Integrated Logistic

2015
Inteegraated Loggistiics
BeullennsP.
UniverrsityofSouth
hampton
2/1/20015
Integrated Logistics
Contents
1
Introduction .............................................................................................. 4
1.1
Defining Supply Chain Management ........................................................... 4
1.2
Understanding Supply Chain Management .................................................... 4
1.3
Measuring Supply Chain Performance ......................................................... 4
1.4
What is Integrated Logistics? ................................................................... 4
2 IL & Finance .............................................................................................. 5
2.1
Strategy and Finance ............................................................................ 5
2.2
Time value of money............................................................................. 6
2.2.1 Net Present Value for discrete interest rates ............................................. 6
2.2.2 Net Present Value for continuous interest rates ......................................... 8
2.2.3 Annuity Stream ............................................................................... 10
2.2.4 Linear approximations of NPV and AS ..................................................... 10
2.2.5 NPV and AS of a few useful cases .......................................................... 11
2.3
Economic Order Quantity (EOQ) Harris (1913) ............................................ 14
2.4
Economic Production Quantity (EPQ) Taft (1918) ........................................ 18
2.5
EOQ with batch demand Grubbstrm (1980) .............................................. 21
2.6
Lot-for-lot production at finite rate Monahan (1984) .................................... 24
2.7
EOQ for batch demand Goyal (1976) ....................................................... 26
2.8
EPQ for batch demand Joglekar (1988) .................................................... 28
2.9
Vending machine ................................................................................ 29
2.10 Payment structures ............................................................................. 30
2.11 Consignment arrangements .................................................................... 32
2.12 The profit function of the integrated supply chain ........................................ 34
2.13 Using the NPV framework to include other cost components ............................ 35
3 IL in Buyer-Supplier Supply Chains .................................................................. 38
3.1
One-to-one shipping............................................................................. 38
3.1.1 Shortest Path Problem ....................................................................... 38
3.1.2 Economic Transport Quantity (ETQ) ....................................................... 41
3.1.3 Maximum Economic Haulage Radius (MEHR) ............................................. 45
3.1.4 Optimal policy to order N different items from a Cross-Docking Facility (CDF).... 46
3.2
One-to-many shipping .......................................................................... 48
3.2.1 Length of an optimal TSP tour visiting many customers ............................... 48
3.2.2 Expected length of an optimal TSP tour visiting a few customers ................... 51
3.2.3 Continuous approximation of an optimal vehicle routing solution ................... 52
3.2.4 One-to-many ETQ ............................................................................ 54
4 Strategy in the supply chain: Alliances versus Leaders .......................................... 61
4.1
Alliances .......................................................................................... 61
4.1.1 Cooperative game theory ................................................................... 61
4.1.2 Alternative methods ......................................................................... 71
4.2
Two-party alliances in the supply chain ..................................................... 71
4.2.1 Two-party alliance: example ............................................................... 71
4.2.2 Two-party alliance: example 2 ............................................................. 79
4.3
Perfect coordination ............................................................................ 82
4.3.1 Perfect coordination schemes: examples ................................................ 83

4.4
Leaders and followers .......................................................................... 88
4.4.1 Leaders and followers: Stackelberg games ............................................... 88
4.4.2 Stackelberg leader in the supply chain: examples ...................................... 90
5 Stochastic Models ...................................................................................... 96
5.1
When is the assumption of a constant demand rate valid? ............................... 96
5.2
(r, Q) reorder point models .................................................................... 97
5.2.1 Backorder case ................................................................................ 98
5.2.2 Lost sales case .............................................................................. 103
5.2.3 Service level approach .................................................................... 103
5.2.4 Standard Tables ............................................................................ 105
5.2.5 Exercises ..................................................................................... 110
5.3
News vendor problems ........................................................................ 111
5.3.1 Example ...................................................................................... 111
5.3.2 Cost minimisation .......................................................................... 111
5.3.3 Profit maximisation ........................................................................ 112
5.3.4 Regret minimisation ....................................................................... 113
5.3.5 Exercises ..................................................................................... 114
6 MRP, JIT, and Bottlenecks .......................................................................... 116
6.1
Materials Requirements Planning ........................................................... 116
6.1.1 MRP inputs ................................................................................... 116
6.1.2 MRP outputs ................................................................................. 118
6.1.3 Lot sizing policies .......................................................................... 122
6.1.4 Remarks on MRP ............................................................................ 125
6.2
Just-In-Time .................................................................................... 130
6.2.1 Motivation ................................................................................... 131
6.2.2 Push and pull systems ..................................................................... 131
6.2.3 The Kanban System ........................................................................ 131
6.2.4 How many cards? ........................................................................... 132
6.2.5 Subcontractors .............................................................................. 134
6.2.6 Fluctuations in demand ................................................................... 134
6.2.7 Comparison JIT and MRP .................................................................. 136
6.3
Bottleneck scheduling ........................................................................ 139
6.3.1 Optimised Production Technology (OPT) ............................................... 139
6.3.2 Theory Of Constraints (TOC).............................................................. 143
1 Introduction
Foranyquestions,email:P.Beullens@soton.ac.uk
Seealsothematerialonblackboard.
This text follows the lectures given, but I may have arranged the sequence of a few topics in order to
arriveatamorelogicalflow.
1.1 Defining Supply Chain Management

Seeslidesonblackboardandreadthefollowingarticle(onblackboard):
MENTZER J T, DE WITT W, KEEBLER J S, MIN S, NIX N W, SMITH C D, AND ZACHARIA Z G. 2001.
DEFININGSUPPLYCHAINMANAGEMENT.JOURNALOFBUSINESSLOGISTICS22(2),125.
1.2 Understanding Supply Chain Management

Seeslidesonblackboardandreadthefollowingarticle(onblackboard):
CHENIJANDPAULRAJA.2004.UNDERSTANDINGSUPPLYCHAINMANAGEMENT:CRITICALRESEARCH
ANDATHEORETICALFRAMEWORK.INTERNATIONALJOURNALOFPRODUCTIONRESEARCH 42(1),131
163.
1.3 Measuring Supply Chain Performance

Seeslidesonblackboardandreadthefollowingarticle(handout):
SHEPHERDCANDGNTERH.2006.MEASURINGSUPPLYCHAINPERFORMANCE:CURRENTRESEARCH
AND FUTURE DIRECTIONS. INTERNATIONAL JOURNAL OF PRODUCTIVITY AND PERFORMANCE
MANAGEMENT55(3/4),242258.
1.4 What is Integrated Logistics?

Seetheslidesonblackboard.
2 IL & Finance
2.1 Strategy and Finance

Source: SILVER A., PYKE D.F., AND PETERSON R. 1998. INVENTORY MANAGEMENT AND PRODUCTION
PLANNING AND SCHEDULING, THIRD ED. JOHN WILEY & SONS, NEW YORK, CHAPTER 2: STRATEGIC
ISSUES,P.14.
Integrated Logistics (IL) should be linked to the corporate and business strategy. The most important
objectiveofanyfirmisarguablylongtermprofitability.Inthiscontexttheoperatingprofitisdefinedas:
ILcanaffectbothtermsontherighthandside.Byreducinge.g.aggregateinventorylevelsinthefirm,
the investment cost can be reduced. By allocating proper inventory levels among different items in an
improvedway,salesrevenuemayincrease.
One common aggregate performance measure in IL and inventory management is the inventory
turnover:
An increase in sales without a corresponding increase in inventory will increase the inventory
turnover,aswilladecreaseininventorywithoutadeclineinsales.Turnovercanbeausefulmeasureto
comparedivisionsofafirmorfirmsinanindustry.
Ahigherturnoverratioforthesamelevelofsalesmeansamoreprofitablebusiness,aslessmoneyis
tiedupininventories.Thedangeristhatareductionofinventorylevelsmayalsonegativelyaffectsales.
Whenitisnotknownwithcertaintyhowmuchdemandthereisperperiod,anamountofsafetystockis
needed to make sure enough products are in stock in case demand would be somewhat higher than
expected.Furthermore,therightfigureofinventoryturnoverforyourfirmdependsonthelevelofin
houseproductionversusoutsourcing.Afirmthatdoeseverythinginhousewillneedalowerinventory
turnoverthanafirmthatiscompletelybasedonoutsourcingoftheproduction.Indeed,thefirstfirmwill
alsohaveastockofrawmaterialsandworkinprocess,whilethesecondwillonlyhaveendproductsin
inventory. These considerations are important when comparing inventory turnover figures of different
firms.
OtherusefulperformancemeasuresforILincludethosethatmeasureallsortsof:costs;averageand
variabilityofleadtimes(oftenseenasthetimebetweeninitiationofsomesalesorderandrealisationof
the sales, sometimes also just thetimeis takes for aproduct to move through a particular part of the
supply chain); product and service quality; customer satisfaction; and innovativeness (see also Section
1.3).
2.2 Time value of money

Source (on blackboard): GRUBBSTRM, R.W. 1980. A PRINCIPLE FOR DETERMINING THE CORRECT
CAPITAL COSTS OF WORKINPROGRESS AND INVENTORY. INT. J. OF PRODUCTION ECONOMICS 18(2),
259271.
2.2.1
Net Present Value for discrete interest rates
IfIinvestV()intoaprojectnow,theprojecthavingarateofreturn =0.2afteroneyear,whatwillbe
theamountofmoneya()thatIwillreceiveoneyearlater?
Cashflows
Time
Theanswer:
1.2
IfIkeeptheinvestmentrunningnotforonebutforTyearsintotal,whatwillbemyrewardatthe
end?
Cashflows
...
Time
Theanswer:
1
Wecanturnthisaroundandaskthequestion:whatisthecurrentvalueV()ofreceivinga()within
Tyearstimefromnow?Algebraicmanipulationoftheaboveequationgives:
ViscalledtheNetPresentValueofa.Itthusalldependsonthevalueof ,calledthediscountfactor,
interestrate,orinternalrateofreturn.Companiestypicallyusevaluesofwithintherange0.1to0.3.
Considerasequenceofnpaymentsofdifferentamounts ,
1, , atequidistantpointsintime
withcycletimeT(seeFigurebelow).WhatistheNetPresentValueofthesepayments,if istherateof
returnoveroneperiodT?
a2
Cashflows
V
an
a1
...
Time
Theanswer:
Therateofreturnisafunctionofthetimeperiodoverwhichitisdefined.Forexample,if isthe
rateofreturnoveraoneyearperiod,whatistheequivalentrateofreturndefinedoveraperiodofone
month(takethistobe1/12thofayear)thatwouldgivethesameNetPresentValue?
Answer:Letuscall theequivalentrateofreturnoveronemonth,thenwithT=12:
Mathsrefresher
ln

ln 1
1
ln 1
T
ln 1
ln 1
Thus,iftheannualinterestrateis0.2,theequivalentmonthlyinterestratewouldbegivenby:
7
1
ln 1
12
0.2
ln 1
1 0.0153
Notethatiftheinterestrate wouldbedefinedoverasmalltimeperiod,thenln 1
2.2.2
Net Present Value for continuous interest rates
In general, the conversion of interest rates corresponding to different lengths of period obeys the
formula:
1
,
ln 1
where istheinterestratepertainingtoaperiodoflength and isthecontinuousinterestrate

correspondingtothelimitlengthzero.
ThedefinitionofNetPresentValueinthecontinuouscasebecomes:
where
isthecashflowattime plussomemultiple ofDiracsDeltafunctionatpoints at
whichtherearefinitepayments .
Wewilltypicallyneedtosolveonlyspecialcases,givenbelow.
Example 1 A oneoff lump sum () received at future time L

Cashflows
a
V
Time

Thus the NPV of a cashflow received L time units in the future is the cashflow multiplied with its
delayfactor
.
Example 2 A finite number of cash revenues, each received their own future moment
T1
T2
a2
Cashflows
an
a1
V
0
...
Time
Example 3 An infinite number of equal cash revenues received at equidistant moments

T
T
Cashflows
...
a
...
Time
Mathsrefresher
If| | 1,then
For
, | | 1
Thus:
Example 4 A continuous cashflow at a rate of a (/year) received for eternity.

Cashflows
a
....
Time
2.2.3
Annuity Stream
TheAnnuityStreamASofaseriesofcashflowsistheNetPresentValueVofthesecashstreamstimes
therateofreturn :
Fromexample4,itisclearthattheannuitystreamisthatcontinuousstreamofcashyieldingthesame
netpresentvalueastheoriginalseriesofcashflows.
2.2.4
Linear approximations of NPV and AS
Mathsrefresher
Maclaurinexpansionofanexponentialfunction
1
andconvergesfor
Usingthisresultfor
,itiseasytoseethat:
1
anditcanalsobeproven(afterlengthyalgebraicmanipulation):
2
12
1
This can be used to derive linear or quadratic approximations in of NPV or AS functions, as

illustratedinthenextsection.
10
2.2.5
NPV and AS of a few useful cases
Case 1 A oneoff lump sum a () received at future moment L

Cashflows
Time

Foraoneofflumpsum,boththelinearapproximationoftheNPVandthequadraticapproximationin
of the AS are acceptable, and indeed would be of the same accuracy. However, the linear
approximationofASwouldbeinsufficientlyaccurateasindeedtheaboveshows, cannotbetheAS
as a itself is not its NPV. The linear approximation of the AS would thus neglect the delay effect
altogether.
Case 2 An infinite series of lumpsum payments a () received with cycle time T.
T
T
Cashflows
...
a
...
Time
1 1
1
1
2
12
12
1
1
Foraninfiniteseriesofcashflows,thelinearapproximationofASisacceptable.
11
Case 3 A continuous cashflow at rate a (/year), starting at time L, and forever lasting.
L
Cashflows
a
....
Time
Itcanbeobservedthatthisresultcouldhavebeenobtainedbycombiningexample4andcase3from
above.IndeedtheNPVattimeLofthecontinuouscashflowaisa/ (example4),andthenaccounting
forthedelaywithtimeL(case1)givestheaboveresult.
Case 4 A continuous cashflow at rate a (/year) received in future time period T, starting at
time L.
Cashflows
a
0
Time
Thisresultcanalsobeobtainedbyviewingthetemporarycontinuouscashflowaasthesumoftwo
infinitecontinuouscashflows+aanda(startingatimeTlater),andthusbyapplyingtheresultofcase3
twice:
12
To find the linear approximation, it is safe to take the quadratic terms first into consideration and
approximatelateron:
Case 5 An infinite series of continuous cashflows at rate a (/year) with cycle time L and each
time received for a length of time T (T L).
L
Cashflows
T
a
L
T
....
Time
The result of case 4 (without delay) can first be applied to find the NPV of the cashflow of every
periodL.Usingtheapproachasincase2thengives:
1
1

TofindthelinearapproximationofAS,itisagainsafetofirstconsiderthequadratictermsaswell:
1

1
1
1

2!
2
13
2.3 Economic Order Quantity (EOQ) Harris (1913)

Aretailersellstocustomersatypeofproductatthepricepperproduct.Demandfortheproductcan
beassumedtooccurataconstantrateaccordingtoanannualdemandof products.
Theretailerhastopurchasefromanexternalsupplieratprice perproduct,andalsohastopaya
fixedordercost foreachorderplacedatthissupplier(thiscouldbethefixedcostoftransportplusthe
fixedcostofadministrationtoplaceanorder).
retailer
w(/product)
s(/order)
y(products/year)
p(/product)
Q(products/order)?
T(cycletime)?
Inventory
retailer
...
Q
Time
Figure 1. Lot-size model (EOQ).
When the retailer would place an order or size Q (products/order) with cycle time T, the inventory
levelovertimeattheretailerwillfollowtheclassicalsawtoothpatternasillustratedintheFigureabove.
Itcanbeobservedthat:
If there is a nonzero leadtime , and we want to make sure that the order arrives when the
inventory drops to zero, we must order in advance when the inventory level is . This is called the
reorderpoint.
The traditional approach to deriving the optimal policy
Weconsideradeterministicsysteminwhichallrelevantparametersareconstantandshortagesarenot
allowed.Thepolicyusedis(r,Q).Althoughtheaimistofindoptimalvaluesforbothrandq,theoptimal
valuefor iseasilydetermined.TheproblemthereforereducestofindingtheoptimallotsizeQ.Inthis
classiceconomiclotsizesystemthefollowingassumptionsaremade:
1. constantannualdemandratey(items/year);
14
2.
3.
4.
5.
6.
7.
constantinfinitereplenishmentrateR=;
constantunitholdingcosth(/item,year);
constantunitordercosts(/order);
noshortagesallowed;
constantleadtimeL=0,easilyextendedtoconstantL0(years).
constantreplenishmentquantityQ(items/order).
TheinventoryfluctuationsinthissystemareillustratedinFigure1.Itisclearthatweplacetheorder
atexactlythatmomentsothatreplenishmentsarrivewhenonhandinventoryreacheszero:ifleadtime
L=0,weorderwhentheinventorylevelI(t)=r*=0;ifL0(andL<T),weorderwhenI(t)=r*=DL.
Shortagesarethereforenotpossibleandshortagecostsdonotneedtobeconsidered.Totalcostswill
henceconsistofinventoryholdingcostsandprocurementcosts.IncreasingthelotsizeQwillreducethe
numberoforderstomakeperyearandhencetheannualprocurementcosts.However,itwillincrease
the average inventory onhand and therefore the annual holding costs. The optimal lot size Q* will be
thatquantitythatminimisesthesumofbothannualcosts.
TheaverageamountofinventoryonhandbeingE(I)=Q/2,theholdingcostperyearis:
hQ
1
h (Q)
Asy/Qrepresentsthenumberofordersperyear,theordercostperyearisgivenby:
p (Q)
sy
Q
Perdefinitionwewantnobackordersorlostsales:
s (Q) 0
Itfollowsthatthetotalcostequals:
(Q) h (Q) p (Q) s (Q)
hQ s y
Q
2
Tofindtheoptimallotsizewetakethederivativeof(Q)withrespecttoQ:
d(Q) h s y
2 0
dQ
2 Q
whichgives:
Q*
2s y
h
Notethatwewillalwaysdenotewithsuperscript*theoptimalvalueofadecisionvariable;i.e.Q*is
theoptimallotsize.Thecorrespondingoptimalcostis:
15
(Q)
Totalcost
Holdingcost
Ordercost
Q*
Figure 2. Global cost function of the EOQ model.
Q* 2 s h y
Andsince
y = Q/T,
Q*
2s
y
hy
theoptimalcycletimeis:
T*
Graphically, the cost equations can be described as in Figure 2. At optimum, annual holding costs
equalannualreplenishmentcosts.
Using the NPV framework to derive the optimal policy

TheNPVframeworkcanalsobeusedtoderivetheoptimalvaluesofQandT.Therefore,thecashflows
for the retailer have to be determined. The following assumptions are adopted: Since demand is
occurring at a constant rate , the customers pay a continuous cashflow of to the retailer. The
tothe
retailerwillpaythesetupcost uponreceivingeverybatch ,aswellastheamount
supplier.ThisisillustratedinFigure3.
16
T
Cashflows
py
....
....
Time
s+wyT
Figure 3. Cash-flows representation of the EOQ model.
Theannuitystreamoftheprofitfunctionfortheretaileris:
Thelinearapproximation
in isthus:
1
2
Since
The optimal value for Q can be obtained by taking the derivative of this profit function to Q, and
settingthisequalto0:
Thusthesameresultisobtained,andinadditionitbecomesveryclearhowtheholdingcost(per
productperyear),usedinthetraditionalinventoryframework,needstobecalculated:
Thus,theholdingcostfortheretailerisrelatedtotheamountofmoneyinvestedperproduct,i.e. .
Wewilllaterencounterexamplesweretheholdingcostsperproductperyearwillbedifferent.
17
2.4 Economic Production Quantity (EPQ) Taft (1918)

Inthissectionwewillanalysealotsizesysteminwhichthereplenishmentrateisnotnecessarilyinfinite
ashasbeenassumedintheprevioussection.Specifically,thesystemhasauniformreplenishmentrateR
(items/year),whereitisobviouslynecessarythatRy.Thistypeofreplenishinggenerallyoccurswhen
the demand has to be met by a manufacturing department inside the company. The inventory
fluctuationscanthenbedescribedgraphicallyasinFigure4.
producer
c(/product)
s(/order)
R(products/yr)
y(products/year)
w(/product)
Q(products/order)?
T(cycletime)?
Aproducersellstocustomersatypeofproductatthepricewperproduct.Demandfortheproduct
canbeassumedtooccurataconstantrateaccordingtoanannualdemandof products.
Theproducerhastomaketheproductsatavariableproductioncost perproduct,andalsohasto
payafixedsetupcost foreachrunoftheseproducts.Productionoccursataconstantfiniteproduction
rateequivalenttoanannualrateof (productsperyear).
I(t)
a
b
R
c
0
Lr
t
T
Figure 4. Manufacturing lot size system.
Theaverageamountofinventoryequals
E(I) = |bc|/2
10
Wehavethefollowingrelationships:
18
bc ac ab
(geometrical relationship)
11
ab
ac
12
(demand rate)
Q
Lr
(replenishment rate)
13
Hencetheaverageamountininventorycanberewrittenasafunctionoftheknownparametersyand
RandthevariableQ:
1
y Q
y
E ( I ) Q Q 1
2
R 2 R
14
Thenumberofreplenishmentsperyearequalsy/Q.Thetotalsystemcostisthesumofholdingcosts
andreplenishmentcosts:
15
y hQ y
y
(Q) hE( I ) s
1 s
2 R Q
ThevalueQ*whichminimisestotalcostscanbeobtainedasfollows:
d(Q) h
y sy
1 2 0
dQ
2 R Q
16
Q*
where Q
*
EOQ
2 sy
*
QEOQ
y
h 1
R
17
1
y
1
R
referstotheeconomicorderquantityofthebasicEOQmodel.Thecorrespondingcost
isgivenbysubstitutionof
(Q* )
h
y
1
2 R
2 sy
s
y
h1
R
y
2 sy
y
h1
R
18
Rearranging:
19
(Q* )
19
y
y
shy1
shy1
R
R
2
2
20
y
y
(Q * ) 2 shy 1 *EOQ 1
R
R
where *EOQ referstothecostobtainedinbasicEOQmodel.ItiseasytoshowthattheEOQmodelis

aspecialcaseofthecontinuousrateEOQmodelbysimplysubstitutingR=.
Example.
Lety=1000items/year,R=2000units/year,h=1.6/year,ands=200/year.Then:
2 sy
h1
R
Q*
21
2 (1000)(2000)
500000 707 units/order.
1.61 0.5

