The Single-Period Inventory Problem

Imagine a decision problem of the following type:

You face a "quantity" decision: For example, how many tickets to sell for a flight, how
many minutes to allow for a trip, how many product catalogs to print for this year, or
how many dollars to put in an ATM machine.

You are facing an uncertain (i.e., random) demand: Continuing the examples, the
number of seats on the airplane plus the number of no-shows, the time the trip will
actually take, the number of catalog requests that will come in over the year, or the
amount of money that patrons will (attempt to) withdraw from the machine before it is
restocked.

You must live with the consequences of your decision: You can't sell extra tickets in the
final minutes before departure, you can't stop the clock or go back in time, the setup
cost of a second press-run is prohibitive, or you can't justify the cost of an "emergency"
armored-car run.

The cost of being "under"( i.e., of setting your quantity below demand, rather than
precisely at the demanded level) varies linearly with the amount by which you are under
(i.e., is a fixed per-unit-under cost).

The cost of being "over" (i.e., of setting your quantity above the demanded level) also
varies linearly with the amount by which you are over.

Let D be the random variable which represents demand, and let c under and cover,
respectively, be the per-unit costs of being "under" or "over."

Let your policy (quantity) variable be Q, and consider the difference between the.
expected cost of adopting a policy of Q+1, and a policy of Q (i.e., consider the marginal
expected cost difference):

Providing a (Q+1)st unit will be costly if D ≤ Q ; it will be beneficial if D > Q. Therefore,

the net expected marginal benefit of setting your policy at Q+1, instead of at Q, is

cunder∙Pr(D>Q) - cover∙Pr(D≤Q) .

If this is positive, Q+1 is better than Q.

Similarly, the net marginal cost of providing only Q-1 units, instead of Q, is

cunder∙Pr(D>Q-1) - cover∙Pr(D≤Q-1) .

If this is negative, Q-1 is better than Q.

Pulling this all together, and using the facts that Pr(D>Q) = 1-Pr(D≤Q) and
Pr(D>Q-1) = 1-Pr(D≤Q-1), we find that an optimal policy Q* (i.e., one from which
you don't want to move either up or down) must satisfy

c under
Pr ( D≤Q*-1)< ≤Pr ( D≤Q*) .
c under +c over

Therefore, the optimal policy Q* can be found by solving

c under
Pr ( D≤Q* )=
c under +c over

(and rounding up, if necessary).

The fraction on the right is called the "critical fractile." The optimal policy involves
choosing Q so the chance that you don't "run out" (equivalently, the chance that you
are "over") is equal to this critical fractile.
 Examples

You order Christmas trees for your lot in Evanston from a tree farm in Oregon. Trees
cost you $30 apiece (including shipping), and you sell them for $75. Per Evanston
regulations, any leftover (unsold) trees must be properly disposed of, at a cost of $5 per
tree. You anticipate that demand over the pre-Christmas season will be normally
distributed, with an expected value of 300 and a standard deviation of 50. How many
trees should you order?

Buying one more tree than the number demanded, rather than exactly the correct
number (i.e., being "over"), will leave you $30+$5 = $35 poorer. Buying one less tree
than the number you could sell, rather than exactly the correct number (i.e., being
"under"), will leave you $75-$30 - $45 poorer. Therefore,

$35 cover
$45 cunder

56.25% critical fractile 0 50 100 150

308 optimal order quantity

You are selling tickets for a 300-seat flight. You profit $500 from each filled seat, but lose
$250 on each person bumped from the flight. The number of no-shows is equally likely
to be anywhere between 5 and 95.

$250 cover
$500 cunder

66.67% critical fractile

365 optimal order quantity,
since Pr(300 + noshows ≤ 364) = 60/91 < 66.67% < 61/91 = Pr(300 + noshows) ≤ 365)
0 50 100 150 200 250 300 350 400 450 500
The optimal policy is to position ourselves 56.25% of the way "up"
in the demand distribution, i.e., to order enough trees to give us
a 56.25% chance of meeting demand.
300 expected sales
50 standard deviation

0 0.0000
25 0.0000
50 0.0000
75 0.0000
100 0.0000
125 0.0000
150 0.0001
175 0.0004
200 0.0011 chart data
225 0.0026
250 0.0048
275 0.0070
300 0.0080
325 0.0070
350 0.0048
375 0.0026
400 0.0011
425 0.0004
450 0.0001
475 0.0000
500 0.0000

308 0.0000
308 0.0090
 Accounting

Determing cunder and cover requires some care.

