Session

10
The Newsvendor model II
Winter2017Module3
Krannert SchoolofManagement

ProfessorPengyiShi
Clarifications
Thenewsvendorproblemsetisprescheduledfortodaysclass,
not thelighthomeworkchangeImentionedyesterday.

Afterclass,Iwillassignapracticeproblem.Itisoptional andyou
donotneedtoturnin.Wewillgothroughitatthebeginningof
nextclass.

Ifyouneedmoretimetofinishthenewsvendorproblemset,
youcanreturnittomenextMonday

2
Today

Reviewnewsvendormodel

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Practiceproblems

3
 Newsvendor Model Review
Place an order Q

Begin End Shortage CU

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Excess CO
Singlesellingseason
Orderatthebeginningoftheperiod
Realizedemandduringtheperiod
Salvageorloseitemsattheendoftheperiod
Newsvendor Review
Unitprice: R
Unitcost:
Unitsalvagevalue:

Underagecost:

Overagecost:

CriticalRatio:

Solution:
6
PolyMere Inc.
PolyMere Inc needstoorderarawmaterialtomakeaspecial
polymerforacustomer.Thecustomersdemandisforecastedtobe
Normallydistributedwithameanof250gallonsandastandard
deviationof125gallons.PolyMere sellsthepolymertothe

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Introduction to Operations Management
customerfor$25 pergallon.PolyMere suppliercharges$10per
gallonofrawmaterialandPolyMere mustspend$5 pergallonto
disposeunusedrawmaterial.Polymere needsonegallonofraw
materialtomakeonegallonofpolymer.

8
PolyMere Inc.
SupposePolyMere purchases300gallonsofrawmaterial.
Howmanygallonsofdemandonaveragewouldbelostand
fulfilledbyanotherproducer?

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Introduction to Operations Management
ExpectedShortage
z=(300 250)/125=0.4
L(0.4)=0.2304(UsingStandardNormalLosstableorExcel)
ExpectedShortage= *L(z)=125*0.2304=28.8

9
PolyMere Inc.
SupposePolyMere purchases300gallonsofrawmaterial.
Whatwillbetheexpectedsales?

Expectedsales=Meandemand Expectedshortage=

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25028.8=221.2

Whatwillbetheexpectedleftover?

ExpectedLeftover=Q ExpectedSales=300221.2=78.8

10
PolyMere Inc.
SupposePolyMere purchases300gallons ofrawmaterial.
Whatwillbethefillrate?

.
1

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Fillrate=1 =88.48%

Whatwillbetheexpectedprofit?

ExpectedProfit=
Price*Exp.Sales+Salvage*Exp.Leftovers Cost*Q=
$25*221.2+($5)*78.8 $10*300=$2136

11
Different views on Expected
Profit
View1:CashIn CashOut

ExpectedProfit=Sales*Price+Leftovers*Salvage Q*Cost

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View2:Profitsforunitssold Lossforleftovers

ExpectedProfit=CU *ExpectedSale CO *ExpectedLeftover

View3:Profitwithperfectinformation Costofmismatch

ExpectedProfit=
CU *MeanDemand [CO ExpectedLeftover+CU *ExpectedShortage] 12
PolyMere Inc.
SupposePolyMere wantstoensurethatthereisa92%
probabilitythattheywillbeabletosatisfythecustomers
entiredemand.Howmanygallonsoftherawmaterialshould
theypurchase?

