Chapter 6: Perishable Items

Characteristics
One-time Decision
Simplest Case: the unconstrained, single-item,
newsvendor problem
Single-period, Constrained, Multi-item Situation
The General Newsvendor Model
Extensions to Multiple Periods
Ref: Chapter 10, text book
 1. Characteristics of style goods
and perishable items
▪ A relatively short selling season. short sell life
▪ There might be one or some chances for replenishment after the initial order is
placed.
▪ When the demand in the season exceeds the stock made available, there are
associated underage costs. shortage cost,
▪ When the demand in the season is less than the stock, overage costs result. The
when order to much
value of items is reduced at a particular point in time.
▪ Style goods products are often substitutable.like iphone. Customer can choose other types
▪ Sales of style goods are usually influenced by promotion activities and space
allocation in the store.
 2. One-Time Decision
Situation is common to retail and manufacturing environment
Consider seasonal goods, which are in demand during short period only.

Product losses its value at the end of the season. The lead time can be longer than
the selling season → if demand is higher than the original order, can not rush order
for additional products.

Example
newspaper stand
Christmas ornament retailer “newsvendor” model
Christmas tree or
finished good inventory “Christmas tree” model
Trivial problem if demand is known (deterministic case), in practical situations demand is
described as random variable (stochastic case).

3
 Example: One-Time Decision
Mrs. Kandell has been in the Christmas tree business for years. She
keeps track of sales volume each year and has made a table of the
demand for the Christmas trees and its probability (frequency
histogram).
Demand, Probability Solution:
X g(X) Q – order quantity; Q* - optimal
22 0.05 X – demand: random variable with
probability density function g(x)
24 0.10
G(x) – cumulative probability function:
26 0.15 G(x) = Pr (demand ≤ x)
28 0.20 co – cost per unit of positive inventoryoverage cost
30 0.20 cu – cost per unit of unsatisfied demand underage
cost

32 0.15
Economics marginal analysis:
34 0.10 overage and underage costs are balanced
36 0.05 4
 The Concept of Marginal Analysis
Marginal analysis:
finding the expected profit of ordering one more unit.

Probability of not selling

Your Last item in stock and
having extra inventory on hand
at the end on the period Probability of
P(X < Q) Selling
everything, and
facing shortage
P(X ≥ Q)

m Q
5
Critical ratio for the newsvendor problem
P(X<Q)
(Co applies)

P(X>Q)
(Cu applies)
Probability

0 2 4 6 8 10 12 14

New spaper demand, X

Single Period Inventory Model Marginal Analysis:

overage cost underage cost
E (revenue on last sale) = E (loss on last sale)
6
 Example: One-Time Decision (cont)
 Shortages = lost profit + lost of goodwill
 Overage = unit cost + cost of disposal of the overage - salvage cost
 Either ignore the purchase cost, because it does not impact the optimal
solution or implicitly consider it in the overage and underage costs.
 Expected overage cost of the order Q* is: P(Demand < Q*) co = G(Q*)co
 Expected shortage cost is: P(Demand > Q*) cu = (1-G(Q*)) cu
 For order Q* those two costs are equal: G(Q*)co = (1-G(Q*))cu
Then, probability of satisfying demand during the period, also is known
as critical ratio.
cu
P ( X < Q ) = G (Q ) =
* *

cu + co
 To calculate Q* we must use cumulative probability distribution.
 Example: One-Time Decision (cont.)
Demand Probabilit Cum Mrs. Kandell estimates that
x y g(x) Probability if she buys more trees than
G(x) she can sell, it costs about
22 0.05 0.05 $40 for the tree and its
24 0.10 0.15 disposal. If demand is
26 0.15 0.30
higher than the number of
trees she orders, she looses
28 0.20 0.50
a profit of $40 per tree.
30 0.20 0.70
32 0.15 0.85
34 0.10 0.95
36 0.05 1.00
cu
G (Q ) =
40
*
= = 0.50 Q = 28
cu + co 40 + 40
8
3. Simplest case: the unconstrained,
single item, news vendor problem
• Overage, co
• Probability: Pr(X < Q)
• Expectation: co ×Pr(X < Q)
• Underage, cu
• Probability: Pr(X > Q) = 1 - Pr(X < Q)
• Expectation: cu × 1 – [Pr(X < Q)]

Decision: Choose Q* satisfies:

Pr ( X  Q ) =* cu
c o + cu
 Simplest case: the unconstrained,
single item, news vendor problem
• If: X = demand
• v = acquisition cost ($/unit)
• p = revenue per sale ($/unit)
• B = penalty for not satisfying demand ($/unit)
• g = salvage value ($/unit)

