Newsvendor (Single Period)

Inventory Models

Hamed Mamani

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 Single Period Inventory Model

• Applies to:
Products/services with one selling period (limited
lifecycle)
Uncertain demand
No replenishment during the selling period
Leftover is not kept for the next period (salvaged or
discarded)
Unsatisfied demand is lost

• Examples?

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 Single Period Models (News-Vendor)

• Sequence of Actions:
– Prior to the beginning of the period, Q units are ordered at unit cost of c
that are delivered in its entirety before the beginning of the period
– Demand for the period occurs and items are sold from inventory
– At the end of the period:
• If demand is larger than Q, the system will have shortages (underage)
• If demand is smaller (or equal) than Q, there will be leftovers that may be
salvaged (overage) or become worthless depending on the situation

Place an order Q

Undertrain demand occurs. Items are Shortages

sold as long as available on shelves Unmet demand is lost

Begin End Leftovers

Unsold items are salvaged

Receive order Q
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Newsvendor Example 1

• Production cost per unit (C): $3

• Selling price per unit (S): $12
• Salvage value per unit (V): $0
• Q is production quantity, D (uncertain) demand

Demand is uncertain. Suppose you bought 10 items

• High demand scenario: Demand is 100. You will sell all 10 items,
and make a profit of 10*(12-3) = $90
• Low demand scenario: Demand is 0. You will sell nothing and lose
10*3 = $30
 Newsvendor Example 1

• Max demand = 81
• Min demand = 15
• Average = 52.8

How much should you order?

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 Types of Demand Functions

• Continuous Demand
– Normal Distribution
– …

• Discrete Demand
– Demand Scenarios
– Poisson Distribution
– ….

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 Side Notes

• Model is also known as “Newsvendor problem” or “Newsboy

problem”

• Building block of “Revenue Management” analysis in the service

sectors (Airline , Hotel, etc.)

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 Newsvendor (Single-Period) Inventory Model

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 Optimal Strategy
• What’s the decision?
– How much to make (Q)?

• What’s the objective function?

– Maximize expected profit
• Expectation is taken over all realizations of demand according
to a prespecified distribution

Expected Profit = (Weighted) Average Profit (over all D)

Profit (for a given D) = Revenue - Cost + Salvage Value

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 Newsvendor Problem - Analysis

• Let’s discuss the analysis on the example:

• Production cost per unit (C): $30

• Selling price per unit (S): $60
• Salvage value per unit (V): $20
• Demand forecast: ??

• Rules of forecasting
– 1st rule: (point) forecasts are always wrong!

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 Forecast

• A good forecast is always a distribution!

Demand Probability
Low 300 0.2
Medium-Low 400 0.3
Medium-High 500 0.4
High 600 0.1

Expected Demand 440

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 Expected profit

• Purchasing cost = $30

• Salvage value = $20
• Selling price = $60 & Order size = 400

Demand Probability Profit

300 0.2

400 0.3

500 0.4

600 0.1

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 Expected profit

• Purchasing cost = $30

• Salvage value = $20
• Selling price = $60 & Order size = 400

Demand Probability Profit

= $60*min(300,400) - $30*400 + $20*(400-min(300,400))
300 0.2
= $8,000
= $60*min(400,400) - $30*400 + $20*(400-min(400,400))
400 0.3
= $12,000
= $60*min(500,400) - $30*400 + $20*(400-min(500,400))
500 0.4
= $12,000
= $60*min(600,400) - $30*400 + $20*(400-min(600,400))
600 0.1
= $12,000

Expected Profit (Q=400) = 0.2*8000 + 0.3*12000 + 0.4*12000 + 0.1*12000

Expected Profit (Q=400) = $11,200
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 Expected profit

• Do the same calculations for order sizes of 300, 500, and 600:

Order size Expected Profit

300 $9,000

400 $11,200

500 $12,200

600 $11,600

How else can we calculate that?

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 Cost of “Mismatch”

• Without perfect information, there could be mismatch between

supply and demand.

• Profit reduction due to imperfect information can be interpreted as

the cost of mismatch.

• The goal of inventory management is to minimize the cost of

mismatch.

• Mismatch between supply and demand leads to shortages and

leftovers.

