.65
24.18
50
80.73
28.49
172.75
40.29
10
6.10
94.80
6.06
8.25
194.34
8.25
30
18.31
84.41
18.19
24.75
183.03
24.75
50
30.51
74.02
30.31
41.25
171.71
41.24
10
5.23
97.48
5.17
7.68
195.54
7.65
30
15.69
92.43
15.50
23.04
186.62
22.97
50
26.14
87.39
25.83
38.40
177.70
38.28
10
5.50
96.59
5.49
7.96
194.89
7.94
30
16.49
89.76
16.47
23.71
184.70
23.68
50
27.49
82.94
27.46
39.52
174.48
39.51
63
Table 3
Service Level = 0.35 (Category II)

Before pooling
Demand distribution
Lognormal
Gamma
Weibull
After pooling
Standard deviation
N cost
OPT level
OPT cost
OPT overage cost
N cost
OPT level
OPT cost
OPT overage cost
10
5.57
95.75
5.57
2.13
7.94
194.15
7.94
3.11
30
15.69
85.54
15.60
5.08
22.79
180.44
22.78
7.96
50
24.07
35.85
74.56
23.76
6.54
165.23
35.79
11.09
70
64.23
30.06
7.02
149.98
46.68
12.83
80
59.55
32.59
7.03
142.68
51.34
13.31
90
55.24
34.78
6.94
135.72
55.54
13.60
100
51.31
36.67
6.79
129.13
59.30
13.74
110
47.73
38.31
6.60
122.95
62.66
13.76
120
44.49
39.72
6.39
117.17
65.68
13.70
3.18
10
5.62
95.87
5.62
2.21
7.98
194.27
7.98
30
16.29
86.10
16.23
5.69
23.41
181.25
23.37
8.63
50
26.00
74.69
25.74
7.88
37.99
166.37
37.80
12.80
70
62.21
33.86
8.78
149.99
51.04
15.67
80
55.78
37.34
8.79
141.36
57.15
16.62
90
49.37
40.41
8.55
132.51
62.89
17.26
100
43.08
43.08
8.08
123.50
68.25
17.59
110
37.02
45.36
7.44
114.42
73.20
17.63
120
31.30
47.26
6.68
105.32
77.76
17.41
10
5.88
97.32
5.85
2.86
8.27
195.67
8.24
3.84
30
17.35
88.31
17.35
7.19
24.36
183.54
24.35
10.07
50
27.56
39.34
75.63
27.41
9.28
168.17
39.25
14.37
70
61.74
35.25
9.52
150.67
52.43
16.81
80
55.06
38.34
9.19
141.55
58.25
17.40
90
48.81
40.93
8.69
132.44
63.51
17.64
100
43.08
43.08
8.08
123.50
68.25
17.59
110
37.92
44.86
7.43
114.89
72.46
17.31
120
33.32
46.32
6.77
106.69
76.21
16.88
timal order-up-to level, the optimal costs (before

and after pooling), as well as the absolute
and relative savings that can be expected from
centralization.
The absolute savings D increases sharply with the
variability of demand for all distributions for both low
and high service levels. The relative savings C is relatively constant for Category I distributions. For
Category II distributions, the behavior is more complex and depends on both the distribution and the
service level. Still, the values of C stay within the 25
31% range in all cases, and approximating them by
the 29.29% constant value for the Normal distribution
would not be unreasonable.
Overall, the behavior established analytically for the
Normal distribution in Example 1 appears to reflect
rather accurately the benefits that can be expected
from the centralization of inventory under low-variability conditions, irrespective of the actual
underlying distribution of demand. The results also
imply that as long as the variability of demand remains in the low range, it is not necessary to
determine the actual distribution of demandordering based on the Normal approximation should yield
near-optimal results.
For high levels of variability (i.e., s450 equivalent
to CV40.5), the results are very different. As
noted earlier, only Category II distributions can
be analyzed in this case. First, we observe that for
all the distributions for both the centralized and
the decentralized systems, the optimal order-upto level is decreasing quite rapidly (for a40.5, it
initially increases, peaks, and then decreases rapidly). The absolute savings D initially increases
(up to s 5 100 for the a 5 0.35 case) but then begins to decline rapidly. While the decline is most
pronounced for the Gamma distribution (D actually reaches 0 in this case), the general tendency is
the same for all Category II distributions. The
relative savings C declines rapidly (for a40.5, it
64
Figure 1
Pooling Savings as Functions of r for a = 0.35
reaches a peak and then decreases rapidly) for all

