Reducing the Cost of Demand Uncertainty through Accurate Response to Early Sale Marshall Fisher; Ananth Raman Operations Research, Vol. 44, No. 1, Special Issue on New Directions in Operations Management (Jan. - Feb., 1996), 87-99. Stable URL hhup:/flinks,jstor-org/sicisici=0030-364X%28199601%2F02%2044% 3A 1%3C87%3 AR TCODU%3E2.0.CO%3B2-Z, Operations Research is currently published by INFORMS. ‘Your use of the ISTOR archive indicates your acceptance of JSTOR’s Terms and Conditions of Use, available at hup:/www stor orglabout/terms.html. ISTOR’s Terms and Conditions of Use provides, in par, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at bhupulwww.jstor.org/journals/informs. html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the sercen or printed page of such transmission. STOR is an independent not-for-profit organization dedicated to creating and preserving a digital archive of scholarly journals. For more information regarding JSTOR, please contact support @ jstor.org, hupulwww jstor.org/ Mon Jun 13 12:10:21 2005REDUCING THE COST OF DEMAND UNCERTAINTY THROUGH ACCURATE RESPONSE TO EARLY SALES MARSHALL FISHER University of Pennsylvania, Philadelphia, Pennspivania ANANTH RAMAN Harvard University, Boston, Massachusetts (Received November 1992; revisions received February, May 1994; accepted July 1994) ‘Traditionally, fashion products have incurred high losses due to stockouts and inventory obsolence because long lead times, ‘coupled with @ concentrated selling season force all or at least most production to be committed before demand information is avalable. Under a Quick Response system, lead times are shortened sufficiently to alow a greater portion of production to be i dema Scheduled in response to int 1. We model and analyze the decisions required under Quick Response and give a method for estimating the demand probability distributions nceded in our model. We applied these procedures with a major fashion skiwear frm and found that cost relative tothe current informal response system was reduced by enough to increase pros by ‘60%. Relative to the cost that would have been incurred if no response were used, optimized response reduces cost by enough 10 roughly quadruple profits. Mi ‘has been written about the growing impor- tance of time in operations, particularly the lead time required to manufacturer and distribute products. ‘The fashion apparel industry provides an excellent con- text within which to study the role of time because the industry is so dynamic. For example, most fashion ap- parel companies introduce a completely new product line every season which must be designed and produced in time to be sold during a concentrated retail selling sea- ‘son, typically about ten weeks in duration. Quick Response is an apparel industry initiative in- tended to cut manufacturing and distribution lead times through a variety of means, including information tech- nology such as electronic data interchange, point of sale scanners, and bar coding, logistics improvements such as ‘automated warehousing and increased use of air freight, ‘and improved manufacturing methods, ranging from laser fabric cutting to reorganization of the sewing process into modular sewing cells. Hammond (1990) contains an excellent overview of Quick Response in the apparel in- dustry and Hammond (1992) documents one company's experience implementing modular sewing cells. Quick Response was created to reduce inventory costs in the apparel supply channel, particularly the cost of excess inventory that must be sold below cost at the end of the season and of lost sales due to inventory stock- outs. These costs are high in the apparel industry be- cause of unpredictable demand coupled with a complex supply chain. It is not uncommon for design, production of fabric, cutting and sewing of garments, and sales in a retail outlet to take place in different countries spread all over the globe. Typically, two years are required from the start of design and one year from the start of produc- tion until a garment is sold. Because of these long lead times, demand forecasts and production commitments for a particular style and color must be made well in advance of the actual sales season before any demand history is available. These long-range forecasts tend to be quite inaccurate, particularly since the demand for fashion apparel depends more on taste than objective consumer needs. ‘As a result, the amount produced of a particular gar- ment often exceeds or falls short of what customers ‘would actually like to buy at full price. Supply shortages result in lost sales opportunities while excess supply is reduced in price until it eventually sells, often at a price below the cost of production. Frazier (1986) estimated the annual cost of inventory carrying, shortage, and ex- ccess supply at $25 billion for the U.S. apparel industry, ‘or 25% of annual retail sales. Itis likely that these enor- ‘mous inventory losses actually exceed manufacturing costs. Most manufacturers use outside suppliers and mark up their charges 100% before selling to retailers ‘who again mark up by 100% to determine the retail sales price, Under such a system, manufacturing costs would not exceed 25% of annual retail sales, the cost of inven- tory losses. This problem seems to be getting steadily worse. Pashigian (1988) shows that markdowns as a percentage of sales since World War II have increased from 3% to 16% for many apparel segments, as well as other products. Several years ago, we began to study how the apparel industry Was using Quick Response to reduce the cost of Subject closifcations: Cost analysis: accurate response. Foreasting applications. Indust: elevate “Area of review: Mastractunn, Oexxtens so SEHEEULMNG (SPECIAL ISSUE ON NeW DigcHON IN OFERATIONS MANAGEMENT, ‘Wie, No. I, January-February 1996 on 66x 440-0097 $01.25 1986 INFORMS88 / Fiser AND RAMAN stockouts and excess inventory. Our investigation began with visits and interviews at seventeen apparel firms (in- cluding retailers, manufacturers, and fabric finishers in Europe, the United States, and Japan) who were at vari- ‘ous stages of adopting Quick Response. We found that while these companies were vigorously pursuing various approaches to lead time reduction, they were uncertain as to how much these lead time reduction efforts would reduce the cost of stockouts and excess inventory. Most companies were even unclear as to the mechanism by which shortened lead times would reduce inventory costs, other than the obvious intuition that making pro- duction commitments closer to the time at which a gar- ment sells should improve the accuracy of those commitments. It appeared that Quick Response could reduce stock- ‘out and markdown costs by reducing lead time sufi- ciently to allow a portion of production to be committed after Some initial demand has been observed. The poten- tial power of this approach is illustrated in Figure 1 which shows forecasts made at the start of the season and after observing 20% of demand for one product line Of a fashion skiwear firm that provided the real context for the study reported here. The dramatic improvement in forecast accuracy after observing only 20% of initial ‘demand suggests a strategy for reducing the cast of too ‘much or too little inventory: commit to a modest amount of initial inventory for each product, observe initial de- mand, and then produce an additional amount of each product based on improved forecasts. However, this mode of operation complicates production planning. Now one must decide not only how much to produce in total, but at different points during the season, and to ‘work out a method for incorporating observed demand information into the planning process. ‘This paper provides a methodology for performing this more complex response-based production planning. Our approach was developed during several years of exten- sive interaction with Sport Obermeyer, @ major fashion skiwear designer and manufacturer that has been imple- ‘menting Quick Response. We formulate the production planning decisions as a two-stage stochastic program and use various relaxations to obtain feasible solutions and ower bounds on the minimum cost. Our model includes a number of key features that we found to be essential in a real situation. First, because ‘our approach is motivated by a desire to improve the accuracy of production decisions by conditioning them to some extent on early sales, we felt it was critical to allow for correlation between first and second period demand. In our application, we allow for correlation by modeling total and first period demand as a bivariate normal. We estimated the correlation between total and first period demand and found it to be high—around 0.8 to 0.9 for ‘most products. Second, since we are dealing with prod- ucts for which we have no demand history, estimating demand density parameters was especially challenging. am tid cts co Seaton Sales z Revised Forecast 3 am Based 5 : Fist 20% i a ot Demand ‘gure 1, Observing a portion of demand improves fore~ cast accuracy. ‘We describe a new approach for such situations that has worked remarkably well. Third, production planning is challenging in a real situation because of scarce capacity during the peak of the sales season, which requires that a significant portion of production be committed prior to observing any demand. Holding enough capacity to pro- duce everything during the short selling season would not be economical. Therefore, we have included a sec- ‘ond period capacity constraint in our model. Finally, production of apparel involves setups and other econo- mies of scale that make it uneconomical to produce in small quantities. We model this by allowing a minimum lot size constraint whenever a product is produced, To evaluate the impact this approach can have on stockout and markdown costs, we executed our method- ology in parallel with traditional decision making atObermeyer for the 92/93 season. Use of the approach described here reduced stockout and markdown costs by 1.82% of sales as compared with current decisions. Moreover, some of the rules of thumb that were used at Obermeyer to make actual decisions for the 92/93 season ‘were improved by insights derived from seeing results of the model during the decision process. Based on compar- ing the 92/93 and 91/92 stockout cost, itis believed that these improvements reduced costs by another 1% t0 2% of sales. In the skiwear industry, profits average about 3% of sales. Thus, use of the procedures described here has the potential of increasing profit by 60% to 127%. We have since implemented our approach and confirmed this potential. ‘We can measure the value of Quick Response by com- paring the cost of the model solution with the cost that ‘would be incurred if production commitments had to be made before observing any demand. This difference is 8.5% of sales. These results suggest that Quick Re- sponse, together with optimized decision making, has the potential to nearly quadruple profits. ‘Although we describe our methodology for an apparel industry manufacturer, our approach is applicable to any product line that has the characteristics of fashion ap- parel, such as short product lifetimes, long lead times, or demand that is difficult to predict leading to high stock- out and markdown losses. Other products with docu- mented high losses due to over or under supply include