Lecture 11 Inventory Management with Perishable Demand

LO11-1. Use the newsvendor model to decide how much product to order when
demand is perishable and uncertain.

The Newsvendor Model (or Newsboy Model) is a classic inventory management model
designed to help businesses decide the optimal order quantity for products that have
uncertain demand over a single selling period. The model is named after the scenario of a
newspaper vendor who must decide how many newspapers to purchase in the morning to
maximize profit, considering the risk of unsold newspapers at the end of the day and lost
sales if demand exceeds the supply.

Key Concepts of the Newsvendor Model:

1. Single-Period Inventory Model:

o The newsvendor model is used in situations where inventory is only relevant
for a single period, typically perishable or seasonal goods (e.g., newspapers,
flowers, fashion items). After the period ends, leftover inventory becomes
obsolete or loses significant value.
2. Uncertain Demand:
o The primary challenge in the newsvendor model is that demand is uncertain. A
key part of the model is determining how to order in the face of this
uncertainty while minimizing potential costs.
3. Balancing Two Types of Costs:
o The model focuses on balancing two conflicting costs:
▪ Underage Cost (𝐶𝑢 ): The cost of ordering too little (lost sales, missed
profits, customer dissatisfaction).
▪ Overage Cost (𝐶𝑜 ): The cost of ordering too much (unsold inventory,
markdowns, disposal costs).

Underage Cost:

-Definition: The underage cost represents the profit you miss out on when you don’t have
enough inventory to meet demand. It’s the opportunity cost of not having enough items to
sell.

-Formula:

Underage Cost = Selling Price - Cost of Procurement = p - c

-Selling Price: The price at which you could have sold the item.

-Cost of Procurement: The cost you incur to get or produce the item.

Example:

- Suppose you could sell an item for $100, and it costs you $70 to produce.
- If you don’t have enough of the item to meet demand, your underage cost per unit is:

Underage Cost = 100 - 70 = 30

So, for every customer you turn away, you lose $30 in potential profit.

Overage Cost:

-Definition: The overage cost represents the loss you incur when you have excess inventory
that cannot be sold at full price. This typically happens when you have to sell the leftover
inventory at a discount or, in extreme cases, discard it.

-Formula:

Overage Cost = Cost of Procurement - Salvage Value = c - v

-Cost of Procurement: The cost you paid to acquire or produce the item.

-Salvage Value: The amount you can recover from unsold inventory, which could come
from discounts, returns, or reselling at a lower price.

Example:

- Suppose you produced an item at a cost of $70, but you can only sell it at a discount for $40
if it doesn’t sell at full price.

- The overage cost per unit is: Overage Cost = 70 - 40 = 30

So, for every unsold unit, you lose $30 because you’re only recovering $40 instead of the $70
it cost to make the item.

4. Critical Ratio (CR):

o The optimal order quantity for Newsvendor Model is determined by the
critical ratio, which is calculated as:

𝐶𝑢
𝐹(𝑄 ∗ ) = 𝑃𝑟𝑜𝑏(𝐷𝑒𝑚𝑎𝑛𝑑 ≤ 𝑄 ∗ ) = → 𝐶𝑟𝑖𝑡𝑖𝑐𝑎𝑙 𝑅𝑎𝑡𝑖𝑜
𝐶𝑢 + 𝐶𝑜

o
The business orders inventory such that the probability of selling less than or
equal to the order quantity is equal to the critical ratio.
5. Optimal Order Quantity (Q*):
o The optimal order quantity is based on the critical ratio and the demand
distribution. Assuming the demand follows a probability distribution (e.g.,
normal distribution), the optimal order quantity is the point where the
cumulative distribution function (CDF) equals the critical ratio.
▪ For normal distribution: Q∗ = 𝜇 + (𝑧 × 𝜎)
▪ Where 𝜇 is the mean demand, 𝜎 is the standard deviation of
demand, and 𝑧 = 𝑁𝑂𝑅𝑀. 𝑆. 𝐼𝑁𝑉 (𝐶𝑟𝑖𝑡𝑖𝑐𝑎𝑙 𝑟𝑎𝑡𝑖𝑜) is the critical
ratio corresponding to the z-score in the standard normal
distribution.
Note: You can be given with two types of tables to calculate optimal ordering quantity. Table
13.2 provides the distribution of the demand with specific mean and standard deviation,
you can use it directly after getting critical ratio F(Q∗ ) to get Q∗ .

While Table 13.4 provides distribution for the standard normal! You need to further convert
the numbers using Q∗ = 𝜇 + (𝑧 × 𝜎)
How to find Q∗

Discussion:

• As the order quantity Q increases, the overage cost (from having excess inventory) grows,
while the underage cost (from having insufficient inventory) shrinks.
• The optimal order quantity in the newsvendor model is found by balancing these two
opposing forces, where the marginal cost of ordering one more unit equals the marginal
benefit of preventing a stockout.
LO11-2 Evaluate important measures such as expected profit and the probability that
all demand is served.

1. z-Score Calculation:

𝑸−𝝁
𝒛=
𝝈

• Explanation: This formula represents the z-score, which standardizes the order
quantity 𝑸 based on the mean demand 𝝁 and standard deviation 𝝈. The z-score
helps determine how far 𝑸 is from the average demand, in terms of standard
deviations.

