Session 23:: Operations Management

Managing Flow Variability: Safety Inventory
Operations Management
Session 23: Newsvendor Model

Uncertain Demand
2
Uncertain Demand: What are the relevant trade-offs?

– Overstock
• Demand is lower than the available inventory
• Inventory holding cost
– Understock
• Shortage- Demand is higher than the available inventory
– Why do we have shortages?

– What is the effect of shortages?
Session 23 Operations Management 2

The Magnitude of Shortages (Out of Stock)

3

What are the Reasons?

4

Consumer Reaction
5

What can be done to minimize shortages?

6
Better forecast
Produce to order and not to stock
– Is it always feasible?
Have large inventory levels
Order the right quantity
– What do we mean by the right quantity?

Uncertain Demand
7
What is the objective?

– Minimize the expected cost (Maximize the expected profits).
What are the decision variables?

– The optimal purchasing quantity, or the optimal inventory
level.

Optimal Service Level: The Newsvendor Problem

8
How do we choose what level of service a firm should offer?
Cost of Holding
Extra Inventory
Improved
Service
Optimal Service Level under uncertainty
The Newsvendor Problem
The decision maker balances the expected costs of ordering
too much with the expected costs of ordering too little to
determine the optimal order quantity.
News Vendor Model

9
Assumptions
– Demand is random
– Distribution of demand is known
– No initial inventory
– Set-up cost is equal to zero
– Single period
– Zero lead time
– Linear costs:
• Purchasing (production)
• Salvage value
• Revenue
• Goodwill

10
Cost =1800, Sales Price = 2500, Salvage Price = 1700

Underage Cost = 2500-1800 = 700, Overage Cost = 1800-1700 = 100
Demand Probability of Demand
100 0.02
110 0.05
120 0.08
130 0.09
140 0.11
150 0.16
160 0.2
170 0.15
180 0.08
190 0.05
200 0.01
What is probability of demand to be equal to 130?

What is probability of demand to be less than or equal to 140?
What is probability of demand to be greater than 140?

11
Demand Probability of Demand Demand Probability of Demand

100 0.002 110 0.005
101 0.002 111 0.005
102 0.002 112 0.005
103 0.002 113 0.005
104 0.002 114 0.005
105 0.002 115 0.005
106 0.002 116 0.005
107 0.002 117 0.005
108 0.002 118 0.005
109 0.002 119 0.005

What is probability of demand to be less than or equal to 116?
What is probability of demand to be greater than 116?
What is probability of demand to be equal to 113.3?


12
Average Demand Probability of Demand

100 0.02
What is probability of demand to be equal to
110 0.05 130?
120 0.08
130 0.09
What is probability of demand to be less than
140 0.11 or equal to 145?
150 0.16
160 0.2
What is probability of demand to be greater
170 0.15 than 145?
180 0.08
190 0.05
200 0.01
Compute the Average Demand

13
N
Average Demand   X i P( x  X i ) X P(x=X)
i 1 100 0.02
110 0.05
Average Demand = 120 0.08
+100×0.02 +110×0.05+120×0.08 130 0.09
140 0.11
+130×0.09+140×0.11 +150×0.16 150 0.16
+160×0.20 +170×0.15 +180×0.08 160 0.2
+190×0.05+200×0.01 170 0.15
Average Demand = 151.6 180 0.08
190 0.05
200 0.01
How many units should I have to sell 151.6 units (on average)?
How many units do I sell (on average) if I have 100 units?

Deamand (X) 100 110 120 130 140 150 160 170 180 190 200
Porbability 0.02 0.05 0.08 0.09 0.11 0.16 0.20 0.15 0.08 0.05 0.01
Prob(x ≥ X) 1.00 0.98 0.93 0.85 0.76 0.65 0.49 0.29 0.14 0.06 0.01
14
Suppose I have ordered 140 Unities.

