From the author:
To estimate the demand correctly
All unsold blouses must be sold in the retail sale at a special price. The textile retailer estimates the demand for its experiences in past seasons on 100 pieces with a possible uncertainty (variation) of +/- 30 pieces.
The net sales price is planned with 70 Euro, the purchase price with 25 Euro and the selling price at the end of the season with 20 Euro. On the basis of these few data alone, the so-called news vendor model can be used to calculate how high the maximum profit order quantity should be. In this specific case, it is about 138 pieces.
It can already be seen from this simple example that for the relevant cost minimization both cost components are necessary, namely the excess inventory costs and the substandard costs. These two cost components are the risk costs of the stock.
In the cost accounting or accounting you will search in vain for both. The most important costs are not available for a management decision! The reason: In classic cost accounting only so-called money costs are recorded, but not the alternative costs relevant for management decisions, also called opportunity costs.
Overstock costs are cheaper
The excess inventory costs per piece are the difference between the procurement costs per unit minus the selling price per unit. In our example, this is the difference between 25 Euro and 20 Euro = 5 Euro. The understock costs per piece are calculated as the difference between the selling price per piece minus the purchase cost per piece. Here is the difference between 70 Euro and 25 Euro, thus 45 Euro.
It can be seen that the sub-stock costs per piece are significantly higher than the excess stock costs per piece. An insufficient supply quantity is therefore significantly more expensive than a too large supply quantity. Therefore, you will order a quantity that will be above the mean.
Calculate the risk
The key measure in the example is the ratio of the inventory cost per item to the total out-of-stock cost per item (the so-called risk inventory cost per item) as the sum of under-inventory and excess inventory costs per item. This is called the Critical Ratio (CR). In the example, 45 is Euro divided by 50 Euro (the sum of under- and overstock costs per item).
This critical ratio is now to be classified in a normal distribution, with the available data of the expected average demand quantity of 100 pieces and the mean demand deviation of 30 pieces. This results in a critical ratio of 0,90.
Risk calculation with Excel
This means that in addition to the average amount of 100 pieces, there is still a safety buffer to add from 0,90. The security buffer of 0,90 corresponds to a so-called z-value of 1,27. If you multiply the mean deviation of 30 pieces with the z-value (the z-value is the safety factor of the normal distribution), then you get a lot of 38 pieces.
This can be calculated without problems in Excel using the function wizard with NORMINV. In a specific case, 100 + 38 = 138 blouses must be ordered. Then the costs are the lowest and the expected profit is the highest. Try it yourself with other numbers and you will be able to quickly grasp the relationships.
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