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Uncertain Demand: The Newsvendor Model

Inventory Models
Background: expected value
What is the expected profit for a stock of 100 mangoes ?
0.8 x 100 ($4) + 0.2 x 100 x ($1) = 320 + 20 = $340
Undamaged mango Damaged mango
Profit $ 4 $ 1
Probability 80% 20%
random variable: a
i
probability: p
i
Expected value = a
1
p
1
+ a
2
p
2
+ + a
k
p
k
= E
i = 1,,k
a
i
p
i

A fruit seller example
Probabilistic models: Flower seller example
Wedding bouquets:

Selling price: $50 (if sold on same day), $ 0 (if not sold on that day)

Cost = $35
number of bouquets 3 4 5 6 7 8 9
probability 0.05 0.12 0.20 0.24 0.17 0.14 0.08
How many bouquets should he make each morning
to maximize the expected profit?
Probabilistic models: Flower seller example..
number of bouquets 3 4 5 6 7 8 9
probability 0.05 0.12 0.20 0.24 0.17 0.14 0.08
CASE 1: Make 3 bouquets

probability( demand 3) = 1 Exp. Profit = 3x50 3x35 = $45
CASE 2: Make 4 bouquets

if demand = 3, then revenue = 3x $50 = $150
if demand = 4 or more, then revenue = 4x $50 = $200
prob = 0.05
prob = 0.95
Exp. Profit = 150x0.05 + 200x0.95 4x35 = $57.5
Probabilistic models: Flower seller example
number of bouquets 3 4 5 6 7 8 9
probability 0.05 0.12 0.20 0.24 0.17 0.14 0.08
Expected profit 45 57.5 64 60.5 45 21 -10
Making 5 bouquets will maximize expected profit.
Compute expected profit for each case
Probabilistic models: definitions
number of bouquets 3 4 5 6 7 8 9
probability 0.05 0.12 0.20 0.24 0.17 0.14 0.08
Discrete random variable
Probability (sum of all likelihoods = 1)
Continuous random variable:

Example, height of people in a city
Probability density function (area under curve = integral over entire range = 1)
-4 -3 -2 -1 0 1 2 3 4
140 150 160 170 180 190 200
Probabilistic models: normal distribution function
Standard normal distribution curve: mean = 0, std dev. = 1
-4 -3 -2 -1 0 1 2 3 4
a
b
P( a x b) = }
a
b
f(x) dx
Property:
normally distributed random variable x,
mean = , standard deviation = o,
Corresponding standard random variable: z = (x )/ o
z is normally distributed, with a = 0 and o = 1.
The Newsvendor Model
Assumptions:

- Plan for single period inventory level

- Demand is unknown

- p(y) = probability( demand = y), known

- Zero setup (ordering) cost
Example: Mrs. Kandells Christmas Tree Shop
How many trees should she order?
Order for Christmas trees must be placed in Sept
If she orders too few, the unit shortage cost is c
u
= 55 25 = $30
If she orders too many, the unit overage cost is c
o
= 25 15 = $10
Sales 22 24 26 28 30 32 34 36
Probability .05 .10 .15 .20 .20 .15 .10 .05
Past
Data
Cost per tree: $25 Price per tree:
$55 before Dec 25
$15 after Dec 25
Stockout and Markdown Risks
D total demand before Christmas

F(x) the demand distribution,

D > Q stockout, at a cost of: c
u
(D Q)
+
= c
u
max{D Q, 0}

D < Q overstock, at a cost of c
o
(QD)
+
= c
o
max{Q D, 0}
1. Mrs. Kandell has only one chance to order
until the sales begin: no information to revise the forecast;
after the sales start: too late to order more.

2. She has to decide an order quantity Q now
Key elements of the model
1. Uncertain demand

2. One chance to order (long) before demand

3. ( order > demand OR order < demand) COST
Model development
Stockout cost = c
u
max{D Q, 0}

Overstock cost = c
o
max{Q D, 0}
Total cost = G(Q) = c
u
(D Q)
+
+ c
o
(Q D)
+

Expected cost, E( G(Q) ) = E(c
u
(D Q)
+
+ c
o
(Q D)
+
)

= c
u
E(D Q)
+
+ c
o
E(Q D)
+

=
+

=
+

=
+ +
+ = + =
Q
x
o
Q x
u
x
o u
x P x Q c x P Q x c x P x Q c Q x c
0 0
) ( ] ) ( [ ) ( ] ) ( [ ) ( ] ) ( ) ( [
Model Development: generalization
Suppose Demand a continuous variable

++ good approximation when number of possibilities is high

-- difficult to generate probabilities, but
++ probability distribution can be guessed

=
+

=
+
+ =
Q
x
o
Q x
u
x P x Q c x P Q x c Q G E
0
) ( ] ) ( [ ) ( ] ) ( [ )) ( (
} }

= =
+ = =
Q x
u
Q
x
dx x P Q x c dx x P x Q c Q G E Q g ) ( ) ( ) ( ) ( )) ( ( ) (
0
0
Model solution
} }

= =
+ = =
Q x
u
Q
x
dx x P Q x c dx x P x Q c Q G E Q g ) ( ) ( ) ( ) ( )) ( ( ) (
0
0
0 ) ( ) ( ) ( ) (
0
0
=
|
|
.
|

\
|
+
} }

= = Q x
u
Q
x
dx x P Q x c dx x P x Q c
dQ
d
g(Q) is a convex function: it has a unique minimum

when g(Q) is at minimum value, F(Q) = c
u
/(c
u
+ c
o
)
Minimize g(Q)
0
) (
=
dQ
Q g d
The Critical Ratio
= c
u
/(c
o
+ c
u
) is called the critical ratio
| relative importance of stockout cost vs. markdown cost
Solution to the Newsvendor problem:
u
u
c c
c
Q F
dQ
Q dg
+
= =
0
*) ( 0
) (
Mrs. Kandells Problem, solved:
= c
u
/(c
o
+ c
u
) = 30/(30 + 10) = 0.75
c
u
= 55 25 = $30
c
o
= 25 15 = $10
Past
Data
D 22 24 26 28 30 32 34 36
Probability 0.05 0.1 0.15 0.2 0.2 0.15 0.1 0.05
F (D) 0.05 0.15 0.3 0.5 0.7 0.85 0.95 1
optimum 31
NOTE: E(D) = 22x 0.05 + 24 x 0.1 + + 36 x 0.05 = 29
Newsvendor model: effect of critical ratio
= c
u
/(c
o
+ c
u
) = 30/(30 + 10) = 0.75 optimum: 31
D 22 24 26 28 30 32 34 36
Probability 0.05 0.1 0.15 0.2 0.2 0.15 0.1 0.05
F (D) 0.05 0.15 0.3 0.5 0.7 0.85 0.95 1
| overstock cost less significant order more
| overstock cost dominates order less
Summary
When demand is uncertain, we minimize expected costs

newsvendor model: single period, with over- and under-stock costs

Critical ratio determines the optimum order point

Critical ratio affects the direction and magnitude of order quantity
Example: Dell I nc.
Dell's direct model enables us to keep low component inventories
that enable us to give customers immediate savings when
component prices are reduced, ...
Because of our inventory management, Dell is able to offer some
of the newest technologies at low prices while our competitors struggle
to sell off older products.
Concluding remarks on inventory control
Inventory costs lead to success/failure of a company
Drive to reduce inventory costs was main motivation for
Supply Chain Management
next: Quality Control

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