The Newsvendor Model:

Betting on Uncertain Demand

CM-13, CT-12, Example taken from CT-12
O‘Neill‘s Hammer 3/2 wetsuit

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

• Marketing has forecasted sales of 3,200 units.

• We have previously developed a demand model with distribution
𝑁 𝜇, 𝜎 = 𝑁(3192, 1181)

3
Hammer 3/2 economics

• The „too much or too little problem“:

◦ Order too much and inventory is left over at the end of the season.
◦ Oder too little and sales are lost (demand is left unsatisfied, customers
might buy a competitor‘s product instead).

• Each units sells for 𝑟 = 190$.

• TEC charges 𝑐 = 110$ per wetsuit.
• Discounted suits sell for 𝑣 = 90$ (salvage value).

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

• Ordering one more unit increases the chance of overage …

◦ Expected loss on the Qth unit = 𝐶𝑜 ∙ 𝐹(𝑄)
◦ Recall: 𝐹(𝑄) = Distribution function of demand = 𝑃 𝐷 ≤ 𝑄
• … but the benefit/gain of ordering one more unit is the reduction
in the chance of underage:
◦ Expected gain on the Qth unit = 𝐶𝑢 ∙ (1 − 𝐹(𝑄))
90
80 expected sales expected loss
70 As more units are ordered,
Expected Gain/Loss

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

Qth unit ordered

6
Newsvendor model implementation steps

1. Gather economic inputs 

◦ Selling price, production/procurement costs, salvage value of
inventory, point forecast

2. Generate a demand model 

◦ Use empirical demand distribution or choose a standard distribution
function to represent demand, e.g. the normal distribution.

3. Choose an objective
◦ E.g. maximize expected profit or satisfy a fill rate constraint.

4. Choose a quantity 𝑄 to order.

7
Objective 1: Profit maximization

• To maximize expected profit order Q units, so that the expected

loss on the Qth unit equals the expected gain on the Qth unit:
𝐶0 ∙ 𝐹 𝑄 = 𝐶𝑢 ∙ (1 − 𝐹 𝑄 )

• Rearrange the terms in the above equation to get:

𝐶𝑢
𝐹 𝑄 =
𝐶𝑜 + 𝐶𝑢

• 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

• In the empirical 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

9
Objective 1: Profit maximization
Using the empirical distribution function

• In the empirical distribution function, find the demand, that (for

the first time) exceeds the critical ratio (or cycle service level):
Actual
Product Forecast Error A-F ratio Percentile A-F-ratio * 3200
Demand
18 470 116 354 0.25 0.03 789.79
31 3190 1195 1995 0.37 0.06 1 198.75
14 430 239 191 0.56 0.09 1 778.60
21 650 364 286 0.56 0.12 1 792.00
33 6490 3673 2817 0.57 0.15 1 811.03
27 1220 721 499 0.59 0.18 1 891.15
13 430 274 156 0.64 0.21 2 039.07
23 680 453 227 0.67 0.24 2 131.76
2 120 83 37 0.69 0.27 2 213.33
25 1020 732 288 0.72 0.30 2 296.47
12 390 311 79 0.80 0.33 2 551.79
16 450 365 85 0.81 0.36 2 595.56
24 740 607 133 0.82 0.39 2 624.86
32 3810 3289 521 0.86 0.42 2 762.41
4 170 163 7 0.96 0.45 3 068.24
6 180 175 5 0.97 0.48 3 111.11
17 460 450 10 0.98 0.52 3 130.43
3 140 143 -3 1.02 0.55 3 268.57
7 180 195 -15 1.08 0.58 3 466.67
9 320 369 -49 1.15 0.61 3 690.00
8 270 317 -47 1.17 0.64 3 757.04
22 660 788 -128 1.19 0.67 3 820.61
29 1490 1832 -342 1.23 0.70 3 934.50
5 170 212 -42 1.25 0.73 3 990.59
19 500 635 -135 1.27 0.76 4 064.00
28 1300 1696 -396 1.30 0.79 4 174.77
20 610 830 -220 1.36 0.82 4 354.10
15 440 623 -183 1.42 0.85 4 530.91
26 1060 1552 -492 1.46 0.88 4 685.28
11 380 571 -191 1.50 0.91 4 808.42
10 380 587 -207 1.54 0.94 4 943.16
1 90 140 -50 1.56 0.97 4 977.78
30 2190 3504 -1314 1.60 1.00 5 120.00