the distributions as s increases.
3.2. The Effect of the Number of Locations
Here, we investigate the sensitivity of the centralization savings to the number of locations n. We are
particularly interested in this behavior under the
high-variability conditions. Thus, we limit ourselves
to Category II distributions in the current section. We
restrict the analysis to the Gamma distribution where
the distribution of the centralized demand fT is available in closed form.
We keep the values of parameters co, m, and a the
same as in the previous section. Let s 5 100 and 400
(corresponding to CV 5 1 and 4) and let n 5 2, . . ., 20.
The results are displayed in Figure 2.
Based on our computational results, we make the
following observations:
For a given level of demand variability, pooling
inventory across larger number of locations increases both the absolute and the relative cost
savings compared with the decentralized system.
The rate of increase in both measures is largest
when the service level is high (this is natural

since in this case, there is more inventory in the
system).
Under the moderate variability of demand (CV 5
1), we observe growth in the absolute and relative cost savings for all service levelsthis is in
line with the results obtained for the Normally
distributed demand in Example 1.
Under the high variability of demand (CV 5 4)
and low-to-moderate service levels (a 0.55), the
inventory must be pooled across a certain minimum number of locations n before any significant
absolute and relative cost savings are observed.
For example, for a 5 0.15, the savings are not significant and do not begin to grow until n 5 8,
while for a 5 0.35, the growth does not happen
until n 5 5; for a 5 0.55, the savings become significant when n 5 3.
4. Impact of Centralization: The

Distribution-Free Approach
In this section, we analyze the impact of centralization
under the distribution-free approach. Under this
65
Figure 2 Pooling Savings as Functions of n for Gamma Distribution
approach, we assume that nothing is known about the

distribution of demand at each location, except for the
mean m and the standard deviation s. We then obtain
an upper bound on the optimal inventory cost and the
corresponding distribution-free optimal order-upto level.
This approach holds several advantages. First, it
is quite practical since in many real-life situations,
the form of the demand distribution may not be
known, however, estimates of m and s are likely to
be available. Second, as will be shown below,
the bound on the optimal expected cost has a particularly simple form, which allows us to derive
closed-form expressions for D and C for the
distribution-free case. The analysis of these expressions provides some insights into the behavior of
these measures. Finally, by applying the distribution-free approach to the centralized system, we
can obtain lower bounds on D and C. We start by
summarizing the relevant results from Gallego and
Moon (1993).
THEOREM 1 (Gallego and Moon). Let D be a random
variable with mean m and variance s2. Then,
1. For an order-up-to level y 0,

q
s2 y m2 y m
:
ED y
2
Moreover, the upper bound on the expected cost
Ly is given by
^
Ly
co y m co cu
q
s2 y m2 y m
:

2
There exists a distribution of D (the maximal dis^
tribution) for which Ly
is the actual expected cost
of the corresponding newsvendor model.
^
2. The function Ly
is strictly convex and is maximized at
(
p
o s
if CVo cu =co ;
m c2upc

c
c
o
u
y^
6
0
otherwise;
where CV 5 s/m is the coefficient of variation of D.
3. Let y be the optimal order-up-to level (under the actual
^ ^y , and this updistribution of D). Then Ly L
per bound above is tight for the maximal distribution.
66
It is not hard to show that the optimal distributionfree cost is given by

p
^ ^
L
y minfcu m; s co cu g
( p
p
7
s co cu if CVo cu =co ;
otherwise:
cu m
^ is the optimal order-up-to level for

Observe that y
the maximal distribution. Moreover, it behaves in an
interesting p
way:
as
long as the variability is not too

high (CVo cu =co ), orders take place; once the variability exceeds this threshold, the system essentially
shuts down (y 5 0) and accepts the maximum underage cost of cum.
The previous discussion extends directly to the
centralized system. Indeed,
since DT has mean
p
p nm,
standard deviation
ns, and CVT CV= n, (7)
implies
( p p
p
ns co cu if CVT o cu =co ;

