Example: Mrs.

Kandells Christmas Tree Shop

Order for Christmas trees must be placed in Sept

Cost per tree: $25

$55 before Dec 25

Price per tree: $15 after Dec 25

If she orders too few, the unit shortage cost is cu = 55 25 = $30

If she orders too many, the unit overage cost is co = 25 15 = $10
Past
Data

Sales

22

24

26

28

30

32

34

36

Probability

.05

.10

.15

.20

.20

.15

.10

.05

Stockout and Markdown Risks

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
D total demand before Christmas
F(x) the demand distribution,
D > Q stockout, at a cost of: cu (D Q)+ = cu max{D
Q, 0}
D < Q overstock, at a cost of co (QD)+ = co
max{Q D, 0}

Model development
Stockout cost = cu max{D
Q, 0}
Overstock cost = co max{Q
D, 0}
Total cost = G(Q) = cu (D Q)+ + co (Q D)+
Expected cost, E( G(Q) ) = E(cu (D Q)+ + co
(Q D)+)
= cu E(D Q)+ + co E(Q D)+

[c ( x Q )
x 0

co (Q x) ]P ( x)

[c ( x Q )
x Q

]P ( x) [co (Q x) ]P ( x)
x 0

Model Development: generalization

E (G (Q))

[c ( x Q )
x Q

]P ( x) [co (Q x) ]P ( x)
x 0

g (Q) E ( G (Q))

x 0

(Q x) P ( x) dx

x Q

( x Q ) P( x) dx

Model solution
Q

g (Q ) E ( G (Q))

(Q x) P( x) dx

x 0

x 0

(Q x) P ( x) dx

( x Q) P( x) dx

x Q

d g (Q )
0
dQ

Minimize g(Q)

d
dQ

x Q

( x Q) P ( x) dx 0

g(Q) is a convex function: it has a unique minimum

when g(Q) is at minimum value, F(Q) = cu/(cu + co)

The Critical Ratio

Solution to the Newsvendor problem:
cu
dg (Q)
0 F (Q*)
dQ
c0 cu

= cu /(co + cu ) is called the critical ratio

relative importance of stockout cost vs. markdown cost

Mrs. Kandells Problem, solved:

cu = 55 25 = $30 co = 25 15 = $10
Past
Data

D 22
Probability 0.05
F (D ) 0.05

24
0.1
0.15

26
0.15
0.3

28
0.2
0.5

30
0.2
0.7

= cu /(co + cu ) = 30/(30 + 10) = 0.75

32
0.15
0.85

34
0.1
0.95

36
0.05
1

optimum 31

Newsvendor model: effect of critical ratio

D 22
Probability 0.05
F (D ) 0.05

24
0.1
0.15

26
0.15
0.3

28
0.2
0.5

30
0.2
0.7

32
0.15
0.85

34
0.1
0.95

36
0.05
1

= cu /(co + cu ) = 30/(30 + 10) = 0.75 optimum: 31

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