Inventory Decisions Under Uncertainty: Normal Demand

1. Review of Inventory issues

2. The newsvendor model
3. Demand forecasts
4. Performance Measures
5. Order quantities

Goals:

1. Describe inventory systems operationally.

2. Understand financial measures of inventory systems.

3. Formulate a model describing the behavior of an inventory system.

4. Derive an optimal policy with respect to the formulated model.

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What can happen: Cellphones (NYTimes Article)

Source: “Cellphone envy lays Motorola low”, Brad Stone, New York Times, Business Day Section, page B1, 2/3/2007.

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Some inventory items have short shelf lives

Perishable items (fresh food, flowers)

Trend-driven items (clothing and fashion items)
Items where technology is changes quickly (cell phones, DVD players, other electronics)
Seasonal items (Holiday cards, foods, ornaments, etc.)

If you keep an unsold item in inventory, it is stealing some of your capital.

If you don’t keep an unsold item in inventory you may have to sell it at a loss.

If you don’t order enough inventory, you lose the opportunity to make a sale.

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A brief look at the fashion industry

Typical apparel companies average 5.0 inventory turns per year.

Zara
The Spanish Zara turns it’s inventory 10+ times per year. Abercrombie & Fitch
Arcadia
Benetton
El Corte Inglés
Etam Développement
Zara’s secrets? Good forecasts, small lot sizes, moving fast. Fast Retailing
French Connection
Zara has a 30 day production cycle. The Gap
H&M
U.S. companies take about 105-240 days for their production cycle. Limited Brands
Marks & Spencer
Naf Naf
Zara introduces new items ≈ every 2 weeks. New Look
NEXT
Customers can’t “wait for a discount” if the item will be gone the next Vivarte

time they visit.

Zara has low “inventory mismatch costs”

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Single-period inventory model: O’Neill, Inc.

O’Neill, Inc. Sports apparel (wet suits) for water sports.

Designed in U.S.A. made in Mexico and Asia.
Two selling seasons (Fall, Spring)
Some products have a “long shelf life” (neoprene booties)
Some products are subject to “the whims of fashion”...
... they are difficult to sell at the end of the season. The “Hammer
3/2” is one of these...

Hammer 3/2 Suit

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Order cycle: O’Neill, Inc. “Hammer 3/2 Suit”
Three month lead time on ordering:
Orders must be submitted in Nov. (for spring selling
season.)
“Point Estimate” of demand = 3200 units.
O’Neill has a much better estimate of demand after
the season starts (hot? cold? or just average?)...
... By then it is too late to order from Asian
manufacturers for delivery for this season.
Experience: forecast is off by 25% or more at least
half the time:

Hammer 3/2 Suit

Half the time demand is between 75% and 125%
of the original point estimate forecast.

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Economics: O’Neill, Inc. “Hammer 3/2 Suit”

Demand is forecast for 3,200 units sold in the spring,

O’Neill’s manufacturing cost = $110.
Sale price (direct, to retailer) = $180.
End-of-season discount price (direct, to retailer) = $90.
Hammer 3/2 Suit

How many units should O’Neill order?

1. Order at the forecast, point estimate of 3,200?

2. Order less than 3,200?

3. Order more than 3,200?

Order first, then observe the random variable of demand later

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A problem similar to O’Neill’s

The news vendor must purchase newspapers at the start of the day before attempting to
sell them at her designated street corner.
The news vendor pays $0.35 for each newspaper, sells each newspaper for $1.00 and
each unsold newspaper has a value of $0.01 at the end of the day.
Our news vendor orders a quantity y first, then observes (probabilistic) demand second.

There is a trade-off between ordering too many and too few:

1. If she orders too few, she could have sold more (an oppor-
tunity loss: $0.65 each.)
2. If she orders too many, she will have left overs, (at a net
loss of $0.34 each.)

The newsvendor must make a firm “bet” (how much inven-

tory to order) before some random event occurs (demand).