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Introduction to Operations Management
92%istherequired servicelevelhere!
meaningProb(DemandQ)=0.92

NeedtofindProb (Z(Q )/)=0.92

Lookup0.92intheStandardDistributionfunctiontable
andwefindthatz=1.41
Converttoanorderquantity:
Q=250+1.41x125=426.25 13
PolyMere Inc.
SupposePolyMere wantstoensurethattheysatisfy95%fill
rate.Howmanygallonsoftherawmaterialshouldthey
purchase?
Findz:

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1 0.95

ExpectedShortage=(10.95)*MeanDemand=12.5
ExpectedShortage=L(z) =>L(z)=0.1
UseStandardNormalLosstable:z=.91
Q= +z :
Q=250+.91*125=363.75

14
PolyMere Inc.
AssumethatPolyMere sourcesfromseveralsuppliersthatcharge$5,$10,
and$15dependingontheregion.
Computethetargetservicelevelforeachcostlevel:
Cost CO CU Target servicelevel

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$5 $5+$5=$10 $25 $5=$20 Cu /(Cu+Co)=0.6667
$10 $10+$5=$15 $25 $10=$15 Cu /(Cu+Co)=0.5
$15 $15+$5=$20 $25 $15=$10 Cu /(Cu+Co)=0.3333

Salvage value V = -$5 here!

15
 PolyMere Inc.
Findzvaluecorrespondingtothisservicelevelforeachcostlevel:(lookup
intheStandardNormaltable)

z>0equivalentto

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Servicelevel>0.5
Ordermorethanthemeandemand
(Q*>)
Cost zvalue CO <CU (Cheapertohaveleftovers)

$5 0.44 z=0equivalentto
$10 0 Servicelevel=0.5
Orderthemeandemand(Q*=)
$15 0.43 CO =CU

z<0equivalentto
Servicelevel<0.5
Orderlessthanthemeandemand 16
(Q*<)
CO >CU (Cheapertostockout)
PolyMere Inc.
HowmanygallonsshouldPolyMere purchasetomaximizeits
expectedprofitateachcostlevel?

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Cost OptimalQuantity Q*
$5 250+125*0.44 =305
$10 250+125*0=250
$15 250+125*(0.43)=196.25

17
Sourcing Problem Teddy
Bower
TeddyBowersourcesaparkafromanAsiansupplierfor$10each
andsellstocustomerfor$22each.Leftoverparkasattheendofthe
seasonhavenovalue.Thedemandforecastisnormallydistributed
withmean2,100andstandarddeviation1,200.NowsupposeTeddy

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BowerfoundareliablevendorintheUnitedStatesthatcanproduce
parkasveryquicklybutatahigherpricethantheAsiansupplier.
Hence,inadditiontoparkasfromAsia,TeddyBowercanbuyan
unlimitedquantityofadditionalparkasfromthisAmericanvendor
at$15eachafterthedemandisknown.

21
Teddy Bower
SupposeTeddyBowerorders1500parkasfromAsiansupplier.
WhatistheprobabilitythatTeddyBowerwillorderfrom
Americansupplieroncedemandisknown?
WearelookingforP(Demand>1500)

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P(Demand>1500)=1P(DemandQ)=1 servicelevel
z= = =0.5
(z)=0.3085
1F(z)=69%
P(Demand>1500)

22
Teddy Bower
Assumeorderof1500fromAsiansupplier.Whatisthe
expectedpurchaseamountfromtheAmericansupplier?

ExpectedShortagewithQ=1500

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Z=0.5

L(0.5)=0.6978

1200xL(0.5)=1200x0.6978=837.4

23
Teddy Bower
GiventhefutureopportunitytopurchasefromtheAmerican
supplierat$15perparka,whatistheoptimalorderquantity
fromtheAsiansupplier?
CO =100

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CU =1510=5(notusing22here!)
Criticalfractile:5/15=0.3333
z=0.43
Q=2100 0.43*1200=1584

WhatistheorderquantityfromtheU.S.Supplier?
ExpectedShortage:L(z)*1200=0.65*1200=780

24
Teddy Bower
Whatistheexpectedprofit?

UseView1:Cashin Cashout

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CashIn=PricexMeanDemand=$22x2100=$46,200

CashOut=$10x1584(fromAsiavendor)+$15x780(fromAmerican
vendor)=$27,540

Profit=$46,200 $27,546=$18,660
25
Umbra Visage (UV)
Zamatia makessunglassatacostof$35andsellsthemtoUmbraVisage(UV)
for$75.UVsellsthemfor$115andsalvagesleftoverinventoryfor$25per
unit.Demandisnormalwithmean250andstandarddeviation125.
WhatshouldbetheoptimalorderingquantityforUV?