^ T ^
L
yT
8
otherwise:
ncu m
This leads to the following expressions for D and C
(we note that these expressions represent the absolute
and relative centralization savings when the demand
at each location follows the maximal distribution):
p
8
p p
n

n
s
c
if
0oCVo
cu =co ;
c
>
o
u
<
p
p
p
D ncu m s nco cu if
cu =co CVo ncu =co ;
>
p
:
0
if
ncu =co CV:

8
>
100 1 p1n
>
>
<

q
C 100 1 CV co
ncu
>
>
>
:
0
p
if 0oCVo cu =co ;
p
p
if
cu =co CVo ncu =co ;
p
if
ncu =co CV:
The behavior of D and C with respect to s is depicted in Figures 3 and 4, respectively. Observe that
the general pattern is quite similar to the patterns seen
earlier for other distributions: the absolute savings
initially increase with s, followed by a period of decline and eventually reach 0, while the relative
savings are initially constant and then decline to 0.
However, unlike the previous section, the reasons for
Figure 3 Absolute Savings vs. Standard Deviation (Distribution Free)
(n n)cu
cu/co
ncu /co
this behavior are quite transparent here. In fact, the

distribution-free configuration operates in three
modes:
Mode 1: Both systems operational. As long as the demand p
variability
does not exceed a certain threshold
(CVo cu =co ), both the centralized and the decentralized systems place non-zero orders. The inventory
costs grow with s for both systems, however, the rate
of growth is larger for the decentralized system by
1001 p1n%. Thus, for a fixed value of n, the absolute
savings are growing, while the relative savings are
constant.
Modep
2: Decentralized
system shutdown. For
p
CV 2 cu =co ; ncu =co , the decentralized system
stops ordering, accepting the maximal underage cost,
while the centralized system continues to place orders. Thus, the inventory cost of the centralized
system is increasing with s, while the inventory cost
of the decentralized system is constant, leading to the
decrease in the absolute and relative savings. Clearly,
this apparent decrease in the benefits of centralization
is due to the unfairness of the comparison: a functional system is compared with the stopped one. In
Figure 4 Relative Savings vs. Standard Deviation (Distribution Free)
100 (1 1 / n )
The maximal distribution has the two-point c.d.f.

that assigns weight
q
s2 y m2 y m
q
b
2 s2 y m2
q
to y s2 y m2 , and weight 1 b to
q
y s2 y m2 .
cu /co
ncu /co
fact, centralization of inventory (and the resulting decrease in variability) is what allows the centralized
system to continue operating in this range.
3: Complete system shutdown. Once CV
pMode
ncu =co , the centralized system stops placing orders
as well, leading to a constant inventory cost equal to
the maximal underage cost (same as for the decentralized system). Thus, both the absolute and the
relative savings measures are 0 in this range.
We also observe that the behavior of D and C with
respect to the number of locations n for the distribution-free approach is quite similar to the one observed
for other distributions in the previous sections: for a
fixed s (or CV) and a (or cu), both the absolute and the
relative savings due to centralization generally increase with n, but a certain minimum number of
locations may have to be pooled before this increase
starts. Specifically,
1. If n CV2(co/cu), then D 5 C 5 0.
2. If n4CV2(co/cu), then both D and C are positive
and increasing in n. Note that limn!1 C 100%.
Of course, the reason for this behavior is that n has
to be large enough (in relation to CV) to enable the
centralized system to operate. When CV is sufficiently
small so that the decentralized system is operating,
the increase in D and C starts at n 5 2.
To summarize, we see that, at least in the case of the
maximal distribution, the seemingly counter-intuitive behavior of the absolute and the relative savings
measures is easily explained by understanding the
underlying workings of the decentralized and the
centralized systems. In the following section, we will
see that similar (albeit modified) effects hold in the
case of other distributions as well.
We close the current section by pointing out that the
distribution-free approach can be used to obtain lower
bounds on the absolute and relative savings for the
cases where the distribution of demand at each location is known but the distribution of the centralized
demand cannot be derived. The following proposition
follows directly from Theorem 1, Equation (8), and the
definitions of D and C.
PROPOSITION 2. Let Ly be the optimal cost of the newsvendor model with per-period p
demand D and the coefficient
p
p
^
of variation CV. Let L
ns co cu if CVo ncu =co
T