Thefollowingcashflowsareassumed:
T
Cashflows yT/R
wy
....
....
cR
Time
Then,usingCase5ofSection2.2.5forthevariableproductioncosts:
1
2
Theoptimalorderquantityisderivedintheusualmannerfromthefirstorderconditions:
20
Thesameresultisthusobtainedasinthetraditionalderivationif:
2.5 EOQ with batch demand Grubbstrm (1980)

Weconsiderthesamesystemasintheprevioussectionbutwithtwomodifications:
1. Theproductionrateissetsuchthat
;
2. Salesoccursinbatchesofsize
producer
c(/product)
s(/order)
R(products/yr)
y(products/year)
w(/product)
Q(products/order)?
T(cycletime)?
TheinventorylevelasafunctionoftimelookslikeamirrorimageoftheEOQsawtoothpattern:
T
Inventory
....
0
Time

ThiswouldbeexactlythesamemodelastheEOQofHarrisandwouldproduce:
(Q) hE( I ) s
y hQ
y
s
Q 2
Q

FirstNPVsolution.ThisishowGrubbstrm(1980)derivedasolution:
21
Integrated Logiistics
on:
Henccethelinearaapproximatio
1
2
Thereefore:
Thism
meansthatth
heholdingco
ostsinthetraaditionalfram
meworkaretobebasedoonthesalesp
price of
theprod
ductandnottthepurchaseprice :
deliveryoforrderstotheccustomer
Noticce,however, thatwiththeincreaseoff wearedelayingthed
whiletheestartofpro
oductioniske
eptfixedatccurrenttime 0.Wecanin
nterpretthis asamodelw
wherewe
haveplacedaboundaarycondition
nattime0.Thhisisnotneccessarilyalwaysthebestaassumption.
ution.Beullen
nsandJansseens(2011)in
ntroducedanothermodelwherethisb
boundary
AlternattiveNPVsolu
conditionisplacedattthemomen
ntintimewh enthefirstb
batchtotheccustomerhasstobedelive
ered.This
assumpttion would make
m
more sense if the ccustomer waants this to happen,
h
becaause otherwise if the
momenttoffirstdelivveryisnotfixxed,thecusttomermaye
eitherrunoutofstockor
rreceivethe products
too earlyy and has un
nnecessary stock too earrly. A produccer under the
ese circumsttances would
d need to
derivean
noptimalpollicyfromthefollowingNPPVcalculation
ns:
Thiscanberewritten
nas:
22
dconstant,w
weneedtoffindtheoptim
malpolicyfro
omthefuncttioninsideth
hesquare
Andsincce isafixed
bracketss:
Giving,when
3
2
2
2
elattercase, theproduce
erhasanince
entivetomakkethelotsize
easlarge
and otheerwise.(Inthe
asalloweedbythecusstomerandsu
uchthat
.
Theh
holdingcostsinthiscaseccouldhencebbetakenas:
Alternatively,wecanlookat toderivetw
woterms:
products,justtlikeinthettraditionalEO
OQ,tobe
1. TTheproducerrwillhavea holdingcost ofkeepingp
vvalued at his own invesstment costss and this holding costt correspondds to the trraditional
in
nterpretation
nofbeingbassedoninvesttmentsmade
eintotheproductplacediinstock:
;
2. TTheproducerrwillalsohavveapositiveeeffectfromth
hebatchdeliveriestothe
ecustomergivvingaso
ccalled unit suppliers rew
ward
(B
Beullens and Janssens, 22011). Note that this
p
producesareevenue,notacost!
nction:
Wecantthenrewritetheprofitfun
2
2
2
usion, it is in
n some mode
els therefore important how
h
to set th
he boundary condition in the NPV
In conclu
framewo
ork.Thisboun
ndaryconditiioniscalledttheAnchorPo
oint(BeullensandJanssenns,2011).
23
2.6 Lotforlot production at finite rate Monahan (1984)

We can extend the previous model of batch demand by assuming that the producer runs every batch
at some finite production rate
. The producer would hence only start a production run
sometime / earlierrelativetothedeliveryofabatchtothecustomer.
T
Inventory
yT/R
....
0
Time
Theclassiccostfunctionofthissystem(Monahan,1984)isgivenby:
A first solution using NPV is found from setting the Anchor Point at start of production at time 0,
assumingthecashflowsasinthefigurebelow.
T
Cashflows yT/R
wyT
....
....
cR
Time
Ifthestartofproductionhastooccurattime0,theannuitystreamis:
1
2
Comparingwiththeclassiccostfunction,wefindthat
2
andwehaveasanextraterm
thesuppliersrewardwith
.
Inthespecialcasethat weretrievethesolutionfromtheprevioussection:
24
and the holding cost is then

. Note, however, that we can always write
2
,soinsteadofadoptingaspecialinterpretation
,weseethatwecanequallyadoptthe
moregeneralinterpretation(sincevalidforany
ofhaving
2
andanextraterm,the
.
suppliersreward,with
WhensettingtheAnchorPointatthestartofsales,wefind:
Thefunctioninbetweenthesquarebracketsisrewrittenas:
1 2
2
Thus we can take

and identify, again, the suppliers reward as an extra term with
. The special case of is as seen in the previous section and can use the same
interpretationsfor and .
Usingthetraditionalinventorymodelingapproach,onewouldonlyfindthefirstpart .Thisisinfact
whathappenedintheliteraturethathasfollowedMonahans(1984)model,andhencetherearemodels
intheliteratureforwhichitmaynotbeeasytoseewhethertheywillleadtoinventorypolicieswhichwill
alsomaximisetheNPVofthefutureprofitsofthefirm.SeealsoBeullens(2014).
Wefinishthissectionbyproviding some intuitionbehindthesuppliersreward. As shownabove,it

indicatesthatthereisapositiverevenuetermintheproducerslinearisedASprofitfunction:
Thesuppliersrewardarisesfromthefactthatthecustomerordersinbatchratherthanoneproduct
atatime.Anintuitiveexplanationisthefollowing:
CaseA.Supposeyouhavetwooptionstoreceiveincome:eitherreceiving1,200atthestartofevery
year, or 100 at the start of every month, what would you choose? The logical answer would be to
choosethefirstoption.
Case B. Suppose you have two options to pay expenses: either paying 1,200 at the start of every
year, or 100 at the start of every month, what would you choose? The logical answer this time is to
choosethelatteroption.
The fact that a customer orders in batch will cause inventory costs for this customer. The
disadvantageforthecustomertoorderinbatchisextrainventoryholdingcoststobevaluedatinvested
cost , but at the same time this creates an advantage for the supplier as he receives his revenues
earlier. The suppliers reward term incorporates this advantage into the suppliers profit
function.
Homework
Derivetheoptimalorderquantityusingtheclassiccostfunction
inwhich
andthenderive
theoptimalorderquantityusingthelinearisedannuitystreamfunction underthetwoassumptionsof
theAnchorPoint.Comparethethreeresults.
25
2.7 EOQ for batch demand Goyal (1976)

Weconsideramodelofadistributorwhoneedstodeliverordersofbatchsize tocustomerswithan
average demand rate . Customers pay per product to the distributor but the distributor incurs a
deliverycost perdelivery.Thedistributorcanplaceordersofsize toitsownsupplierandhastopay
perproductandhasanordercostof perorder.
distributor
c(/product)
(/order)
y(products/year)
w(/product)
(products/order)
(/order)
(products/order)?
(cycletime)?

Inventory
....
0
Time
Itcanbeproventhatitisoptimalforthedistributortohave
for somepositiveinteger.
Seealsotheabovefigure.Theclassicderivationofthecostfunctionisagainbasedontrigonometryand
producestheresult(Goyal,1976):
1
2
ToderivetheASprofitfunction,weusethefollowingcashflows:

Cashflows
wyT
wyT
....
0
s
....
Time
NotethatplacingtheAnchorPointatstartofsalestothecustomersorplacingtheAnchorPointat
startofthefirstbatcharrivingfromthesupplierproducesthesameboundaryconditionattime0.TheAS
functionis:
26
Comparisonofthisresultwiththeclassiccostfunctionshowsthat
.
extraterm,thesuppliersreward,with
,butalsothatthereisan
Exercise
Derivetheoptimalorderquantity usingtheclassiccostfunction
inwhich
thenderivetheoptimalorderquantityusingthelinearisedannuitystreamfunction .
Weillustratetheprocedurefortheclassicfunction.Weneedtominimise:
and
1
2
bychoosingandoptimalintegervalue,say .Thisvaluemustsatisfytwoconditions:
Fromthefirstconditionwecanderive:
1
2
Hence
1
1
Or
Thisinequalityisaquadraticfunctionin
.Thenonnegativerootisgivenby:
1
1
2
But the solution has to be integer: (=the largest integer not larger than
quadraticinequality.
Fromthesecondconditionwederivesimilarlythat:
2
1

.
Andwecanproceedasforthefirstconditiontoderivethesame
.Hence:
togetherimply
1
1
2
always satisfies the
asalwaysfeasible.Bothconditions
27
ptimal fo r canbed
derivedfromthisresultfoortheclassiccfunction
Notethaatthederivattionoftheop
by substtitution of
. The reason
r
is thaat the suppliers reward is a constantt term that does not
dependo
on .
2.8 E
EPQ for ba
atch dema
and Jogleekar (198
88)
We intro
oduce in thee previous model
m
a finitee production
n rate (with
h
). In this model, is the
productioncostperp
productand isthesetuupcostfora productionrun.Thedecissionvariable isthe
orasinglepro
oductionrun..
productionlotsizefo
producer
c(/productt)
(/order)
R(products//year)
(prooducts/order)?
(cyccletime)?
y(products/year)
w(/prroduct)
(prod
ducts/order)
(/orrder)
Ifweassumethatt
a
asintheprevviousmodel, theinventorrylevelover timemaylooklikein
nexample).
thefollowingfigure(tthisisjustan
unctionisderivedinJoglekkar(1988):
Thecclassiccostfu
Settin
ngtheAncho
orPointatsta
artofsalesa sinthefigurreabove,and
dwhenmakinngassumptio
onsabout
the timing of cashfflows as in the
t previouss sections, produces the following li nearised AS function
ns,2014):
(BeullenssandJanssen
2
1
1
2
2
2
2
Hencce,
.
,an
ndagaintherreistheextraatermwith
ngtheAncho
orPointatstartofthefirsstproduction
nrunwillpro
oduceadiffeerent funcction.We
Settin
donotderivetheresulthere.
28
NotethatthemodelofJoglekarincorporatespreviouslyconsideredmodels:
For ,wegetGoyalsmodel;
For
1,wegetMonahansmodel;
For
1and
,theEOQmodelwithbatchdemandofGrubbstrm.
Homework
inwhich
andthenderive
Derivetheoptimalorderquantityusingtheclassiccostfunction
theoptimalorderquantityusingthelinearisedannuitystreamfunction .Comparethetworesults.
2.9 Vending machine

WeillustratetheusefulnessoftheNPVframeworkforderivingtheprofitfunctionofavendingmachine
operator.Weconsiderasingleproductsoldataprice inavendingmachineofcapacity .Theproduct
hasacostprice forthevendor.Thevendorhasasetupcost fordeliveringabatchofproductstothe
vendingmachine.Uponthedeliveryofproductstothevendingmachine,theoperatorcollectsthecoins
ofthecustomers.Assumeaconstantdemandrate .
The inventory level over time follows the EOQ sawtooth pattern. The cashflows however differ from
thatintheEOQmodelandaregiveninthefigurebelow.
T
Cashflows
pyT
....
....
Time
s+wyT
Theholdingcostforavendingmachineistobebasedon
,i.e.basedonthesumofcost
priceandsalesprice!
ThereasonwhythisresultdiffersfromtheEOQmodelisthatthecoinsputintoavendingmachineby
customersiscashthatisnotyetaccessibletothevendoroperator.Onlyuponcollectionofthesecoins
canthevendorhaveaccesstothiscapitalforreinvestment.Itisasifthecustomersonlyexchangethe
cashwiththeoperatorthemomenttheoperatoremptiesthevendingmachinescoinsregister.
Itcanbeproventhattheoptimallotsizeis
min
ThisexampleillustratesthattheprofitfunctionintheNPVframeworkwilldependontheassumptions
wemakeaboutwhencashisexchanged.Wecallthisthepaymentstructureanditisfurtherdiscussedin
thenextsection.
29
2.10 P
Payment sstructuress
Considerrthetransferofabatch of producttsbetweenaabuyerand asupplier.Leet bethe priceper
product thatthebuyyerhastopaythesupplieer.Inthepre
evioussections,wehave consistently assumed
thatthetotalamountt ispaidfforthemomeent thatthe
ebatcharrive
esatthebuyeer.
If thee payment occurs in full at the time of delivery then it is said that the payment strructure is
Conventtional (C). It is not the on
nly reasonab le assumptio
on we can make. In realitty, it may be
e that the
buyerpaaysatdifferen
ntmomentsintime,incluuding:
t buyer paays at some time

t
before the delivery is made, sayy at time
CashInAdvaance (CIA): the
,with
0.
,with
Credit(CR):tthebuyercan
npaythesuppplierlaterth
hanthetimeofdelivery,ssayattime
0
Thereearefurtherm
morethefollowingtwocoonsiderationss:
ninstalmentss.Thebuyer maypay,forrexample,a fractionoft heamountd

due
,
Paymentsin
with0
1,asCIA(thiscouldbeaadepositpaidthemomen
ntwhenthebbuyerplaceshisorder
atthesupplier),andtherremainder 1
witthaCRarrangement.
ansactiondellays.Duetoinefficiencies andcostschhargedbythe
efinancial
Transactioncostsandtra
used,thesup
ppliermayrecceiveadifferrentamountandatadiffferenttimere
elativeto
instrumentu
theamountaandtimethe buyerhasm
madeapayme
ent.
Thepayment oftheamou
unt isCIA, of isC,anndof isCR
Randhas
Theffigurebelow illustrates.T
transactiion costs an
nd delays. We
W call the first two paayments
andd the third payment
.
will hencefortth assume th

hat transactioon costs and
d delays are zero or so sm
mall that the
ey can be
We w
ignored.Allpaymentsfurtherconsideredarehhence
.
Itisnotd
difficulttoad
daptallpreviouslyconsideeredmodelsforsituationswherepaym
mentsoccurCIAorCR
incaseswherethetim
me isspeciffied.Anexam
mplefollows.
EOQ mo
odel with CR
R and CIA pay
yment strucctures
Assume thatallcusto
omerspaywithaCRoftiime butth
hatyouhavetopaythessupplierwithCIAwith
owdiagramisgivenbelow
w.Sincewe havetopay thesupplier inadvance, wemust
time . Thecashflo
assumetthatthefirstdeliverywilloccuratsom
mefuturetime with
.
30
Cashflows

py
....
....Time
s
wyT
Thisgives:

Wealsoget:
and

Note.ItiseasytoseethatifcustomerswouldpayCIAwecanusetheabovemodelbutconsidernegative
valuesfor .Likewise,wecanstudytheimpactofreceivingacreditperiodfromthesupplierbytakingin
theabovemodelnegativevaluesfor .
Numerical example
The table below illustrates the impact for an example with
25/
,
150/
,
2000
/
,
0 and
50/
. We take
0.2. <Note. We only evaluate
thepartoftheprofitASfunctionthatiswithinthesquarebrackets.>
The%gapisacommonmeasureforgettinginsightinrelativedifferencesbetweenascenarioanda
base case scenario. In the table it is calculated as the percentage difference relative to the base case
scenarioofaconventionalpaymentofthesupplieri.e.for
0.The%gapformeasure is:
0
,
%

100
0
where in the above table is, respectively, , , and . It can be observed that the increase in
logistics costs is much smaller than the corresponding profit loss. For assessing the impact of different
timingsofpaymentsitishencemuchsafertoconsidertheprofitfunction.
31
(months)
(products/order)
% gap
% gap
(-)
(/year)
(-)
(/year)
% gap
(-)
346
0.00
1732
0.00
48253
0.00
344
0.83
1747
0.84
47398
1.77
341
1.65
1761
1.68
46529
3.57
338
2.47
1776
2.53
45646
5.40
335
3.28
1791
3.39
44747
7.27
332
4.08
1806
4.25
43834
9.16
330
4.88
1821
5.13
42906
11.08
2.11 Consignment arrangements

Consignment arrangements are popular payment structures in some industries between suppliers and
buyers.Thesebuyersarecompaniesthemselvesandmayberetailersorproductioncompanies.Thestock
held at a buyer under this arrangement is called the consignment stock. It is hence inventory that is
physicallyheldatthepremisesofthebuyer,butfinanciallyitisstillunderthe(partial)ownershipofthe
supplier.Onlywhenaproductisremovedfromthisconsignmentstock,willthebuyerhavetocomplete
thepaymentfortheproducttothesupplier.
Assumethatthepriceforaproductthatabuyerneedstopaytothesupplieris .
Wecandistinguishbetweenthefollowingthreecommonconsignmentarrangements:
FullConsignment(FC):thesupplierretainsownershipoftheinventoryatthebuyerandthisis
implementedbylettingthebuyerpaysthesuppliertheprice foraproductonlyatthemoment
thatthisproductisactuallytakenoutoftheconsignmentstockatthebuyer.Thisproductisthen
tobeusedinthebuyersproductionprocess,orinthecaseofthebuyerbeingaretailer,when
thebuyeractuallysellstheproducttooneofitsowncustomers.
PartialConsignment(PC):thesupplierispaidanamount foreachproductwhentheproductis
delivered to the buyers consignment inventory, but the remainder
is only paid out the
moment the product is taken out of the consignment stock by the buyer (for reasons as
explained above for the case of full consignment). The price can in principle be any agreed
amount;itdoesnotneedtobethesuppliersowncostprice.
Graceperiod(GP(z)):ThisissomewhatsimilartoPCinthatthebuyermayfirstpayanamount
the moment that products are delivered to its consignment stock, but the remainder
is
thentobepaidbackaccordingtoacreditarrangementthatdependsontheaveragecycletime
betweendeliveries.Thiscreditperiodiscalledthegraceperiodanditsmomentofpaymentisin
generalasfollows:
where is a suitably chosen constant. The idea isthat when a buyer orders in larger lotsizes,
thatthecreditperiodthesupplieriswillingtoofferalsobecomeslonger.
Weillustratethethreepaymentstructureswiththefollowingexample.
32
A buyersupplier model with consignment arrangements

WeconsiderabuyerhavinganEOQproblemandthesupplierdeliveringtothisbuyerthentohavethe
EOQproblemwithbatchdemand.Bothmodelswerediscussedpreviously.TheASfunctionofthebuyer,
underconventionalpaymentstructures,was:
wherethesubscript isusedtomakeclearthatitconcernsthebuyer.ThesuppliersASfunctionwas:
Wenowintroduceageneralisedpaymentstructurewhichhastheabovediscussedthreevariationsof
consignmentinit:
Anamount ispaidforaproductwhenitisdeliveredtothebuyer;
Anamount ispaidforaproductwhenthebuyersellstheproducttoitsowncustomers;
is paid for with a grace period time units after the
The remainder
deliveryoftheproducttothebuyer.
Hence, for
0 ,
0 and
this corresponds to FC; for
0 but
0 this
correspondstoPC;andwith
0but
0 toGP(z).Themoregeneralcasehasallthreeamounts
nonzero.Notethat
.
CustomersofthebuyerstillpayaccordingtotheconventionalstructureC,asintheEOQmodel.
ThebuyersASfunctionchangesto:
Welinearisetheexponentialtermsinthedecisionvariable andfind:
Note that the holding cost for the buyer is based on

1 2 . For
, the
holdingcostforthe componentiszero.For
1,theholdingcostforthe componentbecomesa
negativecosti.e.willincreasethebuyersprofitfunction.
ThesuppliersASfunctionchangesto:
Thesuppliersrewardisaffectedandnowtobebasedon
2
1
2
2
33
2.12 The profit function of the integrated supply chain