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Cu =115 75=40,Co =75 25=50,
Criticalratio=40/90=0.4444
z=0.13
Optimalorderquantity=250 0.13*125=233.75

Expectedsales=MeanDemand L(z) =2500.4673*125=191.6

Expectedprofit= Cu Sales Co Leftovers=
$40*191.6 $50*(233.75191.6)=$5,557
26
Double marginalization
Whatisthetotalsupplychainprofit(UV&Zamatia)?
Zamatia Sales=233.75
Zamatia Profit=233.75*$40=$9,350
Totalsupplychainprofit

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=$5,557+$9,350=$14,907

But,whatwouldbetheoptimalorderquantityforthesupplychain?
Supplychain:
Cu =115 35=80,Co =35 25=10,Criticalratio=80/90=0.89=>
z=1.23
Orderquantity=250+125*1.23=404
Expectedsales=MeanDemand L(z) =2500.0527*125=243
Expectedprofit=Cu Sales Co Leftover=
$80*243 $10*(404243)=$17,830.
~20%higherthan$14,790! 27
Usecontractstosharetheriskandimprovesupplychainprofitability!
Solution: use contracts to share
risk!
Examplesofcontracts:

BuybackContracts: Inabuybackcontract,theretaileris
allowedtoreturnunsoldinventoryuptoaspecifiedamount,at
anagreeduponprice.Themanufacturerspecifiesawholesale

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pricealongwithabuybackprice.

RevenueSharingContract: Themanufacturerchargesthe
retaileralowwholesalepriceandsharesafractionofthe
retailersrevenue.

QuantityFlexibilityContracts: Themanufacturerallowsthe
retailertochangethequantityorderedafterobservingthe
demand.Forexample,iftheoriginalquantityorderedis100then
themanufacturercommitstoprovidingupto110unitsandthe
retailercommitstobuyingatleast90units. 28
PanAir Problem
PanAir operatesaflightfromIndianapolistoSanFranciscothat
has250seats.PanAir offersahighandlowfare.Thereisample
demandforthelowfare.Lowfarecustomersbuyinadvanceof
highfarecustomers.DemandforthehighfareisNormally

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distributedwithameanof100andastandarddeviationof40.
Thehighfareis$700andthelowfareis$450.

Howmanyseatsshouldweprotectforhighpayingcustomers?

29
Some theory
LetQ bethenumberofticketswewillprotectforthehighfare
class.
Youwillsellnomorethan250 Q lowfareticketsbecauseyouare

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protecting(orreserving)Q seatsforhighfarepassengers.250 Qis
calledthebookinglimit.

0 250

Sell no more than the low Q seats protected for

fare booking limit, 250 - Q high fare passengers
30
The connection to the
newsvendor
Asingledecisionismadebeforeuncertaindemandisrealized.
LetDbethedemandforhighfare

Thereisanoveragecost:

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IfD<Q thenyouprotectedtoomanyseats (youover protected),so
someseatsareemptywhichcouldhavebeensoldtoalowfaretraveler.
Thereisanunderagecost:
IfD>Qthenyouprotectedtoofewseats(youunder protected),so
someseatscouldhavebeensoldatthehighfareinsteadofthelowfare.

ChooseQ tobalancetheoverageandunderagecosts.

31
Back to PanAir
Overagecost:
IfD<Q weprotectedtoomanyseatsandearnnothingonQ D
seats.
Wecouldhavesoldthoseemptyseatsatthelowfare,soCo =450.

