Session 9

The Newsvendor model

Winter 2017 Module 3

Krannert

School of Management

Professor Pengyi Shi

Midterm feedback

>70% students found the pace just about right, ~15%

students found the pace too fast, and ~10% too slow

More examples and practice problems

Some light HW after class

Summary slides at the end of class

Norton case (NAS) becomes optional

From your side:

Actively participate in case assignments

Go over class examples carefully, and finish the practice problems

Check video posted online

Today

The Flanders case discussion

The newsvendor model

Task: work on the newsvendor problem set

for tomorrows class

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Flanders of Springfield

Catalog Retailer

Womens clothing (Sweaters)

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Introduction to

Operations Management

Important decisions:

What products?

Quantity to order?

Catalog design? Distribution?

Selling price?

Demand forecast

How will you generate a demand forecast?

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Forecast

A good forecast is always a distribution!

Demand

Price $100 Price $120

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600 0.3 0.6

1200 0.4 0.3

2400 0.3

0.1

Expected Demand 1380 960

7
Expected contribution

Purchasing cost C = $35/sweater

Salvage value V = $15/sweater (liquidated at $15)

Selling price R = $100 & Order size Q = 1200

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Management

Demand Pty Contribution

600 (sale)

x 100$ + 600 (leftover) x 15$ 1200 x 35$ =

600 0.3

$27,000

1200 0.4 1200 x 100 1200 x 35 = $78,000

2400 0.3 1200 x 100

1200 x 35 = $78,000

Expected contribution = 0.3 x 27000 + 0.4 x 78000 + 0.3 x

78000=$62,700
Expected profit

Do the same calculations for order size of 600 and 2400:

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Order size Expected Profit Expected Profit

if Price is $100 if Price is $120

600 $39,000

$51,000

1200 $62,700 $64,200

2400 $69,300

$52,800
9
Perfect information

Assume you have perfect demand information.

How much will you order?

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Expected profit with perfect information:

600 x 65 x 0.3 + 1200 x 65 x 0.4 + 2400 x 65 x 0.3 = 89,700

How else can we calculate that?

Expected Demand (1380) x Profit margin ($65) = $89,700

Value of perfect information: $89,700$69,300= $20,400

10
Cost of mismatch

Perfect information leads to a perfect match between supply

and demand, and we have no leftovers or shortages.

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Without perfect information, there could be mismatch

between supply and demand. Value of information can be

interpreted as the cost of mismatch.

The goal of inventory management is to minimize the cost of

mismatch.
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Discussion

What are the pros and cons for ordering

more or ordering less?

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Example: Mr. Smiths

Christmas Tree Shop

Order for Christmas trees must be placed in Sept

If he orders too few

(shortage)

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Operations Management

If he orders too many (overage)

Mr. Smith has only one chance to order

until the sales begin: imperfect demand information;

after the sales start: too late to order more.

He has to decide an order quantity Q now

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Mr. Smiths Christmas

Tree Shop

Situation 1: Ordering too few

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Management

16
Mr. Smiths Christmas

Tree Shop

Situation 2: Ordering too many

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Newsvendor Model

Place an order

Begin

End Shortage

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Excess

Demand is realized

Objective:

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decide an order quantity Q to maximize the expected profit

Why Newsvendor?

Selling newspapers:

One day horizon;

Order at the beginning of the day;

Realize demand throughout the day;

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Newspapers become useless by the end of the day.

Important features

No inventory carry over

Also known as singleperiod inventory problem (no

replenishment)

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Where

can it be applicable?

Perishable items

Food

Seasonal goods

Fashion

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Sports

Flu vaccine

Revenue management

Seats on a plane

Hotel rooms

Rental cars

Entertainment events

Service industry
 Staffing

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Operating Room time allocation

Discrete demand example:

calendar

production

DateIt Co. must decide how many calendars to produce (order)

this year. Calendars are to be manufactured in advance of the

selling season (and only one manufacturing run is practical).

Demand is estimated to have the following distribution:

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Demand Probability

Sales price: $10

1,000 0.1

2,000 0.1


Salvage price: $1

3,000 0.2

Cost: $2

4,000 0.3

5,000

0.2

6,000 0.1

Mean 3,700

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How many calendars should we order?