If firms in a supply chain want to identify the optimal way of coordinating, then a commonly used
benchmarkisassumingthatthefirmswouldoperateasonevirtualorganisation.Thisvirtualorganisation
represents the integrated supply chain. To derive its optimal policy, we arguably need to have a profit
functionaswell.Weillustratewithanexamplewhatcanbedone,andwheretherearestillsomeopen
problems.
Consider the buyersupplier model from the previous section, but assume conventional payment
structures.Theprofitfunctionsofbothfirmsare,respectively:
2
1
Itistemptingtopostulatethattheprofitfunctionoftheintegratedsupplychainisfoundastheirsum:
Thisgives:
However,thisfunctionnowmakesuseoftwodifferentopportunitycostsofcapital, and .Would

an integrated firm not be in a position to use one common opportunity cost of capital instead? If we
wouldassumethatbothcapitalcostratesarereplacedbyonecommonrate wewouldfind:
Sucharesultwouldalsobefoundifwestartedfromthecashflowdiagramsofbothfirms,andthen
recognisingthatcashexchangedbetweenthefirmswouldcanceleachotherout.
Thisconundrumhasnotyetbeenadequatelyaddressedintheliterature.Wewillassumehenceforth
; in this case the problem does not present itself. Under this assumption, we can
that
indeedsumtheprofitfunctionsofindividualfirmstofindtheprofitfunctionoftheirintegratedsupply
chain.
Exercise 1
Derivefortheabovebuyersuppliermodelwithconventionalpaymentstructurestheorderquantities
.
and thatwillmaximise
Wetakethepartialderivativeof
, to foraconstant ,andfromsettingthistozerowe
find:
Substitutionofthisresultinto
:
34
Theoptimalpositiveintegervalueishence
1.Therefore,wealsoget
and
Exercise 2
Considerthebuyersuppliermodelwithconsignmentpaymentstructuresderivedpreviously.Repeatthe
aboveanalysisforthiscase,i.e:
a. Findtheprofitfunctionoftheintegratedsupplychain;
b. Findthevaluesof and thatmaximisethisfunction.
Youwillfindthattheprofitfunctionoftheintegratedsupplychainisexactlythesame,andtherefore
also the optimal values derived above apply. This gives an important insight: the payment structures
betweenthefirmsinasupplychaindonotaffecttheirintegratedprofitfunction!
Homework
Considerthesetofmodelswehavelookedatsofar,andmakeupyourownfeasiblecombinationofa
singlesuppliersinglebuyermodelandrepeattheaboveanalysis,i.e.determinetheintegratedsupply
chainprofitfunction,andderivetheoptimalpolicythatwillmaximisethisfunction.
2.13 Using the NPV framework to include other cost components

TheNPVframeworkalsoallowsfortheconsiderationofothercostcomponents.Weillustratewithafew
examples,usingtheEOQmodelasourbasecasescenario.
Material handling and insurance
A variable material handling cost e (/product) for each product placed in inventory, paid upon
receivingthebatch
Acost directlyproportionaltotheaverageinventorylevel(e.g.thecostofinsuranceagainstfirefor
theaverageamountofinventoryheld),tobepaidase.g.acontinuousstreamattherateof /2
(/year).
TheASfunctionfortheEOQmodelisadaptedto:
35
1
2
Thustheoptimallotsizebecomes:
andtheholdingcostsaretobecalculatedasfollows:
Ingeneral,wecanhenceidentifytwodifferentcomponentsofholdingcosts:
a. Thefinancialcostofkeepingstock,arisingfrominvestmentsmadeintoproductsstored,herethe
term
;
b. Outofpocketholdingcosts,arisingasrealexpensestobemadewhenplacingproductsinstock;
here .Notethatthesecostsneedtobeafunctionofthestockpositioni.e.thecorresponding
annualcostneedstovarywith .
It is generally accepted that in many practical situations the financial holding costs are much larger
than the outofpocket holding costs. That is also why in many models outofpocket holding costs are
simplyignored.
Price elastic demand functions
Finaldemand foraproductcouldbeafunctionofprice .Forexample,onepossiblefunctionis(for
0):
where and are positive constants. If the retailer with an EOQ model could decide on the price
,thenthereisthepracticalconstraint:
asotherwisetheretailerwouldnotmakeanyprofits.
TheretailerthushastheASprofitfunction:
Onewaytosolvethisproblemistakingpartialderivativesto and andsolvethenonlinearsystem

oftwoequations.Amorepragmaticapproachwouldbetoapplythefollowingalgorithm:
1. Input:Valuesfor , , ,andafunction
withmaximumprice
,
2 ,,
2. Forasequenceofprices ,
2.1. Determine
2.2. Usethistocalculate
2.3. Calculate
,
3. Retainthatpricethatgivesthehighestvaluefor
36
Credit elastic demand functions

Sometimes firms will offer a delay of payments in order to boost demand. In the simplest case, the
completeamount hastobepaidfor timeunitsafterthepurchase.Assumethatthefunction
is
known.TheASfunctionfortheretailernowbecomes:
1
1
TofindtheoptimalvaluesforLandQ,thefollowingpragmaticalgorithmcouldbeused:
1. Input:Valuesfor , , , andafunction
withmaximumcreditperiod
2. Forasequenceofdelayvalues 0, , 2 , ,
2.1. Determine
2.2. Usethistocalculate
2
2.3. Calculate
,
3. RetainthatLthatgivesthehighestvaluefor
References
GRUBBSTRM,R.W.1980.APRINCIPLEFORDETERMININGTHECORRECTCAPITALCOSTSOFWORKIN
PROGRESSANDINVENTORY.INT.J.OFPRODUCTIONECONOMICS18(2),259271.
BEULLENS, P. AND JANSSENS, G.K. 2011. HOLDING COSTS UNDER PUSH OR PULL CONDITIONS THE
IMPACTOFTHEANCHORPOINT.EUROPEANJOURNALOFOPERATIONALRESEARCH215,(1),115125.
BEULLENS, P. 2014. REVISITING FOUNDATIONS IN LOT SIZING CONNECTIONS BETWEEN HARRIS,

CROWTHER,MONAHAN,ANDCLARK.INT.J.OFPRODUCTIONECONOMICS155,6881.
BEULLENS, P. AND JANSSENS, G.K. 2014. ADAPTING INVENTORY MODELS FOR HANDLING VARIOUS
PAYMENT STRUCTURES USING NET PRESENT VALUE EQUIVALENCE ANALYSIS. INT. J. OF PRODUCTION
ECONOMICS157,190200.
37
3 IL in Buyer-Supplier Supply Chains
3.1 Onetoone shipping

ThisstrategyinvolvesshippingproductsfromalocationAtoalocationB,bylettingavehicle(truck,taxi,
train,ship,airplane)takingafeasibleandoptimalroute,typicallythecheapestorfastest.
Let us assume that the vehicle is dedicated to the transaction, i.e. during its trip it will not make
detours or perform other transportation duties. It is then also called Direct Shipping (DS) or linehaul
shipping.
Figure 5: One-to-one shipping (Direct shipping, line-haul shipping, FTL shipping)
Thetransittimeisthetimethegoodsareunderwayfromthesourcetothedestination.Itisingeneral
thesmallestrelativetoothershippingstrategies(discussedlater).
Becauseavehicleisdedicatedtothissingletransportationjob,itisingeneralonlyjustifiablefroma
costperspectivetotransportsmallamountswhentheproducttransportedhasahighvaluedensity(/m3
or/kg)orwhenitneedstoarrivefast(emergencyshipment).Itisnotunusual,forexample,todispatcha
privatejetorhelicopterforthetransferofhumantransplantorgansinordertosavealife,ortodelivera
singlesparepartbytaxiinordertopreventexcessivedelaysforapassengerairflight.
Forgoodswithlowervaluedensity,directshippingisonlycosteffectivewhenavehiclecantransport
a large enough amount. Therefore this strategy is sometimes also referred to as FullTruckLoad (FTL)
shipping,althoughitisnotrestrictedtoroadtransport,norisitalwaysoptimaltoshipinquantitiesthat
fillupthevehiclescapacity.
3.1.1
Shortest Path Problem
FindingtheoptimalroutefromAtoBcanbemodelledasaShortestPathProblem(SPP).TheSPPcallsfor
findingtheshortestpathfromanoriginnodetoadestinationnodeinaconnecteddirectedgraphG=(N,
A) with node set N and arc set A and where every arc a A has a nonnegative length. Shortest path
problemscanbeefficientlysolvedusingDijkstrasalgorithm.
4
2
4
2
1
2
3
3
Figure 6: A shortest path problem
38
Figure 6 shows an example of a shortest path problem. There are six nodes in the graph numbered
from1to6,andsevenarcs,whereeacharcsdirectionandlengthisalsoindicated.Theheadofanarcis
thenodeadjacenttothearcsarrowhead,andtheotheradjacentnodeofanarciscalledthearcstail.
Dijkstras Algorithm
Tofindtheshortestpathfrominsuchgraphfromsomeoriginnodetosomedestinationnode,wecan
useDijkstrasalgorithm:
Dijkstras
Algorithm
1. Associatewithallnodesatemporarylabelwithvalue
2. Startattheoriginnodebychangingitslabelto0andmakethelabelpermanent.Callit
thecurrentnode.
3. Foreveryarcgoingoutofthecurrentnodethathasaheadnodewithatemporarylabel,
replacethevalueofthetemporarylabelofthisheadnodewiththevalue:
min

,

4. Amongalltemporarylabellednodes,selectonewiththesmallestlabelvalueandmake
the label permanent. If this node is the destination node, stop, else call this node the
currentnodeandgobacktoStep3(iterate).
Theoptimaltotallengthisnowequaltothelabelvalueofthedestinationnode.Todetermine
theoptimalpath,startatthedestinationnodeandworkbackwardsinthegraphbyfinding
thearcwhichcostcorrespondstothedifferenceofthelabelsofitsheadandtailnodes.There
maybemorethanoneoptimalpath.
Appliedtotheproblemin Figure6,thealgorithmgivesthefollowingsequenceoflabelvaluesforeach
node (note that permanent label values are indicated with a*, and the position in the sequence
correspondstothenodenumber):
[]
[0*]
[0*43]
[0*43*]
[0*43*6]
[0*4*3*6]
[0*4*3*76]
[0*4*3*76*]
[0*4*3*76*8]
[0*4*3*7*6*8]
[0*4*3*7*6*8*]
Thelengthoftheoptimalpathisthus8.Theoptimalpathisderivedstartingfromnode6andgoing
backtonode5sincethelength2ofthatarcisequaltothedifferenceofitsheadlabelandtaillabels,2=
86.Itistheneitherpossibletogotonode2,sincethearcslength2=64,ortonode3sinceitsarcs
length3=63.Fromnode2wegobacktonode1.Fromnode3wewouldalsogobacktonode1.There
arethustwooptimalpaths:eitherthesequenceofnodes1256orthesequenceofnodes1356.
Note that all nodes in this examples have permanent labels at the end. This is not always so; in
generaltherecouldbenodesthatstillcarrytemporarylabels.Notealsothatthealgorithmstillworksif
theretherearemultiplearcshavingthesametailandheadnodes,aslongasweselectinStep3ofthe
algorithmtheshortestarcintheformula.
39
Thealgorithmfindstheoptimalsolutionsinceeverytimewemakealabelofsomenodejpermanent,
wewillhavefoundtheshortestpathfromtheoriginnodetothatnodejanditspermanentlabelvalueis
the length of this optimal path. The optimality of this path from origin to j is not depending on any
decisionsweneedtomakelateroninthealgorithm,andviceversa:iftheoptimalpathfromoriginto
destinationwouldpassnodej,thentheoptimalpathfromtheorigintojwillbecompletelypartofthe
optimalsolutionindependentofthedecisionmadeinthepathfromjtothedestination.Wecallthisthe
principleofoptimality.(Wewillfurtherdiscussconditionsunderwhichthisprincipleisnolongertrueand
thereforethealgorithmwouldnotbeapplicable.)
Different objective functions
Differentobjectivefunctionscanbeusedminimisingtotallength,timeorcostbylettingthelengthof
eacharcintheSPPcorrespondtoitsdistance,expectedtransporttimetocrossthearc,ortotalcostto
useit,respectively.Itiseasytoincorporateanyfixedcostsorfixeddelaysencounteredonarcs,suchas
ontollroads,attollbridges,andattolltunnels,oratbordercrossings(administration,bordercontrol).
Tachograph legislation
Fortrucktransportoverlongerdistances,attentionhastobepaidtothesocalledtachographlegislation
which requires drivers to take breaks and limits the total number of driving hours per day. Typical
constraintsmayincludethefollowing:
1. nomorethan2hoursofconsecutivedrivingisallowed;
2. 45minutesofresttimeneedstobetakeneitherafter2hoursofconstantdrivingorduringthe2
hoursofdriving(inbreaksofminimum15minuteseach);
3. totalnumberofdrivinghoursperdriveranddayisrestrictedto8hours.
Companiesmayhavethechoicebetweenusingtwodriversreducingtotalroutetimeorusingasingle
driver with longer total travel time. To minimise to total costs, one can run the SPP algorithm on the
graphusingonlytraveltimerelatedcostsforonedriverandthen,alsoknowingthetotaltraveltime,add
thecostsoftheextradriver,requiredbreaks,andresttimestofindthetotalcostandrealtotaltime.The
optionthatisthecheapestcanthenberetained.
Timedependent travel times
Theproblemofminimisingtotaltraveltimeingraphswithtimedependentexpectedtraveltimesonarcs
can be adequately modelled as a SPP if the start time at the origin node is given. The algorithm now
needstouseinStep3theexpectedtraveltimeofanarcbasedonthecalculatedexpectedarrivaltimeat
itstailnode.
Undertheassumptionthatvehiclesthatarrivelateratthetailnodeofanarccanneverarriveearlier
attheheadofthearcthenvehiclesofthesametypethatarrivedearlieratthetailnode,thealgorithm
finds the optimal path. The assumption is in general realistic for queue induced travel delays on roads
sincevehiclesofsometypeattheendofaqueuewillfinditverydifficulttobeatvehiclesofthesame
typeatthetopofthequeue.Theassumptionisknownasthenoovertakingproperty.Notethatthis
property implies that waiting at any node in the graph is never optimal. This approach also works for
when a desired arrival time at the destination node is given by letting the algorithm start at the
destinationnode,workingbacktotheoriginnode,andsubtractingtimesduringthesearch.
Tofindminimumcostsolutionsfortimedependenttraveltimesforwhichthenoovertakingproperty
holds, the travel cost must be monotone increasing with travel time and a given units of driving time
mustcostthesameasthesameunitsofwaitingtimeonnodes.Inthatcasethereisalwaysanoptimal
solutioninwhichnowaitingoccurs,andthusthealgorithmwillfindanoptimalsolution.
If waiting (i.e. resting) is less costly than driving, it may be optimal to wait for times with less
congestion on roads in order to minimise costs. However, waiting at some tail node means that
opportunities for faster driving may be lost on arcs closer to the destination. Thus, the principle of
optimalitynolongerholdsandotheralgorithmsaretobeused.
40
Multimodel transportation
MultimodaltransportationproblemscanbemodelledasSPPsbyassociatingwitheacharcinthegraph
thedatarelevantforaspecificmodeandvehicletype;multimodeltransfernodesareintroducedinthe
graph which connect the graphs of the different transportation modes. Each transfer node will add its
transfercostorexpectedtimeoftransfertotherelevantarcleavingthenode.ThenormalSPPalgorithm
willthenbeapplicable.
However,theremaybeotherconstraintsinpracticemakingthisapproachlessrealistic.Ships,trains,
andairplanestypicallytravelaccordingtoprespecifiedschedulesandroutesandsomeshipsortrainsare
cheaperthanothers.Itmaythusbecheapertowaitatatransfernodeforthecheapestvehicle(train,
ship)orroute.Thishowever,violatestheprincipleofoptimality.
Note. For calculating SPP on road networks, various internetbased resources can now be used. For
example,GooglemapshasafunctiontoallowyoutoseekforthequickestroutefromAtoB,whereyou
canspecifyyourstartingtimeandwhichtakesintoaccounttimedependenttraveltimes.
3.1.2
Economic Transport Quantity (ETQ)
Considerthesituationthatabuyerneedsregularsupplyofsomegood.Weconstructacostmodelforthe
situation of direct shipping of the product from a supplier to this buyer. We assume that the optimal
travelroutehasbeendetermined(ase.g.anSPP)andthatitscostandtotaltraveltimeareindependent
ofthetimeoftheyearatwhichitisundertaken.Wedenoteby thetotaltransittime.
WeassumeabuyerwithanEOQmodelandasupplierproducinglotforlotatafiniteproductionrate.
Wenowalsoconsidertheintermediatestagewheretheproductsareonavehicleintransit.Weplacethe
AnchorPointatthedeliveryofthefirstbatchtothebuyeratarbitrarytime .
T
Inventory
supplier
yT/R
....
Time
T
Inventory
intransit
L
....
Time
T
Inventory
buyer
L
....
Time
41
T
Cashflows
supplier
yT/R
wyT
....
Time
cR
T
L
Cashflows
3PL
....
0
Time

Cashflows
buyer
....
0
Time
Figure 7: Inventory positions and cash-flows in the direct shipping model
Weassumethatthetransportisundertakenbya3PLandthatthebuyerpaysthiscompanyafixed
transportcostpershipmentandavariabletransportcostthatdependsonthelotsizebeingshipped.The
buyerpaysthesupplierfortheproductsthemomentthatabatchisdelivered.Weassumethatnextto
setupcostsforloadingandunloadingthevehicle,the3PLalsoincursatransportcostatarate forthe
durationofthejourney.SeealsoFigure7.Thecapacityofthevehicleis .
We proceed by deriving the AS profit functions of the three firms involved from their cashflow
functions.Forthebuyer,wehave:
Forthe3PL,wefind:
42
Define:
1
Then:
Forthesupplier,finally,wederive:
Thisleadsto,aftersomealgebraicmanipulation:
Optimal threefirm solution

Ifthethreefirmsareinterestedindeterminingtheoptimalshippingstrategyfortheirintegratedsupply
chain, we can derive this from their supply chain profit function. This function is found from the
).Thisproduces:
summationoftheirprofitfunctions.(Asalways,assuming
Define:
Then:
Thisproducesanoptimalunrestrictedlotsize
However,sincethevehiclecapacityis ,theoptimalfeasibleEconomicTransportQuantity(ETQ)is:
min ,
43
Determining the value of

Theparameter isanannuitystreamcostrateandhenceneedstobeexpressedin(/year).Weshow
howtoincorporatetworelevantcomponentsincasethatthevehicleisaroadvehicle:driverwagesand
fuel costs. Driver wages are typically given in (/hr), so if a driver costs (/hr), then it has to be
convertedtoacostrate (/year)asfollows:
8760 ,
since there are approximately 24 365

8760 hours in one year (i.e. not counting years with an
extradayinFebruary).Fuelcostsaretypicallyexpressedin(/km).Therefore,afuelcost (/km)hasto
beconvertedintoarate (/year)byassuminganaveragespeedofthevehicleof (km/hr):
8760 .
Ifthesearetheonlyrelevantcosts,itwouldhenceproduce
.
Exercise
Determinetheoptimallotsizewhenthebuyerwouldindependentlybeabletodetermine .
.Thisproduces min
, where:
Inthatcase,thebuyerwouldaimtomaximise
Note.Observethattheunrestrictedoptimallotsizefortheintegratedthreefirmsolutionisafunctionof
thetransitleadtime.However,fortheabovesolutionforthebuyeritisindependentofthisleadtime.
Optimal solution when transport is outsourced
If the 3PL works independently and the supplier and buyer want to determine the optimal shipping
strategyforthemselvesastwofirms,wecanderivethisfrom:
Redefine:
Then:
Thisproducesanoptimalunrestrictedlotsize
However,sincethevehiclecapacityis ,theoptimalfeasibleresultis
min
44
Note
Ininternationaltransportbyseaitisoftenthatcasethatbuyerandsupplierneedtorelyona3PLforthe
shipping. Here, could be the maximum load of the product into one container. The 3PL may charge
differentratesbetweenshippingafullcontainerversusshippingafractionofacontainerload.
Homework
Derivetheoptimallotsizewhen:(1)buyerand3PLwouldseektofindtheirintegratedoptimalsolution;
(2)supplierand3PLwouldseektofindtheirintegratedoptimalsolution.
Note
Thesituationoflotforlotataninfiniteratecanberetrievedfromtheabovefunctionsbyconsideringthe
case .ThecasethatthesupplierproducesaccordingtoanEOQwithbatchdemandisretrievedby
setting
.
3.1.3
Maximum Economic Haulage Radius (MEHR)
Thereisalimitastohowfaronecanreasonablytransportacertaintypeofproductusingdirectshipping.
Ingeneral,thehigherthevaluedensityofaproductthefurtheritcanbetransportedinsmallquantities.
Thismakesitreasonabletousededicatedsmalltransportvehiclessuchassmallvans,taxis,orexpensive
vehiclessuchasaeroplanes.
Thelowerthevaluedensityofaproduct,theshorterthedistanceoverwhichitcanbeeconomically
transported.Tocoverlongerdistanceswouldneedshipmentsinlargequantitiessuchaslargetruckswith
asecondtrailerorbulktransportinabarge(inlandwaterways),orcontainertransportontrains(rail)or
ships (sea and ocean transport) where transport costs can be shared with other goods from other
companies.
Using the profit function to derive the MEHR
KnowledgeoftheASprofitfunctionallowsustocalculatethemaximumdistanceoverwhichaproduct
can be transported. Since
, only strictly positive value for will also produce strictly
positivevaluesforNPV.AsanyprojectisnotconsideredworthwhilebyacompanyifitsrespectiveNPV
wouldbecomenegative,theboundaryconditionwouldbethat:
,
0
Note that when