automobiles (Jordan and Graves 1991, White 1992) and personal computers (Hooper and Yamada 1992 and Stewart 1992). Our approach can also be applied to the inventory management problems of a retailer, but would require modification to allow for the fact that demand is lost unless a product is available in inventory. ‘A number of papers in the literature deal with prob- lems that are similar to ours; however, all of them differ in some vital aspects. The papers by Murray and Silver (1966), Miller (1986), and Lovejoy (1990) deal with uncer- tain demand and forecast updating. Their models are lim- ited to a single product and ignore capacity restrictions and minimum lot size constraints. Bradford and Sugrue (1990) and Eppen and Iyer (1992) address multiproduct problems but they too ignore capacity limitations and ‘minimum lot size constraints. Hausman and Peterson (1972) account for forecast updating and capacity limita- tions in their model, but the heuristics they propose do not encorporate the impact of forecast updating. In addi- tion, theit model ignores minimum lot size requirements entirely. Bitran, Haas and Matsuo (1986) and Matsuo (1990) formulate the problem as a two-level hierarchical structure characterized by families and items. One way their work differs from ours is that they assume that production changeover costs from one family to another are so high that a family of products may be produced only once. Producing only once limits the ability to ad- just production in response to early demand, an essential feature of our approach. In addition, they assume that Fister aND RAMAN. / 89 the forecast for a family's demand is known with cer- tainty prior to the season. The uncertainty in their model is confined to the allocation of family demand to the various items. These assumptions are difficult to justify in the fashion apparel industry. In addition, none of these papers include procedures for estimating demand density functions or for modeling the correlation of demand over time. Finally, we know of no other paper that can dem- ‘onstrate actual implementation in a company. In Section 1 we present our model and a methodology for its analysis. Section 2 shows how to compute lower ‘bounds on the optimal objective value of this model. In Section 3 we adapt our procedures to deal with produc- tion minimum constraints, a complication that exists at most apparel manufacturers. Section 4 concerns the use of this methodology at Sport Obermeyer and a review of the impact it has had. Subsection 4.1 describes the oper- ations of Obermeyer and their forecasting/production planning process, subsection 4.2 the method used to es- timate demand probability distributions and some evi- dence as to its effectiveness, subsection 4.3 a closed- form solution for a special case of our relaxation that was, important in the application at Sport Obermeyer, and subsection 4.4 computational results. Some of the mana- geril implications of our work are discussed in Fisher et al. (19848, b) 1. MODEL AND ANALYSIS We consider the production commitment decisions for a set of fashion products supplied by a manufacturer to various retail outlets that comprise the manufacturer's customers. The retailers have a primary sales season during which products command full price, followed by a markdown season during which produets can only be sold at a reduced price. Somewhat earlier, there are pr- mary and markdown seasons for the manufacturer during Which retailers place orders at full and then reduced prices. To achieve efficient capacity utilization, produc- tion occurs over a longer time interval than the selling seasons. The manufacturer must begin production before receiving any orders and finish production before receiv ing all orders. Sport Obermeyer, the company with whom we collab- orated to test the ideas presented here, illustrates the typical pattern. The primary retail skiwear selling season begins September 1. It ends December 24 for urban stores and mid-February for ski-area stores. The retail markdown season extends into the spring. Retailers place initial orders with Obermeyer from mid-February through May. About 10% of demand consists of reorders placed after September 1. These are filled as inventory is available. Inventory held by Obermeyer that has not sold by December 31 is marked down for clearance. Produc- tion at Sport Obermeyer is accomplished from January 1 (about eight months prior tothe start ofthe primary retail season) to September 1. There isa lead time of about one90 Fister AND Raman ‘month in committing production. For example, a gar- ‘ment made January 1 must be scheduled by December 1. Although, in principle, one could update the produc- tion schedule whenever new demand information is re- ceived, for simplicity in modeling we assume that production commitments for all products are made at ‘wo points in time. An initial commitment is made before any orders have been received and a second commitment is made at a given point in time after some orders have been received. ‘Our assumption of a two-period model is not as restric- tive as it might first seem, Usually, a large fraction of orders are received during some concentrated period, often at the time of a major product show. Immediately after such an event is the best time to update the produc- tion schedule. Also, setup costs and other economies of scale often make it prohibitively expensive to produce a product more than twice per season. The problem of determining optimal production com- mitments will be modeled using the following parameters and variables. Demand and production are measured in units of product produced or demanded. We assume that producing a unit of each