On average, how many of them are sold? In other words, what
is the expected value of the number of sold units?
When I can sell all 140 units?
I can sell all 140 units if  x ≥ 140
Prob(x ≥ 140) = 0.76
The expected number of units sold –for this part- is
(0.76)(140) = 106.4
Also, there is 0.02 probability that I sell 100 units 2 units
Also, there is 0.05 probability that I sell 110 units5.5
Also, there is 0.08 probability that I sell 120 units 9.6
Also, there is 0.09 probability that I sell 130 units 11.7
106.4 + 2 + 5.5 + 9.6 + 11.7 = 135.2
Deamand (X) 100 110 120 130 140 150 160 170 180 190 200
Porbability 0.02 0.05 0.08 0.09 0.11 0.16 0.20 0.15 0.08 0.05 0.01
Prob(x ≥ X) 1.00 0.98 0.93 0.85 0.76 0.65 0.49 0.29 0.14 0.06 0.01
15
Suppose I have ordered 140 Unities.

On average, how many of them are salvaged? In other words,
what is the expected value of the number of salvaged units?
0.02 probability that I sell 100 units.
In that case 40 units are salvaged  0.02(40) = .8
0.05 probability to sell 110  30 salvaged  0.05(30)= 1.5
0.08 probability to sell 120  20 salvaged  0.08(20) = 1.6
0.09 probability to sell 130  10 salvaged  0.09(10) =0.9
0.8 + 1.5 + 1.6 + 0.9 = 4.8
Total number Sold 135.2 @ 700 = 94640

Total number Salvaged 4.8 @ -100 = -480
Expected Profit = 94640 – 480 = 94,160
Cumulative Probabilities
16
Probabilities
X P(x=X) P(x<X) P(x≥X)
100 0.02 0 1
110 0.05 0.02 0.98
120 0.08 0.07 0.93
130 0.09 0.15 0.85
140 0.11 0.24 0.76
150 0.16 0.35 0.65
160 0.2 0.51 0.49
170 0.15 0.71 0.29
180 0.08 0.86 0.14
190 0.05 0.94 0.06
200 0.01 0.99 0.01

Number of Units Sold, Salvages

17
Probabilities Units Sold@700

X P(x=X) P(x<X) P(x≥X) Sold Salvage
100 0.02 0 1 100 0
Salvaged@-100
110 0.05 0.02 0.98 109.8 0.2
120 0.08 0.07 0.93 119.1 0.9
130 0.09 0.15 0.85 127.6 2.4
140 0.11 0.24 0.76 135.2 4.8
150 0.16 0.35 0.65 141.7 8.3
160 0.2 0.51 0.49 146.6 13.4
170 0.15 0.71 0.29 149.5 20.5
180 0.08 0.86 0.14 150.9 29.1
190 0.05 0.94 0.06 151.5 38.5
200 0.01 0.99 0.01 151.6 48.4

Total Revenue for Different Ordering Policies

18
Probabilities Units Revenue

X P(x=X) P(x<X) P(x≥X) Sold Salvaged Sold Salvaged Total
100 0.02 0 1 100 0 70000 0 70000
110 0.05 0.02 0.98 109.8 0.2 76860 20 76840
120 0.08 0.07 0.93 119.1 0.9 83370 90 83280
130 0.09 0.15 0.85 127.6 2.4 89320 240 89080
140 0.11 0.24 0.76 135.2 4.8 94640 480 94160
150 0.16 0.35 0.65 141.7 8.3 99190 830 98360
160 0.2 0.51 0.49 146.6 13.4 102620 1340 101280
170 0.15 0.71 0.29 149.5 20.5 104650 2050 102600
180 0.08 0.86 0.14 150.9 29.1 105630 2910 102720
190 0.05 0.94 0.06 151.5 38.5 106050 3850 102200
200 0.01 0.99 0.01 151.6 48.4 106120 4840 101280

Example 2: Denim Wholesaler

19
The demand for denim is:

– 1000 with probability 0.1
Cost parameters:
Unit Revenue (r ) = 30
– 3000 with probability 0.15 Unit purchase cost (c )= 10
Salvage value (v )= 5
– 4000 with probability 0.2 Goodwill cost (g )= 0
How much should we order?
20
Example 2: Marginal Analysis

21
Marginal analysis: What is the value of an additional unit?
Suppose the wholesaler purchases 1000 units

What is the value of the 1001st unit?