,
0, this does not mean that the company would not produce a positive
profitinaccountingterms.Itsimplymeansthatitwouldnotproducemoreprofitthanfromthenextbest
available alternative! If
0.20 then the firm would still gain a respective 20% of profits from this
activity.
We sketch the approach with the following example. Take the threefirm integrated profit function
derivedpreviously:
It is sufficient to focus on the function in between the square brackets. Furthermore, we can
substitute intothisfunction,producingtheboundarycondition:
0,
where
45
nowneedtocconsidertwocases.
Wen
Case
.
Thelotssizeisinotheerwordsaco
onstant.Itcaanbeobserve
edfromthea
abovefunctioonsthatwe havetwo
types off terms in th
he boundary condition: tterms that arre not a function of , aand terms th
hat are a
functionof
.W
Workingoutthisboundaryycondition,w
wewillhencefindaformuulaofthesortt:
wherreworkingou
uttheactualvvaluesfor aand isleftaasanexercise
etotheread er.Thismean
nsthat:
The righthand side

s
of this inequality w
would be the
e maximum economic h aulage radiu
us
expresseedin(years).Toconvertth
histoadistannce,youneed
dtoconsiderrthetypeofvvehicleused.
.
Case
Substituttionofthereesultfor
derivedprreviouslywou
uldproducettheconditionn:

he maximum possible vallue of . Ho

owever, a
It maay be difficult to derive an analytic result for th
practicall approach would
w
be to use
u an algoritthm where you
y would increase unttil the righth
hand side
reducestozero.(Similartothealggorithmspressentedatthe
eendofSection2.13).
3.1.4
er N differen
nt items from
m a CrossD
Docking Faciility (CDF)
Optimal policy to orde
CrossD
DockingFacility
Inboundtransport
1
Outboundtransport
Figurre 8: Cross-Do
ocking Facility
y
46
A CrossDocking Facility (CDF) is typically located near the boundaries of a populated area. It receives
goods in (large) vehicles from various suppliers; these incoming goods are separated and mixed as
required at the CDF, and subsequently sent out in vehicles without being held in storage to different
destinationsinthelocalarea.
Thecrossdockingoperationsmayrequirelargeareasinthewarehousewhereinboundmaterialsare
sorted,consolidated,andstoreduntiltheoutboundshipmentiscompleteandreadytoship.Ifthistakes
severaldaysorevenweeksitisnotconsideredaCDFbutawarehouse.InmostCDFs,goodsdonotstay
longerthan48hours.
Optimal order policy for N items received from a CDF
Considertheproblemwhereyourfirmrepresentsstockingpoint2inFigure8.Yourfirmhasademandfor
N different types of items (i = 1, ..., N). For each item the uniform annual demand rate of your
customers is yi and your cost price is . You order each of these items from the CDF. Each time a
vehiclefromtheCDFvisitsyourfirm,however,youhavetopayafixedtransportcost .Whatwouldbe
theoptimallotsize fororderingeachitem?
Sinceyouhaveconstantannualdemandforeachitem,youhaveanEOQtypeproblemforeachitem.
YourASprofitfunctionforitem ,wheneachitemisorderedseparately,isthenarguablyofthefollowing
form:
For each delivery, the CDF charges a setup cost , and that is why in the above function we have
.Yourtotalprofitfunctionwouldthenbethesumoverallitems:
Couldtherebeabetterwayofordering?Isitperhapsworthwhiletoordersomeitemstogetherinto
onetrip?Thiswouldsafeontransportationcharges .
Property.AnoptimalpolicycontainsschedulingperiodsTiofequallength,i.e.Ti=TforalliN.
Proof. Suppose the theorem does not hold. Let T designate the smallest scheduling period which
happens to be for item k, i.e. T = Tk < Ti ( i k). Consider now an item j for which Tj > T and let the
averageinventorycarriedofthisitembeE(Ij)
.
NowsupposewedecreaseitsschedulingperiodtoTj`=T.Theaverageinventorywilldecreasefrom
E(Ij) to E(Ij`). Since the replenishment cost is independent of the quantity ordered, no additional
replenishmentcostisincurredforreplenishingitemtypejeveryTj`=Tunitsoftime.Hencetheglobal
costwilldecrease.
SinceanoptimalpolicycontainsperiodsTofequallength,wehave:
Andweget:
47
Wefind:
And:
3.2 Onetomany shipping

3.2.1
Length of an optimal TSP tour visiting many customers
Drawonapieceofpaperasquare.Callthisyourserviceregion.Indicatethexandyaxis(see
Figure9).Wearbitrarilytakethelengthofthesidesequalto1m,sothattheserviceregioncoversanarea
of1x1=1m2.
(x1,y1)
0
(x1,y1)
(x1,y1)
(x1,y1)
x
0
Figure 9: Randomly distributed points in a rectangle.
Nowdrawarandomnumberfromtheinterval[0,1]andcallthisx1.Drawasecondrandomnumber
from the interval [0, 1] and call this y1. Use these coordinates to draw a point (x1, y1) in your service
region. Repeat this procedure. Now you will have a second point located at some coordinates (x2, y2).
Continue until you have generated n points in your service region. Figure 9 shows the exercise at four
differentstages,i.e.forn=5,n=10,n=15andn=20.WecallthesetofnpointobtainedXn:
X n {( x1 , y1 ), ( x2 , y2 ),...., ( xn , yn )}
Drawatourthroughyournpoints,visitingeachpointonlyonceandreturningtothefirstcitywhere
youstartedasin Figure10.Notethateachtimeyouleaveapointyouhavetodecidewhichpointtogoto
next.Youcanthusconstructseveraldifferenttours,allhavingadifferenttotaldistance.Infact,thereare
(n1)!/2differentpossibletoursthroughnpoints.
48
Figure 10: A TSP tour through 9 points.
Suppose we are interested in that tour of which the total distance travelled is minimal. If n grows
large, the number of possible tours becomes excessively large and we cant just find the best tour by
tryingallpossibletoursandretainthebestone.
We call this problem of finding the shortest tour through n points the Travelling Salesman Problem
(TSP).TheTSPisoneoftheclassicproblemsinOperationalResearch.
Without knowing the optimal tour itself, let us call the length of the optimal TSP tour T*(Xn) in our
exampleofrandomlydistributedpointsinasquareofarea1.ThenBeardwoodetal.(1959)provedthat
whenyoumakenverylarge,theratioT*(Xn)/ n becomesconstant.Inotherwords,forverylargen:
T *(X n ) n
wheretheconstantisbelievedtobe0.7124.
Infact,thisalsoholdsforaserviceregionofmoreirregularshapes(asinFigure11).IfAisthearea
(m2)ofaserviceregionofanyfiniteshape,then
T *(X n )
An
Figure 11: Locations randomly distributed in a service region.
49
Finally,theresultisevenmoregeneralthanthat.Thepointsdonotneedtobedrawnfromauniform
distributionacrosstheservicearea,anydistributionwilldo.TheTheoremofBeardwoodetal.(1959)is
giveninFigure12.
Theorem BBH. (Beardwood et al., 1959). If T*(Xn) is

the length of the optimal travelling salesman tour
through n points which are independently drawn from
an identical distribution over a bounded region a
of the Euclidean plane, then there exists a constant
such that with probability one
lim
T *(X n )
n
where the integration is with respect to the

Lebesgue (area) measure. For the uniform
distribution over [0,1]2, the integration term is
equal to one.
Note:0.7124(Johnsonetal.,1996,PercusandMartin,1996).
Figure 12: Theorem of Beardwood et al. (1959).
Example 1
Aprintedcircuitboardof20cmby10cmneeds1000littleholesdrilledinit.Drillingisperformedbya
moving pin. What is the expected distance that the pen needs to travel? Assume that the holes are
uniformlydistributedacrosstheboard.
UsingtheTheorem,wegetforA=200cm2,n=1000
T *(X n )
An 0.71 200(1000) 318cm
Example 2
In his small van, an express courier has small packages destined for 250 customers located across
Hampshire.AssumethatHampshirecovers22500km2andcustomersareuniformlydistributed.
a)Estimatethedistancetobetravelledtodeliverallmail.
b)Giveareasonableestimateofhowlongitisgoingtotakethecouriertodeliverthemail.
c)Whatwillbetheresultofdividingtheworkupinfivevans,eachcoveringanequalpartofHampshire?
a)UsingtheTheorem,wegetforA=22500km2,n=250
T * ( X n ) An 0.71 22500(250) 1690km
b)Takinganaveragedrivingspeedof50km/hour,totaltraveltime=1690km/(50km/hr)=33.8hours.
Inaddition,itmaytakeourdriveratleastoneminuteforeverycustomertomakethedelivery,which
addsanother250min=4.2hourstothetotaldeliverytime.
c)Thedistancetravelledbyeachdriver,sincenowA=22500/5km2andn=250/5
T * ( X n ) An 0.71 (22500 / 5)(250 / 5) 1690/5=338km
Takinganaveragedrivingspeedof50km/hour,totaltraveltime=338km/(50km/hr)=6.76hours.A
drivernowvisitsabout50customers,whichshouldkeeptotalworkingtimeperdriverwithin8hours.
50
3.2.2
Expected length of an optimal TSP tour visiting a few customers
Computationaltestsforuniformlygeneratedrandomcustomersinasquareareafindthattheformulaof
Beardwoodetal.alsoservesasagoodpredictionfortheexpectedoraverageoptimalTSPtourlength
evenwhennisrelativelysmall(Eilonetal.,1971,seealsoHaimovichandRinnooyKan,1985).
Figure 13: Few customers uniformly distributed in a square.
Figure13showsthreeexamples.Thefirstrowshowsfourdifferentinstancesforn=5.Thelengthof
theoptimalTSPtourinallfourwillbedifferent,say Ti * (i=1,,4).Theaveragelength,however,canbe
expectedtobe
1 4 *
Ti
4 i 1
An
A5 0.71 5
Example
A pizza takeaway also makes home deliveries using scooters. On average there are 10 home delivery
ordersperhour,randomlylocatedina50km2serviceregionlocatedaroundthepizzarestaurant.
a) Estimate the average total distance a scooter will travel to deliver 3 orders and return to the
restaurant.
b) Estimate the average total time needed for a scooter to deliver 3 orders and return to the pizza
restaurant.
c) Estimate the minimum number of scooters needed when a scooter will deliver on average to 3
customerspertrip.
d)Estimatethetimewhenthescooterarrivesatthethirdcustomeronitstrip(relativetoitsstartingtime
attherestaurant).
a) With three customers plus the restaurant, n = 3 +1, and A = 50, the formula gives us an estimated
averagetimeofvisitingthreecustomersinthebestsequenceastominimisetraveldistance:
51
An 0.71 50(4) 10 km
b)Assumingtheaveragespeedofascooterisaround35km/hour,totaltraveltimeis10/35=0.28hour=
17min.Assumingittakes4minutestodeliveratacustomerlocation,itwilltakeintotalonaverage17+
12=29minutesorabouthalfanhourtomakethedeliverytrip.
c)Ittakesonescooterhalfanhourtodeliverto3customersandinthesametime10/2=5neworders
arrive.Thereforeoneneedsminimum2scooters.(Inordertobeabletoperformalldeliverieswithone
scooter,theaveragenumberofdeliveryordersneedstodropto6perhour,orsmaller.)
d)Thetotaltraveltimeof17minpertripisdividedover4legs,andthethirdcustomerisreachedat
theendofthethirdleg.Thescooteristhereforeexpectedtoarriveaftertravellingatotaltimeof
(17)=12.75min.However,wehavetoaddtothisthetimeistakesfordeliveringthefirstandsecond
order,intotal8min.Thereforethetimeofarrivalatthethirdcustomerisestimatedtobe12.75+821
min.afterleavingtherestaurant.
3.2.3
Continuous approximation of an optimal vehicle routing solution
Inphysicaldistribution,goodsneedtobedeliveredusingvehiclesoflimitedcapacity.Intheonetomany
shipping mode, a vehicle will deliver to more than one customer during one trip. In the socalled
Capacitated Vehicle Routing Problem (CVRP) (Dantzig and Ramser, 1959), all vehicles have the same
capacity.TheCVRPconsistsoffindingasetofvehicleroutesofminimumcostsuchthat:everycustomer
isservicedexactlybyonevehicle,eachroutestartsandendsatthedepotandthetotaldemandserviced
by a route does not exceed vehicle capacity. The CVRP, like TSP, is a classic problem in Operational
Research.
To find an optimal set of routes for the CVRP is a difficult problem that can require a lot of
computationaltimeforlargeproblems.Oneoftenmakesuseofheuristicsi.e.methodsthatcanfindina
relativelyshorttimeagood,butnotnecessarilyoptimal,solution.Good(nearoptimal)solutionstypically
look like in Figure 14 a: the total service region is divided into a number of districts; and customers
belongingtoonedistrictareservedbyoneandthesamevehicle,asindicatedinFigure14b.
Agoodapproximationforthedistancetravelledbyavehicleservingadistrictiis(Daganzo,1984):
Di* 2ri (ni ) Ai ni
whereAiisthesizeofthedistrict, ri istheaveragedistancefromacustomerindistrictitothedepot,
niisthenumberofcustomersinthedistrict,andthedimensionlessfactor (ni)dependsonthemetric
andthenumberofcustomersinthedistrict.Forni6andtheEuclideanmetric, (ni)isaconstant =
0.57,andforsmallervaluesofni,theparameterbecomeslargerandgoestoabout0.73forni=2(see
Campbell,1993).Thefirstterm 2ri representsthelineandbackhauldistancetravelledbythevehicle
fromthedepottothecentreofdistrictiandback.Thesecondterm
(ni ) Ai ni
representsthelocaldistancetravelledtoserviceallcustomersinthedistrict.Thecompleteformula
*
for Di is accurate when the density of points is (nearly) uniform over the service region; the density
shouldnotvarymuchoveradistrict(Daganzo,1984,Campbell,1993).
In particular,assuming identical vehicles and unit loads and a uniform density of the locations over
theareaAoftheserviceregion,thetotalroutedistanceoveralldistrictsis(takingthesum):
52
D * 2r
n
(q) A n
q
where r is the average distance between a customer and the depot, q is the number of customers
*
serviced per vehicle, and n is the total number of customers. The above formulas for Di* and D also
holdforsituationswherethedepotwouldbelocatedoutsidetheservicearea.
a
AreaA
b
AreaAi
Backhaulri
Linehaulri
Depot
Figure 14: a) Service area, 18 districts, b) A vehicle serving district i

Example
The data are given in Table 1. If vehicles can serve about 5 customers on one tour, the total distance
travelled D * isapproximately(taking=0.57)
D * 2r
n
40
(q) A n 2 (48.62)
0.57 10000 (40) 1138.47 km
q
5
Thissolutionneedsn/q=40/5=8tours(orvehicles).
When vehicles are bigger or smaller quantities are delivered so that 10 customers can be served in
onetourbyavehicle,thenthetotaldistancetravelledbecomes
D * 2r
n
40
(q ) A n 2 (48.62)
0.57 10000 (40) 759.75 km
q
10
and4toursareneeded.
Approximation when customers order different quantities

Consider the situation where customers
1, , each order a quantity and the vehicles each
haveacapacity .Campbell(1993)foundthatDaganzosresultisfairlyrobustifthedistributionoforder
quantitiesisreasonablycentredarounditsaverage

:
53
Table 1: Data for example

2
Service area (km )

No. customers
Customer no.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
Total distance
Average distance
3.2.4
10000.00
40.00
Distance to depot
(km)
55.90
48.32
31.70
89.85
71.73
18.45
65.19
53.83
32.59
13.81
74.65
6.16
8.94
47.71
39.65
48.19
32.44
10.40
62.04
15.55
95.75
22.29
47.97
68.17
62.55
61.73
54.90
31.16
54.74
36.30
52.74
90.40
99.25
90.75
13.14
19.65
47.14
39.08
65.69
64.42
1944.92
48.62
Onetomany ETQ
We model the distribution from a supplier to buyers. The general optimal distribution pattern is a
difficultproblemforwhichageneralanalyticalsolutionisunknown.Weassumethatthebuyersorders
are small relative to the vehicle capacity, so that an optimal integrated solution would make use of a
CVRPtypesolution.Weassumethatthetotaltimeintransitisrelativelysmall.If,forexample,thetotal
transporttimeisonetoafewdaysonlyforasingledistributionround,theeffectintheNPVapproach
wouldremainfairlysmallsothatthisleadtimeeffectfromtransportcanbeeasilyignored.
If the buyers are located in close vicinity to each other relative to the suppliers location, then the
transportationcostislargelydeterminedfromthelinehauldistancebetweenthesupplierslocationand
54
the centre of these buyers, and this then resembles somewhat the problem we have seen before of
orderingNitemsfromaCDFwithacommontransportcost.WerecallfromtheproblemoforderingN
itemsfromaCDFthatinthatcaseitisoptimaltoorderallitemswiththesamecycletime .
Thismotivesustodevelopthefollowingmodelasdepictedinthefigurebelow.
T
yT/R
Inventory
supplier
....
Time
T
Inventory
Buyer
....
Time
T
Inventory
Buyer
....
Time
T
Cashflows
supplier
....
0
Time
s
cR
cR
T
Inventory
Buyer
0
....
Time
55
We further make the simplifying assumptions that all buyers order the same product from the
supplierandpaytheprice .
Wehaveforbuyer :
Forthesupplier,where
Theintegratedprofitfunctionacrosssupplierandallbuyers:
Onemustnowbeawareofthefactthat
solutionfromtheabovefunction.
isafunctionof ,sowecannotyetderivetheoptimal
Determination of
Thisisthecost()ofaCVRPsolutiontodeliverfromthesuppliertothe buyers.Itarguablyconsistsof:
a. Thecostforloadingavehicleatthesupplier, (/vehicle);
b. Thecostforunloadinggoodsateachbuyer , (/stop);
c. Thecostfordeliveringwithafleetofvehicles.
/ vehiclesontheroad,thetotalcostofthisis:
a. Sincethereare

b. Sincethereare stopstobemade,thetotalcostofthisis:
c.
The cost for delivering a fleet of vehicles are mainly arising from driver wages and fuel costs. The
totaldistancetravelledinanoptimalCVRPsolutionisapproximately:
0.57
0.57
56
With (km/hr)theaveragevehiclespeed,
wecanhencespecifythetravelcostas:
(/hr)thecostforadriver,and (/km)thefuelcost,
0.57
Wehencefind:
0.57
Substitionofthisresultintotheprofitfunction:
0.57
2
0.57
2
1
Afteralgebraicmanipulationthisgives:
0.57
0.57
2
1
2
2
Andtherefore:
0.57

Notethatthissolutionwillnotbefoundusingclassicinventorytheory.Thereasonisthatintheclassic
inventorytheory,theopportunitycostofthesetupcost wouldnotbeaccountedfor,andthisproves
intheabovederivationofcrucialimportancetoretrievethecorrectholdingcostsinthismodel,which
are:
2
1
.