product requires the same amount of capacity, so capacity is also expressed as the total number of product units that can be produced: n= the number of products; 4% =the number of units of product i produced before receiving any demand information; the total units of product i produced during the season (s0 x; ~ x9 is the second production commitment); Dy = the units of product i demand observed before the commitment x; — xy (Wwe treat Dy as a random variable when determining 0); D, = the total units demanded for product i; ‘F(Dy, D,) = the joint density (Section 4 describes our method for estimating densities in a practical situation); (Dj) = the marginal density on Dip defined by S(Daye Dis A{D|D) = the conditional density on D, given Dy defined by f(Dio» Dis 4 = the vector of x03 x = the vector of x;5 Dy = the vector of Dis D = the vector of Djs ‘Dy D) = the joint density on Dy, D ‘g(Dz) = the marginal density on Dy: I(D|D,) = the joint conditional density on D given Dos 0, = the overproduction cost for product i, the per unit cost of producing more than is demanded; U, = the underproduction cost for product i, the per unit cost of producing less than is demanded; a? = max(0, a); ey, D)) = O,(x, ~ D))* + UMD, ~ x)" el, D) = Bas et» Ds Epp¢te, D) = Ji etx, Dyh(D[Do)dDs EnJ(Do) = Jo F(Do\g(Da)dDo, (F(Do) is any scalar valued function); the second period production capacity, ie. second period prodtion must sais Sis by — aa) < K. We do not impose « frst period production capacity constraint because the cost stricture of our problem rakes it desirable to minimize fst period production. If production capacity per unit time isin limited supply during the first period, production can simply be started early enough to provide sulfcient total capacity, because there is no information penalty in doing 50. K ‘The decision process involves choosing xy, observing Dg, and then choosing x > xy to minimize the total of over and under production, Z* = minZ(x) = Ep, minE pp, (x, D) Sa K + fa Xi is first removed by Lagrangian methods, as de- scribed in Nahmias and Schmidt (1984). Then setting Xx; = max(xjo, x), where x} is the optimal newsboy solution with cost function ¢,(x, D,) and probability dis- tribution h,(D,|Dj), Solves min, ,,2"(x, Dg). However, this procedure does not provide a closed-form expression for x in Dy and Z%(xo, Do) is nonseperable in x) $0 computing E p,Z°(vo, Dy) becomes prohibitive when n is large, as does finding 2 (9)/2¥, For this reason, we elected to derive a new problem in which we seek to approximate P as closely as possible, while achieving tractability. It is the second period ca- pacity constraint that makes P intractable. However, re- moving this constraint produces the unrealistic solution Xo = 0. Our approach is to replace the second period capacity constraint with a lower limit on total frst period production. With a suitable value for the lower limit, we believe this can provide a good approximation to P. Let 2x3 denote the optimal value of xy and define L* = iL xip- Clearly, P is equivalent to the following problem with L = L*. WL) = min, Ep min Epp, ¢(x, D). sant Sacks Soe Our approximation is created by relaxing the second period capacity constraint du Dio, X; = ¥{(Djo). Partials of Z(xp) can be approximated with differences and P solved using standard convex program- ming methods (¢.g., Bertsckas 1982). ‘While we use an approximation to find xp, once Dp is knowin the second stage problem P, can be solved ex- actly as we have described. Now consider setting L. Let xo(L) denote the value of Xp that solves B with given L. We use Monte Carlo generation of Dy to evaluate Z(xy(L)) and choose L by applying a line search algorithm (c.g., see Bradley, Hax and Magnanti_ 1977, pp. 602-608) to the problem rin, »02(x9(L))- 2. LOWER BOUNDS Note that W(L) is a lower bound on W(L), but not a very useful one in bounding Z* since min, IV(L) = W(Q). However, relaxing the constraint x > xy provides a second lower bound Wa(L) = sin, Epe tin En, D) Sxoat Sucks 3 xe This bound nicely complements W(L) because it is largest when L = 0, so min, ,9 max(W(L), W,(L)) is a nontrivial bound on 2". ‘To evaluate W,(L), note that x9 appears only as 27. xo, 80 WL) = Ep, min p,e(x, D) Sx io = M). ‘The problem defining Z} has the same form as P de- fined in Section 1, and can be solved by the method described there. 4. APPLICATION In this section we describe use of this methodology at ‘Sport Obermeyer and summarize the impact. Although ‘our method for estimating demand densities is described within the context of Sport Obermeyer, the method ‘could be used in any similar situation, 4.1. Sport Obermeyer Sport Obermeyer designs and manufacturers fashion ski- ‘wear sold primarily through specialty ski shops located in metropolitan areas or at ski resorts, Their market share fluctuates between the number one or two position for U.S. manufacturers selling to specialty stores. Ski wear products include parkas, pants, suits, shells, jack- ets, sweaters, turtlenecks, and various accessories. Over 95% of their products are new designs each year, featuring changes in patterns, fabrics, and colors. The design process begins two years prior to the winter in which the garments will be worn, and culminates with final designs, rendered in drawings in October, one year prior to the start of the retail sales season. The following ‘month a seven-member buying committee comprised of the president, vice president, two designers, and the ‘managers of marketing, production, and customer ser- vice/sales review these designs and forecast how much will be sold of each style and color. ‘As discussed in Section 1, production occurs from January 1 to September 1. Production