Managing Inventories: The Newsvendor Model

This note uses the traditional newsvendor model to present strategies for inventory management when demand is uncertain. Methods for determining the critical ratio of overage and underage costs and the optimal stock level are discussed. Excerpt UVA-OM-1456 Rev. Oct. 9, 2013 Managing inventories: The Newsvendor model Managing inventories is important in every company and under many circumstances, but it is especially critical for firms facing uncertain demand in only one selling season. This problem is commonly referred to as the newsvendor problem or newsvendor model, derived from the problem faced by a newsvendor who must decide on the number of newspapers to purchase at the beginning of the day before demand can be observed. This model, however, can be applied to any situation where the selling season is short enough that ordering decisions must be made before the season starts, such as for fashion goods, influenza vaccines and other health care products, short-life-cycle technology products (consumer electronics and telecommunications equipment), and perishable goods. Determining the Optimal Inventory Level When determining how much inventory to hold before the selling season starts, a firm needs to balance two possible outcomes. If the firm orders too much, inventory remaining at the end of the selling season will have to be sold at a discount or thrown away. But if the firm doesn't order enough, it may lose potential sales and possibly also cause customers to obtain the product from a competitor. To take those two possible outcomes into account, we define two types of costs: the overstocking cost, Co, which is the loss for the firm for each unit of leftover, and the understocking cost, Cu, which is the loss of margin for the firm for each unit of lost sales. . . .