57
Example
Consider an integrated supply chain of a producer of sports articles and a set of retailers, with the
followingcharacteristics:
Theproductioncostofsportsarticlesis1000/m3
Productionrateis20,000m3/yearandsetupcostis500/productionrun
Thereare45retailerlocatedacrosstheserviceareaofsize80000km2
Annualdemandateachretailshopisonaverage300m3/year
Thecostofastopataretailerisonaverage25
Thecostofdispatchingavehicle(loadingatthecentraldepot)is40
Allvehicleshaveacapacityof20m3
Thetotalvariabletransportcost(fromfuelanddriverwages)is0.5/km
Averagedistancebetweentheproductionfacilityandaretaileris160km
Thevalueofsportsarticlesatconsumersalespricesis1500/m3
Theopportunitycostofcapitalis20%.
Inanoptimaldistributionpatternfortheintegratedsupplychain,whatwouldbe,approximately:
a)Thenumberoftimesperyeararetailshopwillbesupplied?
b)Theshipmentsizeperretailerdeliveryandthenumberofvisitsonevehiclewillmakeononeround
trip?
c)Theyearlynetprofit?
d)Thetotallogisticscostofdistributionperyear?
Donotonlyprovideanumericalanswer,butshowwhichanalyticalformulasyouhaveused,andstatethe
assumptionsonwhichtheyarebased.
Solution
WeadoptthemodeldevelopedinLNp.57.(LN:LectureNotes.)Hencethemainassumptionsare:
1. UseofNPVprofitfunctionswithAnchorPointattimeofdeliveryoffirstbatchtoretailers
2. Conventionalandsymmetricpaymentstructuresthroughout
3. Productionmodel:lotforlotasinMonahan(1984)withonelotcorrespondingtothetotalfreight
loadoverallvehiclesusedinonedeliveryround
4. AdeliveryroundastheoptimalsolutiontoaCVRPwithvehiclesloadedatfullcapacity,inevery
deliveryeachretailerisvisited
5. A continuous approximation model as in Daganzo (1984) to estimate the cost of the CVRP
solution,forretaillocationsapproximatelyuniformlydistributedovertheserviceregion
6. Leadtime in transit is not in the model since it is assumed small compared to average time a
product spends waiting at the production site and at the retailer before it is sold to customers
(needstobecheckedafterwardsseenoteonp.60)andthenitsimpactonholdingcostscanbe
ignored
7. EachretailerhasanEOQmodelasinHarris(1913)
a) Wefirstdeterminethetimebetweentwodeliveryroundsfrom:
0.57

2 500
0.2 1,000 1
1,125 0.57 0.5 3,600,000

13,500
40 2 160

0.5 13,500
20,000
20
20
0.03083
11.3
58
32.4
/
Thereforeeachretailerisvisitedabout
.
b) Itwilldependoneachretailersannualdemandratesince:
Theexpectedquantitydeliveredperstop,foranaverageretailer,is

300 0.0308
9.23 /
The number of stops each vehicle will make depends on the annual demand rate of the set of
retailersitvisits,asthisdeterminesthelotsizedeliveredtoeach.Aroughestimate,assumingallretailers
haveademandrateclosetotheaverage:
20
2.17
/
9.23
c) ThelinearapproximationoftheASprofitfunctionfortheintegratedsupplychainisasonLNp.57,
andisanapproximationofthenetprofitperyear:
0.57
0.57
2
1
and a numerical value is found from evaluating the above equation using the optimal distribution
cycletime .Thisislefttothereader.
Notethatthevalueof isanunspecifiedarbitraryconstant,soyoucanonlyfindanumericalresult
for the equation in between the square brackets. It is, however, possible to determine the smallest
feasiblevaluefor :
.
,
0.208
76
And therefore, if your evaluation of the equation within the square brackets leads to a numerical
valueof ,theannualprofitscantbelargerthan
0.96 /
.
d) Thelogisticscostsfortheintegratedsupplychainarefoundfromsubtractingfromtheresult inpart
c)theannualmarginalprofit:
Since
1,500 /
,theannualmarginalprofitisequalto:
1,500
1,000 45 300
6,750,000 /
59
Thenumericalevaluationislefttothereader.Ifthisfindsalogisticscostof /
asinpartc)above.
correctedwithfactor
,itshouldalsobe
Note
Isitreasonabletoneglecttheimpactoftheleadtimeintransitonholdingcostsintheaboveexample?
Leadtimeintransitcanbeestimatedfromthreecomponents:
1. Anestimateforthetimeofloadingavehicleatthedepot.At40dispatchcosts,assumingdriver
ispaidatfullcostofaround20/hour,itwilltakenolongerthan2hours.
2. ThetotaldistancetravelledasinLNp.56:
0.57
0.57
Weneedtoestimate,however,thetimeittakesforonesinglevehicleasthisiswhatcountsforevery
singleproductstimeontheroad.
Sincethereare
vehiclesontheroad,theaveragetimespendonthelinehaulpartofasingle
160 .Ataconservativespeedof
50 /
thisparttakes3.2hours.
vehiclerouteis
The average local distance travelled by one single vehicle is the total local distance travelled,
0.57
,dividedbythenumberofvehicles,
0.57
0.573,600,000
52.1
45 9.23

20
Atanaveragespeed(oncityroadswithsomecongestion)of
35 /
,thiswilltakeabout
1.5
.Theaverageproductwillspendabouthalfthistimeinthevehicle.
3. An estimate for the time of unloading at each retailer. At 25 for unloading, driver wages of
20/hour plus one extra person at retail shop at same rate, this wil take about 38 minutes
0.6
.
Intotal,wearriveatanapproximationofthetimeaproductspendsintransitbysummationofthe
aboveresults:
1.5
0.6 6.55
2 3.2
2
Theaveragecycletimeis11.3
(foraproduct,halfofthistimeisspendintheproductionsite,
andhalfofthistimeisspendattheretailer).Sotheassumption6onp.58isreasonable.
Homework
Consider the data of the example on p.58. Now consider an individual customer located at a distance

from the production site. Use a direct shipping ETQ model (LN. p 41) to anwser the following
questions:
a) In an integrated supply chain of production site, 3PL, and this retailer only, what is the optimal
delivery quantity to this retailer as a function of ? (Hints: (1) Insert the numerical values of all
knownparametersinanappropriateformula;(2)becarefultonotconfusedistancewithleadtime,
i.e.
.)
b) Whichofthefollowingtwostatementsiscorrect,andwhy:(X)Ifthedistanceissmallerthansome
critical value then it is optimal to not fill the vehicle at full capacity, i.e. the optimal delivery
quantityislowerthanthevehiclecapacity;or(Y)Ifthedistanceislargerthan thentheoptimal
deliveryquantityislowerthanthevehiclecapacity?(Hint:Usetheresultobtainedfromanswering
parta)todetermineanumericalvaluefor atwhichpointitbecomesoptimaltofillthevehicleup
tocapacity.)
60
4 Strategy in the supply chain: Alliances

versus Leaders
4.1 Alliances
Anallianceisapartnershipbetweentwoormorecompaniesinwhichboththerisksandrewardsofthe
cooperation are shared. Alliances may be formed when it is thought to lead to long term strategic
benefitsforallpartnersinvolved.
One problem with alliances is to reach an agreement about how exactly the risks and rewards are
shared.Suchanagreementshouldbe(considered)fairbyeachpartner,otherwisethealliancemight
break down.However, it is difficult to define fairness: there aremany ways in which fairness can be
defined in a seemingly objective way. Therefore a single universal method to devise such a fair
agreementdoesnotseemtoexist.
In this section, we discuss two solution concepts to determine a way for sharing risks or rewards
amongpartners:thecoreandtheShapleyvalue.Beforewedothis,weneedtointroducesomeconcepts
fromcooperativegametheory.
4.1.1
Cooperative game theory
Source: WINSTON, L.W. 1994. OPERATIONS RESEARCH: APPLICATIONS AND ALGORITHMS (3RD ED.).
DUXBURYPRESS,CALIFORNIA.ISBN0534209718.(CHAPTER15)
Let there be a set of n players N ={1, 2, , n}. A game between these players is specified by its
characteristic function. The characteristic function v(S), for every subset S N, is defined as the total
rewardthatthemembersofScanbesureofreceivingiftheyacttogetherandformacoalition.
Example 1: The Drug Game
Joe Willie has invented a new drug. Joe cannot manufacture the drug
himself, but he can sell the drugs formula to company 2 or company 3. The
lucky company will split a $1 mio profit with Joe Willie. Find the
characteristic function of this game.
Solution
Letting Joe Willie be player 1, company 2 be player 2, and company 3 be
player 3:
v({})=v({1})= v({2})= v({3})= v({2, 3})=$0
v({1, 2}) = v({1, 3})= v({1, 2, 3}) = $1000000
Example 2: The Garbage Game
Each of 4 property owners has one bag of garbage and must dump it on
somebodys property. If b bags of garbage are dumped on the coalition of
property owners, the coalition receives a reward of b. Find the
characteristic function of this game.
Solution
61
The best that the members of any coalition S can do is to dump all of their
garbage on the property of owners who are not in S. With |S| denoting the
number of players in S, the characteristic function
v({S})= - 4 + |S|
v({S})= - 4
(if |S| < 4)

(if |S| = 4)
Example 3: The Land Development Game

Player 1 owns a piece of land and values the land at $10000. Player 2 is a
subdivider who can develop the land and increase its worth to $20000.
Player 3 is a subdivider who can develop the land and increase its worth to
$30000. There are no other prospective buyers. Find the characteristic
function for this game.
Solution
Any coalition that does not contain player 1, who owns the land, has a
worth or value of $0. Any other coalition has a value equal to the maximum
value that a member of a coalition places on the piece of land:
v({})= v({2})= v({3})= v({2, 3})=$0
v({1}) = $10000; v({1, 2})=$20000; v({1, 3})=$30000
v({1, 2, 3})=$30000
ConsideranytwosubsetsAandBofNsuchthatAandBhavenoplayersincommon(AB=).In
manygames,thefollowinginequalityholds:
v({A,B})v({A})+v({B}).
This property of the characteristic function is called superaddivitity. It is often a valid assumption,
because if the players in A B form a coalition, one of their options (but not necessarily their only
option)istoletplayersAfendforthemselvesandletplayersBfendforthemselves.Thiswouldresultin
thecoalitionreceivinganamountv({A})+v({B}).Thusv({A,B})mustatleastbeaslargeasv({A})+v({B}).
Assume that we know the characteristic function. The problem now is to find a reasonable and
acceptable way to divide the reward v(N) between the n partners. Often, the solution concept is build
around finding a reward vector x = { x1, x2, , xn}, in which xi specifies the reward for player i of the
coalition.Theminimumconditionsforxtobereasonablearethefollowing:
(GroupRationality)
v(N)=x1+x2++xn
(IndividualRationality)
xiv({i})(foreachiN)
GroupRationalitysaysthatthesumofindividualrewardsgiventoeachplayerneedtosumuptothe
total value that can be attained by the supercoalition consisting of all players. Individual Rationality
means that each player needs to be at least as best of as when not participating at all within any
coalition,becauseotherwisethisplayerwillindeedplayonitsownandearnv({i}).Ifthesetwoconditions
hold,therewardvectorisalsocalledanimputation.
Example 4
Let there be two players, N = {1, 2}, with the following characteristic
function:
v({1}) = 100, v({2}) = -50, and v({1,2}) = 70.
Questions
a) Does superadditivity hold?
b) Find an imputation.
62
Solution
a) Yes because v({1,2}) v({1}) + v({2}) since 70 100 -50
b) For x = { x1, x2} to be an imputation, we need
1) group rationality i.e. x1 + x2 = 70
2) individual rationality i.e.
x1 100 and x2 -50
An imputation therefore is e.g. x1 = 110 and x2 = 70 - x1 = - 40
x
($10000, $10000, $10000)
($5000, $20000, $5000)
($10000, $20000, $0)
($10000, $0, $20000)
($30000, $0, $0)
($12000, $19000, -$1000)
($11000, $11000, $11000)
Is x an imputation?
Yes
No, x1 < v({1})
Yes
Yes
Yes
No, x3 < v({3})
No, v(N) < x1 + x2 + x3
Asolutionconceptforannpersongameisthespecificationofhowtochoosesomesubsetoftheset
ofimputations(possiblyempty)asthesolutiontothegame.Wediscusstwosolutionconcepts:thecore
andtheShapleyvalue.
Core
Thecoreofthegameisthesetofallimputationswhichareundominated.Amorepracticaldefinition
ofthecorefollows:
Animputationxisinthecoreifandonlyif:
S N : xi v S
iS
ThecoreisthesetofimputationsforwhichalsoSubgroupRationalityholds.Takingarewardvector
fromthecorewillavoidthesituationinwhichsomeplayerswouldliketoformasubgroupandfendfor
themselvesbecausetheycouldbebetteroffbyexcludingsomeotherplayers.

x
($10000, $10000, $10000)
Is x an imputation?
Yes
($10000, $20000, $0)
Yes
($10000, $0, $20000)

($30000, $0, $0)
Yes
Yes
Is x in the core?
No, because {1, 3} could
do better by themselves
No, because {1, 3} could
do better by themselves
Yes
Yes

Find the core of the game.
Solution
For this game, x = { x1, x2, x3} will be an imputation if and only if:
x1
x2
x3
x1
0
0
0
x2 + x3 = 1000000
63
For this game, x = { x1, x2, x3} will be in the core if and only if in
addition:
x1
x1
x2
x1
+
+
+
+
x2
x3
x3
x2
1000000
1000000
0
x3 1000000
The unique solution is ($1000000, 0, 0). The core emphasises the importance
of player 1. The core contains a single solution.
Remark: Consider the game with only two players and show that the core of
the game now puts less emphasis on player 1.
Example 2: The Garbage Game

Solution
Requirements for imputation:
x1 -3
x2 -3
x3 -3
x4 -3
x1 + x2 + x3
In addition:
x1 + x2 -2
x1 + x3 -2
x1 + x4 -2
x2 + x3 -2
x2 + x4 -2
x3 + x4 -2
x1 + x2 + x3
x1 + x2 + x4
x1 + x3 + x4
x2 + x3 + x4
+ x4 = -4
-1
-1
-1
-1
The system of equalities has no solution. Indeed, note that the last four
inequalities can be added together, which gives:
3(x1 + x2 + x3 + x4) -4
But this can never holds since in order to be an imputation,
x4 = -4. Therefore the core of this game is empty!
x1 + x2 + x3 +
Remark: Consider the game with only two players and show that the core is
not empty and equal to (-1, -1) !
Solution
For this game, x = { x1, x2, x3} will be an imputation if and only if:
x1
x2
x3
x1
$10000
$0
$0
x2 + x3 = $30000
64
For this game, x = { x1, x2, x3} will be in the core if and only if in
addition:
x1
x1
x2
x1
+
+
+
+
x2
x3
x3
x2
$20000
$30000
$0
x3 $30000
The solution is the set of imputations ($20000 x1 $30000, $0, $(30000x1)). The core contains an infinite number of solutions.
In conclusion, the core can be empty, contain one unique solution, or have an infinite number of
solutions.Asaresult,thecoreleavesstillroomonthenegotiationtable.
Shapley Value
TheShapleyvaluegiven,incontrasttothecore,alwaysauniquerewardvectorx={x1,x2,,xn}where:
xi
pn (S)v S {i } v S
all S for which

i is not in S
where
pn S
S ! n S 1!
n!
and|S|isthenumberofplayersinS,andforn1,n!=n(n1)2(1)
Althoughtheequationseemscomplex,ithasasimpleinterpretation.Supposethatplayers1,2,,n
arrive in random order. Then, any of the n! permutations of 1, 2, , n has a 1/n! chance of being the
orderinwhichtheplayersarrive.
Supposethatwhenplayeriarrives,heofshefindsthattheplayersinthesetShavealreadyarrived.If
player i forms a coalition with the players who are present when he arrives, player i adds
v S {i } v S tothecoalitionS.Itcanbeshownthattheprobabilitythatwhenplayeriarrivesthe
playersinthecoalitionSarepresentis pn S .TheShapleyvalueimpliesthatplayersirewardshouldbe
theexpectedamountthatplayeriaddstothecoalitionmadeupofplayerswhoarepresentwhenheor
shearrives.
Find the Shapley value.
Solution
Player 1. First, list all coalitions S for which player 1 is not a member.
For each of these coalitions, we compute v S {i } v S and pn S .
pn S
vS {i} vS
{ }
2/6
$0
{2}
1/6
$1000000
{3}
1/6
$1000000
{2, 3}
2/6
$1000000
65
Since player 1 adds on average

(2/6)(0)+(1/6)($1000000)+(2/6)($1000000)+(1/6)($1000000)=$4000000/6
the Shapley value concept recommends that player 1 receive a reward of

$4000000/6.
Player 2. First, list all coalitions S for which player 2 is not a member.
For each of these coalitions, we compute vS {i} vS and pn S
vS {i} vS
pn S
S
{ }
2/6
$0
{1}
1/6
$1000000
{3}
1/6
$0
{1, 3}
2/6
$0
The Shapley value concept recommends that player 2 receive a reward of

$1000000/6.
Since v({1, 2, 3}) = $1000000, Player 3 will receive a reward x3 =
$10000000 x1 x2=$1000000/6.
Note that, compared to the core in which all the money went to player 1,
the Shapley value gives a more equitable solution.
Alternative solution method for Shapley Value ***RECOMMENDED**

Forgameswithafewplayers,itmaybeeasiertocomputeeachplayersShapleyvaluebyusingthefact
thatplayerishouldreceivetheexpectedamountthatheorsheaddstothecoalitionpresentwhenheor
shearrives.
Forathreeplayergame,thegeneralapproachistofillinthistable:
Order
of
Cost Added by Players Arrival
Arrival
Player 1
Player 2
Player 3
1,2,3
v({1})
v({1,2})-v({1})
v({1,2,3}-v({1,2})
1,3,2
v({1})
v({1,2,3}-v({1, 3})
v({1,3})-v({1})
2,1,3
v({1,2})-v({2})
v({2})
v({1,2,3}-v({1,2})
2,3,1
v({1,2,3})-v({2,3})
v({2})
v({2,3})-v({2})
3,1,2
v({1,3})-v({3})
v({1,2,3})-v({1,3})
v({3})
3,2,1
v({1,2,3})-v({2,3})
v({2,3})-v({3})
v({3})
Thevalueassignedtoeachplayerisnowthesumofitscolumndividedbythenumberofrows.

Find the Shapley value.
66
Order
Amount Added by Players Arrival
of Arrival
Player 1
Player 2
Player 3
1,2,3
$0
$1000000
$0
1,3,2
$0
$0
$1000000
2,1,3
$1000000
$0
$0
2,3,1
$1000000
$0
$0
3,1,2
$1000000
$0
$0
3,2,1
$1000000
$0
$0
Since each of the six orderings of arrivals are equally likely, the
expected amount added by each player is the average of its column.
Example 5: Runway
Suppose three types of planes (Piper Cubs, DC-10s, and 707s) use an
airport. A Piper Cub requires a 100-yd runway, a DC-10 requires a 250-yd
runway, and a 707 requires a 400-yd runway. Suppose the cost (in $) of
maintaining a runway for one year is equal to the length of the runway.
Since 707s land at the airport, the airport will have a 400-yd runway. How
much of the $400 annual maintenance cost should be charged to each plane?
Solution
Let player 1 = Piper Cub, player 2 = DC-10, player 3 = 707. We can now
define a 3-player game in which the value to a coalition is the cost
associated with the runway length needed to service thee largest plane in
the coalition. The characteristic function therefore is:
v({})=$0
v({1})=-$100
v({2})= v({1, 2})= -$150
v({3})= v({1, 3})= v({2, 3})= v({1, 2, 3})=-$400
Order
of
Cost Added by Players Arrival
Arrival
Player 1
Player 2
Player 3
1,2,3
$100
$50
$250
1,3,2
$100
$0
$300
2,1,3
$0
$150
$250
2,3,1
$0
$150
$250
3,1,2
$0
$0
$400
3,2,1
$0
$0
$400
The Shapley value concept suggests that Piper Cub pay $33.33, the DC-10
pay $58.33, and the 707 pay $308.33.
Note. In general, it has been shown that for more than one plane of each
type, the Shapley value for the airport problem allocates runway operating
costs as follows: all planes that use a portion of the runway should divide
equally the cost of that portion of the runway. Thus, all planes should
cover the cost of the first 100 yard of runway, the DC-10s and 707s should
pay for the next 150-100=50 yard of runway, and the 707 should pay for the
67
last 400-150 = 250 yard runway. If there were ten Piper Cub landings, five
DC-10 landings, and two 707 landings, the Shapley value concept would
recommend that each Piper Cub pay 100/(10+5+2) = $5.88 in landing fees,
each DC-10 pay $5.88+50/(5+2) = $13.03, and each 707 pay $13.03 + 250/2 =
$138.03.
Exercise 1
Three companies consider a strategic alliance which has the following characteristic cost function: v(1)
=10,v(2)=20,v(3)=30,v(1,2)=25,v(1,3)=32,v(2,3)=45,v(1,2,3)=50.
a. How much of the total cost would each company carry when they would adopt the Shapley value
method?
b. Check the collaboration for stability are there any companies or subcoalitions who might wish to
breakfromthegrandcoalitionandwhy(not)?
Solution
a.
arrival
123
132
213
231
312
321
cost
Player1
10
10
5
5
2
5
6.17
Player2
15
18
20
20
18
15
17.67
Player3
25
22
25
25
30
30
26.17
b.Individualrationality=ok;Subgrouprationality:v(1.2)>6.17+17.67=23.84;v(1,3)<6.17+26.17=
32.34(slightly);v(2,3)>17.67+26.17=43,..Subgroup(1,3)causesinstabilityandmightbreakoff(asmall
incentiveonly).
Exercise 2
Three companies (A, B, and C) have their depot in the harbour of Rotterdam, from which they supply
theircustomersintheNetherlands(anareaof10 km2):CompanyAhas300customers,CompanyB200
customers,andCompanyC100customers.Allthreecompaniesusesimilarvehiclesof10toncapacity.
The average demand for company A is 0.5 ton/customer, for B 1 ton/customer, and for C 0.5
ton/customer.Assumethatallcustomersareuniformlydistributedovertheareaandthattheaverage
distancefromthedepottoacustomeris220km.Weignorethecostofloadingandunloadingandusea
costof0.5/kmforthetransportcost.
a) EstimatethedistancetravelledfordeliverytoallcustomersifcompanyA,B,andCdonotcooperate
witheachother.
b) Estimate the distance travelled when company A, B, and C would cooperate and share the same
vehiclesfordistributingtotheircustomers.
c) Use the Shapley value to allocate the total transport cost under cooperation to each of the
companiesA,B,andC.
Solution
a) UsingDaganzosapproximationformulaforaCVRPsolution(LNp.53):

