Objective: To understand why the round-up rule is correct

Methodology: We need to derive the optimal order quantity with a discrete demand distribution
function.

Derivation: Suppose demand will be one of a finite set of outcomes, 𝐷 ∈ {𝑑1 , 𝑑2 , … , 𝑑𝑛 }. For example,
with the empirical distribution function for the Apparel A, the possible demand outcomes will include
{800, 1184, … , 5120}. Clearly, the optimal order quantity will equal one of these possible demand
outcomes.

Suppose we have deiced to order 𝑑𝑖 units and we are deciding whether to order 𝑑𝑖+1 units.

This is prudent if the expected gain from this larger order quantity is at least as large as the expected
cost.

The expected gain is 𝐶𝑢 (𝑑𝑖+1 − 𝑑𝑖 )(1 − 𝐹(𝑑𝑖 )) because we sell an additional (𝑑𝑖+1 − 𝑑𝑖 ) units if
demand is greater than 𝑑𝑖 , which occurs with probability = 1 − 𝐹(𝑑𝑖 ).

The expected loss is 𝐶𝑜 (𝑑𝑖+1 − 𝑑𝑖 )𝐹(𝑑𝑖 ) because we need to salvage an additional (𝑑𝑖+1 − 𝑑𝑖 ) units, if
demand is 𝑑𝑖 or fewer, which occurs with probability 𝐹(𝑑𝑖 ).

So we should increase our order from 𝑑𝑖 to 𝑑𝑖+1 when

𝐶𝑢 (𝑑𝑖+1 − 𝑑𝑖 )(1 − 𝐹(𝑑𝑖 )) ≥ 𝐶𝑜 (𝑑𝑖+1 − 𝑑𝑖 )𝐹(𝑑𝑖 )

Which simplifies to

𝐶𝑢
≥ 𝐹(𝑑𝑖 )
𝐶𝑢 + 𝐶𝑜

Thus, if the critical ratio is greater than 𝐹(𝑑𝑖 ), then we should increase our order from 𝑑𝑖 to 𝑑𝑖+1 .

When the critical ratio is greater than 𝐹(𝑑𝑖 ), but less than 𝐹(𝑑𝑖+1 ), we should order 𝑑𝑖+1 units and not
increase our order quantity further.

This is the round – up rule.