Example:

• Suppose the mean demand 𝝁 is 100 units, and the standard deviation 𝝈 is 20 units. If
the retailer orders 120 units (Q=120):

120 − 100
𝑧= =1
20

A z-score of 1 indicates the order quantity is one standard deviation above the average
demand.

2. Expected (leftover) Inventory (Equation 13.3):

𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 (leftover) 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 = 𝝈 × 𝑰(𝒛)

• Explanation: The expected (leftover) inventory depends on the standard deviation 𝝈

of demand and the inventory factor 𝑰(𝒛) which is based on the z-score.

where

𝑰(𝐳) = 𝐍𝐎𝐑𝐌. 𝐃𝐈𝐒𝐓(𝒛, 𝟎, 𝟏, 𝟎) + (𝒛 × 𝐍𝐎𝐑𝐌. 𝐒. 𝐃𝐈𝐒𝐓(𝒛))

How to find 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 (leftover) 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲:

3. Expected Sales (Equation 13.4):

𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐬𝐚𝐥𝐞𝐬 = 𝑸 − 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

Explanation: Expected sales represent the quantity ordered 𝑸 minus the expected leftover
inventory. This gives the anticipated number of units sold based on the demand distribution.

Example:

• If the retailer orders 120 units (𝑸 = 𝟏𝟐𝟎) and the expected inventory is 3.2 units,
then expected sales would be: Expected Sales=120−3.2=116.8 units. The retailer
expects to sell 116.8 units out of the 120 ordered.

4. Expected Profit Formula:

𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐩𝐫𝐨𝐟𝐢𝐭 = (𝐏𝐫𝐢𝐜𝐞 × 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐬𝐚𝐥𝐞𝐬) +

(𝐒𝐚𝐥𝐯𝐚𝐠𝐞 𝐯𝐚𝐥𝐮𝐞 × 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 ) − (𝐂𝐨𝐬𝐭 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 × 𝑸)
 • Explanation: This formula calculates the expected profit by summing the revenues
from expected sales and the salvage value of unsold inventory, then subtracting the
total cost of ordering 𝑸 units.

Example:

• Suppose:
o Price per unit = $50
o Salvage value = $10
o Cost per unit = $30
o Expected sales = 116.8 units
o Expected inventory = 3.2 units
o Order quantity Q=120Q = 120Q=120

Expected Profit=(50×116.8)+(10×3.2)−(30×120)=5,840+32−3,600=2,272

5. In-Stock Probability (Equation 13.5):

𝐈𝐧-𝐬𝐭𝐨𝐜𝐤 𝐩𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲 = 𝑭(𝑸) = 𝑷𝒓𝒐𝒃(𝑫𝒆𝒎𝒂𝒏𝒅 ≤ 𝑸)

Explanation: The in-stock probability is the probability that the demand will be less than or
equal to the order quantity 𝑸. This is determined by the cumulative distribution function
𝑭(𝑸) for demand.

Example:

• If Q=120 and the demand follows a normal distribution with mean 100 and standard
deviation 20, then: F(120)=[Link](120,100,20,1)= 0.8413. This gives the
probability that the demand will be 120 units or less. Then the in-stock probability is
84.13%.

6. Stockout Probability:

𝐒𝐭𝐨𝐜𝐤𝐨𝐮𝐭 𝐩𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲 = 𝟏 − 𝐈𝐧-𝐬𝐭𝐨𝐜𝐤 𝐩𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲

Explanation: The stockout probability represents the chance that demand will exceed the
order quantity Q, meaning the retailer will run out of stock.

Example:

• If the in-stock probability is 84.13%, then the stockout probability is: Stockout
Probability = 1 - 0.8413 = 0.1587 or 15.87%. This means there is a 15.87% chance of
running out of stock.
LO 11-3 Evaluate order quantity for a desired level of service

1. Mismatch costs
One benchmark to which we can compare the newsvendor profit is Maximum profit.
Maximum profit – The highest possible expected profit. This occurs when inventory is
available for all customers and there is no leftover inventory.

Maximum profit = Expected demand X Profit per unit sold

Mismatch costs – Costs related to mismatch between demand and supply. These usually
include the cost of leftover inventory and the opportunity cost of stock outs. The difference
between maximum profit and the newsvendor expected profit equals the sum of mismatch
costs:

Expected profit = Maximum profit – Mismatch costs

 2. Evaluate order quantity for a desired level of service

IF the business wants to achieve certain service level, for example, 99%. That means I want
to satisfy 99% of the demand. → So P(D<=Q) =0.99, equivalent to F(Q) =0.99

So we are given the critical ratio F(Q), find Q.

LO11-4. Understand the conditions in which mismatches between supply and demand
are most costly.

Factors that influence mismatch costs

• Low Critical Ratio (Lecture Notes 13-18)

• Occurs when overage cost (Co) is high compared to the underage cost
i.e., it is costly to have inventory left over relative to the profit that can
be earned on each sale
• High CV (Lecture Notes 13-18)
• You don’t want to be a newsvendor if you are highly unsure about demand