Managing Uncertainty in Demand:

The Newsvendor Problem

• Short life cycle products

• Stochastic demand
• Single ordering opportunity
• Timing of order: before the realization of random demand
• Trade-off: stocking more vs less
 The Newsvendor Problem
notations and assumption

• 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 = 𝑝 /𝑢𝑛𝑖𝑡

• 𝑂𝑟𝑑𝑒𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 = 𝑄, decision variable
• 𝐷𝑒𝑚𝑎𝑛𝑑 − −𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠 𝑟𝑎𝑛𝑑𝑜𝑚 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒, 𝑋 ∈ [𝑎, 𝑏]
• 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑐𝑜𝑠𝑡 = 𝑐/𝑢𝑛𝑖𝑡
• 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑣/𝑢𝑛𝑖𝑡
• 𝑆𝑡𝑜𝑐𝑘𝑜𝑢𝑡 𝑐𝑜𝑠𝑡 = 𝐵/𝑢𝑛𝑖𝑡
• 𝐴𝑠𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛: 𝑝 > 𝑐 > 𝑣 ≥ 0, 𝐵 ≥ 0
𝑝𝑥 − 𝑐𝑄 + 𝑣(𝑄 − 𝑥), 𝑥 ≤ 𝑄
• 𝑃𝑟𝑜𝑓𝑖𝑡, 𝜋 𝑥, 𝑄 = ቊ
(𝑝 − 𝑐)𝑄 − 𝐵(𝑥 − 𝑄), 𝑥 > 𝑄
 The Newsvendor Problem: Marginal Analysis

• Marginal benefit of ordering 1 additional unit, if demand is

larger than quantity stocked = 𝑝 − 𝑐 + 𝐵
• Marginal cost of ordering 1 additional unit, if demand is at or
below the quantity stocked = 𝑐 − 𝑣
• Expected marginal benefit= (𝑝 − 𝑐 + 𝐵)(1 − 𝐹 𝑄 )
• Expected marginal cost= (𝑐 − 𝑣)(𝐹 𝑄 )
• Optimal order quantity corresponds to
Expected marginal benefit = expected marginal cost
→ 𝑝 − 𝑐 + 𝐵 1 − 𝐹 𝑄∗ = (𝑐 − 𝑣)(𝐹 𝑄∗ )
∗
𝑝−𝑐+𝐵
→𝐹 𝑄 =
𝑝−𝑣+𝐵
 The Newsvendor Problem: Service Level

• 𝑈𝑛𝑑𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡, 𝑐𝑢 =
𝑡ℎ𝑒 𝑜𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑛𝑜𝑡 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑎 𝑢𝑛𝑖𝑡 𝑡ℎ𝑎𝑡 𝑐𝑜𝑢𝑙𝑑 ℎ𝑎𝑣𝑒 𝑏𝑒𝑒𝑛 𝑠𝑜𝑙𝑑
• 𝑂𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡, 𝑐𝑜 =
𝑡ℎ𝑒 𝑙𝑜𝑠𝑠 𝑖𝑛𝑐𝑢𝑟𝑒𝑑 𝑤ℎ𝑒𝑛 𝑎 𝑢𝑛𝑖𝑡 𝑖𝑠 𝑜𝑟𝑑𝑒𝑟𝑒𝑑 𝑏𝑢𝑡 𝑛𝑜𝑡 𝑠𝑜𝑙𝑑
𝑐𝑢 = 𝑝 − 𝑐 + 𝐵, 𝑐𝑜 = 𝑐 − 𝑣

𝑐𝑢
𝐹 𝑄∗ = 𝑐 , 𝑐𝑟𝑖𝑡𝑖𝑐𝑎𝑙 𝑓𝑟𝑎𝑐𝑡𝑖𝑙𝑒,
𝑢 +𝑐𝑜

0 < 𝐹 𝑄∗ < 1

• 𝐹 𝑄∗ gives the service level 1 (cycle service level)---probability that the firm ends
the season having satisfied all the demand---in stock probability

• In-stock probability is the probability the firm has stock available for every
customer.
 The Newsvendor Problem: Service Level