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

For any order quantity we would like to evaluate the following

performance measures:
• Expected lost sales: The expected number of units demand
exceeds the order quantity
• Expected sales: The expected number of units sold
• Expected left over inventory: The expected number of units left
over at the end of the season
• Expected profit
• Expected fill rate: The fraction of demand that is satisfied
immediately
• In-stock probability: Probability all demand is satisfied.
• Stockout probability: Probability at least some demand is lost.

13
Performance Measures
Overview

Expected
Fill rate
demand, m

If Normal Expected
demand, s sales

Loss function Expected

table lost 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

• Step 3: Evaluate lost sales for the actual normal distribution:

Expected Lost Sales = 𝜎 ∙ 𝐿 𝑧 = 1181 ∙ 0.4840 = 571,6 ≅ 572

17
Performance Measures
Expected Lost Sales for Hammer 3/2

If 0 units are ordered, all sales

3500 are lost; Expected Lost Sales
equals mean demand, 3192.
3000
Expected Lost Sales

2500

2000 If 6,000 units are ordered, almost

no sales are lost, Expected Lost
1500
Sales equals ~0.
1000

500

0
0 1000 2000 3000 4000 5000 6000

Order Quantity

18
Performance Measures
following Expected Lost Sales

• If we have ordered 𝑄 = 3000 Hammer 3/2, then…

• Expected Sales = 𝜇 − Expected Lost Sales = 3192 − 572 = 2620

• Expected Leftover Inventory = 𝑄 − Expected Sales

= 3000 − 2610 = 380

• Expected Profit = 𝑟 − 𝑐 ∙ Expected Sales

− 𝑐 − 𝑣 ∙ Expected Leftover Inventory
= 80 ∙ 2620 − 20 ∙ 380 = 202,000

• Note, that these equations hold for any demand distribution.

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 Stock-out Probability is the probability that at least some demand is

lost.
• (At least some) demand is lost, if 𝐷 > 𝑄.
• Hence, Stockout Probability = 1 − 𝐹(𝑄)

• If 3,000 units are ordered, then, given 𝑧 = −0.16:

◦ In−Stock Probability = 𝐹 𝑄 = 0.4364
◦ Stockout Probability = 1 − 𝐹 𝑄 = 0,5636
◦ If 3,000 units are ordered, then there is a 43,64% chance all demand will
be satisfied.
20
Performance Measures
Fill Rate

• 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!

Expected Sales 𝜇−Expected Lost Sales

• Expected Fill Rate = =
𝜇 𝜇
Expected Lost Sales
=1−
𝜇
572
• If Q = 3000 ⇒ Expected Fill Rate = 1 − = 0.8208 ≅ 82.1%
3192

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:

Choose the higher 𝑧-statistic, here: 1.54

• Step 3: Convert the 𝑧-statistic into an order quantity for the actual
demand distribution: 𝑄 = 𝜇 + 𝜎 ∙ 𝑧 = 3192 + 1.54 ∙ 1181 ≅ 5011

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)

Choose the higher 𝑧-statistic, here: 2.33

• 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 model can be applied to settings in which:

◦ There is a single order/production/replenishment opportunity.
◦ Demand is uncertain.
◦ There is a „too much – too little“ challenge:
 If demand exceeds the order quantity, sales are lost.
 If demand is less than the order quantity, there is leftover inventory.

