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2
Hammer 3/2 timeline
Generate forecast
of demand and
submit an order
to TEC
Spring selling season
Nov Dec Jan Feb Mar Apr May Jun Jul Aug
Receive order
from TEC Left-over units
are discounted
3
Hammer 3/2 economics
4
„Too much“ and „too little“ costs
• 𝐶𝑜 = overage cost
◦ The consequence of ordering one more unit than what you would have
ordered had you known demand.
Suppose you had left over inventory (you over-ordered). 𝐶𝑜 is the
increase in profit you would have enjoyed had you ordered one fewer
unit.
◦ For the Hammer 3/2 𝐶𝑜 = 𝐶𝑜𝑠𝑡 – 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑐 – 𝑣 =
110 – 90 = 20
• 𝐶𝑢 = underage cost
◦ The consequence of ordering one fewer unit than what you would
have ordered had you known demand.
Suppose you had lost sales (you under-ordered). 𝐶𝑢 is the increase in
profit you would have enjoyed had you ordered one more unit.
◦ For the Hammer 3/2 𝐶𝑢 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 – 𝐶𝑜𝑠𝑡 = 𝑟 – 𝑐 =
190 – 110 = 80
5
Balancing the risk and benefit of ordering a unit
60
50
the expected benefit from
40 ordering one unit decreases
30
while the expected loss of
20
10
ordering one more unit
- increases.
1
256
511
766
1021
1276
1531
1786
2041
2296
2551
2806
3061
3316
3571
3826
4081
4336
4591
4846
5101
5356
5611
5866
6121
6376
6631
6886
7141
7396
7651
7906
6
Newsvendor model implementation steps
3. Choose an objective
◦ E.g. maximize expected profit or satisfy a fill rate constraint.
7
Objective 1: Profit maximization
• The above fraction is called the critical ratio (CR) or the cycle
service level (CSL)
• Hence, to maximize profit, choose Q such that the probability we
satisfy all demand (i.e., demand is Q or lower) equals the CR.
𝐶𝑢 80
• For the Hammer 3/2, the critical ratio is = = 0.80
𝐶𝑢 +𝐶𝑜 20+80
8
Objective 1: Profit maximization
Using the empirical distribution function
0,9
0,8
0,7
0,6
Probability
0,5 A-F-percentil
Normal(3192,1181)
0,4
0,3
0,2
0,1
0
310 1000 2000 3000 4000 5000
9
Objective 1: Profit maximization
Using the empirical distribution function
10
Objective 1: Profit maximization
Using the estimated normal distribution function
• In the normal distribution function, find the demand, that (for the first
time) exceeds the critical ratio (or cycle service level):
1
0,9
0,8
0,7
0,6
Probability
0,5 A-F-percentil
Normal(3192,1181)
0,4
0,3
0,2
0,1
0
310 1000 2000 3000 4000 5000
11
Objective 1: Profit maximization
Using the estimated normal distribution function
• In the normal distribution function, find the demand, that (for the first
time) exceeds the critical ratio (or cycle service level):
• Find the critical ratio of 0.80 inside the Standard Normal Distribution
Function Table
You can also calculate the 𝑧-statistics and
𝑄 using Excel:
𝑧: =NORM.S.INV(0.8) = 0.8416
𝑄: =NORM.INV(0.8;3192;1181) = 4185.95
Beware to know how to handle
the table for the exam, though!
• If the CR falls between two values in the table, choose the greater 𝑧-
statistic … this is called the „round-up rule“. Here choose 𝑧 = 0.85.
• Convert the 𝑧-statistic into an order quantity by:
𝑄 = 𝜇 + 𝜎 ∙ 𝑧 = 3192 + 0.85 ∙ 1181 = 4195.85 ≅ 4196
12
Performance Measures
Overview
13
Performance Measures
Overview
Expected
Fill rate
demand, m
If Normal Expected
demand, s sales
Order quantity,
Q, and, if Normal Exp. left over Expected
demand, inventory profit
𝑧 = (𝑄 – 𝜇)/𝜎 In-stock
probability
Distribution Stockout
function table probability
Price, cost,
salvage value
14
Performance Measures
Expected Lost Sales, Simple Example
• Suppose we are dealing with a discrete demand distribution.