• 𝐹𝑖𝑙𝑙 𝑟𝑎𝑡𝑒 𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 2 : 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑡ℎ𝑎𝑡 𝑖𝑠 𝑠𝑎𝑡𝑖𝑠𝑓𝑖𝑒𝑑

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠
𝐹𝑖𝑙𝑙 𝑟𝑎𝑡𝑒 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑒𝑚𝑎𝑛𝑑
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 + 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑒𝑚𝑎𝑛𝑑
𝜇 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠
𝐹𝑖𝑙𝑙 𝑟𝑎𝑡𝑒 =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑒𝑚𝑎𝑛𝑑

• 𝐼𝑛 𝑔𝑒𝑛𝑒𝑟𝑎𝑙 , 𝑑𝑒𝑚𝑎𝑛𝑑 𝑖𝑠 𝑎𝑠𝑠𝑢𝑚𝑒𝑑 𝑡𝑜 𝑏𝑒 𝑛𝑜𝑟𝑚𝑎𝑙𝑙𝑦 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝑤𝑖𝑡ℎ

𝑚𝑒𝑎𝑛 𝜇 𝑎𝑛𝑑 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝜎 2
• 𝑈𝑛𝑑𝑒𝑟 𝑛𝑜𝑟𝑚𝑎𝑙 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛, 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 𝜎𝐿 𝑧
𝐿 𝑧 𝑖𝑠 𝑡ℎ𝑒 𝑙𝑜𝑠𝑠 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑤𝑖𝑡ℎ 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑛𝑜𝑟𝑚𝑎𝑙 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
 The Newsvendor Problem:
Expected Profit

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑢𝑛𝑑𝑒𝑟𝑠𝑡𝑜𝑐𝑘 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 𝜎𝐿 𝑧

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 = 𝜇 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘 (𝑙𝑒𝑓𝑡𝑜𝑣𝑒𝑟 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦) = 𝑄 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡 = ( 𝑝 − 𝑐 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑒𝑚𝑎𝑛𝑑) − (𝑐𝑜 ×

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘) − (𝑐𝑢 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠)
• ⟹ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡 =
𝑝 − 𝑐 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 − 𝑐 − 𝑣 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘
− 𝐵 × 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠
 Managing Uncertainty at Sportmart
• The manager at Sportmart, a sporting goods store, has to
decide on the number of skis to be purchased for the winter
season. Based on past demand data and weather forecasts for
the year, management has forecast demand to be normally
distributed, with a mean of 350 and a standard deviation of
100. Each pair of skis costs c = $100 and sells for p = $250. Any
unsold skis at the end of the season are disposed of for $85.
Assume that it costs $5 to hold a pair of skis in inventory for
the season. How many skis should the manager order to
maximize expected profits?
 Managing Uncertainty at Sportmart
• p= $250
• c= $100
• v= $80
• 𝑐0 = $20
• 𝑐𝑢 = $150
• 𝜇 = 350
• 𝜎 = 100
𝑝−𝑐+𝐵 150
• 𝐹 𝑄∗ = = = 0.88235 = 𝐶𝑆𝐿∗
𝑝−𝑣+𝐵 170
𝑄∗ −𝜇
• z= = 1.186 (from table/excel), 𝑄 ∗ =468.68
𝜎
• L(z)= 0.057634 (from table/excel)
• Excel, z= NORMSINV(𝐶𝑆𝐿∗ )
• Excel, 𝑄 ∗ = NORMINV(𝐶𝑆𝐿∗ , 𝜇, 𝜎)
• Excel, L(z)=NORMDIST(z,0,1,0)-z×(1-NORMSDIST(z))

𝐿 𝑧 = 𝜙 𝑧 − 𝑧 × (1 − Φ 𝑧 )
 Managing Uncertainty at Sportmart

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑢𝑛𝑑𝑒𝑟𝑠𝑡𝑜𝑐𝑘 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 𝜎𝐿 𝑧 = 100 × 0.057634 =

5.7634
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 = 𝜇 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 350 − 5.7634 = 344.2365
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘 𝑙𝑒𝑓𝑡𝑜𝑣𝑒𝑟 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑄 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 =
124.4466
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑝 − 𝑐 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 − ൫ 𝑐 − 𝑣 ×

Summary
𝜎 𝑄∗ Expected Expected Expected profit
overstock understock
100 468.86 124.4446 5.7634 49146.547
 Impact of Higher Variance
For 𝜎 =150