For example, in the overbooking problem, the cost to the airline of not having sold a
ticket that would have been used to fill a seat on the flight depends on what the
prospective passenger, refused the purchase of the ticket, would do. If your airline is the
only one flying the passenger's desired route, he/she will probably fly with you at
another time, i.e., cunder is quite small. If, on the other hand, the route is quite
competitive, you might lose that customer's business, and cunder will be much larger.

In the ATM case, by being one dollar short of demand, you generate some ill will (and
potential lost on-premises sales), but you are, in compensation, able to keep that dollar
productively employed elsewhere.

Similarly, not being able to immediately send a requestor a catalog might cost you
some immediate sales, while saving you the cost of printing that catalog. But, if you will
eventually ship that customer a copy of next-year's catalog, you'll still bear the cost of
printing a catalog to meet the customer's demand. Then again, perhaps the customer
would have not only asked for this year's catalog, but eventually for next year's catalog
as well, in which case you have saved the cost of printing a catalog.

It typically falls upon the marketing department to accurately assess the cost of failing
to meet a unit of demand. Marketing would probably - in the "catalog" case - estimate
cunder by averaging over the different ways the customer's catalog request might
ultimately work out.
 ATM Operations

You are currently in charge of ATM operations at a regional bank operating

in northern Illinois.

1 Your bank sends an armored car around to restock ATM machines at local
shopping malls on Monday, Wednesday, and Friday (at around 6:00 AM)
each week. The amount of cash withdrawn from a particular machine in the
Monday-to-Wednesday two-day period is normally distributed, with a mean
of $15,000 and a standard deviation of 3000.

(a) If this machine is stocked with $18,500 on Monday, what's the probability
that it will not run out of cash before the Wednesday restocking?

One dollar, left sitting in this machine for the two-day period, costs you
$0.0006 . (This is the opportunity cost to the bank of having that dollar
nonproductively employed.) The typical customer withdraws about $100 in a
single transaction, and you estimate the loss of goodwill for the bank if the
machine is empty when a customer attempts to withdraw money to be $1.50
This translates to a cost of approximately $0.015 for every dollar in demand that
cannot be met.

(b) What is your "critical fractile" for stocking this machine?

(c) How much money should be put into the machine on Monday?

It has been proposed that you cancel the Wednesday restocking

(and just restock the machine on Mondays and Fridays).

(d) Assuming that there's not much difference in the day-to-day distribution of
weekday total cash withdrawals from the machine, how much money would you
need to put in the machine on Monday in order to have a 99% chance of not
having the machine run out of cash before Friday?

Two of your machines are close enough together that they seem to be
cannibalizing each other's users. Indeed, the draw on each has been averaging
$10,000 per day, with a standard deviation of $3,000, but the correlation
(covariance, divided by the product of the standard deviations) between the
daily draws on the two machines is -0.6 .

(e) If you were to replace the two machines with a single one that serviced the
combined demand of both, what would the mean and standard deviation of the
 daily draw on that one new machine be?

2 An independent contractor is supposed to perform standard preventive

maintenance once every month on the six ATM machines you currently have
placed in various locations within a particular large mall. If an ATM machine is
properly maintained, there is only a 10% chance of encountering unexpected
problems with it in the course of a month.

(a) Assuming that the machines are being properly maintained, what is the
probability that (exactly) two of the six experience unexpected problems in July?

(b) What is the probability that you'll have no unexpected problems with any of the
machines over a two-month period?

The contractor has a good reputation. In fact, going into July you felt there was a
95% chance that the machines in his care were being properly maintained.
However, if the machines are not properly maintained, there's a 25% chance of
encountering unexpected problems with each machine in the course of a month.

(c} Out of curiosity, you check the July service record of one particular machine
located just inside the main entrance to the mall. You find that this machine
encountered unexpected problems in the course of the month. Based on only
this new information, what will be your belief (entering August) concerning the
likelihood that the machines are being properly maintained?