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Underagecost:
IfD>Q weprotectedtoofewseats.
D Q seatscouldhavebeensoldatthehighfarebutweresold
insteadatthelowfare,soCu =700 450=250

Optimalhighfareprotectionlevel:

Cu
F (Q )
*

Co Cu
Optimallowfarebookinglimit 32
=250 Q*
PanAir Solution
Whatistheoptimalprotectionlevel?
Cu 250
Criticalratio: 0.3571
Co Cu 250 450

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LookupzvalueintheStandardNormaltable:
z(0.3571)= 0.36

FindoptimalQ:
Q=100 0.36*40=85.6~86seats

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PanAir Continued
AssumethatPanAir protects110seats.

Howmanyhighfaretravelerswillberefusedareservation?

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z= = =0.25=>L(z)=0.2863
=40*0.2863=11.452
ExpectedShortage=L(z)

Howmanyhighfaretravelerswillbeaccommodated?
Expectedsales =MeanDemand ExpectedShortage=
100 11.452=88.548

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PanAir Continued
AssumethatPanAir protects110seats.

Howmanyseatswillremainempty?

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ExpectedLeftover=Q Expectedsales=110 88.548=21.45

35
Homework (Operating Room)
Thehospitalhastoallocateacertainamountofoperatingroom(OR)timeto
specificcardiacprocedures.SincetheactualproceduretimeintheORisrandom
andwill inthebestofallcases varyaroundtheexpectedproceduretime,
someprocedureswillexceedtheforecasteddurationswhileotherswillbe
completedaheadofschedule.Ifthehospitalreservestoomuchtimetoacase,
theORislikelytoincurexcessiveidletime.If,however,thehospitalreservestoo
littletimetoacase,thehospitalislikelytofacescheduleoverrunsand
decreasedservicequality.

Fromhistoricaldata,theschedulingofficeestimatesthatthecaseduration
followsanormaldistributionwithmean110minutesandstandarddeviation20
minutes.

This is an optional hw; no need to turn in. We will go

through it at the beginning of the next class.
Homework (Operating Room)
TheschedulingofficewondersifNewsvendormodelwouldhelpintheir
planning.
a) Iftheschedulingofficewantstomakesurethatthereservedtimeisenough
fortheprocedurewithatleast80%ofthechance,howmuchtimeshould
bereservedforacase?

b) Whatistheexpectedovertimeforacase?

c) Whatistheexpectedidletimeforacase?
Normal demand: if Q is given SummarySlides

Step1:findthezstatistics correspondingtothegivenQ

Q = + z z = (Q-)/

Step2:

Expected lost sales = L(z)

Expected sales = Expected demand Expected loss sales
Expected leftover = Q Expected sales
Expected profit: Price * Exp. Sales + Salvage * Exp. Leftovers Cost * Q

Step3:

Fillrate=1

Servicelevel=Prob(DQ)=(z)
Normal demand: SummarySlides
if specify service level or fill rate, need to find Q

Ifspecifyservicelevels*,meaningProb(DemandQ)=s*
NeedtofindProb (standardizedDemand(Q )/)=s* andthensolveQ
Step1:findzstatistics correspondingtos*suchthat
(z)=s*
Step2:Converttoanorderquantity:Q= +z

Ifspecifyfillrate

Step1:solveExpectedShortageL* fromFillrate=1

Step2:findzstatistics correspondingtoL*suchthat
L(z)=L*
Step3:Converttoanorderquantity:Q=+z
Normal demand: finding optimal Q SummarySlides

Step1:findzstatisticssuchthatProb(DemandQ)=criticalratio
findzstatistics suchthat
(zratio)=criticalratio

Criticalratio=servicelevel
Step2:ConvertzstatisticsintotheequivalentorderquantityQ*
Q* = + zratio
Step3:Usenormallossfunctiontableforotherperformance
Expected lost sales = L(zratio)
Expected sales = Expected demand Expected loss sales
Expected leftover = Q Expected sales
Expected profit: Price * Exp. Sales + Salvage * Exp. Leftovers
Cost * Q