Constant Salvage Value Models: A Source of Systematic Bias in Predicting the Value of Lead-Time Reduction

Abstract

The assumption that unsold goods can be liquidated at a constant salvage value is widespread in inventory theory. We show that, under general mathematical conditions, this modeling assumption will cause companies to underestimate both the value of lead-time reduction and the cost of lead time increases. Our result does not require that companies actively consider the possibility of non-constant salvage values. Rather we show that, in an environment where salvage values are allowed to depend on the amount of overage, a firm that cuts lead times according to a strategy that assumes a constant salvage value will earn more money than predicted from its lead-time reduction.

Keywords: Lead Time, Newsvendor Model, Martingale Model of Forecast Evolution, Salvage Value