How much inventory should I buy? How much should I manufacture? Will I have too much product, or too little?
If these questions sound awfully familiar, it’s because you’re not alone. This problem is actually so old that it has its own a name: “The Newsvendor Problem“. Newsvendors in the 19th century faced this dilemma every day: if I buy too many newspapers I won’t be able to sell them all, but if I buy too few, I’ll miss potential sales. The good news is that you can follow a few simple rules-of-thumb that will help you plan better and, as a result, could have a significant impact on your cash flow.
Let’s start with some basic terms:
Underage Cost – Profit lost as a result of not having enough inventory. If you’re selling pizza for $10 a slice and it costs you $2 worth of inventory to manufacture, the underage cost is $8, because you’ve lost this amount by not being able to supply the demand.
Overage Cost – The loss incurred as a result of ordering too much inventory. If you’re selling a slice of pizza for $2, and it $2 worth of inventory to manufacture, the overage cost is $2, because you’ve ordered too much inventory.
Assuming you don’t have a crystal ball that tells you how much inventory to order, you will probably do what the rest of us do – guess, or estimate the sales in the coming days or weeks and order inventory accordingly. However, while the math behind the newsvendor model is pretty complex, it still comes to a very simple conclusion.
If your overage costs are significantly lower than your underage costs, as in the example given above – you should order more than what you estimate the sales to be. This is because every sale of pizza slice you’ve missed costs you 4 times more than the loss from a slice you haven’t sold at the end of the day.
On the other hand, if your underage costs are significantly higher than your overage costs, you should order less than what you estimate the sales to be. This is because the loss from a slice you haven’t sold and had to throw away is much higher than the costs you incur when you’re not able to sell to an additional customer.
The Newsvendor model is a great way to help optimize your inventory costs.