^ ncu m otherwise. Define
and L
T
^ nLy L
^ ;
D
T
"
^
C 100 1
#
^
L
T
:
nLy
^ and C C.
^
Then, D D
The previous result can, for example, be applied to
all distributions listed in Table 1 for which Ly is
available in closed form.
67
5. Effective Shutdowns and

Centralization Effects
In the previous section, we analyzed the behavior of D
and C measures with respect to s and n for the distribution-free system. We were able to attribute the
observed patterns in the absolute and relative savings
to the shutdownsfirst of only the decentralized system, and then of the centralized one as well.
It is tempting to look for the same effects in the case
of Category II distributions analyzed earlier in section
3 (since D and C behave similarly). However, it is
clear from Table 3 that pure shutdowns are not
present in this case. While, as discussed earlier, it is
true that the optimal order-up-to levels y and yT approach 0 as s approaches 1, nevertheless y and yT
remain positive for all s and thus, technically, neither
the decentralized nor the centralized system ever
shuts down completely.
However, if we define shutdown to have occurred when y (or yT ) is below some sufficiently
small e40, then this certainly accounts for D 5 C 0
for sufficiently large s. On the other hand, this does
not explain the behavior of the D measure, which first
increases with s, peaks at a certain level, and then
begins to decline. What triggers this decline?
We point out that the behavior of D is not (or, at
least not completely) accounted for by the behavior of
y and yT . For Category II distributions, y first increases and then decreases with s for a40.5 and
decreases everywhere for a 0.5. This was established theoretically for the Gamma and Lognormal
distributions by Gallego et al. (2007) and numerically
for the Weibull distribution in our earlier experiments;
moreover, we observed the same behavior for yT.
However, as we saw in Figure 1, for a 5 0.35 the absolute savings D goes through a period of increase
followed by a decline even though from Table 3 we
see that y and yT are declining throughout.
The behavior of D appears to be driven by the optimal expected overage cost co Ey D . As
illustrated in Figure 5a and b for the Gamma distribution (the patterns for all other distributions are very
similar), the optimal expected overage cost first increases and then decreases with s. This parallels the
behavior of D and, we believe, provides an explanation for it.
Note that the newsvendor model is designed to
balance overage and underage risks. Thus, as the
variability (i.e., coefficient of variation) of demand increases, we would expect both the overage and the
underage costs to rise. However, at some high level of
variability, the expected overage cost begins to fall to 0
while the expected underage cost increases to the
maximal level of cum. Thus, at some level of variability,
the system is no longer willing to take the risk of
68
Figure 5
Optimal Costs (Overage Cost in Black and Underage Cost in Grey) and Pooling Savings as Functions of r
having too much inventory, accepting higher and

higher underage costs instead. We call this the effective shutdown regime for the newsvendor system.
This behavior occurs for both the decentralized and
the centralized systems butbecause of the lower