Demand can take values 𝐷𝜖{0,10,20, … , 190,200}
• Suppose 𝑄 = 120.
• Which sales could be possibly lost?
◦ If 𝐷 ≤ 𝑄, then no sales are lost (all demand is satisfied)
◦ If 𝐷 > 𝑄, then a part 𝐷 − 𝑄 of sales is lost (demand remains
unsatisfied)
E.g. if 𝐷 = 130, then 𝐷 − 𝑄 = 10 sale is lost.
• Expected Lost Sales multiply all possible lost sales 𝐷 − 𝑄 with
the probability of the corresponding demand 𝐷 , given 𝑄 :
◦ Here: Expected Lost Sales = 130 − 120 ∙ 𝑃 𝐷 = 130 +
140 − 120 ∙ 𝑃 𝐷 = 140 + 150 − 120 ∙ 𝑃 𝐷 = 150 +
160 − 120 ∙ 𝑃 𝐷 = 160 + 170 − 120 ∙ 𝑃 𝐷 = 170 +
180 − 120 ∙ 𝑃 𝐷 = 180 + 190 − 120 ∙ 𝑃 𝐷 = 190 +
200 − 120 ∙ 𝑃 𝐷 = 200
15
Performance Measures
Expected Lost Sales, Formula
• Suppose O‘Neill orders 3,000 Hammer 3/2s. How many sales will be lost
if …
◦ …actual demand is 3,800 units, then lost sales is 800 units.
◦ …actual demand is 3,200 units, then lost sales is 200 units.
◦ …actual demand is 2,900 units, then lost sales is 0 units.
• Expected lost sales is the average over all possible demand outcomes,
weighted by the probability of this exact outcome.
16
Performance Measures You can also calculate the 𝐿(𝑧) using Excel:
Expected Lost Sales, Formula 𝐿 𝑧 = NORM.S.DIST 𝑧; 0
−𝑧 ∙ (1 − NORM.S.DIST(𝑧; 1))
• Suppose O‘Neill orders 3,000 Hammer 3/2s. How many sales will be lost
on average?
• Step 1: Normalize the order quantity to find its 𝑧-statistic.
𝑄 − 𝜇 3000 − 3192
𝑧= = ≅ −0.16
𝜎 1181
• Step 2: Look up in the Standard Normal Loss Function Table the
expected lost sales for a standard normal distribution with the above
𝑧-statistic:
𝐿 𝑧 = 0.4840
17
Performance Measures
Expected Lost Sales for Hammer 3/2
2500
500
0
0 1000 2000 3000 4000 5000 6000
Order Quantity
18
Performance Measures
following Expected Lost Sales
19
Performance Measures
In-Stock Probability, Stock-out Probability
• The In-Stock Probability is the probability all demand is satisfied.
• This is the case, if 𝐷 ≤ 𝑄.
• Hence, In−Stock Probability = 𝐹(𝑄)
• The Fill Rate is the fraction of demand that can purchase a unit:
◦ The Fill Rate is also the probability a randomly chosen customer can
purchase a unit.
◦ It is NOT the same as the In-Stock Probability!
21
Objective 2: Satisfy a given fill rate constraint
• Suppose we wish to find the order quantity for the Hammer 3/2 that
minimizes leftover inventory while generating at least a 99% fill rate:
• Step 1: Find the Expected Lost Sales that yields the target fill rate
𝜇 3192
𝐿 𝑧 = ∙ 1 − Expected Fill Rate = 1 − 0.99 = 0.0270
𝜎 1181
• Step 2: Find the 𝑧-statistics that yields the lost sales from step 1:
22
Objective 3: Satisfy minimum In-Stock Prob.