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The newsvendor single-period inventory model
Used to handle ordering perishable items with limited useful life.
1. Items with short shelf-lives: Newspapers, magazines.
2. Perishables: Fruit , flowers, baked goods, etc.

Items are not carried over from period to

period.
Unsold items can be “salvaged”

There are three monetary inputs:

1. p = price (revenue) per unit sold.
2. c = cost per unit.
3. s = salvage value per unit.

Example product
Data Newspaper O’Neill Hammer 3/2
p Per-item sales revenue $1.00 $180
c Manuf./acquisition cost 0.35 110
s End-period salvage revenue 0.01 90

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Steps for implementing the Newsvendor model

Step 1: Gather economic inputs:

p: Selling price,
c: production/procurement cost,
s: salvage value of inventory.

Step 2: Generate a demand model: (From historical data, expert opinion) Use
a probability model for estimating demand. You may choose to use a stan-
dard distribution function to represent demand, e.g. the normal distribu-
tion, the Poisson distribution or base your demand on the use of historical
data using an empirical demand distribution.

Step 3: Choose an objective: e.g. maximize expected profit

Step 4: Choose a quantity to order.

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Building a forecast distribution of demand
You want demand (not just sales), you need a point estimate, a measure of uncertainty and the shape (type)
of distribution of demand (uniform, normal, discrete).
What are the sources of forecast errors and what do they look like?

Forecasts and actual demand for surf wet-suits from the previous season

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Normally distributed demand: Tutorial (or...refresher)
Suppose demand is normally distributed;
Suppose that mean demand = µ and standard deviation = σ.
Case 1: Suppose your boss chooses to order a quantity of items Q
What is the probability that demand is less than the amount Q?

P (demand ≤ Q) ≡ P (Z ≤ z1 ), where
Q−µ
z1 =
σ

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Normally distributed demand: Tutorial (or...refresher)
Example: Suppose µ = 300, σ = 50 and Q = 325,
What is the probability statement?

What is the probability demand is less than Q = 325 units.?

What is standardized z value?

z = 325−300
50 = 0.5.

What is the probability? (Table: page 378).

Probability demand ≤ 325 units is Φ(0.5) = 0.6915.

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Case 2: A 97.5% service level
Case 2: Suppose you want to choose a quantity to order Q so that you have a 97.5%
probability of satisfying all demand in the next period?

Example: Suppose µ = 300, σ = 50. You want

P (demand ≤ Q) = 0.975.

You know µ and σ and now a probability. You must calculate Q.

We need to find the z value for 0.975 (Table: page 378 z = 1.96)

Q = µ + z × σ = 300 + (1.96) × (50) = 398units.

Note:
Q−µ
z1 = or Q = µ + z1 × σ
σ

(The above are two ways to write the same equation, the first allows you to calculate z
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from Q and the second lets you calculate Q from z.)

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Another example using the normal distribution
F (Q) = Probability(demand ≤ Q)

Q−µ
P (d ≤ Q) = P (z ≤ ) ≡ Φ(z)
σ
In this example suppose µ = 3192, σ = 1181
and you desire to find the probability that demand
is less than Q = 3664 units.

To determine P (d ≤ 3664) compute the z

value:
3664 − 3192
z1 = = 0.400,
1181
then

P (d ≤ 3664) = P (z ≤ 0.4) = Φ(0.4) = 0.6554 ,

using the tables, on pages 377–378 of Cachon.

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Single-period inventory model: Costs of lost sales and overstocking
There are two resulting inventory costs from any ordering decision:
1. Stock-out cost (shortage cost) Potential lost profit due to stockout:

Cu = Revenue per unit - cost per unit = (p − c)

2. Mark-down cost (excess cost):

Co = original cost per unit - salvage value per unit = (c − s)

If the news vendor carries one too-many papers, she is left with a marginal profit
of her cost less the salvage value of the extra newspaper (Co ). If the news vendor
carries one too-few papers she incurs the loss of profit corresponding to the price
of the newspaper less her cost (Cu ).