variabilityit sets in at a higher level of s in the latter
case. As we see from Figure 5 (and from Table 3), the
peak of the absolute savings due to centralization D
occurs exactly during the period when the decentralized system has already entered into the effective
shutdown regime, while the centralized system is still
operational. Once both systems are in the effective
shutdown regime, D declines rapidly to 0. The relative
savings measure C appears to be even more sensitive
to this effect: while C is fairly flat when both systems
are operational, it begins to decline rapidly with s as
soon as the decentralized system enters the effective
shutdown regime.
The observed pattern with respect to the number of
locations n for a given level of s is similarly explained.
When the coefficient of variation of demand CV is
sufficiently high to place the decentralized system
into the effective shutdown regime, a certain level
of n may be required before the coefficient of variation
of the centralized system CVT is low enough to ensure
that the system is operational. Once this level is
reached, both D and C increase with n as further decreases in CVT give more and more advantage to the
centralized system.
To summarize, the newsvendor system for Category II distributions analyzed in this paper (and likely
for many other distributions as well) goes through the
following three regimes as s increases:
Regime 1: Normal operation. At low levels of variability, both the optimal overage and the optimal
underage costs increase with variability; we call this
the normal operation regime.
Regime 2: Effective shutdown. Above a certain level of
the coefficient of variation, the optimal overage cost
begins to decrease while the optimal underage cost
continues to increase with variability; we call this the
effective shutdown regime.
Regime 3: Complete shutdown. At still higher levels of
variability, the optimal order-up-to level as well as the
optimal overage cost are essentially equal to 0; we call
this the complete shutdown regime.
An intuitive explanation of the complete shutdown
regime is as follows. When the variance is excessively
large and the mean is fixed, for any y40, there is a
high probability that the demand is much smaller
than y and the overage cost is wasted. On the other
hand, for any y40, there is a high chance of having
demand much larger than y, so the underage is still
very large. Hence, by ordering nothing, we at least
save on the overage cost, i.e., y must be 0.
While both the decentralized and the centralized
systems go through the above three regimes as the
variability is increased, the decentralized system enters them at lower levels of demand variability. Hence,
when comparing the decentralized and centralized
systems, we observe five modes as follows:
Mode 1: Both systems operational. As long as the demand variability does not exceed a certain threshold,
the optimal overage cost increases with s for both the
69
decentralized and the centralized systems. The absolute savings D is growing while the relative savings C
is fairly constant in this range.
Mode 2: Effective shutdown of the decentralized system.
The decentralized system enters the effective shutdown regime: the optimal overage cost (as well as the
optimal order-up-to level y ) is decreasing as s grows.
The centralized system is still in normal operation (the
optimal overage cost is growing with s). The absolute
savings D peaks in this range while the relative
savings C begins to decline.
Mode 3: Both systems in the effective shutdown regime.
The centralized system also enters the effective shutdown regime. The optimal overage cost is decreasing
as s grows for both systems. Both D and C are
decreasing.
Mode 4: Complete shutdown of the decentralized system.
The decentralized system enters the complete shutdown regime: the optimal overage cost (as well as y )
is near 0 for the decentralized system. The centralized
system is still in the effective shutdown regime (the
optimal overage cost is decreasing as s grows). Both D
and C are approaching 0.
Mode 5: Complete system shutdown. The centralized
system also enters the complete shutdown regime.
The optimal overage cost is near 0 for both systems.
No orders are being placedfull underage cost is
booked. In this range, D 5 C 5 0.
The managerial takeaway from this analysis is even
simpler: since, in practice, a system should not be
operated in the effective shutdown regime, the centralization is always increasingly beneficial in the
relevant operating range. Once the absolute savings of
centralization begin to decline, it is a signal that the
variability is too large for the system (at least for the
decentralized configuration)centralization across a
number of locations is required for the system to
operate effectively.
A harder question to answer is: how would one
recognize the on-set of the effective shutdown regime
in practice, when the form of the distribution of D
may not be known? Here, the distribution-free system
appears to be of use: the CV thresholds for the shutdown of the decentralized and centralized
distribution-free systems appear to be good approximations for the on-set of the effective shutdowns in
the corresponding systems operating under various
Category II distributionssee Table 4. For example, if
the demand distribution is Lognormal and a 5 0.15,
the decentralized system enters the effective shutdown regime at CV 5 0.55 and the centralized system
enters the effective shutdown regime when
0.70oCV 0.90. Note that the distribution of the
centralized demand for the Lognormal and Weibull
distributions can only be computed numerically;
therefore, we are only able to compute a range for
70
Table 4
Effective Shutdown Threshold (CV) for Decentralized/Centralized Systems

Service level a
0.15
0.35
0.55
0.75
0.95
Lognormal
Demand distribution
0.55/(0.70, 0.90]
0.76/(1.00, 1.20]
1.02/(1.40, 1.60]
1.53/(2.20, 2.30]
4.54/(5.90, 6.10]
Gamma
0.55/0.78
0.75/1.07
1.01/1.43
1.48/2.09
3.54/5.01
Weibull
0.43/(0.60, 0.80]
0.63/(0.80, 1.00]
0.88/(1.20, 1.40]
1.32/(1.90, 2.10]
3.44/(4.80, 5.00]
Distribution-free
0.42/0.59
0.73/1.04
1.11/1.56
1.73/2.45
4.36/6.16
the CV values in those cases. Since the thresholds for