22
Wholesaler purchases an additional unit
Case 1: Demand is smaller than 1001 (Probability 0.1)

– The retailer must salvage the additional unit and losses $5 (10 – 5)
Case 2: Demand is larger than 1001 (Probability 0.9)

– The retailer makes and extra profit of $20 (30 – 10)
Expected value = -(0.1*5) + (0.9*20) = 17.5


23
What does it mean that the marginal value is positive?

– By purchasing an additional unit, the expected profit
increases by $17.5
The dealer should purchase at least 1,001 units.
Should he purchase 1,002 units?


24


Expected value = -(0.1*5) + (0.9*20) = 17.5


25
Assuming that the initial purchasing quantity is between 1000 and

2000, then by purchasing an additional unit exactly the same
savings will be achieved.
Conclusion: Wholesaler should purchase at least 2000 units.


26
What is the value of the 2001st unit?



Expected value = -(0.25*5) + (0.75*20) = 13.75


27
Why does the marginal value of an additional unit decrease, as

the purchasing quantity increases?
– Expected cost of an additional unit increases
– Expected savings of an additional unit decreases


28
We could continue calculating the marginal values
Cumlative Expected Expected marginal

Demand Probability Probability marginal cost savings Marginal Value
1000 0.1 0.1 0.5 18.0 17.50
2000 0.15 0.25 1.3 15.0 13.75
3000 0.15 0.4 2.0 12.0 10.00
4000 0.2 0.6 3.0 8.0 5.00
5000 0.15 0.75 3.8 5.0 1.25
6000 0.15 0.9 4.5 2.0 -2.50
7000 0.1 1 5.0 0.0 -5.00


29
What is the optimal purchasing quantity?

– Answer: Choose the quantity that makes marginal value: zero
Marginal value
17.5
13.75
10
5
1.3
Quantity
-2.5 1000 2000 3000 4000 5000 6000 7000 8000

-5

Analytical Solution for the Optimal Service Level

30
Net Marginal Benefit: MB = p – c MB = 30 - 10 = 20

Net Marginal Cost: MC = c - v MC = 10-5 = 5
Suppose I have ordered Q units.
What is the expected cost of ordering one more units?
What is the expected benefit of ordering one more units?
If I have ordered one unit more than Q units, the probability of not selling that extra
unit is if the demand is less than or equal to Q. Since we have P( D ≤ Q).
The expected marginal cost =MC× P( D ≤ Q)

If I have ordered one unit more than Q units, the probability of selling that extra
unit is if the demand is greater than Q. We know that P(D>Q) = 1- P( D≤ Q).
The expected marginal benefit = MB× [1-Prob.( D ≤ Q)]

31
As long as expected marginal cost is less than expected marginal

profit we buy the next unit. We stop as soon as: Expected marginal
cost ≥ Expected marginal profit
MC×Prob(D ≤ Q*) ≥ MB× [1 – Prob(D ≤ Q*)]
MB
Prob(D ≤ Q*) ≥
MB  MC
MB = p – c = Underage Cost = Cu
MC = c – v = Overage Cost = Co
MB cu pc pc
P( D  Q ) 
*
  
MB  MC Cu  C o pccv pv

Marginal Value: The General Formula

32
P(D ≤ Q*) ≥ Cu / (Co+Cu)

Cu / (Co+Cu) = (30-10)/[(10-5)+(30-10)] = 20/25 = 0.8
Order until P(D ≤ Q*) ≥ 0.8

P(D ≤ 5000) ≥ = 0.75 not > 0.8 still order
Cum
P(D ≤ 6000) ≥ = 0.9 > 0.8 Stop
Demand Probability Prob
1000 0.1 0
Order 6000 units 2000 0.15 0
3000 0.15 0
4000 0.2 0
5000 0.15 0
6000 0.15 0
7000 0.1


33
In Continuous Model where demand for example has

Uniform or Normal distribution
MB cu pc
P( D  Q ) 
*
 
MB  MC Cu  C o pv

Marginal Value: Uniform distribution

34
Cumlat
Demand Probability Probab
Suppose instead of a discreet demand of 1000 0.1 0.1
2000 0.15 0.25
3000 0.15 0.4
4000 0.2 0.6
5000 0.15 0.75
6000 0.15 0.9
7000 0.1 1
We have a continuous demand uniformly distributed between

1000 and 7000
1000 7000
Pr{D ≤ Q*} = 0.80
How do you find Q?