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑢𝑛𝑑𝑒𝑟𝑠𝑡𝑜𝑐𝑘 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 𝜎𝐿 𝑧 =

150 × 0.057733 = 8.645

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 = 𝜇 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 350-8.645=341.345

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘 𝑙𝑒𝑓𝑡𝑜𝑣𝑒𝑟 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑄 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 =

528.02-341.345=186.6699

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑝 − 𝑐 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 − ( 𝑐 − 𝑣 ×

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘) − ( 𝐵 × 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠) =150× 341.4 −
20 × 186.6 =$47469.82

341.4
• 𝐹𝑖𝑙𝑙 𝑟𝑎𝑡𝑒 = 350
= 0.9754

𝜎 𝑄∗ Expected Expected Expected profit

overstock understock
150 528.0247 186.6699 8.645 47469.82
 Can you Improve the Profitability?

• Increase salvage value

• Find alternatives to reduce the stockout cost
• Reduce demand uncertainty:
• Improve forecast
• Postponement
• Quick response
 Impact of Forecast Error on Profit

𝜎 𝑄∗ Expected Expected Expected profit

overstock understock
150 528.0247 186.6699 8.645 47469.82
100 468.86 124.4446 5.7634 49146.547
50 409.3416 62.223 2.881733 50823.274
0 350 0 0 52500
Postponement Strategy: Impact on Profit

• Postponement strategy implies delaying the product

differentiation
• The production process till the postponement point
will be against the aggregate demand generated from
different products
• After the postponement point, the production process
for independent products will be different.
 Postponement at Benetton
Without Postponement

Knitting
Dyeing

With Postponement Dyeing

Knitting
 Benetton Example
Benetton selling knit garments in solid colors. Starting with thread, two
steps are needed to complete the garment—dyeing and knitting. Traditionally,
thread was dyed and then the garment was knitted (Option 1). Benetton
developed a procedure whereby dyeing was postponed until after the
garment was knitted (Option 2).
Benetton sells each knit garment at a retail price p = $50. Option 1 (no
postponement) results in a manufacturing cost of $20, whereas Option 2
(postponement) results in a manufacturing cost of $22 per garment. Benetton
disposes of any unsold garments at the end of the season in a clearance for v
= $10 each. The knitting or manufacturing process takes a total of 20 weeks.
Benetton sells garments in four colors. Twenty weeks in advance, Benetton
forecasts demand for each color to be normally distributed, with a mean of
1,000 and a standard deviation of 500. Demand for each color is independent.
With Option 1, Benetton makes the buying decision for each color 20 weeks
before the sale period and holds separate inventories for each color. With
Option 2, Benetton forecasts only the aggregate uncolored thread to
purchase 20 weeks in advance. The inventory held is based on the aggregate
demand across all four colors. Benetton decides the quantity for individual
colors after demand is known.
 Benetton: Illustration
Option 1 (without postponement); for color 1
• 𝜇1 = 1000, 𝜎1 = 500, p= $50, c= $20, v= $10, 𝑐0 = $10, 𝑐𝑢 = $30
𝑝−𝑐 30
• 𝐹 𝑄1 ∗ = = = 0.75 = 𝐶𝑆𝐿∗
𝑝−𝑣 40
𝑄1 ∗ −𝜇
• z= = .67449 (from table/excel), 𝑄1 ∗ =1337.245
𝜎
• L(z)=0.149154 (from table/excel)
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑢𝑛𝑑𝑒𝑟𝑠𝑡𝑜𝑐𝑘 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 𝜎𝐿 𝑧 =
500 × 0.149154 = 74.577
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 = 𝜇 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 1000-74.57 = 925.43
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘 𝑙𝑒𝑓𝑡𝑜𝑣𝑒𝑟 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑄1 ∗ − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 =
1337-925.43 = 411.822
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑝 − 𝑐 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 − ൫ 𝑐 − 𝑣 ×
Option 2 (with postponement); Combined order quantity

• p= $50, c= $22, v= $10, 𝑐𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡, 𝜌𝑖𝑗 = 0