3 The newest ATM machines are able to print a small ad on the back of each
receipt. Two competing grocery-store chains have been seeking an exclusive
deal to advertise their stores on a fraction of your receipts. (You've already lined
up non-grocery-related advertisers for the remaining proportion of the receipts.)
One chain has already made you a firm, nonnegotiable offer of $50,000 if you'll
carry their ads for the next six months. You're nearing the end of negotiations
with the other chain, and your best estimate of the most they'd be willing to pay is
$55,000. However, one standard-deviation's-worth of residual uncertainty in your
estimate of the most they'll pay is $6,000.

(a) If you make them a take-it-or-leave-it offer to sign with them for a payment of
$56,500 (if they say "no", you'll sign at $50,000 with their competitor), what is
your net expected revenue from advertising sales to (one of the) chains? [Note:
Once this calculation is set up, you could use trial and error ... or Excel's
 "Solver" ... to find the optimal take-it-or- leave-it offer.]

(b) What is one standard-deviation's-worth of uncertainty in the net revenue you'll be

receiving?

4 There have been recent rumors that a competing bank is planning to open up
ATM operations in your area. Right now, you believe there's only a 30% chance
that the rumors are true. You could guarantee that the competitor stays out of
your area by tying your current ATM licensees into long-term deals through the
preemptive offer of a one- time price break.

Offering these price breaks would cost you (in net present value) about
$700,000. However, an unimpeded entry into the market by your competitor
would cost you about $1,500,000.

(a) If there were some way to learn of your competitor's plans for certain, what would
that source of information be worth to you?

You've looked into hiring a consulting firm that specializes in competitor

intelligence. From their track record you figure that, if the competing bank truly
intends to enter your market, the consulting firm will be able to collect enough
information to correctly predict their entry 80% of the time. If the competitor has
no plans to enter, you believe that the consulting firm will incorrectly predict that
entry is about to occur about 30% of the time.

(b) What is the most you should be willing to pay the consulting firm for the
information it could provide to you?
 ATM Operations

You are currently in charge of ATM operations at a regional bank operating

in northern Illinois.

1 Your bank sends an armored car around to restock ATM machines at local
shopping malls on Monday, Wednesday, and Friday (at around 6:00 AM)
each week. The amount of cash withdrawn from a particular machine in the
Monday-to-Wednesday two-day period is normally distributed, with a mean
of $15,000 and a standard deviation of 3000.

(a) If this machine is stocked with $18,500 on Monday, what's the probability
that it will not run out of cash before the Wednesday restocking?

87.83%

One dollar, left sitting in this machine for the two-day period, costs you
$0.0006 . (This is the opportunity cost to the bank of having that dollar
nonproductively employed.) The typical customer withdraws about $100 in a
single transaction, and you estimate the loss of goodwill for the bank if the
machine is empty when a customer attempts to withdraw money to be $1.50
This translates to a cost of approximately $0.015 for every dollar in demand that
cannot be met.

(b) What is your "critical fractile" for stocking this machine?

96.00%

(c) How much money should be put into the machine on Monday?

$ 20,252.06

It has been proposed that you cancel the Wednesday restocking

(and just restock the machine on Mondays and Fridays).

(d) Assuming that there's not much difference in the day-to-day distribution of
weekday total cash withdrawals from the machine, how much money would you
need to put in the machine on Monday in order to have a 99% chance of not
having the machine run out of cash before Friday?

$ 39,869.86

Two of your machines are close enough together that they seem to be
cannibalizing each other's users. Indeed, the draw on each has been averaging
$10,000 per day, with a standard deviation of $3,000, but the correlation
(covariance, divided by the product of the standard deviations) between the
daily draws on the two machines is -0.6 .

(e) If you were to replace the two machines with a single one that serviced the
combined demand of both, what would the mean and standard deviation of the
 daily draw on that one new machine be?

$ 20,000.00 mean -5400000 covariance

$ 2,683.28 standard deviation

2 An independent contractor is supposed to perform standard preventive

maintenance once every month on the six ATM machines you currently have
placed in various locations within a particular large mall. If an ATM machine is
properly maintained, there is only a 10% chance of encountering unexpected
problems with it in the course of a month.

