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Module SCM103: Supply Chain Strategies II: Improving Responsiveness & Advanced Topics
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Hedging Demand Uncertainty: The Newsvendor Model
Another important hedge against demand uncertainty doesn't involve changing any production processes at all, but understanding where to set your production and inventory targets. In your supply chain, how much revenue do you lose if you underestimate demand and have a stockout situation? What about overstock - what is the cost of producing too much and having to write off inventory or sell it at a discount? The Newsvendor Model, a popular strategy for dealing with this remaining uncertainty, allows us to understand the expected cost of having too much or too little inventory. It simulates running many iterations of a particular inventory strategy (where each iteration is subject to fluctuating demand) and tells us what amount of inventory will, on average, give us the lowest cost in terms of missed revenue versus discounted sales.
First, a short background on the model. Newsvendors buy their papers each morning anticipating that they will sell some approximate number (perhaps based on the prior day's sales, and/or occurrence of a major news event). On one hand, there is an opportunity cost of running out of papers in the form of lost revenue; on the other hand, leftover papers are not very valuable at the end of the day. As a result, each morning the newsvendor must decide how many papers to order, balancing the cost of buying too many versus the opportunity cost of running out.
Now consider a product that we manufacture and then sell to customers. The demand uncertainty for our sample product is shown by the following bell-shaped curve, in which we expect to sell 100 units, but there is a certain probability that we will sell more or less than that number:
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Now suppose we sell this product for $35/unit during the regular selling season, while our marginal manufacturing cost8 is $20/unit. At the end of the selling season, assume any units left over can be sold at a markdown price of $15/unit. Given these economics, is it wise to target the middle of the bell-shaped curve (i.e., the point forecast of 100 units) as the ideal inventory level? Suppose we say that's not the right answer - would you go above or below 100?
One way to analyze the economic situation here is to calculate what we call overage and underage costs. The overage cost is the cost of having one unit left over at the end of the season. In this case we would spend $20 to make the unit but sell it for only $15, incurring an overage cost of $5/unit. On the other hand, the underage cost is the opportunity cost of being under (or short) by one unit. If we were short by one unit in meeting demand, then we lose a potential sale for $35, but we also avoid the $20 manufacturing cost, so the true underage cost is $35 - $20 = $15 per unit. This is often called the contribution margin - the difference between selling price and marginal cost.
If the overage and underage costs were equal, then the right answer would indeed be to aim for the expected demand of 100 units (the point sales forecast), because costs of going over or running out are the same. But since the underage cost ($15) is three times the size of the overage cost ($5), it is more costly to run short, and much less costly to have some leftovers. Thus the right answer is to "aim high" and produce more than 100 units.
How high should one aim? There is a formula answer to that question, but let's first try to get a sense of what happens with different inventory targets. In the box below, type in various values into the "target inventory" box (using a number between 50 and 200), hit return, and we'll calculate the expected cost of using that strategy, showing it under "Expected Cost" and simultaneously graphing it on the chart below. Try a few values before moving on to the next page, and try to zero in on the target inventory that has the lowest cost. Be sure to scroll far enough to see the chart below; it will fill in as you enter values into the calculator.
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$700 |
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| $100 |
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| 50 |
75 |
100 |
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200 |
TARGET INVENTORY |
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On the next page we'll show how to calculate these numbers.
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