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 Performance Measures

• Q = 400:

Demand Probability Sales Leftover Shortage

300 0.2 300 100 0
400 0.3 400 0 0
500 0.4 400 0 100
600 0.1 400 0 200

Expected values: 440 380 20 60

• Coincidence?
– Mean Demand = Expected Sales + Expected Shortage

– Q = Expected Sales + Expected Leftover

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 Performance Measures

• We can re-arrange these two equations in many ways:

• Mean Demand = Expected Sales + Expected Shortage
• Q = Expected Sales + Expected Leftover

• Here is a convenient way that will be useful later:

• Expected Sales = Mean Demand - Expected Shortage
• Expected Leftovers = Q – Expected Sales

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 “Too Many” vs “Too Few”
• CO = overage cost
– The consequence of ordering one unit “too many” than what you would
have ordered had you known demand.
• Example:

• CU = underage cost
– The consequence of ordering one unit “too few” than what you
would have ordered had you known demand.
• Example:

• Is it fair to say that Co = Cost – Salvage and CU = Price – Cost in

general?

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 Marginal Analysis

• Should we increase your order by 1 unit?

– Say we already ordered Q
– What will happen if we increase the order by 1 unit?

– Expected value of purchasing additional unit:

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 Marginal Analysis

• Co = Overage cost = money potentially lost (“LOSS”)

• Cu = Underage cost = money potentially gained (“GAIN”)

Expected gain from

sales

As more units are

added, expected benefit
Expected loss due to leftover
from adding one unit to
Expected gain/loss of marginal unit

inventory decreases
while expected loss of
adding one more unit
increases

Qth unit ordered

 Marginal Analysis

Expectation:
Sell if Demand > Q CU (1-F(Q)) CU
Order
(Q+1)th
unit? Not Sell if Demand ≤ Q
CO - F(Q) CO

• Increase order until expected value form purchasing one additional

unit is zero:
(1-F(Q)) CU - F(Q) CO = 0

– Hence, optimal order Q* should satisfy:

𝐂𝐔
𝐅 𝐐∗ = 𝐏 𝐃𝐞𝐦𝐚𝐧𝐝 ≤ 𝐐∗ =
𝐂𝐔 + 𝐂𝐎

• This ratio is called the Critical Ratio (CR) or Critical Fractile (CF).
CU
CF =
21 CO + CU
 Let’s Try Solving the Example…

Price = $60; Cost = $30; Salvage value = $20;

Probability Probability
Q
= 60-30 (Demand = Q) (Demand ≤ Q)
CU
= $30 300 0.2 0.2
= 30-20
CO 400 0.3 0.5
= $10
CU = 30/(30+10) 500 0.4 0.9
CF = C + C
O U = 0.75
600 0.1 1

How to find optimal quantity to order (Q*):

Find the smallest value for Q, such that Probability (Demand ≤ Q)
is greater than or equal to the critical ratio.

Q* = 500
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 What if Demand is Normally Distributed?

• All normal distributions are characterized by two parameters: mean = µ

and standard deviation = s

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 Standardizing Normal distributions

F(Q)

Q is z standard deviations away from the mean Q = µ + z 𝜎

Q = NORM.INV( F(Q), µ, 𝜎 )

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 Newsvendor Example (Normal Distribution)

• Assume that we updated the demand forecast to be normal with

mean of 440 and standard deviation of 100. Price = $60; Cost =
$30; Salvage value = $20.

• The critical ratio is 0.75 (as calculated earlier)

• Q* = 440 + Z0.75*100 = NORM.INV(0.75, 440, 100) = 507

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 Newsvendor Solution – Summary

• Decision to make:
“How many units (Q) of product should we have available
for the selling period?”

• Information required:
Underage (shortage) cost per unit
Cu = revenue per unit – cost per unit
Overage (excess) cost per unit
Co = cost per unit – salvage value per unit
Demand parameters/distribution

Cost
Info. CF Q
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 Newsvendor Solution – Summary

• Applying optimization rules, the optimal order quantity

can be found by setting the probability of no stockouts
in the period (service level) to the Critical Fractile (CF):

CU
CF =
CO + CU

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 Newsvendor Solution – Summary

Cu , Co CF Q

• For normally distributed demand the optimal order

quantity, Q, will then be equal to:

Q = d + zs d

q For discrete demand distribution where the critical

ratio falls between two cumulative probabilities, choose
Q that yields the higher cumulative probability

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 Single Period Model: Example 2

Past experience indicates the following distribution for

weekly demand for a ESPN magazine at one book stand:

Magazines are purchased at 25 cents/copy and sold for

$1/copy. Any unsold copy can be salvaged for 10 cents.
Demand Probability
Find the optimal order quantity for this magazine.
25 0.05
26 0.15
27 0.20
28 0.30
Cu = 1.00 – 0.25 = 0.75 29 0.15
Co = 0.25 – 0.10 = 0.15 30 0.10
31 0.03
32 0.02

Cost
Info. CF Q
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 Single Period Model: Example 2

