Inventory Models

Uncertain Demand: The Newsvendor Model

Background: expected value

A fruit seller example
Undamaged mango

Damaged mango

Profit

$4

$1

Probability

80%

20%

What is the expected profit for a stock of 100 mangoes ?

0.8 x 100 ($4) + 0.2 x 100 x ($1) = 320 + 20 = $340

random variable: ai

probability: pi

Expected value = a1 p1 + a2 p2 + + ak pk = i = 1,,k aipi

Probabilistic models: Flower seller example

Wedding bouquets:
Selling price: $50 (if sold on same day), $ 0 (if not sold on that day)
Cost = $35

number of bouquets
probability

0.05

0.12

0.20

0.24

0.17

0.14

0.08

How many bouquets should he make each morning

to maximize the expected profit?

Probabilistic models: Flower seller example..

number of bouquets
probability

0.05

0.12

0.20

0.24

0.17

0.14

0.08

CASE 1: Make 3 bouquets

probability( demand 3) = 1

Exp. Profit = 3x50 3x35 = $45

CASE 2: Make 4 bouquets

if demand = 3, then revenue = 3x $50 = $150
if demand = 4 or more, then revenue = 4x $50 = $200

prob = 0.05
prob = 0.95

Exp. Profit = 150x0.05 + 200x0.95 4x35 = $57.5

Probabilistic models: Flower seller example

Compute expected profit for each case

number of bouquets
probability
Expected profit

0.05

0.12

0.20

0.24

0.17

0.14

0.08

45

57.5

64

60.5

45

21

-10

Making 5 bouquets will maximize expected profit.

Probabilistic models: definitions

number of bouquets
probability

0.05

0.12

0.20

0.24

0.17

0.14

0.08

Discrete random variable

Probability (sum of all likelihoods = 1)

Continuous random variable:

Example, height of people in a city
140

150

160

170

180

190

200

Probability density function (area under curve = integral over entire range = 1)

Probabilistic models: normal distribution function

Standard normal distribution curve: mean = 0, std dev. = 1

P( a x b) = ab f(x) dx

Property:
normally distributed random variable x,
mean = , standard deviation = ,
Corresponding standard random variable: z = (x )/
z is normally distributed, with a = 0 and = 1.

The Newsvendor Model

Assumptions:
- Plan for single period inventory level
- Demand is unknown
- p(y) = probability( demand = y), known
- Zero setup (ordering) cost

Example: Mrs. Kandells Christmas Tree Shop

Order for Christmas trees must be placed in Sept

Cost per tree: $25

Price per tree:

$55 before Dec 25

$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

How many trees should she order?

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}

Key elements of the model

1. Uncertain demand
2. One chance to order (long) before demand
3. ( order > demand OR order < demand) COST

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

Suppose Demand a continuous variable
++ good approximation when number of possibilities is high
-- difficult to generate probabilities, but
++ probability distribution can be guessed
E (G (Q))

[
c
(
x

Q
)
]
P
(
x
)

[
c
(
Q

x
)
]P ( x )
u
o

x Q

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 Q) P( x) dx

x Q

d g (Q)
0
Minimize g(Q)
dQ

d
dQ

x 0

(Q x) P( x) dx

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
Past
Data

D 22
Probability 0.05
F (D ) 0.05

co = 25 15 = $10
24
0.1
0.15

26
0.15
0.3

28
0.2
0.5

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

NOTE:

30
0.2
0.7

32
0.15
0.85

34
0.1
0.95

36
0.05
1

optimum 31

E(D) = 22x 0.05 + 24 x 0.1 + + 36 x 0.05 = 29

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

Concluding remarks on inventory control

Inventory costs lead to success/failure of a company
Example: Dell Inc.
Dell's direct model enables us to keep low component inventories
that enable us to give customers immediate savings when
component prices are reduced, ...
Because of our inventory management, Dell is able to offer some
of the newest technologies at low prices while our competitors struggle
to sell off older products.

Drive to reduce inventory costs was main motivation for

Supply Chain Management
next: Quality Control