of components and ‘garments occurs in a variety of countries, including Hong Kong, China, Japan, Korea, Jamaica, and Bangladesh. Once produced, garments are transported to Seattle (usu- ally via ship although air freight is also available at higher ‘cost if speed is necessary) and from there via truck to Obermeyer’s warehouse in Denver. From the Denver ‘warehouse, items are packaged and sent via carrier to fulfil retail store orders that have been received during February-May. About 60% of customer orders are re- ceived at the Las Vegas show in March. The timing of delivery varies, but most stores require delivery by early October, at the latest. Reorders constitute about 10% of demand. The bulk of reorders are received during October-December and are filled as inventory is avail- able. Generally alter January 1, Obermeyer concentrates (on reducing existing inventory through markdowns. This reduced price merchandise is bought by retail stores who sell i, in turn, at a discount. The computational results reported here are based on all outerwear (parkas, pants, suits, shells, and jackets) produced in China and Hong Kong for the 92/93 season. These products comprise the major portion of Obermeyer’s 92/93 volume. A product in our model was « particular style in a particular color. Each style came inbout four colors and there were 339 style/eolors in total. ‘Minimum production levels were imposed for each style, ice, the total production over all colors of a style in the first and second periods was required to be either zero or not less than a defined minimum production level. We ignored size in the definition of a product because the distribution of sizes within a style/eolor is. quite predictable, Over the years, Obermeyer has evolved a response system in which a portion of production is committed in November and a second commitment is made in March immediately following the Las Vegas show. These are the decisions to which the algorithm described in this paper was applied. The arrangement Obermeyer has with its suppliers re- quires that Obermeyer commit about 40% of its produe- tion in November, to insure the suppliers @ reasonably level work load throughout the production season. Thus, the minimum amount L to produce in period 1, which the algorithm described in Section 1 is eapable of computing, was actually given as a constraint in this problem. ‘The shortage cost U, was set to the wholesale price at Which Obermeyer sells a particular style/color minus variable costs. Principal variable costs are a charge per unit paid to the supplier and the sales representative's commission. The overstocking cost O, was set t0 the variable cost fora style/color less the price at which this stylefcolor could be expected to sell during the mark- down season. Note that this isa conservative measure of| overproduction cost, as compared with taking O, to be full price minus reduced price. Typically, U, was two to three times greater than O,, making some degree of pro- duction in excess of forecasted demand desirable, a com- ‘mon situation in the apparel industry. Demand distributions for each style/color was the hardest data requirement to fulfil. Because the method- ology we derived for this purpose is generic, itis de- scribed in a separate section immediately following. 4.2. Demand Density Estimation and Validation Estimating demand densities for fashion products is chal- Tenging because no history of previous demand is avail: able. Our approach was to blend historical data on former products and expert opinion on the products to be offered, using cach source of information where it seemed most appropriate. Our historical data sample consisted of the initial forecast and demand over time for each product sold in the previous season. Although we hhad no demand history for the styles to be offered in the 92/93 season, it seemed reasonable to treat forecast er- ror, the difference between forecasted and actual sales, as a random variable that would follow a similar distribu- tion in past and future seasons, particularly since the same individuals were forecasting in the 91/92 and 92/93, Our history for the 91/92 season provided a large sam- ple of observations of this random variable which we FisHER AND RAMAN. / 93 he bP bE EG EES > poe ge ' fag Figure 2. Distribution of historical forecast errors. carefully examined for guidance in estimating demand distributions for the 92/93 season. Figure 2 is a histogram of forecast errors for the 91/92 season. Guided by the shape of this histogram, we assumed that Dig and Dj, the initial and total demands for product é, follow a variate normal distribution. The random variables Dip and D, follow a nonsingular bivariate normal density dis- tribution if their joint density function is of the form filzo. 2) ela inna? +xh- 291219) 2ar07s07NT > phe where 2; = (D; ~ w,)/0; and 2 = (Dio ~ Hw)! Although the normal distribution allows the possibility of negative demand, the coefficient of variation was gen- rally small enough that the probability of negative de- mand was negligible. In any event, we treated this probability as 0 and rescaled the remainder of the density to have a total mass of 1. The parameters were also such that the probability of Dio, D, such that D, < Djg was negligible. ‘We describe how we estimated the necessary parame- Lets Hips Mis Gros ip and p,, i= 1... and evaluate the accuracy of our estimated densities using actual 92/93 orders. Our estimates of 4, and ; are derived from the demand forecasts made by individual members of the buying committee described previously. Prior to the sea- ‘son, each of the seven members of the buying committee ‘was asked to estimate the season demand for