 Produce mean

demand?

Mean Demand = 3700

What about Q = Mean Demand?

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Demand Probty Sales

Left Short

1,000 0.1 1,000 2,700 0

2,000 0.1 2,000

1,700 0

3,000 0.2 3,000 700 0

4,000 0.3 3,700

0 300

5,000 0.2 3,700 0 1,300

6,000 0.1

3,700 0 2,300
Mean: 3,700 3,120 580 580

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How much to produce?

Mean Demand = 3700

What about Q = 4000?

Demand Probty Sales Left Short

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1,000 0.1 1,000 3,000 0

2,000 0.1 2,000 2,000 0

3,000 0.2 3,000 1,000 0

4,000 0.3 4,000 0 0

5,000 0.2 4,000 0 1,000

6,000 0.1 4,000 0 2,000

Mean: 3,700 3,300 700 400

23
Coincidence?

We ordered 4,000 (Q=4,000)

Demand

Sales Left Short

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Expected: 3,700 3,300

700 400

E[Demand]= E[Sales] + E[Shortage]

Every customer turns into a sale or a shortage

Q = E[Sales] + E[Leftover]

Every unit ordered turns into a sale or a leftover

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How much to produce?

What about Q = 5000?

Demand Probty Sales Left Short

1,000 0.1 1,000 4,000

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2,000 0.1 2,000 3,000 0

3,000 0.2 3,000 2,000 0

4,000 0.3 4,000 1,000 0

5,000 0.2 5,000 0

6,000 0.1 5,000 0 1,000

Mean: 3,700 3,600

1,400 100

Is it better? 25
Compare

profits

Sources of revenue:

Sales: E[Sales] * Price

Salvage: E

[Leftovers] * Salvage

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to Operations Management

Costs: Q * Cost

Q=4000 Sales Left Short

Expected: 3,300 700 400

Profit: 3,300 * 10 + 700 * 1

4,000 * 2 = $25,700

Q=5000 Sales Left Short

Expected: 3,600

1,400 100

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Profit: 3,600 * 10 + 1,400 * 1 5,000 * 2 = $27,400

Compare profits

How much should we order?

Order Profit

3,000 21,300

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4,000

25,700

5,000 27,400

6,000

27,300

7,000 26,300

Why should not we order the mean?

Because having too many costs us less than having too few

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Too many vs too

few

Co = overage cost (marginal cost of a unit not sold)

The consequence of ordering one unit too many than what you would have

ordered had you known demand.

Calendar: 2 1=1

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Operations Management

Flanders: 35 15=20

Cu

= underage cost (opportunity cost or marginal profit)

The consequence of ordering one unit too few than what you

would have ordered had you known demand.

Calendar: 10 2 = 8

Flanders: 100

35 = 65

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Newsvendor critical ratio

What is optimal Q?

Benefit = Loss achieved at

F()

is the

CU

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F (Q ) cumulative

CO CU

distribution

function (CDF)
 This ratio is called the critical ratio or critical fractile.

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What is the

optimal Q?

Heuristic arguments

Benefit of increasing Q by 1 unit:

P(Demand > Q) * CU

= (1F(Q)) CU F() is the

cumulative

distribution

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Loss of increasing Q by 1 unit: function (CDF)

P(Demand Q) * CO =F(Q) CO

If Benefit > Loss, add one more unit to Q



If Benefit < Loss, subtract one more unit from Q

If Benefit = Loss, Q is just right!

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Discrete demand: calendar

The critical ratio is: 8/9 = .889

Demand Probability F(Q) = P

(D Q)

1,000 0.1 0.1

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2,000 0.1 0.2

3,000 0.2

0.4

4,000 0.3 0.7

5,000

0.2 0.9

6,000 0.1 1


Find the smallest value, such that P(D Q) is greater than or

equal

to the critical ratio.