• 𝜇 = 1000×4 = 4000; 𝜇𝑒 = σ𝑁
𝑖=1 𝜇𝑖

𝑁 2
• 𝜎 = 4 × 500=1000; 𝜎𝑒 = σ𝑖=1 𝜎𝑖 + 2 σ𝑁−1 𝑁
𝑖=1 σ𝑗=𝑖+1 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗

𝑝−𝑐
• 𝐹 𝑄∗ = = 0.70 = 𝐶𝑆𝐿∗
𝑝−𝑣
𝑄∗ −𝜇
• z= = 0.5244 (from table/excel), 𝑄∗ = 4524.401
𝜎
• L(z)=0. 190372 (from table/excel)
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑢𝑛𝑑𝑒𝑟𝑠𝑡𝑜𝑐𝑘 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 𝜎𝐿 𝑧 = 190.3725
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 = 𝜇 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑡 𝑠𝑎𝑙𝑒𝑠 = 4000-190.3725=3806.628
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘 𝑙𝑒𝑓𝑡𝑜𝑣𝑒𝑟 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 𝑄 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 =
4524-3806.628 = 714.733
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑝 − 𝑐 × 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 − ൫ 𝑐 − 𝑣 ×
 Comparison of Options
Without postponement With postponement
(across 4 colors)
Order quantity 4 × 1337 = 5348.98 4524.401

Expected profit 4 × 23644 = $94577.87 $98092.29

Expected overstock 4 × 411.82 =1647.28 714.733
Expected understock 4 × 74.577 = 298.31 190.3725

• With postponement option outperforms without postponement

option in the above scenario
• Savings due to postponement depends on the correlation of the
demand and the variance of the demand
Impact of Correlation of Demands on Postponement
Strategy at Benetton
Correlation Expected Profit Expected Profit (No Benefit due to
Coefficient (Postponement) postponement) postponement?

-0.1 $100363.98 $94577.87 Yes

0 $98092.29 $94577.87 Yes
0.5 $90009.99 $94577.87 No
1 $84184.59 $94577.87 No

• In general, if the production cost is increased in the postponement option,

then it may not be a favorable option under
• Highly positively correlated demand
• Highly predictable demand
• In general, if the production cost in the postponement option is the same as that of
no postponement option, then its profit will be higher than or equal to the profit
in no postponement option
 Managing Uncertainty for Non-Perishable Items
(Newsvendor Problem Extended to Multiple Periods)
• Multi-period setting
• Non-perishable products
• Stochastic demand
• Ordering opportunity in each period
• Timing of order: before the realization of random demand in each period
• Trade-off: stocking more vs less
• Stocking more results in holding cost
• Stocking less results in stockout cost in the backorder scenario (as the unmet
demand will be met in the future period)
 Managing Uncertainty for Non-Perishable Items
(Newsvendor Problem Extended to Multiple Periods)
• Average expected cost in multiple-period newsvendor problem
(infinite horizon, backorder scenario) is
𝐺 𝑥, 𝑆 = 𝑐𝑜 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑜𝑣𝑒𝑟𝑠𝑡𝑜𝑐𝑘 + 𝑐𝑢 [𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑢𝑛𝑑𝑒𝑟𝑠𝑡𝑜𝑐𝑘]
Where 𝑆 is the order-up-to level quantity
𝑐𝑜 = ℎ ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 ; 𝑐𝑢 = 𝐵 𝑠𝑡𝑜𝑐𝑘𝑜𝑢𝑡 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
∗
𝐵
𝐹 𝑆 = = 𝐶𝑆𝐿
ℎ+𝐵
⟹ 𝑆 ∗ = 𝜇 + 𝑧𝜎
safety stock
𝑆∗ 𝑖𝑠 𝑡ℎ𝑒 𝑜𝑝𝑡𝑖𝑚𝑎𝑙 𝑜𝑟𝑑𝑒𝑟 − 𝑢𝑝 − 𝑡𝑜 𝑙𝑒𝑣𝑒𝑙 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦, which minimizes
the total cost
• This policy is called base stock policy.
• In every period an order is placed so that the inventory reaches 𝑆 ∗ .
 Risk Pooling in Supply Chain

Individual distribution centers (DC)