Marginal Value: Uniform distribution

35
Q-l = Q-1000
?
0.80 1/6000
l=1000 u=7000
u-l=6000
(Q-1000)*1/6000=0.80
Q = 5800
Type-1 Service Level

36
What is the meaning of the number 0.80?
F(Q) = (30 – 10) / (30 – 5) = 0.8

– Pr {demand is smaller than Q} =
– Pr {No shortage} =
– Pr {All the demand is satisfied from stock} = 0.80
It is optimal to ensure that 80% of the time all the demand is
satisfied.

Marginal Value: Normal Distribution

37
Suppose the demand is normally distributed with a mean of 4000

and a standard deviation of 1000.
What is the optimal order quantity?
Notice: F(Q) = 0.80 is correct for all distributions.

We only need to find the right value of Q assuming the normal
distribution.

Marginal Value: Normal Distribution

38
0.00045
0.0004
Probability of Probability of
0.00035 excess inventory shortage
0.0003 4841
0.00025
Series1
0.0002
0.00015
0.80
0.0001
0.00005
0.20
0
0 1000 2000 3000 4000 5000 6000 7000 8000


39
Recall that:
F(Q) = Cu / (Co + Cu) = Type-1 service level


40
Is it correct to set the service level to 0.8?

Shouldn’t we aim to provide 100% serviceability?


41
What is the optimal purchasing quantity?
0.00045
0.0004 Probability of Probability of
0.00035 excess inventory shortage
0.0003
0.00025
0.0002
5282 Series1
0.00015
0.90
0.0001
0.00005
0
0 1000 2000 3000 4000 5000 6000 7000 8000


42
How do you determine the service level?

For normal distribution, it is always optimal to have:
Mean + z*Standard deviation
µ + zs
The service level determines the value of Z
zs is the level of safety stock
m +zs is the base stock (order-up-to level)


43
Given a service level, how do we calculate z?
From our normal table or

From Excel
– Normsinv(service level)

Additional Example
44
Your store is selling calendars, which cost you $6.00 and sell for
$12.00 You cannot predict demand for the calendars with certainty.
Data from previous years suggest that demand is well described by a
normal distribution with mean value 60 and standard deviation 10.
Calendars which remain unsold after January are returned to the
publisher for a $2.00 "salvage" credit. There is only one opportunity
to order the calendars. What is the right number of calendars to
order?

Additional Example - Solution

45
MC= Overage Cost = Co = Unit Cost – Salvage = 6 – 2 = 4

MB= Underage Cost = Cu = Selling Price – Unit Cost = 12 – 6 = 6
Cu 6
P( D  Q* )    0.6
Cu  C o 6  4
Look for P(Z ≤ z) = 0.6 in Standard Normal table or for

NORMSINV(0.6) in excel  0.2533
Q*  m Q*  m
P( Z  )  0.6   0.2533
s s
Q*  m  0.2533s  60  10(0.2533)  62.533  63
By convention, for the continuous demand distributions, the results are

rounded to the closest integer.


46
Suppose the supplier would like to decrease the unit cost in order to
have you increase your order quantity by 20%. What is the minimum
decrease (in $) that the supplier has to offer.
Qnew = 1.2 * 63 = 75.6 ~ 76 units
76  60
P( D  Q* )  P( D  76)  P( z  )  P( Z  1.6)
10
Look for P(Z ≤ 1.6) = 0.6 in Standard Normal table or for

NORMSDIST(1.6) in excel  0.9452
Cu pc 12  c 12  c
P( D  Q* )  0.9452    
Cu  Co p  c  c  v 12  2 10
12  c  9.452  c  2.55
Additional Example
47
On consecutive Sundays, Mac, the owner of your local newsstand, purchases a

number of copies of “The Computer Journal”. He pays 25 cents for each copy
and sells each for 75 cents. Copies he has not sold during the week can be
returned to his supplier for 10 cents each. The supplier is able to salvage the
paper for printing future issues. Mac has kept careful records of the demand
each week for the journal. The observed demand during the past weeks has the
following distribution:
Quantity Q 4 5 6 7 8 9 10 11 12 13
Probability p(D=Q) 0.04 0.06 0.16 0.18 0.20 0.10 0.10 0.08 0.04 0.04
What is the optimum order quantity for Mac to minimize his cost?