Data Newspaper O’Neill Hammer 3/2

p Per-item sales revenue $1.00 $180
c Manuf./acquisition cost 0.35 110
s End-period salvage revenue 0.01 90
Cu underage (opportunity) cost 0.65 70
Co cost per unit of leftover inventory 0.34 20
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Relationship of Q to expected gains and losses for the Hammer 3/2
Gain on a sold unit = $180 - $110 = $70
Loss on an unsold unit = $110 - $90 = $20
As Q increases, the marginal (per unit) expected gains decrease from $70 and
marginal expected losses increase to $20.

$ per unit

Marginal per unit expected gains and losses: Hammer 3/2

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Balancing Expected Costs

Co Cu

Service Level
↑ Quantity →
Q
Balance point Q = optimal stocking level
Consider the “last” item in the ordering quantity Q.
If demand > Q, then we lose Cu in profits.
If demand < Q then we lose Co in profit.
Since we don’t know demand, we have to compute expected losses.
It makes sense to choose Q so that the marginal expected costs of too much inventory are equal to
the marginal expected cost of too little inventory.

The “expectation” of demand depends on the distribution.

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Choosing Q: Special Case–Uniform Demand
Co Cu

Service Level
↑ Quantity →
Q
Balance point: Q = optimal stocking level
Service level is the probability that demand ≤ the stocking level.
Service level is the key to determining the optimal stocking level Q.
C
The critical value is = C +C
u
u o

Suppose our newsvendor has uniform demand between 200 and 400 papers.
For the newsvendor’s newspaper problem = C C+C
u
= 0.65
0.65+0.34 = 0.657.
u o

For the uniform demand case she orders 200 + 0.657 × (400 − 200) = 331 papers
We order Q so that the probability not having enough (stockout) is the critical value
Cu
P (demand ≤ Q) = Cu +Co

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Choosing Q: Case–Normally Distributed Demand
Suppose that our news vendor had normally distributed demand with mean demand µ = 200 and
standard deviation σ = 40 newspapers. What would be her optimal stocking level Q?
Density Demand Distribution

Service Level =
P(STOCKOUT)=0.656

1. Cu = $1.00 − $0.35 = $0.65 per paper.

50 100 150 200 250 300 350

2. Co = $0.35 − $0.01 = $0.34 per papers.
Demand
Cu 0.65
3. Critical Ratio = Cu +Co
= 0.99
= 0.657
4. Using our table P (Z ≤ z) = SL gives z = 0.41.

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Choosing Q: Case–Normally Distributed Demand
Suppose that our news vendor had normally distributed demand with mean demand µ = 200 and
standard deviation σ = 40 newspapers. What would be her optimal stocking level Q?
Demand Distribution

1. Cu = $1.00 − $0.35 = $0.65 per paper.

Density

2. Co = $0.35 − $0.01 = $0.34 per papers.

Service Level =
P(STOCKOUT)=0.656
Cu 0.65
3. Critical Ratio = Cu +Co
= 0.99
= 0.657
4. Using our table P (Z ≤ z) = SL gives z = 0.41.
50 100 150 200 250 300 350
Demand
5. The optimal stocking level is thus

Q = µ+z×σ
= 200 + (0.41)(40)
= 216 papers.

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Case–Normal distribution method: finding the profit-maximizing Q
Step 1: Gather your inputs (here for the Hammer 3/2 example:)
1. Standard normal table (pgs. 377–378).
2. p = 180; c = 110; s = 90; Cu = 180 − 110 = 70; Co = 110 − 90 = 20
3. µ = 3192 Point estimate–the forecast of demand.

4. σ = 1181 Estimate of standard deviation of the forecast.

Step 2: Evaluate the critical ratio:

Cu 70
Cu +Co
= 70+20
= 0.7778

Step 3: Lookup 0.7778 Look up critical ratio in the Standard Normal Distribution Function Table (page
377–378) If the critical ratio falls between two values in the table, choose the greater z-statistic For this
product, we choose z = 0.77 (From the table we find that z = 0.77 → P (z ≤ 0.77) = 0.7794.)