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Try Flanders on your own

Cost = 35; Salvage

value = 20;

Demand CU Price $100

65

Price $120

.764

CU CO CU 85

10035 = 65 12035=85

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CO

3515 = 20 3515=20

CU

CO CU
 0.764 .809

Demand Price $100 F(Q) Price $120 F

(Q)

600 0.3 0.3 0.6 0.6

1200 0.4

0.7 0.3 0.9

2400 0.3 1 0.1

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Continuous

demand distribution

A more common way is to assume a normal demand

distribution

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Introduction to

Operations Management

All normal distributions are characterized by two parameters:

mean = and standard deviation =

All normal distributions are related

to the standard normal: 34

that has mean = 0 and standard deviation = 1.

Normal distribution tutorial

Find Probability that Demand is less than Q:

Let Q be some quantity, and ( , ) the parameters of the normal

demand forecast.

(D Q) = P(the outcome of a standard normal z) with

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z
36
Normal distribution tutorial

Find Q that guarantees a given probability p=P

(D Q):

For a given p, find corresponding z in the Standard Normal

Distribution Function

(or use Excel: = NORMSINV(p))

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Transform z into Q using formula:

Q z
CU

How to solve F (Q ) ?

CO CU

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Newsvendor Example with

Normal

Distribution

Demand for calendars is estimated to be normal with mean of 4,000

and standard deviation of 1,000.

Assume CO = $1 and CU = $9.

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Management

The critical ratio is: 9/10 = .9

Find z

value corresponding to the critical ratio: 1.29

Q* = mean + z

value * standard deviation =

4000+ 1.29*1000 = 5290

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Expected shortage, sale, and

profit

Slightly different from the discretedemand situation

Expected Shortage = L

(z)

Where L(z) is The Unit Normal Loss Function.

Use table or Excel:

(z) = NORMDIST(z,0,1,FALSE)z*NORMSDIST(z)

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Expected sales = Mean demand Expected shortage

Expected Profit =

Price * Exp. Sales + Salvage * Exp. Leftovers

Cost * Q
 For calendar example:

We found z = 1.29

L(z) = 0.0465

Expected Shortage = 0.0465*1000 = 46.5

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Expected Sales = 4000 46.5 =3953.5

Fill rate

Percentage of demand filled immediately from inventory

Expected Sale

Fill rate

Mean Demand

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Mean Demand - Expected Shortage

Mean Demand

Expected Shortage

1
 Mean Demand

40
Fill rate with Normal distribution

Calendar example:

We found z = 1.29

L(z) = 0.0465

Expected Shortage = 0.0465*1000 = 46.5

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Fill rate = 1

46.5/4000 = 98.83%

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Service

Level

The probability of NOT stocking out

Calendar example

CU

F (Q )

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Target service level:

9/10 = .9

CO CU

How about discrete demand?

42
Purchase price: Cost: C

Revenue: R

Summary Slides

Salvage value: V

Basic framework for newsvendor problem:

First

step: find the newsvendor critical ratio

CU R C

CO CU (C V ) ( R C )

Discrete

demand

Find the optimal order quantity Q such that

Pr{ Demand Q

} critical ratio

Calculate expected sales directly from the demand distribution

Calculate the expected profit: Price * Exp. Sales + Salvage * Exp. Leftovers
 Cost * Q

Normal demand (next slide)

Normal demand

Summary Slides

Normal distribution is characterized by two parameters

Mean demand ()

Standard deviation ()

Step 1: Use standard normal table to find zstatistics ( zratio )

zratio

is the value such that the probability of a standard normal zratio

Step 2: Convert z

statistics into the equivalent order quantity Q*

Q* = + zratio

Step 3: Use normal loss function table for other performance

Expected lost sales =

L(zratio)

Expected sales = Expected demand Expected loss sales

Expected
profit: Price * Exp. Sales + Salvage * Exp. Leftovers

Cost * Q
 Summary Slides

For discrete and normal distributions:

Expected Sale

Fill rate

Mean Demand

Mean Demand - Expected Shortage

Mean Demand

Expected Shortage

Mean Demand

Service level: the probability of NOT stocking out

Target service level CU

F (Q )
CO CU

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Next time

More on newsvendor!

Minimum requirement: finish Q1 in the problem set and find Co

and Cu for other problems

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2/2 Newsvendor Applications

Newsvendor Problem Set

(posted on Blackboard)

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