 Choose Q* satisfies: Pr 𝑋 < 𝑄∗ =

𝐶𝑢
=
𝑝−𝑣+𝐵
=
𝑝−𝑣+𝐵
𝐶𝑜 + 𝐶𝑢 (𝑣 − 𝑔) + (𝑝 − 𝑣 + 𝐵) 𝑝 − 𝑔 + 𝐵

 Expected profit: 𝐸 𝑃 𝑄∗ = 𝑝 − 𝑔 ⋅ 𝑥lj − 𝑣 − 𝑔 𝑄 − 𝑝 − 𝑔 + 𝐵 𝐸𝑆
𝑄∗

Normal case: (
N x , x
2
) 𝐸 𝑃 𝑄∗ = −𝐵 ⋅ 𝑥lj + 𝑝 − 𝑔 + 𝐵 න 𝑥0 𝑓𝑥 𝑥0 𝑑𝑥0
0

Q* = x + z v−g  x 
E P (Q * )  = ( p − v )x − ( p − g + B ) f  v−g 

u
p−g +B x x  p−g+B
Example
Solution
 Critical fractile for the newsvendor problem

When the demand is a discrete random variable, the

condition G(Q) = cu
cu + co

may not be satisfied at equality (jumps, due to

discreteness). Here’s the appropriate condition to
use: *
= 
cu
Q min{Q : PX  (Q) }
cu + co

C(Q+1)-C(Q)=(cu+ co)PX(Q) – cu ≥ 0

13
 Single-Period & Discrete Demand: Lively Lobsters

 Lively Lobsters (L.L.) receives a supply of fresh, live lobsters

from Maine every day. Lively earns a profit of $7.50 for every
lobster sold, but a day-old lobster is worth only $8.50. Each
lobster costs L.L. $14.50
 unit cost of a L.L. stockout
Cu = 7.50 = lost profit
 unit cost of having a left-over lobster
Co = 14.50 - 8.50 = cost – salvage value = 6
 target L.L. service level
CR = Cu/(Cu + Co) = 7.5 / (7.5 + 6) = .56

 Demand follows a discrete (relative frequency) distribution as

given on next page

14
 cu
Lively Lobsters Q = min{Q : PX  (Q ) 
*

cu + co
}

Probability that demand

Demand follows a Cumulative will be less than or equal to x
discrete (relative
Relative Relative
frequency)
distribution: Frequency Frequency
Demand (pmf) (cdf)
Result: 19 0.05 0.05 P(D < 19 )

20 0.05 0.10 P(D < 20 )

order 25 Lobsters,
21 0.08 0.18 P(D < 21 )
because that is the
smallest amount 22 0.08 0.26 P(D < 22 )

that will serve at 23 0.13 0.39 P(D < 23 )

least 56% of the 24 0.14 0.53 P(D < 24 )

0.56
demand on a 25 0.10 0.63 P(D < 25 )
given night.
26 0.12 0.75 P(D < 26 )

27 0.10 … P(D < 27 )

28 0.10 … P(D < 28 )

29 0.05
15 … P(D < 29 )

* pmf = prob. mass function

 The Nature of Uncertainty
 Suppose that we represent demand as
=std
= mean value
X = Xdeterministic + Xrandom
 If the random component is small compared to the deterministic
component, the models used in chapter 4 will be accurate. If not,
randomness must be explicitly accounted for in the model.
 Assume that demand is a random variable with cumulative probability
distribution F(x) and probability density function f(x).
X - continuous random variable, N(μ, σ)
 Estimated from history of demand
 Seems to model many demands accurately
 Objective: minimize the expected costs – law of large numbers

16
 5. Single-period, constrained,
multi-item situation
Some examples:
 Several different newspapers sharing a limited space or budget.

 A buyer for a style goods dept. who has a budget limitation for a
group of items.

 The provisioning of supplies or spare parts on a spacecraft,

submarine prior to a long mission without resupply.

 The repair kit of maintenance crew in operation.

 Single-period, constrained, multi-
item situation
Notation:
 n = number of different items (SKUs)

 xi = demand of item i.

 vi = acquisition cost of item i.

 pi = selling price of item i.

 Bi = penalty for not satisfying demand of item i.

 gi = salvage value of item i.

 W = budget available
 Single-period, constrained, multi-
item situation
 Step 1: Select an initial positive value of the Lagrange multiplier, M.atchoose
beginning
M=0

 Step 2: Determine each Qi to satisfy:

pi − (M + 1)vi + Bi
Pr ( X i  Qi ) = (Qi  0 )
pi − g i + Bi
n

 Step 3: Compare: Q v
i =1
i i vs. W
n

 If Q v
i =1
i i W finish.
n
 If Q v  W i i return to step 2 with smaller W.
ni =1
 If Q v  W
i =1
i i return to step 2 with larger W.
 Example
Suppose the Ski Bum was faced with decisions
on 4 items. The manager accepts that in each
case total demand is normal distribution. The
relevant parameter values are estimated in the
following table. The manager has a budget of
$70,000 to allocate among these 4 items.
Solution
 6. The General Newsvendor Model

 Objective: Minimize the sum of expected shortage and overage

costs

 Tradeoff: If we order too little, we incur a shortage cost; if we

order too much we incur a an overage cost

2
Notation

2
 The Newsvendor Model

The critical ration can also be derived mathematically.

