Newsvendor type problems

1. Noel is selling Christmas trees to pay her college tuition. She purchases trees for $10 each
and sells them for $25 each. The number of trees she can sell is normally distributed with a
mean of 200 and standard deviation of 60. How many trees should Noel purchase?
(Leftover trees are worthless) What is the expected amount overstocked and what is the
expected profit if she orders the optimal quantity?
2. A hot dog vendor at Dodger Stadium sells hot dogs for $1.50 each. She buys them for $1.20
each. All the hot dogs she fails to sell at Dodger Stadium during the game can be sold that
evening at $1 each. The demand for her hot dogs at Dodger Stadium is normally distributed
with a mean of 400 and a standard deviation of 100.
(a) If the vendor wants to maximize her expected profit, how many hot dogs should she buy?
(b) If she buys 520 hot dogs, what is the probability that she will meet the demand for hot
dogs at Dodger Stadium? (Hint: This question has nothing to do with the optimal order
quantity.)
3. A department store is trying to decide how many of JP Bubblesquirt II printers to order.
Since JP is about to come out with a new model in a few months, the store will only order a
limited number of model IIs. The cost per printer is $200, and each printer is sold for $230.
If any model IIs are still in stock when the next model comes out, they will be sold for $150
apiece. These printers are not in great demand. The store estimates that the number of
model IIs that will be demanded during the next few months (before the next model comes
out) is equally likely to be any value from 10 to 20, inclusive.
(a) What would be the order quantity?
(b) If a customer wants a model II and there are none left, the store will special order the
printer at an extra cost (to the store) of $25. How would you now determine the optimal
order quantity? (Hint: Think about the cost model.)

4. In September 2004, a car dealer is trying to determine how many cars of a particular 2005
model to order. The dealer’s invoice cost is $15,000. The demand for this model has the
probability distribution of equally likely between 20 and 40 cars (inclusive). Each car will
sell at an average of $17,000. If the demand for 2005 cars falls short, the dealer will have to
dispose them in an end-of-year clearance sale for $14,500. How many 2005 models should
the dealer order?

5. The manager at Sportmart, a sports equipment store, has to decide on the number of skis to
purchase for the winter season. Considering past demand data and weather forecasts for the
year, management has forecasted demand to be normally distributed with a mean of µ = 350
and a σ = 100. Εach pair of skis costs c= $100 and retails for p = $250. Any unsold skis at the
end of the season are disposed of for $85. Assume that it costs $5 to hold a pair of skis in
inventory for season.

Evaluate the number of skis that the manager should order to maximize expected profits.
Also calculate expected profit. What is the expected amount understocked?

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Solution to Newsboy type problems

1. (Noel sells Christmas trees) p=$25; c=$10; s=$0 (“Leftover trees are worthless”).
Hence the critical fractile = (p-c)/(p-s) = (25-10)/(25-0) = 0.6.
Check the normal table or use the Excel function NORMSINV(0.6), we get the
corresponding z value of 0.2533.
Finally, the optimal number of trees to buy Q = mean + z*(stdev) = 200+0.2533*60 =
215.198 = 215. Noel will order slightly more than the average number of trees.
Expected sales = µ - σL(z) = 200 – 60*0.285 ≈ 183 since L(z) ≈ 0.285 for z = 0.2533.
Expected overstock = 215 – 183 = 32
Expected profit = 25*183 + 0*(32) – 10*215 = $2425.

2. (Hot dog vendor) p=$1.50; c=$1.20; s=$1.00.

Critical fractile = (p-c)/(p-s) = (1.50-1.20)/(1.50-1.00) = 0.6.
The z value for 0.6 is 0.2533.
(a) Optimal Q = mean + z*(stdev) = 400 + 0.2533*100 = 425.33 = 425.
(b) She will meet the demand if demand (D) is less than or equal to 520. Hence
Probability of meeting demand = Pr( D <= 520).
D is normal with mean 400 and standard deviation 100; hence z=(520-400)/100=1.2.
The normal probability corresponding to z=1.2 is (from a standard normal table or from
Excel function NORMSDIST(1.2) ) 0.88493. There is a 0.885 chance that she will meet
the hot dog demand at the stadium.
Note that (b) is the reverse of (a): (a) finds the probability (the critical fractile) then z; (b)
finds z first then the probability.

3. (Department store) p=$230; c=$200; s=$150.

(a) Critical fractile = (p-c)/(p-s) = (230-200)/(230-150) = 0.375.
Here the demand is not normally distributed, we next find the Q that yields the
probability of 0.375. Since each value between 10 and 20 (inclusive) is equally likely,
each value has an equal probability of 1/11; this means that the number 10 occurs with a
probability of 1/11; the number 10 or 11 occurs with a probability of 2/11; and so on.
The number 10, 11, 12 or 13 occurs with a probability of 4/11=0.364 which is closest to
0.375, hence the optimal order quantity would be 13.
Alternatively, you may use the formula Q = 10 (the lower limit) + 0.375/(1/11) -1 =
13.125 = 13.
(Note that you need to subtract 1 because the lower limit 10 would be already accounted
for. Also, you should not use the Q = mean + z*(stdev) formula because demand is NOT
normally distributed.)
(b) Here it is useful to think in terms of understocking and overstocking costs. Normally, we
think of understocking cost as (p-c) since this is the opportunity cost of understocking.

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 However, here one can order the printer after demand is realized and make a sale.
However, the cost of this action or the understocking cost is p-c + 25 - (p-c) = 25. This is
so because the store will incur an incremental $25 cost but “saves” the lost profit of (p-c).
So the true understocking cost is only $25. The overstocking cost is usual (c-s) = 200-
150 =50.
Hence the critical fractile = backlogging / (backlogging + inventory holding) =
25/(25+50) = 0.3333. The optimal Q = 10 + 0.3333/(1/11) -1 = 12.6666 = 13.
This happens to be the same as (a) -- a mere coincidence.

4. (Car dealer) p=$17,000; c=$15,000; s=$14,500.

Critical fractile = (p-c)/(p-s) = (17000-15000)/(17000-14500)=0.8.
Optimal order quantity Q = 20 + 0.8/(1/21) - 1 = 35.8 = 36.

5. (Sportmart)

Salvage value s = end of season sale price – holding cost for the season
= $85 - $ 5
s = $80

Critical fractile =( p-c ) / (p - s)

= (250 – 100)/ ( 250 – 80) = 0.882
We get value of z, using spread sheet function NORMSINV(0.88) = 1.187

(a) For finding optimum order quantity

Qopt = µ + z σ
= 350 + 1.187 * 100
= 469

Expected sales = µ - σL(z) = 350 – 100*0.06 = 344 since L(z) ≈ 0.06 for z = 1.186.

Expected profit = Expected revenues + Expected salvage value - Purchase cost

= 250*344 + 80*(469-344) – 469*100
= $49,100

Expected amount understocked or expected number of stockouts = 6