Single Period Inventory Model: Newsvendor model

Situation:
1. Demand in the period is uncertain.
2. Entire stock that is expected to be sold during the period has to be made
ready at the start of the period and no replenishment is possible in any
subsequent time in that period.
3. Stocking less than the demand would result in opportunity losses.
4. Unsold stock at the end of the period would have to be cleared at a
salvage price that is less than the cost of acquisition.
5. Hence, stocking more than the demand would result in losses owing to
clearance of the stock at price less than acquisition cost.
6. Classic examples: newspaper, perishable products like milk, fashion items
 Single Period Inventory Model

Notations:
D: Demand in the period
c u: Unit cost of under stocking
co: Unit cost of over stocking
Q *: Optimal opening stock
Swimsuit Example
 Fashion items such as swimsuits have short life cycles
and high demand variability
 Swimsuit Production
 About 6 months before summer production quantities are
determined based on demand forecasts
 One production opportunity
 Based on past sales, knowledge of the industry, and economic
conditions, the marketing department has a probabilistic forecast
 Overestimating demand leads to unsold inventory
 Underestimating demand leads to lost sales
Swimsuit Example: Demand Scenarios

Demand Scenarios

30%
Probability

25%
20%
15%
10%
5%
0%

Sales
Swimsuit Example: Costs
 Production cost per unit (C): Rs.80

 Selling price per unit (S): Rs.125

 Salvage value per unit (V): Rs.20

 Q is production quantity, D demand

Swimsuit Example: Solution
 Find order quantity that maximizes average profit.
 Question: Will this quantity be less than, equal to,
or greater than average demand?
Demand Probability

8000 0.11

10000 0.11

12000 0.27
14000 0.22
16000 0.19
18000 0.1
 Single Period Inventory Model
Marginal Analysis for continuous demand (for determining Q):
 A fraction Pr(D ≤ Q) of the time, ordering Q+1 units will cost co more than
ordering Q units; and a fraction Pr(D ≥ Q+1) = 1- Pr(D ≤ Q) of the time,
ordering Q+1 units will cost cu less than ordering Q units.
 Thus on an average, ordering Q+1 units will cost
co Pr(D ≤ Q) +(- cu){1- Pr(D ≤ Q)} more than ordering Q units.

 At the optimal order quantity Q, the expected marginal contribution of raising the
order size from Q to Q+1 is zero
i.e., (co+ cu) Pr(D ≤ Q) – cu = 0
or, Pr(D ≤ Q) = cu /( co+ cu)
Swimsuit Example: Solution
Demand Probability Cum Prob.
8000 0.11 0.11
10000 0.11 0.22
12000 0.27 0.49
14000 0.22 0.71
16000 0.19 0.9
18000 0.1 1

125 − 80 45
Pr( D  Q) = F (Q) = = = 0.43
125 − 80 + 80 − 20 105
Q = F −1 (0.43) = 12000