• 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

• If lead time is short compared to selling season, a second order

after early season sales have been observed.
• Capability of placing multiple orders during the selling season 
integral part of Quick Response.
• Reactive capacity is the capacity that allows a firm to place one
additional order during the season, „second-buy option“.
• Why? To minimize demand-supply mismatch caused by the
„single-buy option“ described above.

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

• Consider the Hammer 3/2 example from above, where we ordered 𝑄 =

3,000 units, Expected Leftover Inventory = 380, Expected Lost Sales
= 572, Expected Profit = 202,000, 𝑝 = 190, 𝑐 = 110, 𝑣 = 90, 𝜇 =
3,192, then:
Mismatch Costs = 20 ∙ 380 + 80 ∙ 572 = 53,360
Maximum Profit = 202,000 + 53,360 = 255,360
The mismatch costs as a percentage of the maximum profit is 20.9%!
28
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

• Consider the Hammer 3/2 example from above, where we ordered 𝑄 =

4,196 units, Expected Leftover Inventory = 1134, Expected Lost
Sales = 130, Expected Profit = 222,280, 𝑝 = 190, 𝑐 = 110, 𝑠 = 90,
𝜇 = 3,192, then:
Mismatch Costs = 20 ∙ 1134 + 80 ∙ 130 = 33,080
Maximum Profit = 222,280 + 33,080 = 255,360
The mismatch costs as a percentage of the maximum profit is still 13.0%!
29
When is the mismatch costs high?

• Mismatch costs as a percentage of the maximum profit increases

as…
◦ (1) the coefficient of variation of demand increases, i.e. the
𝜎 1181
demand variability increases. 𝐶𝑉 = = = 0.37
𝜇 3192
◦ (2) the critical ratio decreases
Critical ratio
Coefficient
of variation 0.4 0.5 0.6 0.7 0.8 0.9
0.10 10% 8% 6% 5% 3% 2%
0.25 24% 20% 16% 12% 9% 5%
0.40 39% 32% 26% 20% 14% 8%
0.55 53% 44% 35% 27% 19% 11%
0.70 68% 56% 45% 35% 24% 14%
0.85 82% 68% 55% 42% 30% 17%
1.00 97% 80% 64% 50% 35% 19%

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

Observe Feb and Mar

sales and submit 2nd Left over units are
order to TEC discounted

• 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

• We apply classic newsvendor logic to the problem with reactive capacity:

• The „too much“ costs of the initial order remain the same:
𝐶𝑜 = 𝑐 − 𝑣 = 110 − 90 = 20
• The „too little“ costs change:
◦ If the 1st order is too low, we cover the difference with the 2nd order.
◦ Hence, the 2nd order option prevents lost sales.
◦ The cost of ordering too little per unit is no longer the gross margin, it is the
premium we pay for the units in the 2nd order:
𝐶𝑢 = 𝑐2 − 𝑐1 = 132 − 110 = 22
𝐶𝑢 22
• The critical ratio equals: 𝐶𝑅 = = = 0.52381
𝐶𝑜 +𝐶𝑢 20+22

• Thus, 𝑧 = 0.06 and 𝑄 = 3192 + 0.06 ∙ 1181 = 3263

33
Reactive Capacity
Example Hammer 3/2

Single Order Second Order

Performance Measure
Opportunity Option
Optimal Order Quantity 𝑄 4,196 3,263
Expected Profit 222,280 235,586
Mismatch Costs 33,080 19,774

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

Mismatch Costs = 𝐶𝑜 ∙ Expected Leftover Inventory

+𝐶𝑢 ∙ Expected 2nd Replenishment Quantity = 20 ∙ 508 + 22 ∙ 437 = 19,774
Expected Profit = Maximum Profit – Mismatch Costs = 255,360 − 19,774 = 235,586

Increase in Profit  5,98%, Reduction in Mismatch Costs  40,22%

34