Newsvendor Model Summary Relevant settings Single order/production/replenishment opportunity Uncertain demand Fixed price too much-too little

ittle challenge: demand > order quantity . lost sales demand < order quantity . left over inventory Firm must have a demand model Average demand; uncertainty in demand At optimal solution: Q Prob {Demand <= Q} = critical ratio Q balances the too much-too little costs. The Newsvendor Model: Performance Measures Financial Performance Measures For any order quantity: Average lost sales The average number of units by which demand will exceed the order quantity Average left over inventory The average number of units left over after demand (but before salvaging)

 Average sales The average number of units sold Average profit Average Lost Sales: Graphical Explanation Suppose demand can be one of the following values 0.12 {0,10,20,,190,200} Suppose Q = 120 0.10 Let D = actual demand What is Average lost 0.08 sales? If D <= Q, lost sales = 0 0.06 If D = 130, lost sales = D Q = 10 0.04 Average lost sales = 0.02 10 x Prob{D = 130} + 20 x Prob{D = 140} + 0.00 + 80 x Prob{D = 200} (Loss = 10) x (Prob X = 130) + (Loss = 20) x (Prob X = 140) (Loss = 80) x (Prob X = 200) 0 20 40 60 80 100 120 140 160 180 200 220 Average Lost Sales of Hammer 3/2s: Q = 3500 Definition: Average number of lost sales over all possible demand outcomes If demand is normally distributed: Step 1: normalize the order quantity to find the z-statistic. Q - 3500 - 3192 z = 0.26 s 1181 Step 2: Look up in Excel L(z) = Normdist(z,0,1,0) - z *(1- Normsdist(z))

 Step 3: Evaluate lost sales for the actual normal distribution: Average lost sales =s L(z) = 1181 0.2824 = 334Measures following Average Lost Sales Sales + Lost sales = Demand => Average sales = -Average lost sales = 3192 334 = 2858 Left over inventory + Sales = Q (order quantity) => Average left over inventory = Q -Average sales = 3500 2858 = 642 Average profit = [(Price -Cost) Average sales] -[(Cost -Salvage value) Average left over inventory] = ($70 2858) -($20642) = $187,221 Note: the above equations hold for any demand distribution Service Level Measures Service Level is a measure of the systems performance from a customers point-of-view Averagesales Averagesales Fill rate = Average demand Average lost sales 642 2858 = 1- =1-== 89.6% 3192 3192 Service Level Measures (contd. In-stock probability=Prob {Demand <= Q}=Normdist(Q,mean,std dev,1) Evaluate In-Stock Probability = Normdist(3500,3192,1181) = 0.6029 100% 90% Stockout probability 80% = 1 Prob {Demand <= Q} 70% 60% = 1 0.6029 = 39.71% Note: the in-stock probability 30% is not the same as the Fill rate 20% Order quantity Fill rate In-stock probability The Newsvendor Model: Service Objectives (target in-stock probability or target fill-rate) for choosing Q

Choose Q subject to a Minimum In-Stock Probability Suppose we wish to find the order quantity for the Hammer 3/2 that minimizes left over inventory while generating at least a 99% in-stock probability. Q = Norminv(In-Stock Prob,mean,std dev) = Norminv(0.99,3192,1181) = 5940. Choose Q subject to a Minimum Fill Rate Suppose we wish to find the order quantity for the Hammer 3/2 that minimizes left over inventory while generating at least a 99% fill rate. Step 1: Find the lost sales with a standard normal distribution that yields the target fill rate. .. . 3192 . L(z) =. .(1-Fill rate)=. .(1- 0.99)= 0.0270 .s.. 1181 Step 2: Find the z-statistic using Goal Seek in Excel Set: 0.027 = L(z) = Normdist(z,0,1,0) - z *(1- Normsdist(z)) z = 1.52 = (Q )/s Step 3: Convert the z-statistic into an order quantity for the actual demand distribution. Q = + z x s= 3192 + 1.52 x 1181 = 4988 Demand-Supply Mismatch Cost = Value of Perfect Demand Information Verify! Definition demand-supply mismatch cost includes cost of left over inventory (too much cost) + opportunity cost of lost sales (too little cost): Mismatch cost =(Overage cost Averageleft over inventory) +(Underage cost Averagelost sales) For Hammer 3/2: Mismatch cost =($201054.814)+ ($70150.814) $31,653 The maximum profit is the profit without any mismatch costs, i.e., every unit is sold and there are no lost sales: Maximumprofit =(Price - Cost) Maximumprofit =($180 - $110)3192 = $223,440 The mismatch cost can also be evaluated with Mismatch cost = Maximum profit Average profit For the Hammer 3/2: Mismatch cost = $223,440 - $191,787 = $31,653

What is the Bullwhip Effect? Demand variability increases as you move up the supply chain from customers towards supply Equipment Tier 1 Supplier Factory Distributor Retailer Customer Consequences of Bullwhip Effect Inefficient production or excessive inventory. Necessity to have capacity far exceeding average demand. High transportation costs. Poor customer service due to stockouts. Causes of Bullwhip Effect Order synchronization Order batching Trade promotions and forward buying Reactive and over-reactive ordering Shortage gaming Order Synchronization 70 Customers order on the same order cycle, e.g., first of the 60 month, every Monday, etc. 50 The graph shows simulated daily consumer demand (solid 40 line) and supplier demand (squares) when retailers order 30 weekly: 9 retailers order on Monday, 5 on Tuesday, 1 on 20 Wednesday, 2 or Thursday and 10 3 on Friday. Time (each period equals one day) Order Batching Retailers may be required to order in 70 integer multiples of some batch size, e.g., case quantities, pallet quantities, 60 full truck load, etc. 50 The graph shows simulated daily 40 consumer demand (solid line) and supplier demand (squares) when 30 retailers order in batches of 15 units, i.e., every 15th demand a retailer 20 orders one batch from the supplier that contains 15 units. 10 Trade Promotions and Forward Buying Supplier gives retailer a temporary discount, called a trade promotion.

 Retailer purchases enough to satisfy demand until the next trade promotion. Example: Campbells Chicken Noodle Soup over a one year period: Total shipments and consumption One retailers buy Reactive and Over-Reactive Ordering Each location forecasts demand to determine shifts in the demand process. How should a firm respond to a high demand observation? Is this a signal of higher future demand or just random variation in current demand? Hedge by assuming this signals higher future demand, i.e. order more than usual. Rational reactions at one level propagate up the supply chain. Unfortunately, it is human to over react, thereby further increasing the bullwhip effect. Shortage Gaming Setting: Retailers submit orders for delivery in a future period. Supplier produces. If supplier production is less than orders, orders are rationed, i.e., retailers are put on allocation. to secure a better allocation, the retailers inflate their orders, i.e., order more than they need So retailer orders do not convey good information about true demand This can be a big problem for the supplier, especially if retailers are later able to cancel a portion of the order: Orders that have been submitted that are likely be canceled are called phantom orders. Strategies to Combat Bullwhip Effect Information sharing: Collaborative Planning, Forecasting and Replenishment (CPFR) Smooth the flow of products Coordinate with retailers to spread deliveries evenly. Reduce minimum batch sizes. Smaller and more frequent replenishments (EDI). Eliminate pathological incentives

 Every day low price Restrict returns and order cancellations Order allocation based on past sales in case of shortages Vendor Managed Inventory (VMI): delegation of stocking decisions Used by Barilla, P&G/Wal-Mart and others. Next Time Quick Response and Reactive Capacity Periodic Inventory Review