Step 4: Convert z score into the order quantity:

Q = µ + z × σ =–21–
3192 + 0.77 × 1181

= 4101.
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The Expected Loss Function-Discrete Case

Since demand is a random variable, for most choices of Q there will be a positive
probability that actual demand exceeds your choice.

This is the expected shortfall of units for your order quantity Q.

Note, even if Q > µ, this quantity may be nontrivially large.

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Lost Sales Explained
Suppose demand is discrete, Q∗ = 120 and demand (D) can be any one of {0, 10, 20, . . . , 200}

Associated with each choice of D is

a probability (e.g. P (D = 140)).
When D ≤ 120 there is no loss.
When D > 120 loss is (D − Q)
Expected Lost Sales =
10 × P (D = 130)+
20 × P (D = 140)+
. . .
. . .
. . .
80 × P (D = 200) =

200
X
(x − Q) × P (D = x).
x=130

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Example: Loss Function for Discrete Demand
The left columns are the distribution of demand.
The Loss is calculated for an order of size Q = 120

L(Q) = Expected Lost sales (the sum of the left-hand column) = 7.777 units.

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The Expected Loss Function - Normal Case
Assume demand is normally distributed.

For any choice of Q there will be a positive probability that demand > Q.
The expected number shortfall of units is a positive number for normal demand.

The loss function is defined for every choice of Q

Z ∞
L(Q) = Loss Function for choice Q = L(Q, µ, σ) = (x − Q)φ(x)dx,
Q

where φ(x) is the normal density with mean µ and standard deviation σ .

Luckily, we do not have to perform the integration above, since

L(Q) = L(z) × σ ,
where we convert Q to find z and then look up L(z) in a table (pages 379–380)...

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Loss Function with the Normal Distibution
Suppose demand is a normally distributed random variable with µ = 5000 σ = 1000.
Your boss chooses order quantity Q = 5900. What is Expected Lost Sales?

Demand Distribution mean=0, std.dev.=1

0.4
0.3
z = 0.9
Density
0.2

Loss=L(.9)=0.1004
Unshaded
0.1

Area=0.8159
0.0

!4 !2 0 2 4
Q=Quantity

Q−µ 5900−5000
z= σ
= 1000
= 0.9

From page 380 of the text, we find that L(z) = L(0.9) = 0.1004,
Expected Lost Sales = L(z) × σ = (0.1004) × (1000) = 100.4.
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Newsvendor model performance measures
For any order quantity we would like to evaluate the following performance measures:

1. Expected lost sales: The average number

of units demand exceeds the order quan-
tity
2. Expected sales: The average number of
units sold.
3. Expected leftover inventory: The average
number of units left over at the end of the
season.
4. Expected profit
5. Expected fill rate: The fraction of demand
that is satisfied immediately
6. In-stock probability: Probability all de-
mand is satisfied
7. Stockout probability: Probability some de-
mand is lost

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1.Expected Lost Sales of Hammer 3/2s with Q = 3500
Definition: The average number of units demand exceeds the order quantity:
e.g., if demand is 3800 and Q = 3500, then lost sales is 300 units.
e.g., if demand is 3200 and Q = 3500, then lost sales is 0 units.
Expected lost sales is the average over all possible demand outcomes. If demand is normally distributed:

Step 1: Normalize the order quantity to find its z-statistic.

Q−µ 3500 − 3192

z= = = 0.26
σ 1181

Step 2: Look up in the Standard Normal Loss Function Table (page 379–380 of the text) the expected lost
sales for a standard normal distribution with that z-statistic: L(0.26) = 0.2824

you can find L(z) in Excel, by plugging in your value for z into (e.g. substitute 0.26 for z):
=Normdist(z,0,1,0)-z*(1-Normsdist(z))

Step 3: Evaluate lost sales for the actual normal distribution:

Expected Lost sales = σ × L(z) = 1181 × 0.2824 = 334.
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Performance measures 2–5 follow from expected lost sales
2. Expected Sales (the average number of units sold)

= µ− Expected lost sales = 3192 − 334 = 2858

3. Expected leftover inventory (The average number of units left over at the end of the season)

= Q− Expected sales = 3500 − 2858 = 642.