68
ForA:
2 220
ForB:
2 220
ForB:
2 220
300 0.5
10
200 1
10
100 0.5
10
0.57 10 300
0.57 10 200
0.57 10 100
b) For{A,B,C}(calculatetheaverageloadinthelinehauldistanceterm):
3 0.5
2 1
1 0.5
600
6
2 220
0.57 10 600
, ,
10
c) Transportcostforcoalition is0.5 .Thecharacteristicfunctionvalueforgrandcoalitioncanbe

foundfrompartb),andfortheindividualfirmsfromparta).Forthesubcoalitions,applythesame
approach:
3 0.5
2 1
500
5
2 220
0.57 10 500
,
10
3 0.5
1 0.5
400
4
2 220
0.57 10 400
,
10
2 1
1 0.5
300
3
2 220
0.57 10 300
,
10
Workouttheaboveformulastofindthenumericalvaluesofthecostsforeach(sub)coalition.Thenfill
inthetablefortheShapleyvalueasintheaboveexamples.Thisislefttothereader.
Homework
Thenetbenefitfromcooperationbetween playerscanbedefinedas:
1, 2, . . ,
<forcostgames,usenegativevaluesfor . >
Prove that for any cooperative game with two players, the Shapley value will assign half of the net
benefitobtainedfromcooperationtoeachplayer.
(Hint: adapt the table format developed for the three player situation on LN p. 66 to a twoplayer
situationandthenshowthateachplayer getsitsoriginalvalue
plushalfthenetbenefit.)
<Note.Thisisingeneralnottrueforgameswithmorethantwoplayers.>
69
Exercise 3
Three companies A, B, and C wish to explore how they could benefit from sharing rented warehouse
space.Itcosts1perm2offloorspaceandpermonthifrentedonayearlybasis,while1.5perm2and
permonthifrentedonamonthlybasis.Table1listsmonthlyspacerequirementsforeachofthethree
companies.
Table1:Warehousespacerequirements(m2floorspaceneededpermonth)
Month
A
B
C
Total
January
100
50
10
160
February
100
50
10
160
March
100
50
10
160
April
100
50
10
160
May
50
100
10
160
June
50
100
10
160
July
50
100
10
160
August
50
100
10
160
September
0
0
200
200
October
0
0
200
200
November
0
0
200
200
December
0
0
200
200
Total
600
600
880
2080
a) Findthecharacteristicfunction.
b) UsingtheShapleyvalue,determinehowthesecompaniescouldsplitthecostsofrentingwarehouse
spacetogetherasonevirtualcompany.
c) Isthecoalitionstable,orwillsomecompaniesorsubcoalitionstrytobreakofffromthiscoalition?
Justifyyouranswer.
Solution
a) LetA=1,B=2,C=3.
Method:Ifcompany1rentsforoneyearishastorent100m2for12monthsat1/m2,thuscosting
1200peryear.Ifitrentspermonth,itwouldrent100m2for4months,and50m2foranother4months
at1.5/m2,thuspaying900peryear.Thusv(1)=min{1200,900}=900.
Similarly:
v(2)=v(1)=900,
v(3)=min{2400,1320}=1320,
v(1,2)=min{1800,1800}=1800,
v(1,3)=min{2400,2220}=2220,
v(2,3)=v(1,3)=2220,
v(1,2,3)=min{2400,3120}=2400.
b) Shapleyvaluetable:
arrival
A=1
B=2
C=3
123
900
900
600
132
900
180
1320
213
900
900
600
231
180
900
1320
312
900
180
1320
321
180
900
1320
cost
660
660
1080
70
c) Checkingstabilitymeanscheckingwhethereachsubcoalitionneedstopaylessthanifitwouldgoby
itself. Thus: v(1)>=600, v(2)>=660, v(3)>= 1080, v(1,3)>=660+1080, v(1,2)>=660+660,
v(2,3)>=660+1080.Therefore,thecoalitionisstable.
(Thethreecompaniesshouldrenttogetheraspaceof200m2forawholeyear.Theextracapacityin
thefirst8monthsmeanstheyalsohavetheflexibilitytousemorespaceifneeded.)
4.1.2
Alternative methods
ThereexistsawealthofothermethodsintheliteraturebesidesthecoreandShapleyvalueapproaches.
Aquitepopularapproachinpractiseisthesocalledproportionalallocationmethod.Thisapproachaims
toleteachpartnerinthecooperationpaycoststhatareproportionaltothispartnersuseoftheshared
resources,whilemakingsurethatallthecostinthesystemareallocated.Thisseemsveryintuitivebut
may cause problems of the coalition being unstable. Indeed, the method does not give any assurance
that partners working by themselves or with only a few of the partners in the coalition are better off
usingthecooperativesystem.Ifpartnersbreakawayfromthecoalitionitisnotagoodthingbecause,for
superadditivegames,thegrandcoalitioncanachievegloballymoreefficientoutcomes.
There exist also a variety of methods that are based on cooperative game theory but use other
mechanismstofindthedistributionoftherewardsofcooperation.Mostofthesetechniques,suchase.g.
thenucleolus,arehowevermoremathematicallychallengingthattheShapleyvalue.
Finally, there is a specific strand of research that investigates the efficiencyfairness tradeoff, see e.g.
Bertsimasetal.(2012)articleOntheefficiencyfairnesstradeoffpublishedinManagementScience58
(12).
4.2 Twoparty alliances in the supply chain

Inordertoapplythecooperativegametheoryframeworkforasituationofasupplier anditsbuyer ,
wewillneedtofindthecharacteristicfunctionsofthefollowingcoalitionalsets:
;
;
,
Whatmakesthissituationsomewhatspecialcomparedtothepreviousexamplesinthischapteristhat
these parties, even when `working alone, remain in a relationship in which they exchange physical
goodsandcashwitheachother.Evenifthesepartieswouldact`independently,theiractionscantbe
completely independent and at least one of them is going to have to consider which actions are
undertaken by the other party. Care should hence be taken when defining the characteristic function
value of a player acting alone how we specify the assumptions of this working relationship and the
orderofdecisionmakingeventsinsucha`statusquoscenario.Thefollowingexampleillustrates.
4.2.1
Twoparty alliance: example
WeconsideranEOQtypebuyeranditssupplierasinthemodelofGoyal(1976).Wewillusetheprofit
functionsoftheplayersunderconsignmentarrangements,functionswehavedevelopedforthiscasein
Section 2.11.Inaddition,weincorporateamaterialhandlingcost perunitofproductasinSection2.13
forthebuyer,paiduponreceivingabatchtoanoutsidethirdparty(i.e.notpaidtothesupplier).Wealso
assumeamaximumcapacityonthewarehouseatthebuyer, .
71
Statusquoscenario
Todetermine
and
,weassumethatthebuyer,givenapaymentstructurewiththesupplier,
|
.Thesupplierwillthendeterminethe
thatmaximises
willfirstdeterminethelotsize

|
.
thatwillmaximise
,
lotsize
Wefind:If
1 2
0,thentheunconstrainedoptimallotsizeis
else
.Therefore,
min
,and:
|
Forthesupplier,given ,theproblemofidentifyingtheoptimalvaluefor isaswaspreviouslyderived

intheexerciseofSection2.7:
1
1
2
andhence:
Notethatthetotalprofitsmadeinthissupplychainunderthestatusquoscenarioare:
|
|

,
, |
Alliance
Thevaluefor
, isfoundfromconsideringthealliancebetweenbuyerandsupplierinwhichthe
, |
.
valuesof and aresimultaneouslyderivedastomaximise
Westartbyfollowingtheapproachofexercise1inSection2.12:
butthecapacityconstraintimpliesthat
min
.
72
Case1:Thehypothesisisthat
, |
.Substitutingthisresultinto

Hence,inthecasethat
0, 1.Inthecasethat
Section2.7.Weseekanintegervalue suchthat:
Thefirstcondition:
0,weapplythetechniquepresentedfirstin
1
1
issimplifiedto:
2
2
Wenowtakethesquareofbothsides,andsimplifytoobtain:
Rearrangingterms:
TheprocedurenowfollowsthesamelogicasbeforeinSection2.7,andwefind:
1
1
2
It can now be tested whether the assumption made holds. If it does, then the profit in the integrated
supplychainis:
, |
Case2:Thehypothesisisthat
.
73
Thederivationoftheoptimalvaluefor isverysimilartotheprocedureappliedinLNSection2.7:
1
1
2
And:
Shapleyvalue
Thenetbenefitofcooperationis
, |
, |

,
Inatwoplayercooperativegame,theShapleyvaluewillassignhalfofthenetbenefittoeachplayer(see
HomeworkLNp.69).
,
,thismeansthattheallocationshouldbe:
Withrewardvector
Exercise 1
Consider the supply chain of an EOQtype buyer and its EOQwithbatchdemandtype wholesaler. We
havethefollowingcharacteristics:
Annualdemandrateatbuyeris5,000products/year;
Salespricechargedbybuyertocustomersis40/product;
Capacityofwarehouseatthebuyeris800products;
Wholesalepricechargedbywholesalertobuyeris30/product;
Materialhandlingcostatbuyeris4/product;
Setupcostatbuyerperlotsizereceivedfromwholesaleris100/order;
Setupcostforwholesalertodeliveralotsizetobuyeris150/order;
Acquisitionpricechargedtowholesalerbyitssupplieris20/product;
Setupcostforwholesalertoreceiveabatchfromitssupplieris1000/order.
Opportunitycostofcapitalis20%.
Determinethevalueofanallianceforsupplierandbuyer,andusetheShapleyvaluetofindtheprofits
eachofthepartiesshouldearnunderthealliance.Dothisforthefollowingtwocases:
A. Inastatusquoscenariowherethepaymentstructurebetweenbuyerandsupplierisconventional;
B. In a statusquo scenario where the payment structure between buyer and supplier is full
consignment.
In each statusquo scenario, the buyer first determines its own optimal pattern of ordering from the
wholesaler,andknowingthis,thewholesalersubsequentlydeterminesitsownoptimalorderingpattern
fromitssupplier.
74
Solution
WeadoptthemodeldevelopedinLNp.7173.Hencethemainassumptionsare:
1. <thisislefttothereader>
3.
A. Conventionalpaymentstructure.
Thebuyerhastopaythewholesalerthefullprice whenaproductisdelivered.Thismeansthat,inthe
schemeasdevelopedinLNSection2.11,that
,and
0.
Since
1 2
30 4 0
wehaveforthebuyer:
min
2 100 5,000
, 800
0.2 30 4
min
min 383.5, 800
383.5
Thisgives:
|
383.5|0.2
4 5,000
100
40
30
30,000
1,303.8
5,000
383.5
10
0.2
100
2
1,303.9
0.2 30
27,382.3/
2
4
383.5
Forthewholesaler:
1
1
2
1
1
2
1
1
2
8 1,000 5,000
0.2 20 383.5
67.995
4.65
Therefore:
9|383.5,0.2
75
30
20 5,000
1,000
9
0.2 30
5,000
383.5
383.5
20

2
150
0.2
1,000 150
2
0.2 20 9
383.5
2
50,000 3,404.32 115 6,136.0 383.5 40,728.2/
For an alliance between buyer and supplier, we first test for which value of the buyers lotsize is
unconstrained:
800 ?
Numerical evaluation shows that for this to hold, it must be that

3. Since for
0, the value
using the unconstrained lotsize for produces 1, and given that is small relative to the other
costparametersinthemodel,wethinkitwillbeunlikelythatweareinCase1.Indeed,ifwecalculatethe
valueof fortheunconstrainedlotsizeweget:
1
1
2
1
1
2
1
1
2
4 1,000 4
100 150 20
3.2
1.52
Weseethatthiswouldproduceanunconstrainedvalue
800:
Case2,with
1
1
2
1
1613.7 .Wehencecalculateunder
1
1
2
8 1,000 5,000
0.2 20 800
2.54
40
20
4 5,000
100
0.2 20 2
2
80,000
150
4 800

4,687.5
125
1,000 5,000
800
2
3,520
2
0.2
100
71667.5/
150
2
1,000
76
Thenetbenefitfromformingtheallianceishence:

,
71667.5 40,728.2 27,382.3 3557/

TheShapleyvaluewillhencerecommendthatthisnetbenefitissharedequally.Thereforethenetprofits
ofbuyerandsupplierbecome,respectively:
3,557
27,382.3
29,160.8/
3,557
40,728.2
42,506.7/
The benefits of forming the alliance in terms of profit increase achieved might not seem much when
comparedtotheoverallprofitfiguresofthefirmsinstatusquo.However,notethatthisbenefithasbeen
realised solely by adopting a logistics strategy that works better for the integrated supply chain. It is
hencemoreinsightfultocomparethislogisticsbenefitrelativetothelogisticscostsofthefirmsinthe
statusquoscenario.Thisiswhatwedonext.
Thelogisticscostscanbefoundfromsubtractingthemarginalprofittermfromafirmsprofitfunction.
Forexample,forthebuyerthelogisticscostsinthestatusquoscenarioare:
2,617.7/

Therelativegainisthen:
3,557
2
100%
67.9%,
2,617.7
andthusthebuyersavesasaresult67.9%onitslogisticscosts.Similarly,wefindthatthelogisticscosts
forthewholesalesinthestatusquoscenarioare9,271.8/
,andthen:
3,557
2
19.2%,
100%
9,271.8
orthewholesalersaves19.2%onitslogisticscosts.
B. Fullconsignment.
The buyer has to pay the wholesaler the full price only the moment that a product is sold to its
customers. This means that, in the scheme as developed in LN Section 2.11, that
0 and
.
Since
1 2
4 0
wehaveforthebuyer:
min
2
1
min
2 100 5,000
, 800
0.2 4
min 1118.0, 800
800
Thisgives:
77
383.5|0.2
40
30
4 5,000
100
30,000
625
10
5,000
800
0.2
320
100
2
0.2 4
29,045.0/
800
Forthewholesaler:
1
1
2
1
1
2
8 1,000 5,000
0.2 20 800
2.53
Therefore:
9|383.5,0.2
30
1,000
2
20 5,000
0.2
20
2
150
800

2
5,000
800
0.2
1,000 150
2
0.2 20 2
2
1
800
2
50,000 4,062.5 115 1,600 1,600 42,622.5/
Foranalliancebetweenbuyerandsupplier,wenotethatthepaymentstructureadoptedbetweenthem
doesnotinfluencetheintegratedsupplychainprofitfunction.Wethereforefindthesameoptimalresult
800and 2andgivesatotalsupplychain
asinScenarioA.Werecallthatthisalsotakes
profitof71667.5/
.Thenetbenefitofanalliancewouldhencebe:
71667.5 42,622.5 29,045.0 0/
In other words, if the firms have adopted the full consignment scheme in statusquo, they derive no
benefitfromforminganalliance.
Note1.Underaconventionalpaymentstructure,bothfirmsdoworseinstatusquothatiftheywould
use a full consignment arrangement in statusquo. If you compare what the firms would get when
adoptingtheallianceunderaconventionalpaymentstructure,thenthebuyerwouldgainabitmorethan
workingunderthefullconsignmentschemeinstatusquo,andalsothesupplierwouldgainrelativelyless
thanwhathecouldgetusingafullconsignmentarrangementinstatusquo.
Inconclusion,startingfromastatusquoscenarioofconventionalpayments,thebuyerwouldpreferto
formanallianceandusetheShapleyvaluecriteriontodistributethenetbenefitsofthealliance,whereas
78
the wholesaler would rather want to propose the adoption of a full consignment payment structure,
withoutforminganalliance.
Note 2. From a practical point of view, changing the payment structure from conventional to full
consignmentismucheasierthanimplementingtheallianceandusingtheShapleyvalue.
In the alliance option, someone has to calculate the optimal scenario of the supply chain first, which
requires a party having knowledge of the integrated supply chain function. This party then needs to
enforce the buyer and wholesaler to select their decision variables and accordingly. This may be
difficulttoachieveifthelogisticsmanagersinbothfirmsareusedtoselectthelotsizesthatoptimises
theprofitfunctionsoftheirownfirms.Itmayseemtothemthatthedecisionsimposedastoarrivetothe
optimalsupplychainresultisnotwhatoptimisestheirownfunctions.(Indeeditoftendoesnot,priorto
establishingthenetbenefitsdistribution.)Thismaycauseinternalfrictioninthefirmsbetweengeneral
management and the logistics division. Then the problem arises of calculating the net benefit of the
supplychainandtoredistributethesesavingstobothparties.Infact,thenetbenefitof3,557/yearisan
annuity stream value, which means that both parties in effect need to receive payments that are
equivalenttosuchacontinuouscashflowthroughouttheyear.Onemaywonder,rightfully,howthisis
going to be established, since in practise there will not be a `central party that has such a source of
fundingavailable
Adoptingthefullconsignmentpaymentstructureinstatusquois,ontheotherhand,muchmoreinline
with what will be common practise in the firms. The logistics manager in the buyers firm will keep
selectingtheoptimallotsizethatmaximisestheprofitforhisfirm,andthenthelogisticsmanagerinthe
wholesalers firm will use this to calculate the optimal value of that will maximise the wholesalers
profit function. Under full consignment, furthermore, both firms realise that this process of sequential
andindependentlocaldecisionmaking,althoughnotoptimalingeneral,wouldinthiscaseindeedalso
be optimal for their integrated supply chain! There is furthermore no need for a central party to keep
track of net benefits and to redistribute these benefits between the parties, because under the full
consignmentpolicytheywillbothfairbetterinastatusquoscenariothanwhenusingtheconventional
paymentstructureunderastatusquoscenario.
4.2.2
Twoparty alliance: example 2
Consider the supply chain of an EOQtype buyer and a lotforlot producer. We have the following
characteristics:
Annualdemandrateatbuyeris5,000products/year;
Salespricechargedbybuyertocustomersis40/product;
Capacityofwarehouseatthebuyeris800products;
Transferpricechargedbyproducertobuyeris30/product;
Materialhandlingcostatbuyeris4/product;
Setupcostatbuyerperlotsizereceivedfromproduceris100/order;
Setupcostforproducertodeliveralotsizetobuyeris0/order;
Productionrateatproduceris10,000products/year;
Productioncostatproduceris20/product;
Setupcostforproducertoinitiateproductionis500/run.
Opportunitycostofcapitalis20%.
A. Determine the value of an alliance for producer and buyer, and use the Shapley value to find the
profitseachofthepartiesshouldearnunderthealliance.Dothisinacaseofaconventionalpayment
structurebetweenbuyerandproducer.
B. Nowassumethatbuyerandproducerkeeppayingeachotheraccordingtoaconventionalpayment
structurewhenadoptingthesolutionthatmaximisesthevalueofthealliance.Comparetheprofits
eachofthesefirmsearnwithyouranswertopartA.
79
Solution
WeadopttheETQmodeldevelopedinLNSection3.1.2,butdonotconsiderthe3PLinthemiddle.Hence
themainassumptionsare:
3.
A. Conventionalpaymentstructure.
where:
Instatusquo,thebuyerwillchoose:
2 100 5000
0.2 30 4
383.5
Thisgives:
40
30
4 5,000
100
5,000
383.5
0.2
100
2
0.2 30
383.5
2
27,382.3/
2
2
80
30
20 5,000
5,000
0
383.5
500
500 1
0.2
383.5

2
0.2 30
20
50,000
6,518.9
1
2
0.2 20
1 383.5

2 2
100
383.5
383.5
43,381.1/
Inthealliance,thelotsizethatmaximisestheintegratedsupplychainsprofitfunctionis:
2 100
1
500
0.2 20 1
0 5,000
1
4
2
939.3
40
20
4 5,000
600
5,000
939.3
0.2
1,100
2
0.2 20 1
1
2
939.3

2
80,000
3193.9
110
3193.9
73,502.2/
Thenetbenefitistherefore:
73,502.2
43,381.1
27,382.3
2,738.8/

TheShapleyvalueawardstheplayersthefollowingprofitswhenadoptingthealliance:
2,738.8
27,382.3
28,751.7/

2,738.8
43,381.1
44,750.5/

B. Using the conventional payment structure when adopting , the buyer and producer will get,
respectively:
40
30
4 5,000
5,000
939.3
0.2
532.3
10
100
100
2
0.2 30
939.3
2
30,000
3193.6
81
26264.1/
30
20 5,000
500
5,000
939.3
0.2
1,000
2
0.2 20
1 939.3

2 2
0.2 30
20
939.3

2
50,000
2661.6
100
939.3
939.3
47,238.4

Notethatthesumofprofitsearnedbybothplayersisstillequaltothesupplychainprofitof 73,502.2/
.
However,theproducerwouldreapmuchmoreofthebenefits.Thebuyerwouldearnevenlessthanits
earnings obtained in the statusquo scenario, and therefore this solution violates the condition of
individualrationalityforthebuyer.Itisveryunlikelythatthiscouldbeadopted(unlessthesuppliercould
enforceit.)
4.3 Perfect coordination

