MA4850 Supply Chain &

Logistics Management

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 Lesson Overview
T1 Introduction T4 Warehousing, Packaging & Material Handling

T2.1 Forecasting Time Series T5.1 Transportation

T2.2 Forecasting Causal Models

T5.2 Transportation Costs & Logistics Network
T3.1 Inventory Management Introduction
T6.1 Supply Chain & Contracting
T3.2 EOQ Models
T6.2 Supply Chain & Product Architecture
T3.3 Newsvendor Model
T7 Global Supply Chain & Logistics
T3.4 QR Model

T3.5 Base Stock Policy T8 Supply Chain & Risk Management

T3.6 Inventory Management & Accounting T9 Information Technology

MA4850: Supply Chain & Logistics Management 2

 Topic 3.3
Inventory Management –
Newsvendor Model

MA4850: Supply Chain & Logistics Management 3

 Learning Objectives
By the end of this course, you should be able to:
• Identify uncertain demand
• Estimate optimal ordering quantity

MA4850: Supply Chain & Logistics Management 4

 Newsvendor Model
How many newspapers should the vendor stock so as to maximize profit in
face of uncertain demand?

Probability
distribution

Demand

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 Fitting Distribution to Demand 1st method

Period Demand Period Demand

1 32 16 17 Demand Distribution
2 21 17 27
Probability
3 39 18 20
0.3
4 32 19 20
5 29 20 53
6 26 21 29 (Mean, standard
0.2 deviation)
7 43 22 18
~Normal (27.9, 10.9)
8 39 23 4
9 37 24 6 0.1
10 21 25 27
11 41 26 31 0.0
12 36 27 32
0 20 40 60 Demand
13 30 28 33
14 25 29 33
15 8 30 28

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 Fitting Distribution to Forecast 2nd method

One-step forecast by exponential smoothing with α = 0.2

Demand Forecast Error2 Demand Forecast Error2
Period Period
𝑨𝒕 𝒇𝒕 𝜺𝒕𝟐 𝑨𝒕 𝒇𝒕 𝜺𝒕𝟐
1 32 16 17 26 81
2 21 32 121 17 27 24 9
3 32 30 81 18 20 25 25
4 32 32 0 19 20 24 16
5 29 32 9 20 53 23 900
6 26 31 25 21 29 29 0
7 43 30 169 22 18 29 121
8 39 33 36 23 4 27 529
9 37 34 9 24 6 22 256
10 21 35 196 25 27 19 64
11 41 32 81 26 31 21 100
12 36 34 4 27 32 23 81
13 30 34 16 28 33 25 64
14 25 33 64 29 33 27 36
15 8 31 529 30 28 28 0

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 Distribution of Forecast Error

Probability
0.4

0.2 εt ~Normal (0, 11.2)

Demand of Period 31
~ Normal (28, 11.2)
0.0
-35 -25 -15 -5 5 15 25 35
Error 𝜺𝐭

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 Newsvendor Model
The Scenario

Salvage value: 𝑠

Demand: 𝑋
Cost: 𝑐 Price: 𝑟
Manufacturer Newsvendor Consumers

• A single product • No backorders

• There is infinite capacity

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 Newsvendor Model Parameter
𝑋 Demand (in units), a random variable
Actual demand that the newsvendor
𝑥 Realized demand (in units) able to sell

𝐺(𝑥) Cumulative density function of 𝑋, i.e. 𝐺 𝑥 = 𝑃𝑟𝑜𝑏 𝑋 < 𝑥

𝑔(𝑥) Probability density function of 𝑋, i.e. 𝑔 𝑥 = 𝑑𝐺(𝑥) 𝑑𝑥

𝜇 Mean demand (in units)

𝜎 Standard deviation of demand (in units)

𝑟 Retail price (in dollars/unit)

𝑠 Salvage value (in dollars/unit)

𝑐 Cost (in dollars/unit)

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 Decision Analysis
Realized demand

𝑥≥𝑞 Shortage Revenue: 𝑞 ∗ 𝑟

Cost: 𝑞 ∗ 𝑐 Place an order

𝑥<𝑞
Overage Revenue: 𝑥 ∗ 𝑟 + 𝑞 − 𝑥 ∗ 𝑠

Conditional profit functions: revenue cost + salvage cost + cost

𝜋 𝑞 𝑥 = 𝑚𝑖𝑛 𝑥, 𝑞 ∗ 𝑟 + 𝑚𝑎𝑥 𝑥, 𝑞 − 𝑥 ∗ 𝑠 − 𝑞 ∗ 𝑐
𝑞 ∗ 𝑟 − 𝑞 ∗ 𝑐, 𝑖𝑓 𝑥 > 𝑞
=
𝑥 ∗ 𝑟 + 𝑞 − 𝑥 ∗ s − 𝑞 ∗ 𝑐, 𝑖𝑓 𝑥 ≤ 𝑞