At the start of each day, a newsvendor must decide on the number of

papers to purchase. Daily sales cannot be predicted exactly, and are
represented by the random variable D with normal distribution N(μ, σ),
where μ = 11.73 and σ = 4.74

It can be shown that the optimal number of papers to purchase is given

by F(Q*) = cu / (cu + co),
where cu = 75 – 25 = 50, and c0 = 25 – 10 =15
unrealized profit per unit = (selling price – purchase price);
loss per excess = (purchase price – disposal price);

F(Q*) = cu / (cu + co) = 0.77 → Pr ( X < Q* ) = 0.77

How to find Q* ?

24
Determination of the Optimal Order Quantity for
Newsvendor Example
Using table normal table
to find z = 0.74, with μ = 11.73 and σ = 4.74
Q* = m + zs =15.24

Newsvendor has to
order 15 copies
every week.

25
Describing Demand

26
 If Demand is deterministic (EOQ)

Inv

Q=600
LT=3 wk

Reorder
Point=300

Time
Place Order Place Order
Order arrives Order arrives
27
 If Demand is stochastic

Inv

Q=600 LT=3 wk LT=3 wk

Reorder
Point=300

Time
Order
Place arrives Place Order
Order Order arrives
28
 If Demand is stochastic

Inv

Q=600 LT=3 wk LT=3 wk

Reorder
Point=400

Place
Order Order Time
Place arrives Order
Order arrives
29
The Cost Function

3
The Cost Function (Cont.)

3
Leibnitz’s Rule

3
 The Optimal Order Quantity

 The optimal solution satisfies

3
 The Exponential Distribution

 The Exponential distribution with parameters 

34
 Example
 Scenario:
¨ Demand for T-shirts has the exponential distribution with
mean 1000 (i.e., G(x) = P(X  x) = 1- e-x/1000)
¨ Cost of shirts is $10.
¨ Selling price is $15.
¨ Unsold shirts can be sold off at $8.
 Model Parameters:
¨ cs = 15 – 10 = $5 (cost of understock)
¨ co = 10 – 8 = $2 (cost of overstock)

3
 Example (Cont.)
 Solution:

 Sensitivity:

¨ If co = $10 (i.e., shirts must be discarded) then

3
 The Normal Distribution
The Normal distribution with parameters m and , N(m, )

• If X has the normal distribution N(m, ), then (X- m)/ has the
standard normal distribution N(0, 1).
• The cumulative distributive function of the Standard normal
distribution is denoted by .

3
 The Normal Distribution (Cont.)

𝟏 − 𝑸∗ −𝝁 𝟐
 G(Q*)= 𝒆𝒙𝒑 =𝐶 𝐶+𝐶
𝑠
𝝈 𝟐𝝅 𝟐𝝈𝟐 𝑠 0

 Pr(X Q*)= 𝐶 𝐶+𝐶

𝑠
𝑠 0

 Pr[(X - m)/   (Q* - m)/] = 𝐶 𝐶+𝐶

𝑠
𝑠 0

 Let Y = (X - m)/, then Y has the standard Normal distribution

 Pr[(Y  (Q* - m)/ ] = [(Q* - m)/ ] = 𝐶 𝐶+𝐶

𝑠
𝑠 0

 Define z such that (z)=𝐶 𝐶+𝐶

𝑠
𝑠 0

 Q* = m + z

3
 The Optimal Cost for Normally
Distributed Demand

Both the optimal order quantity and the optimal cost

increase linearly in the standard deviation of demand.
3
 Example
 Demand has the normal distribution with mean m = 10,000
and standard deviation  = 1,000
 cs = 1
𝐶𝑠
 co = 0.5 → 𝐶𝑆𝐿 = 𝑃𝑟 𝑥 ≤ 𝑄 = = 0.67 = 
𝐶𝑠 +𝐶0

 From a standard normal table, we find that z0.67 = 0.44.

Therefore, we have:

Q* = m + z = 10,000 + 0.44(1,000) = 10,440

4
 Service Levels
Probability of no stockout (service level – S(R))

Fill rate

Fill rate can be significantly higher than the probability of no

stockout

4
 Discrete Demand
X is a discrete random variable

4
 Discrete Demand (Cont.)

The optimal value of Q is the smallest integer that satisfies

This is equivalent to choosing the smallest integer Q that satisfies

or equivalently

4
The Geometric Distribution
The geometric distribution with parameter  , 0    1

4
 The Geometric Distribution

The optimal order quantity Q* is the smallest integer that

satisfies

4
 7. Extension to Multiple Periods

The news-vendor model can be used to a solve a multi-

period problem, when:
¨ We face periodic demands that are independent and
identically distributed (iid) with distribution G(x)
¨ All orders are either backordered (i.e., met eventually) or lost
¨ There is no setup cost associated with producing an order

4
Extension to Multiple Periods

4
Extension to Multiple Periods

4
 Extension to Multiple Periods
In this case
¨ co is the cost to hold one unit of inventory in stock for one
period
¨ cs is either the cost of backordering one unit for one period
or the cost of a lost sale

-cs co

4
Handling Starting Inventory/Backorders

5
 Example

(Q)

optimal order quantity

5
Expected Cost Function