We have seen how for number of firms in the supply chain we can calculate the logistics policy that
wouldbe optimalfortheirintegratedsupplychain.Wedothisbyderivingtheintegratedsupplychain
profitfunctionanduseittodeterminetheoptimalvaluesofalldecisionvariablessimultaneously.
Wehaveseeninprevioussectionhowwecandistributethenetbenefitsoffullcooperationacrossthe
firms, based on cooperative game theory solution concepts such as the Shapley value. If this finds a
, ,,
thatsatisfiestheconditionsofgrouprationality,individual
rewarddistributionvector
rationality,andsubgrouprationality(i.e.iftherewardvectorisasolutioninthecore)thenthisreward
scheme is stable. In that case, no individual firm nor any subcoalition would do financially better by
breakingofffromthegrandcoalitionandactingontheirown.
Thisisnotalwayspossible.Therearegameswherethecoreisempty,andhencenostablerewardvector
existsthatcanofferthisstability.Thesesituationscanbehandledifthefirmsinthecoalitionwouldbe
abletoenforceacontractwherebyafirmwhichbreaksofffromthecoalitionwouldhavetopayafine.If
thefineislargeenough,thenetfinancialbenefitofbreakingoffwouldbecomenegative.However,we
donotfurtherexplorethishere.
The two examples in the previous section illustrated that the implementation of a reward distribution
vectorcanbedifficultinpractise.Thereasonisthatthefirmsinasupplychain,eveniftheywantedto
adopttheoptimalsolutionfortheirsupplychain,remainindividualfirmswiththeirownidentity.They
willlikelynotagreetosetupanoverarchingentitythatwouldcoordinatetheirwholesupplychain.This
entitywouldnotonlyhavetodictatetheoptimallogisticaldecisionstobetakenbyeachfirm,butwill
havetooverseethefinancialflowsexchangedbetweenthemsoastoendupwiththetargetedreward
distributionvectorthatwillendupdistributingthenetbenefitsfairlybetweenthefirms.
Itwouldbemucheasiertofindasolutionwherebythefirmswillretaintheirindividualdecisionmaking
power,butsuchthattheirindividualdecisionswouldleadtothelogisticspolicythatisoptimalforthe
integratedsupplychain.(Onesuchapproachwasadoptingafullconsignmentschemeforthesituationin
Section4.2.1.)
82
ThefollowingtwodefinitionsareadaptedfromChenetal.(2001).
Coordination mechanism
If the firms in a supply chain maintain decentralised decision making, a coordination mechanism is an
approachbywhichthestructureofcostsandrevenuesofeachindividualfirmareadaptedsoastofinda
betteralignmentofeachfirmsdecisionstotheintegratedsupplychainsobjectivefunction.
Perfect coordination
If the coordination mechanism achieves the result that the decentralised decisions also maximise the
integratedsupplychainsobjectivefunction,thecoordinationmechanismissaidtobeperfect.
4.3.1
Perfect coordination schemes: examples
We consider the situation of Section 4.2.2. The payment structure between buyer and producer is
conventionalinthestatusquoscenario.Recalltheprofitfunctions:
2
2
Solution 1
InChenetal.(2001)thecoordinationmechanismpresentedisbasedon:
1. Theproducerchargingthebuyeritssetupcostwheneverthebuyerplacesanorder
2. Tomodifythetransferprice
We now explore how this work. In the statusquo scenario, the buyer determines the lotsize
maximisingitsprofitfunction.Thetermsthatarerelevantforthisare:
by
When we observe the supply chain profit function, then the buyer would arrive at the correct lotsize
thatmaximisesthesupplychainsprofitfunctionifthesetermswere:
Takethedifference(asalways,assume

2
83
Forthebuyertoarriveatthecorrectlotsize ,wecanrestructurethebuyersprofitfunctionso
thattheabovedifferencebecomeszero.
1. Theproducercharginghissetupcosts
everytimethebuyerplacesanorder
Callthenewprofitfunctionofthebuyer . Weseethatthiswillproducetheresultthat
.
willdropoutof
2. Adaptthetransferprice :
Afterimplementingstep1,thedifferenceremainingissettozerotocalculatethevalueof :
Critical evaluation
If Solution 1 is adopted, what would be the profits of the firms? We keep assuming a conventional
paymentstructurebetweenthem.
Inordertoarriveatthecorrectprofitfunctionsofthefirms,weneedtomakeassumptionsaboutwhen
the producercharges his setups costs to the buyer. According to the conventional paymentstructure,
thiswouldhappenthemomentanorderisdelivered.
Afterananalysisofthenewcashflowfunctionsoftheplayers,andthederivationoflinearisedannuity
streamfunctions,weshouldfindthattheprofitfunctionsarenow:
1
2
2
2
ThesupplychainprofitfunctionisthesameaspresentedinSection 4.2.2.Recallthat 939.3.(You
. Hence:
canverifythat
1
5,000
600
1
939.3
40 20 1
4 5,000
600
0.2
0.2 20 1
4
2
939.3
2
2
2
30,000 3,193.9 60 3,193.6
23552.5/
84
20 1
1
2
500
1 939.3
0.2 20
2
2 2
939.3
20

20 5,000
0.2 20 1
1
2
0.2
50,000
50
939.3
939.3
49950.0/
RecallfromSection4.2.2:
27,382.3/
43,381.1/
27,382.3
2,738.8
2
28,751.7/
43,381.1
2,738.8
2
44,750.5/
Itcanbeobservedthatthebuyerwouldnotbehappytoadoptthisperfectcoordinationschemesince
under the statusquo scenario he could make more profits. To achieve the equal distribution of net
profitswhenadoptingthisperfectcoordinationscheme,thesupplierwouldstillneedtopaytothebuyer
anamountof:
49950.0 44,750.5
5199.2/
28,751.7 23552.5
Coordinationmechanismsthatrequiresuchsocalledsidepaymentsarenotidealbecauseitisdifficultto
arrangeforsuchsidepaymentstobeimplementedintherealworld.
In conclusion, perfect coordination should ideally not only look to ensure that decentralised decision
makingleadstothelogisticspolicythatisoptimalfortheintegratedsupplychain,itshouldatthesame
timeensurethatallpartiesareautomaticallyfinanciallyrewardedwithouttheneedtoresorttoanyside
payments.
Solution 2
ThissolutionissimilartoSolution1.ThesetupcostpaymentsarethesameasinSolution1.However,
insteadofchangingthetransferprice itself,wewillchangethepaymentstructurebetweenbuyerand
suppliersothatitsimpactontheholdingcosttermofthebuyerhasthesameeffectastoalignittothat
inthesupplychainprofitfunction.
RecallfromSection 2.11thatbytheintroductionofprices , , andparameter wecanfindprofit

functions that reflect the impact of consignment arrangements on the firms profit functions. If we use
thisschemeforthissupplychain,theprofitfunctionsareasfollows:
85
2
2
2
2
Therefore, an alternative implementation of Solution 1 is to keep the original price but select a
combinationof
1 2 suchthat:
1
astheamounttobe
Thiscanbedoneinaninfinitenumberofways.Forexample,choose
be
paid by buyer to producer the moment a product is delivered, and let the remainder
paidwhenthebuyersellstheproducttoitscustomers.
Ingeneral,suchanimplementationalterstheprofitfunctionsofbuyerandproducerlessbecauseintheir
marginalprofittermwestillretaintheoriginalprice.Thisislikelytoproduceresultsrequiring,inmost
situations,lesssidepayments.However,itcanonitselfnoteliminatethatsidepaymentsmaybeneeded.
Note.Whenapplyingthisschemetothenumericalexample,wehaveinthiscasethesameresultsimply
because
20 1
30/
30/
happens, by sheer coincidence, to be equal to
Solution 3
This solution will adapt Solution 1 and also make use of Solution 2s strategy to change the payment
structure.
We start by investigating what determines the optimal lotsize . We realise thisis given by the ratio
underthesquareroot:
Consideranonzeroconstant ,thenweachievethesame iftheratiowouldbe:
Property:When
0:
Maths refresher
Anaffinetransformationoverrealnumbersisafunction
: :

,
where and areconstants.
isafunctionof thatreachesitsmaximumin ifandonlyif
86
isafunctionthatreachesitsmaximumin .
Therefore,wewillalsoachieveperfectcoordinationbymakingthedifference
equaltozero:

1
0
2
2
Thisleadstothefollowingcoordinationscheme:
1. Thebuyerpaysthesupplierforeveryorderthesetupcostatthetimetheorderisdelivered:
2. Thebuyerpaystheproducerperproductupondeliverytheprice

themomentthattheproductissoldbythe
andinaddition,willpaytheremainder
buyertoitscustomers.
Notethatfor
1,thisschemeisexactlythesameasSolution1,safeforthefactthatwechangethe
paymentstructureinsteadofchangingthetransferprice itself.Weknowfromthecriticalanalysisthat
thebuyerwouldbe5199.2/
shortifimplementingSolution1.
3. Hencewedeterminethevalueof suchthat:
1
5199.2

Critical evaluation
WeworkouttheimpactofimplementingSolution3.
Afterananalysisofthenewcashflowfunctionsoftheplayers,andthederivationoflinearisedannuity
streamfunctions,weshouldfindthattheprofitfunctionsarenow:
Recallthat
939.3.(Youcanverifythat
40
30
4 5,000
600
5,000
939.3
. Hence:
0.2
600
2
0.2 20 1
1
2
939.3
2
30,000
3,193.9
60
3,193.6
87
Wherewerequirethistoequal
28,751.7/
20 5,000
0.2 20
. Itfollows:
1248.3
6447.5
0.1936 600
Wecancheck:
30
1 939.3

2 2
0.2 0.1936 20 1
0.1936
5,000
939.3
0.2 1
1
2
0.1936 4
48.2
50
939.3
20
0.1936
600
2
939.3

2
0.2
500
2
50,000
2575.6
1636.03
44750.4

Hence,thiscoordinationschemeisperfectandwillalsoprovidethefirmswiththefinancialprofitsthey
would receive when adopting the Shapley value distribution of netbenefits from adopting the optimal
solution of their alliance. It does not require that firms give up their independent distributed decision
makingprocesses,anditdoesnotrequiresidepayments.
Notethatwedonotnecessarilyneedtodividethenetbenefitequallybetweenthefirmsthisisonlya
requirementthatcomesfromtheapplicationoftheShapleyvaluetoatwoplayergame.Byadapting
wecanalsofindsolutionswherebythenetbenefitissplitinsomeprespecifiedbutnonequalsplit,e.g.
1/3 ofgoestooneplayer,and2/3oftotheotherplayer.
4.4 Leaders and followers

Theprevioussectionshavelookedintotheapplicationofcooperativegametheoryinthesupplychain.
Thisledtoseekingcoordinationmechanismsthatareperfectandrequirenoadditionalsidepaymentsfor
fairlydistributingthenetbenefitswhenadoptingthecoordinationmechanism.
Intherealworld,noteverysituationcanbehandledwithwhatwehaveseensofar.Therearesituations
inwhichoneofthepartieshasbargainingpower.Thisleadsthisfirmtotakeontheroleofaleaderinthe
supplychain,anditwillsetoutconditions(i.e.acontract)underwhichtheotherfirmsneedtooperate.
While leaders thus have the power to dictate to some degree how other firms should behave, it is
generallyacceptedthataframeworkofleadershipcannotignorethefactthateachfirmretainsitsown
decentralised decision making power. That is, each firm will look at its own profit function and make
decisionsaboutthosevariablesitcontrolsastomaximisethisfunction.Afirmcanalsostepawayfroma
proposalmadebyaleaderandthereforenotengageintheworkingrelationshipwiththisleaderbuttry
itschanceswithotherfirmsinstead.
4.4.1
Leaders and followers: Stackelberg games
TheframeworkofaStackelberggametakestheaboveconsiderationsofindividualdecentraliseddecision
making power into account. We illustrate in subsequent sections how Stackelberg leaders in a supply
chainwouldformulatetheirdecisionproblem.
88
ThekeyideaisthattheStackelbergleaderanticipateshowotherfirmswilltakedecisionsthatoptimise
theirindividualprofitfunctions,andknowingthis,theStackelbergleaderwillsetoutconditionssuchthat
thosedecisionsmadebyotherfirmsundertheseconditionswillmaximisetheprofitsoftheStackelberg
leader.
Therearetwoimportantconsiderationswewillfurtherexplorethroughinvestigatingsomeexamples:
1. How will a leader achieve that other firms are willing to adopt the contract? What are the
minimalconcessionsaleaderhastoofferotherfirms?
2. Whatisthebestpossibleoutcomeforaleader?Isitdifferentorequaltothelogisticspolicythat
isfoundfrommaximisingtheintegratedsupplychainprofitfunction?Istheprofitachievablein
anintegratedsupplychainanupperboundontheprofitthataStackelbergleadercanachieve?
WewillfirstderiveageneralmodelforonefirmasaStackelbergleaderandanotherfirmasthefollower.
betheprofitfunctionoftheleader,and
thatofthefollower.
Let
AssumethattheStackelbergleaderhaspoweroverdeterminingtheconditionsofworkingtogether.Let
theseconditionsbecalled ,where istheset(ordomain)ofallpossiblewaysinwhichtheleader
canspecifytheseconditions.Thefollower,giventheconditionsfromtheleaderasexpressedthrough ,
willaimtooptimiseitsownprofitfunction:
, ,
max
where isthesetofallpossiblewaysinwhichthefollowercansetitsowndecisions.Letthisoptimalset
of decisions that the buyer can make be represented by
. We can use the following
mathematicalnotationforthis:
,
arg max
NotethataccordingtotheNPVcriterionthebuyerasafirmshouldengageinactivitieswhentheNPVof
thisactivityisnonnegative.Hencewehaveanadditionalconstraintthat:
,
0
Sothisistheminimalconditionthattheleaderhastoofferthefollower!
Theleadertherefore,hastofindtheconditions underwhichthefollowersprofitremainsnonnegative
andsuchthatthedecisions , maximisetheprofitsoftheleader.
Itisalsoarequirementthatunder , theleadersprofitmustitselfremainnonnegative.
Hencetheleadersproblemcanbewrittenasfollows:
|
max
,
arg max
89
4.4.2
Stackelberg leader in the supply chain: examples
WewillusetheexampleusedpreviouslyinSection4.3.1andalsoinSection4.2.2.
Producer is Stackelberg leader

WeconsiderthesituationthattheproduceristheStackelbergleaderandthebuyeristhefollower.
Youmayrecallfromprevioussectionsthat istheonlylogisticaldecisioninthismodelanditissetby
thebuyer.Sowhatis,therefore,thepoweroftheleader?
Contractmenu
Wewillconsiderthattheleadercandeterminethefinancialarrangementsoftheworkingrelationships,
includingsettingtheprice foraproductandthetypeofpaymentstructureadoptedwiththebuyer.
Weinparticularassumethattheingredientsofacontracttheleaderwilloffer,i.e. ,isgivenasfollows:
1. Theproducerwillspecifyaprice perunitofproductthatthebuyerhastopayassetoutin
thecondition4.below;
2. Theproducerwillspecifyanonzerovaluefor thatgovernswhatthebuyerswillpayforand
how,assetoutinconditions3.and4below;
3. Thebuyeristopaythesupplierforeveryorderthesetupcostatthetimetheorderisdelivered:
4. Thebuyerpaystheproducerperproductupondeliverytheprice

themomentthattheproductissoldby
andinaddition,willpaytheremainder
thebuyertoitscustomers.
Inshort,theleaderhastochoosevaluesfor and .Thebuyerwillchoosetheoptimallotsize .
Solution
WenotethattheabovecontractschemeisaswhatwasusedinSolution3inSection4.3.1.Wehencecan
specifytheprofitfunctionsoftheplayersasfollows:
, ,
90
Tosolvethisgame,westartbyderivingtheoptimaldecisionforthefollower,givensomevalues
.Thesolutionthatmaximises
, , is:
and
Wesubstitutethisinto
Definethesquareroottermas
(logisticscostsofbuyer).
Intuitionsaysthatanoptimalsolutionfortheleaderwillaimtoextractallprofitsfromthebuyer,orin
,
0 is binding, i.e. the an optimal set , will make
other words that the condition

0.Thismeansthatifwesolvefor ,wefindthefollowingcondition:
,
Aninterpretationforthisisthattheleaderwillsetitspriceequaltothedifferencebetweentherevenue
per product received by the buyer and the total logistics costs per product experienced by the buyer.
With the numerical data of this example, we have
40/
, and for 1, we would get
40
1.2775 4
0.012 34.71/
.
Wenowlookattheleadersprofitfunction.Wetakeaccountoftheresultfoundfor .Wechoose
1.Wethenget:
1 ,
whichsimplifiesto:
Wesubstitutetheresultfor
2
2
andfind:
2
2
2
1
Noticethattheproducersprofitsarenowequaltooptimalsolutionoftheintegratedsupplychainprofit
asgivenon
function.(Recallthat istheoptimalsolutionforthealliance,andsubstitute into
LNSection4.2.1,Solution2).Ifyouusethenumericaldata,youwillhencefindthatunderthiscontract:
91
0/
73,502.2/
So,ifthereisvalueinthisactivityfromtheviewpointoftheintegratedsupplychain,asisclearlythecase
,
0isautomaticallyalsosatisfied.Furthermore,intuition
inthisexample,thenthecondition
saysthatthismustindeedbeanoptimalsolutionfortheStackelbergleader:thereisnomorevalueinthe
supplychainthenbyadoptingapolicythatisoptimalfortheintegratedsupplychainsothismustbean
upperbound.
Foranyotherchoicefor ,itcanbeshownthatthesameconclusioncanbereached.
Generalconclusion
It seems that we can conclude that a Stackelberg leader will extract maximum value by ensuring the
logisticspolicyimplementedisthatwhichmaximisestheintegratedsupplychainprofitfunction,andby
furtherspecifyingtherightmixoftransferpriceandpaymentstructuresuchthatalltheprofitachievedin
theintegratedsupplychaingoestotheleader.
Wehavemerelyusedanexampletoillustratethis,butitisthoughttoholdingeneral.
Buyer is Stackelberg leader

We consider the case that the buyer is the leader. The buyer will not only specify but will offer a
contractsettingoutthepaymentconditions.Weusethesamecontractschemeasinthepreviouscase,
butnow and arespecifiedbythebuyertoo.
Theproducerasfollowerhasnodecisiontotakebuttoconsidereithertoacceptthecontractorto
walkaway.
Weproceedasbefore,butnowwhenitcomestodetermining and ,weusethecondition:

0
, ,
Thatis:

Ifwechoose

2
2
1thisreducesto:
Therefore:
2
2
Aninterpretationforthisisthattheleaderwillsetthepriceitiswillingtopaytotheproducertobeequal
totheproducerunitcostperproductplusallotherrelevantlogisticscostsperproduct,whichareinthis
caseonlythefinancialopportunitycostofhissetups.With
20/
,thepriceofferedisjusta
!
fractionhigher,i.e. 20.01/
92
Substitutionof andthisvaluefor intothebuyersprofitfunctionshowsthatthebuyersprofit

nowequalthemaximumprofitobtainablefromtheintegratedsupplychainprofitfunction:
2
2
2
1
Numericalevaluationthusshowsthatadoptingthiscontractleadsto:
0/
73,502.2/
Thisisagaininsupportofthegeneralconclusion.
Critical evaluation
Dontrelyonasinglepowerfulbuyerorasinglepowerfulsupplier
AStackelbergleadergameismuchmore`unfairforanoutsiderwhowouldcareforbothfirmsequally
thanacooperativegame.Firmswhoareunderthreatfromfindingthemselvesinafollowersroleshould
anticipatethispotentialdevelopmentwellinadvanceandseekbusinessopportunitieswithotherfirms.It
isoneofthereasonswhygoodintentionstodevelopa`strategicrelationshipwithonepowerfulsupplier
or with one powerful buyer may turn sour. It is good advice that for strategic components of your
businessyouseektodeveloprelationshipswithmorefirmsthanjustone.
Avoidgettingtrappedwhenitrequiresinvestmenttobreakawayfromarelationshipwithaleader
Imaginethatyourfirmisasupplierofaparticularcomponenttoabigmanufacturer.Therelationshiphas
gonesowellthatyourfirmisnowdevelopingabespokecomponentforthismanufacturer.Asaresult,
thecomponentisofhighvalueforthemanufacturersoyoustillgetagoodprice.However,yourfirmhad
to configure your own manufacturing facility to a highly specialised degree, so you cant produce
componentsforotherpotentialclientsanymore.
If your firm wants to switch to producing for another client, your firm will need to invest in new
(itwillbeanegativevalue.)
technology.Lettheannuitystreamvalueofthisinvestmentcostbe
Nowifthecurrentclientmanufacturerrealisesthatyourfirmhaslockeditselfintobeingtoospecialised,
it can extort your firm even more, since the condition for your firm to reject any contract from the
currentmanufacture(seethegeneralmodelinSection4.4.1)nowbecomes:
Inotherwords,if
10,000/
,thenthemanufacturercanresettheboundarycondition
inhisleadersoptimisationmodelto:
,
10,000
Sotheleadercanextortyourfirmevenmore!
This is not entirely sustainable because your firm may have to lendmoney to compensate for liquidity
problemsandinthelongtermyourfirmmaygobankrupt.Theleadermayinfactnotcareforthisifthe
93
leaderhasatthesametimerelationshipswithothersuppliers.Onlyifyouasasupplierarevitaltoyour
clientmanufacturerwillyouprobablygetaslightlybetterdealsothatyourfirmdoesntgobankrupt.In
anycase,itisthenstillnotanentirelysatisfactorywayforyourfirm.
Itisforyourfirmhencenotsufficienttostressthatyourfirmisvitaltothemanufacturer(whenisthat
reallythecaseifthemanufacturerisaleader?).Yourfirmmustmakesureitcansomehowcreatethe
conditionunderwhichyourfirmcouldswitchtosupplyinganotherfirm,andmakesurethatthisisknown
tothecurrentmanufacturerasacrediblethreat,i.e.anactionthatyourfirmcanandiswillingtotakeif
necessary.
Anaccountingperspective
YoumaybescepticalabouttheStackelberggameswehaveanalysedinthesupplierbuyermodelsabove.
Inparticular,youmayfindthatusingtheboundarycondition:
,
0,
seemsunrealistic.However,thisonlymeansthattheannuitystreamprofitfunctionis settozero.You
maybemoreconvincedoftherealityofthisifweanalysetheaccountingprofitsofthefollower.Wewill
showthatundertheseconditionsthefollowerwilltypicallystillmakeapositiveaccountingprofit.
Wemustfirstrealisethefollowingimportantdifference:
1. The profit functions we have used are not those used in traditional accounting. Our profit
functionsreflectthenetbenefittodayoffuturecashflowsderivedfromanactivity,i.e.itistobe
usedtomakeoptimaldecisionsaboutthefuturedirectionsfor yourfirmundertherealisation
that there is a next best available alternative activity that the firm could invest its money in
instead.
2. Traditionalaccountinglooksontheotherhandintothepast,andrecordswhichcashflowshave
goneoutandcomeinoverafiscalyear,withoutconsiderationoftheactualtimingofthesecash
flowsnorofmakingacomparisonwithwhatwouldbethenextbestavailablealternativetothe
firm.
Ifweusethesameexampleasbefore,theaccountingprofitoverapastyearwillbefoundfromourAS
functions,beforesubstitutionofanyoptimalpolicy(!),bysettingtheopportunitycostofcapital
0.
(This is in fact a rough approximation of accounting profit, since e.g. we then do not account for any
inventoryattheendofthefiscalyear,depreciationofassets,etc.)
IfweconsiderthegamewheretheproduceristheStackelbergleader,theaccountingprofit
forthe
buyerwith 1is:
With
939.3
40
and
34.71
4 5,000
34.71/
600
5,000
939.3
,thisevaluatesto:
6450
3193.9
3256.1/
0,inaccountingtermsthefollowerwillstillendupwitha(small)profit.
Hencewhile
If we consider the game where the buyer is the Stackelberg leader, the accounting profit
supplierwith 1is:
20.01 20 5,000 50/

for the
94
Quitesmallindeed,butnotzero!
Includingallrelevantcosts
There is also another reason which may help sceptical readers look more favourably on using the
,
0.
boundarycondition
Inourmodelwehavenotconsideredfixedoverheadcostsofabusiness.Thatis,tobeabletoexecutean
activitysomemanagersandotheremployeesneedtodevotesomeoftheirtimetothisactivity.Thisis
not a direct variable cost because they are paid monthly salaries. These fixed costs are in part to be
allocatedtothecurrentactivityneverthelessinordertoreallyestablishtheprofitsobtained.
They are typically ignored in logistics models because these costs do not determine optimal logistical
parameterssuchasalotsize.However,infinancialtermstheywouldactuallyneedtobeincluded.Ifwe
wouldadaptourASfunctionaccordingly,thenaStackelbergleader,fromconsiderationoftheboundary
condition:
,
0
wouldarriveatsolutionswherebythetransferprice willnotbesetsosharplyasthosevaluewefound
inourexamplesinprevioussections.
95
5 Stochastic Models
Source: PETERSON, R. AND SILVER, E. 1985. DECISION SYSTEMS FOR INVENTORY MANAGEMENT AND
PRODUCTIONPLANNING.WILEY,NEWYORK.
5.1 When is the assumption of a constant demand rate valid?