each of the94 | FisHER AND RaMAN 339 products. We denote member ’s estimate for prod uct sales by y,. We estimate 4 a8 1 (vy ~ i?) 6. We estimate 6; = 04;, where 0's a scale factor chosen to equate the average predicated standard deviation for this, ‘year’s products 0 the sample standard deviation of last season’s observations of forecast errors. In our computa tional study, 6 was about 1.75. It is apparent that & will be low for those products where the members of the buying committee had similar estimates of season demand. ‘This method for estimating o; requires some motiva- tion. Frequently, one’s uncertainty about the value of a random variable is caused both by inherent randomness in the process generating the value and by uncertainty about the parameters of that process. For example, imag- ine drawing n balls from an urn containing a mixture of red and black balls in unknown proportions. Our uncer- tainty about how many red balls will be drawn in m trials. derives both from randomness inherent in the Bernoulli process and uncertainty about the fraction of red balls in the urn. If the urn is made of cloudy glass so we have partial visibility of the balls, then we could ask someone to look at the urn and make a point estimate of the frac- tion of red balls, or to specify a distribution showing their perceived likelihood of different fractions of red balls. A distribution of the number of red balls drawn in n trials would then depend both on the distribution of the frac- tion of red balls and on the randomness inherent in the drawing process. Also, as it becomes harder to estimate the fraction of red balls (e.g., the glass of the urn is cloudier), the variance in the distribution on the fraction of red balls should be greater and we will also see greater dispersion in independent point estimates of the fraction of red balls made by a number of individuals. Thus, vari- ance in our distribution of the number of red balls drawn should correlate with dispersion in individual point esti- ‘mates of the fraction of red balls. The process of predict- ing how many units of a particular ski parka will be sold is similar to this; our uncertainty derives both from inher- ent randomness in the customer choice process and from uncertainty in our estimation of customer utility func- tions. Dispersion in independent expert point forecasts captures this second type of uncertainty, and would be expected to be a good prediction of g; when this source of uncertainty is dominant, ‘This method for estimating the standard deviation of season sales performed well with 92/93 data. Figure 3 plots the root mean square deviation of actual deviation from forecast against the predicted standard deviation. In ‘compiling this graph, we divided the possible values of, Figure 3. Predicted versus actual standard deviation. predicted standard deviation into segments of 50 and grouped all styles and colors whose predicted standard ‘deviation falls within the same segment. For example, the lft-most point corresponds to all stylelcolors with & predicted standard devition between 0 and 0. As may be seen, actual deviation is well coreelated with pre- dicted standard deviation. Malkiel (1982) has observed a similar phenomenon; he found dispersion in experts opinions of a stock's performance to be the best of sev- eral predictors of the variance in performance. Estimat- jing g; can be thought of as “forecasting absolute forecast error.” Figure 3 shows that while demand itself may be hard to forecast, our forecasts of absolute forecast errors, were quite accurate. The data suggest that estimating 0 by the function @, + 0,0 would have provided a better fit than 6, but prior to seeing the data in Figure 3, we had no basis for estimating 6, and 0. We used historical sales data to evaluate the correla- tion coefficients p,. We assumed that correlation coef- cients were the same forall products within five major product eategories—ladies, mens, boys, gins, and pre- school, and estimated p a the observed statistical corre- lation between total and intial demand in the previous season. Management at Sport Obermeyer felt that such an assumption was reasonable. We also used historical sales data to estimate k, the fraction of season sales that would be observed in period Land estimated ip a8 fy = ki. Let 3, denote the correlation coefficient between Dy and (D; — Dio). We estimate 3, using historical data inthe same way we esti- mated p,. We then estimate ap asProposition 1 provides the rationale for this estimation of Proposition 4 cox ~ 3, (iced w= ail. 895, | Proof. Let gj: denote the standard deviation of (D, — jo), E(- ) expected value and Cov( - ) covariance. By definition Cov(D;, Dio) 0 Gea Cov(Dins Di = Dio) _ BD (Di ~ Din) ~ ED EW; - Div) _ E(D:Diw) ~ E(D3i) ~ E(Din Ei) + (EDan))? _ Cov(D;Dia) ~ oi _ 010189 - ob 101 = Hence OH = pit, ~ Bi. We also know that oht oh + Wo2om. Solving these two expressions for 12 and oy we obtain lh We checked the normality of actual total season de- ‘mand with a Quantile-Quantile (Q-Q) plot. As discussed in Morrison (1990) and Chambers et al. (1988), a Q ~ Q plot isa graphical construction used to check the reason- ableness of a proposed probability distribution against a sample of observations. Let 7, < rp <*** < ry denote NN ordered observations of a random variable. If N is sufficiently large and if the random variable has cumula- tive probability distribution 4 ), then the distribution of| the sample points should tend to resemble the FisHen and Raman / 95 Figure 4. 0-0 plot for the normal distribution. distribution function in the sense that the fraction of points within a given interval is approximately equal to the probability mass for that interval. Morrison (1990) and Chambers etal. (1988) point ut that this is equiva- lent to the points (q,, r;), i = 1, .