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 Expected Profit
Unconditional profit function:


  q     min{x, q}* r   max{x, q}  x  * s  q * c  g ( x )dx
0

   x * r  ( q  x ) * s  q * c  g ( x )dx   ( q * r  q * c ) g ( x )dx
q

0 q
q q 
 ( r  s )  x  g ( x )dx  q * s *  g ( x )dx q * r *  g ( x )dx  q * c
0 0 q

 ( r  s ) q  G ( q)   G ( x )dx   q * s * G ( q)  q * r * 1  G ( q)   q * c
 q

 0 
q
 q *( r  c )  ( r  s )  G ( x )dx
0

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 Profit Maximization
• First order condition

𝑑𝜋(𝑞)
= 𝑟−𝑐 − 𝑟−𝑠 𝐺 𝑞 = 0
𝑑𝑞 𝑎2 (𝑄)
𝑟−𝑐 𝑑
∗ 𝑓 𝑥, 𝑄 𝑑𝑥
⟹𝐺 𝑞 = 𝑑𝑄
𝑟−𝑠 𝑎1 (𝑄)
𝑎2 (𝑄)
𝜕 𝑑𝑎2 (𝑄)
= 𝑓 𝑥, 𝑄 𝑑𝑥 + 𝑓 𝑎2 (𝑄 , 𝑄)
𝜕𝑄 𝑑𝑄
𝑎1 (𝑄)
• Second order condition 𝑑𝑎2 (𝑄)
− 𝑓(𝑎1 𝑄 , 𝑄)
𝑑𝑄
𝑑 2 𝜋(𝑞) Leibniz’s rule
= − 𝑟 − 𝑠 𝑔(𝑞) < 0
𝑑𝑞 2

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 Critical Ratio

G(x)

∗
𝑟−𝑐 (𝑟 − 𝑐)
𝐺 𝑞 = =
𝑟−𝑠 𝑟 − 𝑐 + (𝑐 − 𝑠) 1
𝑘𝑢 Critical
=
𝑘𝑢 + 𝑘0 ratio

Underage Overage
cost cost

q* x

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 Optimal Solution – Normal Distribution
• If demand is normally distributed, we can use the standard normal
variable 𝑧 and its distribution 𝑁 0,1
• To convert any normally distributed variable 𝑋 to the standard normal
variable 𝑧, we use the formula:

𝑋−𝜇
𝑧=
𝜎

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 Standard Normal Distribution (pdf)

0.02
0.018
𝐴𝑟𝑒𝑎 𝑡𝑜 𝑙𝑒𝑓𝑡 𝑜𝑓 1.5 𝑖𝑠
0.016
𝑃(𝑧 ≤ 1.5)
0.014
0.012
𝒈(𝒛)

0.01
0.008
0.006
0.004
0.002

-3.5 -3 -2.5 -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 3 3.5

Standard normal variable 𝒛

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 Standard Normal Distribution (cdf)
1.2

0.8

0.6

0.4

0.2

-4 -3 -2 -1 0 1 2 3 4
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 Finding Optimal Order Quantity
• Calculate the critical ratio :
𝑟−𝑐 𝑘𝑢
𝐶𝑟 = =
𝑟 − 𝑠 𝑘𝑢 + 𝑘0

• Find the corresponding 𝑧-value for desired critical ratio value

𝑧 ∗ = Normsinv 𝐶𝑟 in Excel

• Transform 𝑧-value to 𝑞 :
𝑞−𝜇
𝑧= ⟹ 𝑞∗ = 𝑧 ∗𝜎 + 𝜇
𝜎

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 Example
John sells next year’s calendar at a newsstand. He must order in August,
and each calendar costs $4.50. John sells each calendar for $12.00. Any
leftover calendars are sold at $2.00 a piece. John estimates demand
distribution ~N(1500, 1002).

How many calendars should John order?

By Daniel X. O'Neil from USA [CC BY 2.0

(http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons
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 Example (Con’t)
• Overage cost : $4.50-$2.00 = $2.50
• Underage cost : $12-$4.50 = $7.50
• Critical ratio : 7.5/(2.5+7.5) = 0.75 ~75% probability that the demand < or
= order

• John should cover 75% of demand distribution

• Corresponding 𝑧-value is 0.674
• John should order (1500+0.674*100) = 1567
calendars

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 Summary
• Key component of trade-off is between two kinds of costs
• Overage – order too much
• Shortage – order too little
• Challenge in balancing with the newsvendor model to make optimal
decision when facing uncertain demand

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Thank you

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