Past experience indicates the following distribution for

weekly demand for a ESPN magazine at one book stand:

Magazines are purchased at 25 cents/copy and sold for

$1/copy. Any unsold copy can be salvaged for 10 cents.
Demand Probability
Find the optimal order quantity for this magazine.
25 0.05
26 0.15
27 0.20
28 0.30
𝐶$ 0.75 29 0.15
CF = = = 0.833
𝐶$ + 𝐶% 0.75 + 0.15 30 0.10
31 0.03
32 0.02

Cost
Info. CF Q
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 Single Period Model: Example 2

Past experience indicates the following distribution for

weekly demand for a ESPN magazine at one book stand:

Magazines are purchased at 25 cents/copy and sold for

$1/copy. Any unsold copy can be salvaged for 10 cents. Cumulative
Demand Probability
Find the optimal order quantity for this magazine. Probability
25 0.05 0.05
26 0.15 0.20
27 0.20 0.40
28 0.30 0.70
𝐶$ 0.75
CF = = = 0.833 29 0.15 0.85
𝐶$ + 𝐶% 0.75 + 0.15 30 0.10 0.95
31 0.03 0.98
32 0.02 1.00

Cost
Info. CF Q
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 Single Period Model: Example 2

Past experience indicates the following distribution for

weekly demand for a ESPN magazine at one book stand:

Magazines are purchased at 25 cents/copy and sold for

$1/copy. Any unsold copy can be salvaged for 10 cents.
Find the optimal order quantity for this magazine. Cumulative
Demand Probability
Probability
25 0.05 0.05
26 0.15 0.20
0.833 27 0.20 0.40
28 0.30 0.70
29 0.15 0.85
Choosethe next oneup 30 0.10 0.95
Q = 29 that gives F (Q) = 0.850 31 0.03 0.98
32 0.02 1.00

Cost
Info. CF Q
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 Single Period Model: Example 3

Joe’s Slop House is a little hole in the wall restaurant that serves slow-cooked
barbecue beef sandwiches. The beef for the sandwiches cooks overnight, so each
evening Joe decides how much beef to cook for the next day. The beef costs $2 a
pound and Joe sells each sandwich (filled with 1 pound of beef) for $4. At the end of
the day, any leftover beef is given to the neighborhood church for their soup kitchen.
The tax deduction for this is worth $0.50 a pound. Daily demand for the beef can be
approximated by a normal distribution with a mean of 80 pounds and a standard
deviation of 20 pounds. How many pounds of beef should Joe cook for the next day?

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 Single Period Model: Example 3

Joe’s Slop House is a little hole in the wall restaurant that serves slow-cooked
barbecue beef sandwiches. The beef for the sandwiches cooks overnight, so each
evening Joe decides how much beef to cook for the next day. The beef costs $2 a
pound and Joe sells each sandwich (filled with 1 pound of beef) for $4. At the end of
the day, any leftover beef is given to the neighborhood church for their soup kitchen.
The tax deduction for this is worth $0.50 a pound. Daily demand for the beef can be
approximated by a normal distribution with a mean of 80 pounds and a standard
deviation of 20 pounds. How many pounds of beef should Joe cook for the next day?

Step 1 – Acquired information and calculated costs

Cu = 4 – 2 = 2
Co = 2 – 0.5 = 1.5

Cost
Info. CF Q
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 Single Period Model: Example 3

Joe’s Slop House is a little hole in the wall restaurant that serves slow-cooked
barbecue beef sandwiches. The beef for the sandwiches cooks overnight, so each
evening Joe decides how much beef to cook for the next day. The beef costs $2 a
pound and Joe sells each sandwich (filled with 1 pound of beef) for $4. At the end of
the day, any leftover beef is given to the neighborhood church for their soup kitchen.
The tax deduction for this is worth $0.50 a pound. Daily demand for the beef can be
approximated by a normal distribution with a mean of 80 pounds and a standard
deviation of 20 pounds. How many pounds of beef should Joe cook for the next day?

Step 2 – Calculated optimal service level

𝐶! 2
CF = = = 0.5714
𝐶! + 𝐶" 2 + 1.5

Cost
Info. CF Q
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 Single Period Model: Example 3

Joe’s Slop House is a little hole in the wall restaurant that serves slow-cooked
barbecue beef sandwiches. The beef for the sandwiches cooks overnight, so each
evening Joe decides how much beef to cook for the next day. The beef costs $2 a
pound and Joe sells each sandwich (filled with 1 pound of beef) for $4. At the end of
the day, any leftover beef is given to the neighborhood church for their soup kitchen.
The tax deduction for this is worth $0.50 a pound. Daily demand for the beef can be
approximated by a normal distribution with a mean of 80 pounds and a standard
deviation of 20 pounds. How many pounds of beef should Joe cook for the next day?