• Suppose we wish to find the order quantity for the Hammer 3/2 that
minimizes leftover inventory while generating at least a 99% in-stock
probability:
• Step 1: Find the 𝑧-statistic that yields the target in-stock probability from
the Standard Normal Distribution Function Table:
You can also calculate the 𝑧 and
𝑄 using Excel:
𝑧 = NORM.S.INV(0.99)
𝑄 = NORM.INV(0.99; 3192; 1181)
• Step 2: Convert the 𝑧-statistic into an order quantity for the actual
demand distribution: 𝑄 = 𝜇 + 𝜎 ∙ 𝑧 = 3192 + 2.33 ∙ 1181 ≅ 5944
23
Trade-Off between Profit and Service
300 000
Expected Profit, Expected Leftover Costs, Expected Sales
250 000
200 000
150 000
100 000
50 000
-
0,05 0,10 0,15 0,20 0,25 0,30 0,35 0,40 0,45 0,50 0,55 0,60 0,65 0,70 0,75 0,80 0,85 0,90 0,95 1,00
In-Stock Probability
expected sales * (p-c) expected leftover * (c-s) expected profit
24
Newsvendor Model Summary
• The firm must develop a demand model that includes an expected demand
and uncertainty in that demand.
◦ Either the empirical distribution can be used…
◦ … or the normal distribution with uncertainty captured by the standard deviation.
• At the order quantity that maximizes expected profit, the probability that
demand is less than or equal to the order quantity equals the critical ratio:
◦ The expected profit maximizing order quantity balances the „too much – too little“
costs.
25
Reactive Capacity – Allowing for a quick response
„Responding to trends rather than predicting them.“
CT-13, CM-13.3
Quick Response and Reactive Capacity
27
Expected Demand-Supply Mismatch Costs
• The mismatch costs are the costs of leftover inventory (the „too much“
costs) plus the opportunity costs of lost sales (the „too little“ costs):
Mismatch Costs = 𝐶𝑜 ∙ Expected Leftover Inventory + 𝐶𝑢 ∙ Expected Lost Sales
• The maximum profit is then the profit without any mismatch costs, i.e.,
every unit is sold and there are no lost sales:
Maximum Profit = (𝑟 − 𝑐) ∙ 𝜇
Maximum Profit = Expected Profit + Mismatch Costs
• The mismatch costs are the costs of leftover inventory (the „too much“
costs) plus the opportunity costs of lost sales (the „too little“ costs):
Mismatch Costs = 𝐶𝑜 ∙ Expected Leftover Inventory + 𝐶𝑢 ∙ Expected Lost Sales
• The maximum profit is then the profit without any mismatch costs, i.e.,
every unit is sold and there are no lost sales:
Maximum Profit = (𝑟 − 𝑐) ∙ 𝜇
Maximum Profit = Expected Profit + Mismatch Costs
30
The Coefficient of Variation (CV)
𝜎
• 𝐶𝑉 = 𝜇 is a better measure of demand uncertainty than 𝜎 alone.
• Imagine you would like to know the probability of demand lying within 20% of
the mean demand, here 𝑃 48 ≤ 𝐷 ≤ 72 :
1
CV=10/60 = 0.17
0,9
0,8
CV=30/60 = 0.50
0,7
0,6
77.0% 31.1% Normal(60,30)
0,5
Normal(60,10)
0,4
0,3
0,2
0,1
20%
0
0 10 20 30 40 50 60 70 80 90 100
31
Reactive Capacity
Example Hammer 3/2
Generate forecast
of demand and Receive 1st order Receive 2nd order
submit an order from TEC from TEC
to TEC
Spring selling season
Nov Dec Jan Feb Mar Apr May Jun Jul Aug
• TEC charges a premium of 20% per unit (132 instead of 110) in the
second order.
• There are no restrictions imposed on the 2nd order quantity.
• O‘Neill forecast of total season sales is nearly perfect after observing
initial season sales.
• How many units should O‘Neill order in October?
32
Reactive Capacity
Example Hammer 3/2
33
Reactive Capacity
Example Hammer 3/2
Expected Lost Sales = Expected 2nd Replenishment Quantity = 𝜎 ∙ 𝐿(𝑧) with 𝑧 = 0.06
and 𝐿 𝑧 = 0.3697 (see Table) = 1181 ∙ 0.3697 ≅ 437
Expected Sales = 𝜇 − Expected Lost Sales = 3192 − 437 = 2755
Expected Leftover Inventory = 𝑄 − Expected Sales = 3263 − 2755 = 508