Newsvendor Problem

Rohit Kapoor

Summary
Process for using
Historical A/F ratio
To construct an empirical distribution
Step1: Assemble a data set of products for which the
forecasting task is comparable to the product of interest
Data set should include products that we expect would
have similar forecast errors to the product of interest
Data should include initial forecast of demand and the
actual demand for each item
An initial forecast for the product for the upcoming
season

Summary
Step 2
Evaluate A/F ratio for each product in the data set

Step 3
Sort the data in ascending A/F ratio order and
rank the items from 1 to N
N is the number of items in the data set

Step 4
Probability of the ith item equals i/N

Fitting Normal Distribution to

Empirical Distribution
Expected actual demand = Expected A/F ratio * Forecast
3192 (0.9976 * 3200)

Std. dev. of demand = std. dev. of A/F ratio * Forecast

1181 (0.369 * 3200)

Cumulative Distribution
Normdist(Q, 3192, 1181, 1)

1.00
0.90

Probability

0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
0

1000

2000

3000

4000

5000

6000

Quantity

Empirical distribution function (diamonds) and normal distribution function with

mean 3192 and standard deviation 1181 (solid line)

Newsvendor Model
Critical Ratio?
Ordering one more unit increases the
chance of overage
Expected loss on the Qth unit = Co x F(Q)
F(Q) = Distribution function of demand = Prob{Demand <= Q)

but the benefit/gain of ordering one more

unit
the reduction in the chance of underage:
Expected gain on the Qth unit = Cu x (1-F(Q))

An Exercise Problem
In August, L. L. Bean, Inc. must decide on how many of next years
cardigans should be ordered. Each cardigan costs L. L. Bean $2 and it is
sold for $4.50. After January 1, any unsold cardigans are returned to the
supplier for a refund of 75 cents per cardigan. The product manager
believes the number of cardigans sold by January 1 follows the probability
distribution shown in Table L. L. Bean wants to maximize the expected net
profit from cardigans sales. How many cardigans should the product
manager order in August?

No. of Cardigans Sold

Probability

100

0.3

150

0.2

200

0.3

250

0.15

300

0.05

Fill Rate and Cycle Service Level

Suppose that for a given inventory situation, average annual
demand is 1000 and the EOQ is 100. Demand during lead time
is random and is described by the probability distribution. For
a reorder point of 30 units determine the fill rate and
expected no. of cycles having shortages.
Lead
Time
Demand
20
30
40
50
60

Probability
0.2
0.2
0.2
0.2
0.2

Performance Measures

Expected lost sales

Expected sales
Expected leftover inventory
Expected profit
Fill rate
In-Stock probability
Stock-out probability