The newsvendor model is a mathematical approach in operations management to determine optimal inventory levels. The name is based on a newsboy trying to decide how many copies of newspaper will contemplate the demand of the day.
If the boy can’t sell of the newspaper of the day, he knows that it will be worthless in the next day. Facing that problem, he must find a way to sell every copy every single day.
Basically, as supply chain specialist Nicolas Vandeput explains, that story means that if you are not able to replenish your stock trough the sale cycle you must decide the quantity of products you’ll have before the sales come in.
So, this model should be applied to products with a limited lifecycle that needs to be produced or ordered beforehand.
Nicolas Vandeput states 4 basic conditions to define a problem as newsvendor. They are:
- The order happened before the season.
- You cannot make an order through the season.
- There is cost if you buy too much.
- There is cost for buying too low.
Then, he proceeds elucidating a few examples that contemplate those conditions. Among them, seasonal products, ordered ahead of the season.
Stocks for special occasions since you can’t replenish stock while the event is happening. And finally, safety stock, because you must decide before cycle how much you’ll need for the period.
But before we try to analyze a situation and see how a newsvendor model would optimize stock, we need to go trough some basic concepts that will help understand better the method.
Newsvendor basic concepts
Although the newsvendor model is based on a simple situation, it can be applied to a variety of problems. But is important to clarify aspects relatable to supply chain before discussing the model.
- Cost of Underage (CU) – opportunity cost of turning away a customer.
- Cost of Overage (CO) – cost of discarding an unsold item.
- Critical Fractile (CF) – the ideal point for demand distribution.
The calculation of CF uses the costs, so the simple formula to get to your ideal point for demand distribution is:
CF = CU / (CU+CO)
Although those concepts can elucidate a lot, they aren’t enough to deal with the real complexity of modern supply chains. Pat DeMarle, founder and CEO of Gears Analytic, proposes some components to make a more advanced analysis:
- Salvage Value – when it’s possible to recover something that usually would be wasted.
- Inventory Holding Costs – how much is spent in keeping a warehouse and items stocked.
- Opportunity Cost of Capital – other possibilities of investment that aren’t related to inventory.
The influence of the model
The newsvendor model, also known as the single period inventory model, is one of the most widespread and influential models. It follows only the economic order quantity (EOQ).
That popularity is due to its versatility. Newsvendor, for instance, allows variable and stochastic demand while maintaining a single period for your cycle. That means, all inventories must be ordered beforehand.
Differently from EOQ, that tries to minimize the expected costs, the newsvendor is seeking to maximize the profit expected from that period.
It does that by ordering sufficient inventory, in a way that the probability that the demand is less or equal to this amount is equal to the critical ratio, which is the ratio of the shortage costs divided by the sum of the shortage and excess costs.
The best uses of newsvendor
As said previously, one of the great points of the method is its flexibility. It can be used in a lot of different scenarios and get to a satisfactory result. Even so, there is the best suited uses for it.
For instance, newsvendor is a great method to use when the demand is uncertain. Because it provides a structured way to deal with those variabilities and choosing the better stocking point.
Another scenario that newsvendor is a great choice is seasonal decisions. If you must decide a stock for an event or order with months of advance, newsvendor helps finding the best quantity.
Finally, it’s a good method for competitive markets. Newsvendor can relatively easy estimate overage and underage costs and take account of elasticity. Those advantages make the method good for maximizing profit.
The mathematical problem that sustains the newsvendor method dates to 1888, since then, it has been researched and improved constantly, making it one of the most studied inventory models.
A modern approach, though, was formulated by the economists K. Arrow, T. Harris and J. Marshack in 1951. Today there are several data-driven models for the newsvendor problem.
Also, more recent research on the subject focuses on behavioral aspects of the problem. For example, trying to solve real world problems with experimental and empirical data to match decision making with the optimal point.
The newsvendor model is a solid model that can help with different scenarios and when well-structured will maximize profit and make process more efficient for procurement.
With Supply Brain, we have already helped large companies improve demand planning accuracy and significantly increase gross margin return on inventory investment.
Find out which inventory policy is ideal for your company and when to buy considering inventory costs. Let’s talk!