How to develop a forecast by applying the critical ratio to a distribution?

Expert Solution

Critical Ratio is a ratio of Underage cost to the sum of Underage cost and Overage Cost. This ratio helps us conclude upon the demand probability we should profitably satisfy for a given Selling Price, Cost Price and Sunk Cost. In other words, it provides us with the statistics about the desired In-Stock Probability, we should target so as to remain profitable to great extent.

After getting this target service level, we can easily transfer that to a Z value and hence by using it along with the Average demand and standard deviation of demand, we can easily find the order/production quantity we should purchase/produce so as to maintain profitability of business, in spite of the highly variable demand.

Thus by using the critical ratio, we can forecast our distribution policy because it helps us plan our Order/Production size which would make our activity profitable in spite of the fluctuating demands.

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keosha answered 6 months ago

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