48
Overage Cost = Co = Unit Cost – Salvage = 0.25 – 0.1 = 0.15

Underage Cost = Cu = Selling Price – Unit Cost = 0.75 – 0.25 = 0.50
Cumulative
Probability Probability
Cu 0.50
P( D  Q*)    0.77 Q p(D=Q) F(Q)
Cu  Co 0.50  0.15 4
5
0.04
0.06
0.04
0.10
6 0.16 0.26
P( D  Q* )  0.77 7 0.18 0.44
8 0.20 0.64
9 0.10 0.74
10 0.10 0.84
11 0.08 0.92
12 0.04 0.96
The critical ratio, 0.77, is between Q = 9 and Q = 10. 13 0.04 1.00
Remember from the marginal analysis explanation that the results are rounded up.
Because at 9 still it is at our benefit to order one more.
So Q* = 10

Session 23:: Operations Management

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Managing Flow Variability: Safety Inventory

Session 23: Newsvendor Model

Uncertain Demand: What are the relevant trade-offs?

– Why do we have shortages?

Session 23 Operations Management 2

The Magnitude of Shortages (Out of Stock)

Session 23 Operations Management 3

What are the Reasons?

Session 23 Operations Management 4

Session 23 Operations Management 5

What can be done to minimize shortages?

Session 23 Operations Management 6

What is the objective?

What are the decision variables?

Session 23 Operations Management 7

Optimal Service Level: The Newsvendor Problem

How do we choose what level of service a firm should offer?

News Vendor Model

Optimal Service Level: The Newsvendor Problem

Cost =1800, Sales Price = 2500, Salvage Price = 1700

What is probability of demand to be equal to 130?

Optimal Service Level: The Newsvendor Problem

Demand Probability of Demand Demand Probability of Demand

What is probability of demand to be equal to 116?

Session 23 Operations Management 11

Optimal Service Level: The Newsvendor Problem

Average Demand Probability of Demand

Compute the Average Demand

Session 23 Operations Management 13

Suppose I have ordered 140 Unities.

Suppose I have ordered 140 Unities.

Total number Sold 135.2 @ 700 = 94640

Session 23 Operations Management 16

Number of Units Sold, Salvages

Probabilities Units Sold@700

Session 23 Operations Management 17

Total Revenue for Different Ordering Policies

Probabilities Units Revenue

Session 23 Operations Management 18

Example 2: Denim Wholesaler

The demand for denim is:

Example 2: Marginal Analysis

Marginal analysis: What is the value of an additional unit?

Suppose the wholesaler purchases 1000 units

Session 23 Operations Management 21

Example 2: Marginal Analysis

Wholesaler purchases an additional unit

Case 1: Demand is smaller than 1001 (Probability 0.1)

Case 2: Demand is larger than 1001 (Probability 0.9)

Expected value = -(0.1*5) + (0.9*20) = 17.5

Session 23 Operations Management 22

Example 2: Marginal Analysis

What does it mean that the marginal value is positive?

Session 23 Operations Management 23

Example 2: Marginal Analysis

Wholesaler purchases an additional unit

Case 1: Demand is smaller than 1002 (Probability 0.1)

Case 2: Demand is larger than 1002 (Probability 0.9)

Expected value = -(0.1*5) + (0.9*20) = 17.5

Session 23 Operations Management 24

Example 2: Marginal Analysis

Assuming that the initial purchasing quantity is between 1000 and

Expected value = -(0.15) + (0.920) = 17.5

Expected value = -(0.15) + (0.920) = 17.5

Expected value = -(0.255) + (0.7520) = 13.75