The Newsvendor model helps us to decide what is the optimal (profit-maximizing)

Question

The Newsvendor model helps us to decide what is the optimal (profit-maximizing) order quantity for an order decision taken before a given selling season. If there is not enough stock during the selling season, then we would lose a sale (Cu = p – c). After the selling season the remaining inventory from this first order would have to be sold at a much lower price – salvaged (Co = c – v). 1. Newsvendor Model Lesson The lesson of the newsvendor model was “don’t order the forecast!” Your profit-maximizing order quantity should take into account the overage (Co) and underage (Cu) costs. The critical ratio = Cu/(Cu + Co) gives you the in-stock probability. 1a. If Cu > Co, then your critical ratio will be greater than 0.5 à should you order more or less than the forecasted demand? Explain. 1b. If Cu < Co, then your critical ratio will be less than 0.5. à should you order more or less than the forecasted demand? Explain

Explanation / Answer

a) If Cu > Co, then you should order more than the forecasted demand

Reason: Cu which is cost of un-availability is high then Co which is cost of excess. It means, if there is demand and material is not available, then opportunity loss is higher than cost of excess holding of material. So, in such case, it is advisable to have more than forecasted demand

b) If Cu < Co, then you should order less than the forecasted demand

Reason: The cost excess holding of material is higher than cost of un-availability. So, in such case even if there is demand, the profit is less compared to excess holding of material.

Example: The Minimum demand = 300, Maximum demand = 500. So, forecasted demand = 400

Optimum quantity = Minimum demand + Critical ratio*(Maximum demand - Minimum demand)

Optimum quantity = 300 + Critical ratio*200

So, if Critical ratio >0.5, then Optimum quantity will be >400. Else, lower

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