Step 3 – Given average 80 and SD 20

CF = 0.5714 è z = 0.18 57.1%

Q = 83.6

Cost
Info. CF Q
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 Newsvendor Model – Profit Calculations

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 Cost of “Mismatch”

• Without perfect information, there could be mismatch between supply and

demand.

• Profit reduction due to imperfect information can be interpreted as the cost

of mismatch.

• The goal of inventory management is to minimize the cost of mismatch.

• Mismatch between supply and demand leads to shortages and leftovers.

Finding the expected leftover and lost sales depend on the demand distribution
• Normal distribution
• Discrete distribution
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 Newsvendor Model Profit: Discrete Demand

Past experience indicates the following distribution for

weekly demand for a ESPN magazine at one book stand:

Magazines are purchased at 25 cents/copy and sold for

$1/copy. Any unsold copy can be salvaged for 10 cents.
Find the optimal order quantity for this magazine.

Demand Probability

25 0.05
26 0.15
27 0.20
28 0.30
29 0.15
30 0.10
31 0.03
32 0.02

• Average Demand = 27.87

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 Single Period Model Profit: Discrete Demand

• Expected profit of bookstand for Q=29:

Demand Probability Underage Overage

25 0.05 = 0 (* 0.05) = 4 (* 0.05)

26 0.15 = 0 (* 0.15) = 3 (* 0.15)
27 0.20 = 0 (* 0.20) = 2 (* 0.20)
28 0.30 = 0 (* 0.30) = 1 (* 0.30)
29 0.15 = 0 (* 0.15) = 0 (* 0.15)
30 0.10 = 1 (* 0.10) = 0 (* 0.10)
31 0.03 = 2 (* 0.03) = 0 (* 0.03)
32 0.02 = 3 (* 0.02) = 0 (* 0.02)

Ø Mismatch Cost = 0.22*$0.75 + 1.35*$0.15 = $0.3675

Ø Average Profit = 27.87*$0.75 - $0.3675 = $20.535
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 Newsvendor Model Profit: Normal Demand

• For normal demand there are infinitely many

demand scenarios

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 Single Period Model Profit: Continuous Demand

Joe’s Slop House is a little hole in the wall restaurant that serves slow-cooked
barbecue beef sandwiches. The beef for the sandwiches cooks overnight, so each
evening Joe decides how much beef to cook for the next day. The beef costs $2 a
pound and Joe sells each sandwich (filled with 1 pound of beef) for $4. At the end of
the day, any leftover beef is given to the neighborhood church for their soup kitchen.
The tax deduction for this is worth $0.50 a pound. Daily demand for the beef can be
approximated by a normal distribution with a mean of 80 pounds and a standard
deviation of 20 pounds. How many pounds of beef should Joe cook for the next day?

Cu = 4 – 2 = 2
Co = 2 – 0.5 = 1.5

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 Example
(Warehouse Consolidation/Risk Pooling)
Consider the following problem
– One period, Single item
– Unit cost = $10,
– Unit selling price = $99, and
– Unit holding cost per period = $1 (Assume that the salvage value =
0 at the end of the period)
Currently, there are 4 warehouses. Demand at each warehouse is
independent and normally distributed with a mean of 1,000 and a
standard deviation is 300 per period. Assume that the demand at each
warehouse is independent. Currently each warehouse purchases the
item independently, but there is a proposal which calls for
consolidating all the warehouses into one mega warehouse, and
satisfying the demand from it. Should the proposal be adopted?

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 SC at Apple

Cook reduced the number of Apple’s key suppliers from a

hundred to twenty four, forced them to cut better deals, ….,
and closed ten of the company’s warehouses. By reducing
the places where inventory could pile up, he reduced
inventory. Jobs had cut inventory from 2 months to one by
early 1998. By September of that year Cook had gotten it
to 6 days. By the following September, it was down to an
amazing 2 days! In addition, he cut the production process
for making an Apple computer from 4 to 2 months. All of
this not only saved money, it also allowed each new
computer to have the very latest components available.
From Steve Jobs Biography by Walter Issacson 2011

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 Summary

• Simple inventory model that depicts situations for products with one-
time order

• Deciding order quantities when there is a “too much – too little”

challenge

• Problem is a trade-off between:

Overage (excess) cost
Underage (shortage) cost

• Use the “Optimal Service Level” and information concerning “demand

distribution” to determine order quantities

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