--, N lying along a stright line, where gi defined by #4.) = (= IN Figure 4 is a Q ~ 0 plot to check the normality of (4, ~ nvo, using actual observations of total demand for 39 products inthe 9293 seasons and estimates of and o, as described inthis section. As can be seen, most points ie along a straight line, with the exception of a few outliers, st notably the thee points in the upper right-hand corner associated with observed demand that is higher than would have been expected under the nor malty assumption, Outliers of this type are less of @ concer ina response system because one has the oppor- tunity to cover the unexpectedly high demand with the second period production commitment. However, the outliers above and below the line in Figure 4 suggest chat a distribution wih fatter tals such as the Student’ distribution with a low degree of free- dom, might be more appropriate. Ths is confirmed by Figure 5, a Q — Q plot for the Student’s ¢ distribution with ¢ = 2. Figure 5 suggests that this distribution would rake sense inthe future, although to be conservative in our estimates of benefits, the computational results re ported in the next section are based on the normal densi ties we estimated before observing actual demand. Tn the nal analysis, the real test of estimated density functions isthe quality ofthe decisions based on those estimates, a question we consider in subsection 4496 | Fister AND RaMaN npc uae Figure 5. Q-0 plot for the Student’s ¢ distribution with ‘wo degrees of freedom. 43, Analysis of P for a Special Case In this section we provide a closed-form solution for B in the case in which all products have the same value of U, and of O, and have normally distributed demand with the same correlation p between the first period and total de- mand. In addition to providing insight into the structure of B, this result was useful in dealing with production minimums in the form they arise at Obermeyer. Produe- tion minimums at Sport Obermeyer apply to all colors within a style, and all colors for a style have common values for p,, U,, and O,. Hence, Theorem 2 provides a closed-form solution to the problem at the end of Section 2, which defines Z; inthis situation. Since we are dealing with normal densities, we need to integrate over negative demand values to avoid techni- calities in the proof of Theorem 2. Thus, the theorem is only meaningful in a real situation if ;/u, is suficiently small for all é that the integral of the demand density function over negative demand values is negligible. ‘Thi ‘was the case for the real problem considered here. Theorem 2. Suppose that f(Dy, D,) is a bivariate nor ‘mal with parameters jor bis Vor On and p, and that P= p, U, =U, 0, = 04 = ly ve ym, where p, Uy dnd O are given constants. Then the optimal solution to P is given by Xq = sy + Roy where k= (L ~ Sher Mi Efar O- Proof. Recall that ily Di) = Ople; ~ Dy)* + UD; =¥s)* and further define cH, Dio) = min Ep,o, cui» Di) clin) = Eogc?m> Di) Using standard results on the bivariate normal and the newsboy problem, and substituting p; = p, U, = U, 0, = 0, the value x{Dj9) that minimizes Epjn,c(Xis D)) is given by Dp) = ui +9 Za @ ‘where ‘( +) is the probability distribution function for a standard normal variable. Algebraic manipulation of this expression for x{(Dio) reveals that x{Djq) 2 Xi if and only if Dig 2 L, where oa 2 1 = 28 ln — wi + win po: [ Be Gg Since x; = max(xjo, X{(Dj)), we have vl) = j ° + J CHET). Do =y)fo,(0) dy ce, Dio =) Fo, (¥) dy Using standard rules of differentiation gives devin) ee [. (0 + U)Fo,p,(%0) ~ Ulfow(y) dy. Substituting xo = 4, + ko;, using the fact that f(Djo, ‘D,) is a bivariate normal, and substituting the expression for L; gives eon = aly — no) [orm oon. Changing variables, so that (y ~ wp)/oi9 = = gives ope. where o(2) isthe density function ofa standard normal. The fact that this expression does not depend on i shows thatthe Kubn-Tucker optimality conditions for P are sat. isfied atthe point x9 = 44, + Roy i = Ty vey Note that for the solution x9 = 4; + kor, the proba- bility that Dip exceeds x; is the same for all products. It seems intuitive that a solution to B would have this prop- erty, so one might suspect that Theorem 2 holds more generally, perhaps with the probability that Dig > Xieproportional to U,/(U, + 0,) in the case where U, and 0, fare not constant over i. The following example shows that this is not the case. We haven = 2, L = 75, Uy = U, = 0, = 0; = 1, and demand in each period is independently and uniformly distributed, between 0 and 50 for product 1, period 1 and product 2, period 2, and between 0 and 100 for product 1, period 2 and prod- uuct 2, period 1 Since the second period problem is a newsboy problem with UZ, = 0,, the optimal inventory at the start of period 2, after second period production, is 50 for product 1 and 25 for product 2. Hence, setting xy) = 50 and xay = 25 is optimal because this satisfies the first period produc tion constraint xy + x2y = L = 75 and does not con- strain second period production because we can set x, — 9 = Dw for i = 1, 2 and have an optimal amount of wwentory at the start of the second period. It is easy to verify that Prob (Dio > 50) = 0.75 # Prob (Ds > 25) 9375. 