(a) Assuming that the machines are being properly maintained, what is the
probability that (exactly) two of the six experience unexpected problems in July?

9.84%

(b) What is the probability that you'll have no unexpected problems with any of the
machines over a two-month period?

28.24%

The contractor has a good reputation. In fact, going into July you felt there was a
95% chance that the machines in his care were being properly maintained.
However, if the machines are not properly maintained, there's a 25% chance of
encountering unexpected problems with each machine in the course of a month.

(c} Out of curiosity, you check the July service record of one particular machine
located just inside the main entrance to the mall. You find that this machine
encountered unexpected problems in the course of the month. Based on only
this new information, what will be your belief (entering August) concerning the
likelihood that the machines are being properly maintained?

10.75% Pr(you'd see a problem on this machine)

88.37% Pr(machines are being properly maintained | this machine has problem)

3 The newest ATM machines are able to print a small ad on the back of each
receipt. Two competing grocery-store chains have been seeking an exclusive
deal to advertise their stores on a fraction of your receipts. (You've already lined
up non-grocery-related advertisers for the remaining proportion of the receipts.)
One chain has already made you a firm, nonnegotiable offer of $50,000 if you'll
carry their ads for the next six months. You're nearing the end of negotiations
with the other chain, and your best estimate of the most they'd be willing to pay is
$55,000. However, one standard-deviation's-worth of residual uncertainty in your
estimate of the most they'll pay is $6,000.

(a) If you make them a take-it-or-leave-it offer to sign with them for a payment of
$56,500 (if they say "no", you'll sign at $50,000 with their competitor), what is
your net expected revenue from advertising sales to (one of the) chains? [Note:
Once this calculation is set up, you could use trial and error ... or Excel's
 "Solver" ... to find the optimal take-it-or- leave-it offer.]

(b) What is one standard-deviation's-worth of uncertainty in the net revenue you'll be

receiving?

$ 56,500.00 offer $ 56,344.13 optimal offer

(using "Solver")
offer offer
accepted rejected
40.13% 59.87% probablity
$ 56,500.00 $ 50,000.00 revenue

$ 52,608.41 E[revenue]
$ 3,186.04 Stddev[revenue]

4 There have been recent rumors that a competing bank is planning to open up
ATM operations in your area. Right now, you believe there's only a 30% chance
that the rumors are true. You could guarantee that the competitor stays out of
your area by tying your current ATM licensees into long-term deals through the
preemptive offer of a one- time price break.

Offering these price breaks would cost you (in net present value) about
$700,000. However, an unimpeded entry into the market by your competitor
would cost you about $1,500,000.

(a) If there were some way to learn of your competitor's plans for certain, what would
that source of information be worth to you?

If we knew for certain, then we would only spend the $700,000 when we knew the
competitor was planning to enter. Our expected cost would be

$ 210,000.00

Not knowing, we're best off crossing our fingers and hoping the competitor stays
out. Our expected cost is

$ 450,000.00

Therefore, perfect foreknowledge would be worth

$ 240,000.00

You've looked into hiring a consulting firm that specializes in competitor

intelligence. From their track record you figure that, if the competing bank truly
intends to enter your market, the consulting firm will be able to collect enough
information to correctly predict their entry 80% of the time. If the competitor has
no plans to enter, you believe that the consulting firm will incorrectly predict that
entry is about to occur about 30% of the time.
(b) What is the most you should be willing to pay the consulting firm for the
information it could provide to you?

Building a decision tree, we find that the optimal strategy (using the information
from the consulting firm) is to take preemptive action only if the competitor is
predicted to be planning entry. Following this strategy yields us an expected
cost of $700,000
yes

$ 405,000.00 yes: 53.33%

deter?

Therefore, hiring the firm is worth up to no

entry: 45% e nte r

$ 45,000.00
no: 46.67%
pre dict

yes $700,000
yes no entry: 55%
yes: 10.91%
deter?

hire? no e nte r

no: 89.09%
no $700,000
yes

deter? yes::30% $1,500,000

no e nte r

no: 70% $0
es $700,000

yes: 53.33% $1,500,000

o e nte r

no: 46.67% $0

es $700,000

yes: 10.91%
$1,500,000

o e nte r

no: 89.09% $0

500,000

$0