SESSION 9: SOLUTION OF THE PRACTICE PROBLEM

Problem 1: Find the expected profit maximizing order quantity, first identify the underage
and overage costs. The underage cost is Cu = 121 − 72 = 49 , because each lost sale costs
Flextrola its gross margin. The overage cost is Co = 72 − 50 = 22 , because each unit of
leftover inventory can only be sold for 50. Now evaluate the critical ratio

Cu 49
= = 0.6901 .
Co + Cu 22 + 49

Lookup the critical ratio in the Standard Normal Distribution Function Table:
(0.49) = 0.6879 and (0.50) = 0.6915 , so choose z = 0.50. Now convert the z-statistic into
an order quantity: Q =  + z   = 1000 + 0.5  600 = 1300 .

Problem 2: To determine the profit maximizing order quantity, begin with the underage
cost, Cu = 22 − 10 = 12 , and the overage cost, Co = 10 − 0 = 10 . The critical ratio is
12 /(10 + 12) = 0.5455 . We see from the Standard Normal Distribution Function Table that
(0.11) = 0.5438 and (0.12) = 0.5478 , so we choose z = 0.12 . Convert that z-statistic
back into an order quantity, Q =  + z   = 2100 + 0.12  1200 = 2,244 .

Problem 3:
a) With option 1 Land’s End sales price is $100, purchase cost is $65 and salvage
value is $53 (because Geoff buys back unsold glasses for $53). So the underage
cost is Cu =100 – 65 =35 and the overage cost is Co = 65 − 53 = 12 . The critical
ratio is Cu /(Co + Cu ) = 35/47 = 0.7422. From the Standard Normal Distribution
Function Table we see (0.65) = 0.7422 and (0.66) = 0.7454 , so we choose
z = 0.66 . The optimal order quantity is then
Q =  + z   = 200 + 0.66  125 = 282 .5 .
b) With option 1 Land’s End sales price is $100, purchase cost is $55 and the salvage
value is $0. So the underage cost is Cu = 100 − 55 = 45 and the overage cost is
Co = 55 . The critical ratio is Cu /(Co + Cu ) = 45/100 = 0.4500. From the Standard
Normal Distribution Function Table we see (−0.13) = 0.4483 and
(−0.12) = 0.4522 , so we choose z = −0.12 . The optimal order quantity is then
Q =  + z   = 200 − 0.12  125 = 185 .

Problem 4: The overage cost is Co =10 – 0 = 10, because left over parkas must have been
purchased in the 1st order at a cost of $10 and they have no value at the end of the season.
The underage cost is Cu =15 – 10 = 5 because there is a $5 premium on units ordered from
the American vendor. The critical ratio is 5 / (10 + 5) = 0.3333. From the Std Norm Dist
Func Table we see that (−0.44) = 0.3300 and (−0.43) = 0.3336, so choose z = -0.43.
Convert to Q : Q = 2100 – 0.43  1200 = 1584.