• Consider n distribution centers, each of which faces normally distributed
demand 𝑁 𝜇, 𝜎 2 for a single product for each period
• If each of them wishes to meet CSL= 𝛼, then the safety stock at individual
level is 𝑧𝜎
• Total safety stock across all distribution centers is 𝑛𝑧𝜎
Distribution centers merged
• New distribution center’s demand process--- 𝑁(𝜇𝐶 , 𝜎𝐶 2 )
• Total safety stock to meet CSL= 𝛼 at the centralized level is z𝜎𝑐
• Where
𝑛 𝑛 𝑛−1 𝑛
2
𝜇𝐶 = ෍ 𝜇𝑖 𝜎𝐶 = ෍ 𝜎𝑖 + 2 ෍ ෍ 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗
𝑖=1 𝑖=1 𝑖=1 𝑗=𝑖+1
 Additional Considerations

• Fixed cost for DC’s is not considered

• Transportation cost is not considered
• Any analysis on potential consolidation of DC’s must include
all factors, not the risk pooling factor alone
• In the case of lead time 𝜏, the safety stock in decentralized
and centralized scenarios will be scaled by 𝜏

Decentralized Centralized
Safety stock 𝜏𝑧𝑛𝜎 𝜏𝑧𝜎𝐶
Order upto level 𝜏𝑛𝜇 + 𝜏𝑧𝑛𝜎 𝜏𝑛𝜇𝐶 + 𝜏𝑧𝜎𝐶
 Risk Pooling: Illustration

• A BMW dealership has 4 retail outlets serving the entire Chicago area
(disaggregate option). Weekly demand at each outlet is normally
distributed, with a mean of 25 cars and a standard deviation of 5. The
lead time for replenishment from the manufacturer is 2 weeks. Each
outlet covers a separate geographic area, and the correlation of demand
across any pair of areas is 𝜌. The dealership is considering the possibility of
replacing the four outlets with a single large outlet (aggregate option).
Assume that the demand in the central outlet is the sum of the demand
across all four areas. The dealership is targeting a CSL of 0.90. Compare
the level of safety inventory needed in the two options as the correlation
coefficient 𝜌 varies between 0 and 1.
 Disaggregate Scenario

• 𝜏 = 2; 𝜇𝑖 = 25; 𝜎𝑖 = 5
• For individual retailer, mean lead time demand, 𝜇𝑖 𝐿𝑇𝐷 = 2 × 25 = 50
• Mean lead time demand across retailers= 4 × 50 = 200
• 𝑧 = 𝐹 −1 0.9 = 1.281552
• standard deviation of lead time demand, 𝜎𝑖 𝐿𝑇𝐷 = 𝜏 × 𝜎𝑖 = 2 × 5 = 7.0710
• The safety stock for retailer i = 𝑧 × 𝜎𝑖 𝐿𝑇𝐷 = 1.281552 × 2 × 5 = 9.0619
• Total safety stock across all the retailers = 4 × 9.0619 = 36.25

LTD---lead time demand

 Aggregate Scenario under Independent Demand

• 𝜏 = 2;
• 𝜇𝐶 = 𝑛 × 𝜇 = 4 × 25 = 100

• 𝜎𝐶 = σ4𝑖=1 𝜎𝑖 2 + 2 σ3𝑖=1 σ4𝑗=𝑖+1 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗

• For aggregated retailer scenario,

• Mean lead time demand, 𝜇𝐶 𝐿𝑇𝐷 = 2 × 100 = 200
• 𝜌𝑖𝑗 =0, 𝜎𝐶 = 4 × 5 = 10
• 𝑧 = 𝐹 −1 0.9 = 1.281552
• standard deviation of lead time demand, 𝜎𝐶 𝐿𝑇𝐷 = 𝜏 × 𝜎𝐶 = 2 × 10 =
14.4142
• Safety stock = 𝑧 × 𝜎𝐶 𝐿𝑇𝐷 = 1.281552 × 2 × 10 = 18.12
 Summary

Correlation coefficient Decentralized safety stock Centralized safety stock

0 36.25 18.12
0.2 36.25 22.93
0.4 36.25 22.88
0.6 36.25 30.33
0.8 36.25 33.42
1 36.25 36.25

Under risk pooling, safety inventory in the centralized scenario will

always be less than or equal to the safety inventory in the
decentralized setting