the distribution-free systems are computable from the
values of unit overage and underage costs, they can be
used as guidelines in practice.
6. Concluding Remarks
We consider risk pooling in a multi-location newsvendor problem and investigate the sensitivity of the
inventory pooling benefits to the standard deviation
of demands at each location and the number of locations. We show that as long as the coefficient of
variation of the demands is small (less than approximately 0.5), the behavior of savings due to pooling is
well approximated by the Normal distributionthe
absolute savings increases with the standard deviation of demand and the relative savings remains fairly
constant. The growth in the absolute savings continues as long as both the decentralized and the
centralized systems are in the normal operation regime characterized by the increase in both overage
and underage costs with the standard deviation of
demand. As the standard deviations of demand at
each location continue to grow, first the decentralized
and then the centralized systems enter the effective
shutdown regime where the benefits of risk pooling
decrease; the pooling benefits vanish as both systems
enter the complete shutdown regime. Overall, our
results indicate that pooling is beneficial in the normal operating range of the system.
Many problems remain open in this line of research.
First, a great deal of our analysis is based on Monte
Carlo simulations due to the inability to analyze the
behavior of the centralized system analytically under
Category II distributions. Theoretical analysis substantiating the three regimes described above would
be very valuable. Second, it is intuitively clear that our
results do not apply to all demand distributions
only to those for which the order-up-to level approaches 0 as the standard deviation of demand
grows. The behavior under other positive distributions (i.e., the ones with positive support) that do not
satisfy the above condition remains to be analyzed.
Finally, we note that the lower bound on the benefits of pooling obtained via the distribution-free
approach in section 4 appears to be pretty weak. Obtaining better bounds and/or approximations on the
absolute and relative savings of inventory pooling
would be of theoretical and practical interest.
Acknowledgments
This work was partially supported by NSERC grants of the
first two authors. The authors would like to thank the senior
editor and the two referees for their valuable comments.
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Supporting Information
Additional supporting information may be found in the
Online Supplement of this article:
Appendix S1. Online Supplement.
71
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PRODUCTION AND OPERATIONS MANAGEMENT

Vol. 20, No. 1, JanuaryFebruary 2011, pp. 5771

On the Benefits of Risk Pooling in

The reasons for this behavior have to do with the

We note that while it is possible to analyze the

2. The Model and Preliminary Results

To avoid trivial cases, we will assume that s, co, cu40.

The system above describes the inventory operation at

Observe that D is increasing in the standard deviation

the mean m and the standard deviation s by m 5 k/y

Weibull (Online Supplement)

Gamma (Online Supplement)

Logistic (Online Supplement)

Laplace (Online Supplement)

Uniform (Lau 1997)

Table 1 Expressions for Optimal Order-up-to-Level and Minimum Expected Cost

ln1 ccuo cu ln1 ccuo

relevant derivations can be found in the Online

3.1. The Impact of the Variability of Demand

Thus, yT can be determined by solving the following

Service Level = 0.35 (Category I)

Service Level = 0.35 (Category II)

OPT overage cost

OPT overage cost

timal order-up-to level, the optimal costs (before

Pooling Savings as Functions of r for a = 0.35

reaches a peak and then decreases rapidly) for all

when the service level is high (this is natural

4. Impact of Centralization: The

Figure 2 Pooling Savings as Functions of n for Gamma Distribution

approach, we assume that nothing is known about the

1. For an order-up-to level y 0,

It is not hard to show that the optimal distributionfree cost is given by

^ is the optimal order-up-to level for

long as the variability is not too

Figure 3 Absolute Savings vs. Standard Deviation (Distribution Free)

this behavior are quite transparent here. In fact, the

Figure 4 Relative Savings vs. Standard Deviation (Distribution Free)

The maximal distribution has the two-point c.d.f.

5. Effective Shutdowns and

having too much inventory, accepting higher and

the centralized systems butbecause of the lower

Effective Shutdown Threshold (CV) for Decentralized/Centralized Systems

the CV values in those cases. Since the thresholds for

Please note: Wiley-Blackwell is not responsible for the

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