4. Expected Profit:

= (Price - Cost) × (Expected Sales) −(Cost - Salvage Value) × (Expected Leftover Inventory)
= ($70 × 2858) −($20 × 642)
= $187, 221

5. Expected fill rate (The fraction of demand that is satisfied immediately):

Expected Sales Expected Sales

= =
Expected Demand µ
Expected lost sales
= 1−
µ
2858
=
3192
= 89.6%

Note, the above equations hold for any demand distribution.

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 Performance measures (6–7): Service related performance
6. In-stock probability (Probability all demand is satisfied)= F (Q) = Φ(z):
Evaluate the z-statistic for the order quantity :

Q−µ 3500 − 3192

z= = = 0.26
σ 1181
Look up Φ(z) in the Std. Normal Distribution Function Table (pages 377-378)

Φ(0.26) = 60.26%

Note:The in-stock probability is not the same as the fill rate

7. Stockout probability (Probability some demand is

lost) = 1 − F (Q)
= 1−In-stock probability
= 1 − 0.6026 = 39.74%

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Choosing Q subject to a minimum in-stock probability
Suppose we wish to find the order quantity for the Hammer 3/2 that minimizes left over inventory while
generating at least a 99% in-stock probability.

Step 1: Using pages 377–378 of the textbook, find the z -statistic that yields the target in-stock probability.
In the Standard Normal Distribution Function Table we find Φ(2.32) = 0.9898 and
Φ(2.33) = 0.9901. Choose z = 2.33 to satisfy our in-stock probability constraint.

. . . . . . . . . . .
. . . . . . . . . . .
. . . . . . . . . . .

Step 2: Convert the z -statistic into an order quantity for the actual demand distribution.

Q = µ + z × σ = 3192 + 2.33 × 1181 = 5944

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Choosing Q subject to a minimum fill rate constraint
Suppose we wish to find the order quantity for the Hammer 3/2 that minimizes left over inventory while
generating at least a 99% fill rate.
Step 1: Find the lost sales with a standard normal distribution that yields the target fill rate.
„ «
µ 3192
L(z) = × (1 − Fill rate) = × (1 − 0.99) = 0.0270.
σ 1181
Step 2: Using pages 379–380 of the textbook, find the z -statistic that yields the lost sales found in step 1.
From the Standard Normal Loss Function Table,

L(1.53) = 0.0274 and L(1.54) = 0.0267

Choose the higher z-statistic, z = 1.54

. . . . . . . . . . .
. . . . . . . . . . .
. . . . . . . . . . .

Step 3: Convert the z-statistic into an order quantity for the actual demand distribution.

Q = µ + z × σ = 3192 + 1.54 × 1181 = 5011.

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Newsvendor Summary

Too Little Inventory Too Much Inventory

The model can be applied to settings in which....

1. There is a single order/production/replenishment opportunity.
2. Demand is uncertain.
3. There is a “too much-too little” challenge:
If demand exceeds the order quantity, sales are lost.
If demand is less than the order quantity, there is left over inventory.

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Newsvendor Summary II
Firm must have a demand model that includes an expected demand and
uncertainty in that demand.
With the normal distribution, uncertainty in demand is cap-
tured with the standard deviation parameter.

For maximizing expected profit, find Q so that “the probability that

demand is less than the order quantity” equals the critical ratio defined
by price, salvage value and cost:
Underage
P (demand ≤ Q) = .
Underage + Overage

The expected profit maximizing order quantity balances the too much-too little costs.

Check your HW hand work: NewsvendorDoubleCheck.xls

Spreadsheet is downloadable from blackboard (“Course Materials”).
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