4.4, Results We tested the effectiveness of the procedures described here by executing them in parallel with the actual deci- sion process used at Obermeyer to commit production for the 92/93 season. Production commitments were made by the same buying committee described in subsec- tion 4.1 that is responsible for forecasting. This commit- tee met in the fall of 1991 to forecast total season demands for each styleicolor and to place an initial pro- duction commitment with suppliers in Hong Kong and China. Total demand for the Hong Kong styles was fore cast at 43,911 units and at this time production orders were placed for 19,650 units. For China styles, 74,764 units were forecast and 29,400 units were ordered. In March 1992, this committee met again right after the Las Vegas show to review orders received to date and to place final production orders. ‘The procedures described in this paper were executed in parallel using the same data that were available to the buying committee in the fall of 1991 and March of 1992. Densities and other data were estimated as described in subsections 4.1 and 4.2 and the algorithm described in Sections 1-3 was applied to determine initial produc tion commitments by style and color. Probability densi ties were then updated based on orders received through March 1992 and optimal second period production levels were determined. ‘The Hong Kong and China styles were analyzed sepa- rately because they are produced in separate factories, each with their own production constraints. The lower limit on first period production was set to the amount actually ordered early in each case by the buying com- mittee. Problem P was solved by a simple coordinate search algorithm in which, starting at x» = 0, the xj for which 32(2x9)/axj9 was smallest was increased by a fixed step size, with the modification described in Section 3 for FisHeR AND RAMAN. / 97 minimum lot size constraints, We also used Theorem 2 t0 compute the quantity Z} defined at the end of Section 2. In June 1992, all initial orders had been received from retailers. Traditionally, initial orders comprise about 92% of total orders for the Season. These orders were used to forecast total orders for the Season. This forecast should bee extremely accurate since historically the first 92% of orders have a greater than 0.99 correlation with total season orders. Total season sales by this calculation was 103,831 units. With these data, we are able to calculate the stockout ‘and markdown costs for actual and model decisions. This provides us with an estimate of the reduction in these costs that can be achieved through use of the model. Generally, in a stochastic decision problem, itis not valid to judge the quality of a decision based on outcomes Because of randomness, a good outcome does not neces- sarily imply a good decision. However, in this situation our evaluation is based on a large sample of 339 deci- sions, one for each style/color made with a consistent strategy. We also like the fact that this approach requires essentially no assumptions. If we made a comparison based on the demand density functions that we have es- timated, it would leave open the question of whether we have correctly estimated those functions. By calculating the actual cost incurred under the model decisions, we get an evaluation of the entire process we are proposing including the method for estimation of density functions, modeling of decisions, and the algorithm for analyzing that model. Also note that because the retailers’ orders are unaffected by the available supply, we can have an accurate measure of supply shortages, something that is often hard to estimate. ‘To measure the value of a response capability, we also computed production quantities for each style/color, as- suming that the entie season commitment was made the fall of 1991 with no option for response. Summary data for these three alternatives are displayed in Table I. ‘These results show that the model solution costs 1.82% of sales less than what was actually done and 8.9% of sales less than using no response at all. To ap- preciate the significance of these figures, note that profits in this industry average about 3% of sales. Thus, use of the decision process outlined here can inerease profits by ‘Table, 1 Results for Obermeyer’s 1992/1993 Season Response Model Model Actual Total Production 124,805 121,432 Overproduction 221036 25,094 Underproduetion ‘702 7,493 Overproduction Cost as 1.3% 1.74% ‘% of Sales Underproduction Cost as 0.18% 1.56% % of Sales 3.30% Total Cost as % of Sales 1.48%98 | FisHeR AND RAMAN TEP Understocking & Overstocking Cost Figure 6. Bounding results for China about 60% compared with what is actually being done and quadruple profits compared with no response at all. We believe the improvement over what was actually done comes from several sources, including a better un- derstanding of the costs of being high or low in inventory through tabulation of U; and 0), a better assessment of the relative risk of style/colors through estimation of and optimization of these features using the algorithm outlined in Sections 2 and 3. We applied our algorithm and the lower bounding pro- cedure described in Section 2 to the China and Hong Kong problems, with the minimum lot size constraints relaxed, since our lower bounds do not allow for mini- mum constraints. The results are shown in Figures 6 and 7, where the three curves give Z(xy(L)), W(L) and WAL) for different values of L. In the problem at Sport Obermeyer, L was given a priori and equal to 29,400 for China and 19,650 for Hong Kong. For these values of L, the gap between Z(x,(L)) and max(i7(L), W,(L)) is zero. On the other hand, if Lis regarded as variable, the gap is 11% for China and 7% for Hong Kong, ‘ACKNOWLEDGMENT We are most appreciative to Jan Hammond who intro- ‘duced us to Quick Response in the apparel industry, pro- vided advice on this research, and has been our partner in the broader research effort of which this paper is a part. 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