Demandisoftenirregularorlumpy.Thismaybecausedbyseasonalityorotherfactors.Ifdemandis
irregular,theassumptionofhavingaconstantdemandrate,usedinalltheEOQmodels,mightperhaps
beinaccurate?
Suppose that d1, d2, , dn has been the observed demand during each of n periods of time. We
assumethatthisisrepresentativeforfuturedemandpatterns.
To decide whether demand is sufficiently regular to justify the use of EOQ model assumptions, the
followingtestisreportedinPetersonandSilver(1985):
1.DeterminetheestimateE(D)ofaveragedemandperperiod,givenby:
E(D)
1
n
i 1
2.Determineanestimateofthevariance2oftheperperioddemandfrom:
2 di2 E(D)2
n i 1
3.Determineanestimateoftherelativevariabilityofdemand,calledCV,thecoefficientofvariability:
CV
E(D)2
Notethatifalldiareequal,then2=0,andalsoCV=0.HencethesmallerthevalueofCV,themoreit
indicatesthatdemandfollowsaconstantdemandrateclosely.ResearchhasindicatedthatifCV<0.20
thentheuseoftheEOQassumptionofaconstantdemandrateisreasonable.
Example
Weuseasmallexampletoillustratethemethod.<Youwouldwanttousemorethanfourobservationsif
available.>Demandsduringfourquartersofthepastyearhavebeenasfollows:80units,100units,130
units,and90units.Iffuturedemandisknowntofollowasimilarpattern,istheassumptionofaconstant
demandrateappropriate?
E ( D)
1 n
1
di (80 100 130 90) 100
n i1
4
96
1
1 n 2
2
d i E ( D) (80 2 1002 130 2 90 2 ) 1002 350
4
n i1
CV
E ( D)
350
0.035 0.2
1002
In conclusion, the test indicates that it would be appropriate to use the assumption of a constant
demandrate.
5.2 (r, Q) reorder point models

In this section the assumption is made that demand isa random variable following a known normal
(Gaussian) probability distribution. This distribution is characterised by a mean value
and a
standarddeviation
.Thisprobabilitydistributionissymmetricalarounditsmean.
Note
If representsthedemandperyear,then
,where isthedemandratewehavebeenusingin
ourEOQtypemodelssofar.
The(r,Q)reorderpointmodelrepresentsawidelyusedinventorysystem.ItisalsoknownastheTwo
BinSystem.Itsoriginscanbetracedbacktothepracticeofstoringthestockofanitemintwostorage
bins, as a visual inventory control device. Emptying the first bin is the signal to the stock keeper to
reorderafixedreorderquantityQ,andthecontentsofthesecondbinservetomeetthedemanduntil
thereorderedamounthasbeenreceived.1Therefore,theamountofstockinthissecondbinshouldcover
forthedemandthatarisesduringtheleadtime,thatisthetimethatelapsesbetweenthemomentan
orderisplacedandthemomentthegoodsarereceived.Uponreceiptoftheorder,thesecondbinisfirst
filleduptoitsoriginallevel,andtherestoftheorderisplacedinthefirstbin.
Thus,wheneverthefirstbinhasbeenemptied,weknowthatthereorderpointhasbeenreached:the
reorderpointcorrespondstothenumberofitems wekeepinoursecondbin.Amathematicaltwobin
inventorycontrolsystemiscomposedoftwoparts:
Twobin
System
Part 1. A method of determining how much to reorder when replenishment is necessary. This
part of the system is taken to be deterministic. That is, it uses a single value for each of the
variablesitincorporates;andusesthemeanoraverageannualdemandE(D).Theorderquantity
QisthusdeterminedfollowinganEOQmodel:
Part2.Amethodfordecidingwhentoreorder,thatis,determiningthestocklevelatwhicha
replenishment order should be placed. The method for determining that reorder point s is
probabilistic and considers the item demand as a random variable that may have any one of
severalvalues.
1
In fact, the Kanban system and the basic ideas of the Just-In-Time philosophy by Toyota in Japan supposedly have been
developed from observing such a bin system used in U.S. supermarkets.
97
Therearetwoissuestoconsider:
Part1:IstheEOQorderquantityagoodapproximationfortheoptimalorderquantity?
Part2:Toestablishareorderpoint soastoaccountfortheproperamountofstockneededto
coverthedemandduringtheleadtime.
Notethatbecausedemandisprobabilistic,shortages(i.e.stockouts)maystilloccurduringtheperiod
ofleadtimedemand.Wewillconsidertwocases:
Astockoutismadeup,i.e.thecustomerispromisedtheitem(s)butwillhavetowaituntilthe
nextorderhasarrived.Thissituationiscalledthebackordercase;
Astockoutresultsinalostsale,i.e.thecustomerleavesandwillnotpurchasetheitem(s)atyour
shop(warehouse,).
5.2.1
Backorder case
Weinvestigatethe(r,Q)modelmakingthefollowingassumptions:
1. annual demand D (items / year) is a continuous random variablewith a meanE(D), a variance

2(D),andastandarddeviation(D);
2. constantinfinitereplenishmentrateR=;
3. constantunitholdingcost (/item,year);
4. constantunitreplenishmentcost (/order);
5. constantunitshortagecostcs(/item)whichdoesnotdependonhowlongittakestomakeup
thestockout;
6. constantnonzeroleadtimeL0;
7. constantreplenishmentquantity (items/order)andshortagesaremadeup(backorders);
8. constantreorderpoint .
Possibleinventoryfluctuationsinthe(r,Q)reorderpointmodelaredepictedinFigure15.Notethat
theleadtimeLisconstant,butthecycletimeT,asaconsequenceofvariabilityofdemand,isnolonger
constant. Also note that the amount of items left in inventory when the order arrives varies. This is
causedbythevariabilityofthedemandduringtheleadtime.
I(t)
L
s
r
E(X)
=Averagedemandrate
=Realdemandrate
Figure 15: The (r, Q) reorder point model; no backorders occur
98
Let X denote a random variable representing the demand rate during lead time L, with an average
value a mean E(X), a variance 2(X), and a standard deviation (X). If we assume that the demands at
differentpointsintimeareindependent,thenitcanbeshownthat:
2 ( X ) L 2 ( D)
E ( X ) L E ( D)
( X ) L ( D)
Therefore,wecanexpectthattheinventorylevelduringleadtimeLwilldropfromthereorderpoint
toalevel:
r E( X )
Wecall
thesafetystockinventory.Thesafetystockisusedtobufferagainsttheuncertainty
ondemandduringtheleadtime.Itisthatpartofinventoryinthesecondbinthatwewillonlyusewhen
demandduringleadtimeislargerthantheexpectedamountE(X).Wecannotbesurethatwewillnever
run out of stock. Figure 16 depicts a situation where the variability of demand during lead time has
causedstockouts,whicharethenbackordered.
I(t)
L
Q
Q
s
r
E(X)
backorders
Figure 16: The (r, Q) reorder point model; backorders occur
The expected total annual cost of the system consists of expected replenishment costs, expected
holdingcosts,andexpectedshortagecosts.
1. Westartwiththereplenishmentcostperyear.Sinceeventuallyalldemandwillbemetduringa
year,wewillplaceonaverageE(D)/Qorders.Thustheannualreplenishmentcostis:
2. Theexpectedannualholdingcostisconsiderednext.Theexpectedannualholdingcostsare:
whereE(I)istheexpectedaverageinventorylevelthroughouttheyear.
99
TocalculateE(I),wewillmaketheassumptionthatbackordersoccurveryinfrequently.Thatmeans
we can assume inventory levels to be always positive for the calculation of the expected average
inventory level E(I). The expected inventory value I(t) at the start of a cycle is then r E(X) +Q; the
expected value of I(t) at the end of a cycle is r E(X); and in between it is expected to follow a linear
downwardslope.ThereforetheexpectedtotalamountininventoryduringacycleoflengthTis:
1
QT (r E ( X ))T
2
andthustheexpectedaverageinventorylevelperyearisobtainedbydividingbyT:
1
E(I ) Q r E( X )
2
Theexpectedaveragecostishenceapproximately:
1
h Q r E ( X )
3. We next compute the expected average shortage cost per year. Let us assume that X follows a
probabilitydensityfunctionf(x).Theexpectednumberofstockoutitemsduringacycleistherefore:
( x r ) f ( x)dx
r
The expected number of cycles per year is equal to the expected number of time we place a
replenishmentorder,whichisE(D)/q.Alsorememberthatweassumedthatcsrepresentstheshortage
costperunitshort(/item)andthatisdoesnotdependonthetimeittakestomakeuptheshortage.
Thereforetheannualshortagecostcanbewrittenas:
E ( D)
cs
( x r ) f ( x ) dx
Q r
Thetotalannualcostisthesumofallthreecostcomponents:
(r , Q) s
E ( D) 1
E ( D)
h Q r E ( X ) cs
( x r ) f ( x)dx
Q
Q r
2
Wecouldnowusethewelltroddenpathoftakingthepartialderivatives,andsettingtheseequalto
zerotofindtheoptimalvaluesr*andQ*.Inmostcaseswhenbackordersoccurveryinfrequently,ithas
beenfoundthatQ*isveryclosetotheEOQvalue:
IfweassumethisgivenvalueofQ,whichisnotdependentonr,thetotalcostformulaasafunctionof
thereorderpointrcanbesimplifiedto:
100
(r ) s
E ( D) 1
E ( D)
h Q * r E ( X ) cs
( x r ) f ( x)dx
Q*
Q * r
2
whereQ*isnowaconstant.Tofindtheoptimalvalueofr,wetakethederivative:
d ( r ) d E ( D )
E ( D)
1 *
h
Q
r
E
(
X
)
c
( x r ) f ( x ) dx 0
s
s
*
dr
dr Q
Q* r
2
Sincetheannualreplenishmentcosttermisnotafunctionofrthiscanbesimplifiedto:
d ( r ) d
dr
dr
1 *
E ( D)
h
Q
E
(
X
)
c
( x r ) f ( x ) dx 0
Q* r
Further:
d ( r )
E ( D) d
h cs
( x r ) f ( x ) dx 0
dr
Q * dr r
d(r )
E ( D)
h cs
f ( x)dx 0
dr
Q * r
Notethattheprobabilitythatashortageoccursduringacycleequals:
P( X r ) f ( x)dx
r
Therefore:
P( X r*)
hQ*
cs E ( D )
Thisresultisnotanexplicitbutanimplicitspecificationofthereorderpointr.Ingeneral,wewantto
choosesuchavalueforthereorderpointrsothattheprobabilityofastockoutoccurringduringacycle,
P(Xr),isverysmall.
Inordertomakesuchcalculations,weneedtohaveinformationaboutthedensityfunctionf(x).Often,
demandduringleadtimeisassumedtofollowanormaldistribution.
Example
Given:
s $24 / order
h $3 / item, year
cs $4 / item
E ( D) 10000 items/year
X normallydistributedrandomvariableduringleadtimeL
E ( X ) 300 items
( X ) 100 items
Computetheoptimalvaluesfororderquantityandreorderpoint.
101
1.Orderquantity:
Q*
2 sE ( D )
2 ( 24) (10000 )
400 items/order
3
2.Reorderpoint:
P( X r*)
hQ*
3(400)
0.03
cs E ( D ) 4(10000)
Thismeansa3%probabilityofhavingabackorderinacycle.Thusthereorderpointrshouldbeset
such that the probability of a stockout occurring during a cycle equals 0.03. Standardising the above
formulawithrespecttoX,weobtain
P(
X E( X ) r * E( X )
) 0.03
(X )
(X )
P( Z
r * E( X )
) 0.03
(X )
FromaStandardNormalCumulativeProbabilitiesTable,wecangetthat
P( Z 1.88) 0.97
Then
P( Z 1.88) 0.03
Hence
r * E( X )
1.88
(X )
Thisgives
r* 1.88 ( X ) E ( X ) 488 items
The(r,Q)reorderpointinventorycontrolpolicyforthisitemisnowestablished.Anorderquantityfor
400unitsisplacedwhentheinventorypositionreaches488units.Theannualcostsforthissystemare
shownbelowtobe1180.Thisfollowsfrom
1. reordercosts: sE( D) / Q 24(10000) / 400 $600

2. lotsizeinventoryholdingcosts: hQ / 2 3(400) / 2 $600
3. bufferinventoryholdingcosts: hr E ( X ) 3(488 300) $564
4. stockoutcosts:
E ( D)
cs ( x r ) f ( x)dx 10000
4 (100)(0.0116) $116
400
Q
r
(SeePartialExpectationforStandardNormallyDistributedRandomVariableTable)
Note. ( x r ) f ( x )dx ,i.e.theexpectednumberofitemsstockoutduringonecycle,isalsocalled

r
thepartialexpectation.Thepartialexpectationforastandardnormallydistributedrandomvariablecan
102
be found in a Table; the partial expectation for any normally distributed variable can be found by
simplymultiplyingthecorrespondingvaluewiththestandarddeviation (X ) oftherandomvariable.
5.2.2
Lost sales case
In the lost sales case, similar assumptions hold as in the backorders case, except the following
differences:
Thestockoutcost cs includesthelostprofitaswellasanypenaltycosts.
Whenreplenishmentstockarrivestheinventoryisincreasesbythefullamountoftheorderi.e.by
Q,asnobackordersexisttobefilled.
Fromthesecondpoint,itfollowsthattheexpectedinventorylevelistheexpectedinventorylevelof
thebackorderscase,plustheexpectednumberofitemsshortpercycle.Theexpectedinventorylevelis
therefore:
1
E ( I ) Q r E ( X ) ( x r ) f ( x ) dx
2
r
Alltheothertermsstayequal.Followingthesameapproachasinthebackorderscasegives:
(r ) s
1 *
E ( D)
E ( D)
h
Q
r
E
(
X
)
(
x
r
)
f
(
x
)
d
x
2
s Q * ( x r ) f ( x )d
Q*
r
r
d ( r )
d
E ( D) d
h h ( x r ) f ( x ) d x cs
( x r ) f ( x ) dx 0
dr
dr r
Q * dr r
d(r )
E ( D)
h h f ( x)dx cs
f ( x ) dx 0
dr
Q * r
r
Whichleadsto
P( X r*)
hQ*
cs E ( D) hQ *
Note.Theshortagecost cs isnowthepenaltycostofastockoutplustheopportunitycost(lostprofit)
ofalostsale.
5.2.3
Service level approach
It may be very difficult to determine accurately the cost of being one unit short. For this reason,
managers often decide to control shortages by meeting a specified service level. Service level can be
definedindifferentways.
Definition 1. The service level is the expected number of cycles per year during which a shortage
occurs.
Definition2.Theservicelevelistheexpectedfractionofalldemandthatismetontime.
Assumethatallshortagesarebackordered(backlogged).
103
Definition 1
Givenareorderpointr,thefractionofallcyclesperyearthatwillleadtoastockoutisequalto:
P( X r )
Since E(D)/Q cycles per year will occur, the expected number of cycles per year during which a
shortageoccursequals
P( X r )
E ( D)
Q*
AccordingtoDefinition1,wecanwrite
P( X r )
E ( D)
s1
Q*
wheres1istheallowednumberofexpectedstockoutsperyear.Thisalsogives
P ( X r*) s1
Q*
E ( D)
Definition 2
Givenareorderpointr,theexpectednumberofitemsshortpercycleisequalto:
( x r ) f ( x)dx
r
SinceE(D)/Qcyclesperyearwilloccur,theexpectednumberitemsshortperyearequals
( x r ) f ( x)dx
r
E ( D)
Q*
The expected fraction of items short per year is obtained by dividing the latter equation by E(D),
whichgives
1
( x r ) f ( x)dx
Q* r
AccordingtoDefinition2,wecanwrite
1
( x r ) f ( x)dx 1 s2
Q* r
wheres2istheexpectedfractionofitemsperyearthatcanbemetontime.Rearranged:
( x r*) f ( x)dx Q (1 s )
*
r*
ThelefthandsideisalsocalledthePartialExpectation E ( x r*)
104
E ( x r*) ( x r*) f ( x)dx

r*
ForarandomvariableZfollowingastandardnormaldistribution,PartialExpectations E ( Z z ) in
functionofZhavebeentabulated,Section5.2.4.IfXfollowsanormaldistributionwithexpectedvalue
E(X)andstandarddeviation(X),then
E (Z z )
E ( X r*) Q* (1 s2 )
(X )
(X )
Therefore,fromsuchatablewecanderivez.Thereorderpointcanthenbefoundas
5.2.4
Standard Tables
Standard Normal Cumulative Probability Table
If
denotestheprobabilitydistributionofrandomvariable ,then
P( X r ) f ( x)dx
r
istheprobabilitythatarandomdrawfromthedistributionwillproduceavalueof thatwillbelarger
orequaltoagivenconstant .
Given a normally distributed variable with mean

and standard deviation
, then the
randomvariable ,definedas:
willbestandardnormallydistributed.Thatis,
0and

1.Wehave:
Wedefine:
Thefirsttwotablesonthefollowingpagesletyousolveanyofthefollowingtwoproblems:
1. Given ,whatis
?
2. Given
,whatis ?
Examples
Let
2.15.Thenfromthefirsttable,therowwith 2.1andcolumnwith0.05intersectsat
the value 0.0158. Therefore,
2.15
0.0158. The probability that a random trial
fromanormaldistributionproducesavaluenothigherthan 2.15is1.58%.
105
Let
1.23.Thenfromthesecondtable,therowwith1.2andcolumnwith0.03intersectat
thevalue
1.23
0.8907.Theprobabilitythatarandomtrialfromanormaldistribution
producesavaluenothigherthan1.23is89.07%.
Let
=0.9500.Inthesecondtable,weidentifythisvalueinbetweenthevalues0.9495
and0.9505.Theyarebothintherowof1.6,hencez=1.6x.Tofindthevalueofx,weseefrom
the column headers that it must fall in between 0.04 and 0.05. In aim to be as accurate as
possible,wecould(linearly)interpolatebetween1.64and1.65,leadinginthiscasetoz=1.645.
However,forthesakeofkeepingcalculationstoaminimum,itisadequatetosimplytakethex
fromthecolumnofwhichits
isclosestto0.9500.Hencebothz=1.64orz=1.65are
goodvalues.
Notethat
Standard Normal Loss Function Table
Per definition,
if
0, and
randomvariable ,then
0 if
0. If
denotes a probability distribution of
E ( X r ) ( x r ) f ( x)dx
r
denotestheexpectedvalueoftherandomvariable
Wealsohave:
E (Z z)
,where isagivenconstant.
E ( X r )
(X )
When is normally distributed, will be standard normally distributed, and the Standard Normal
LossTablegivenbelowcanbeusedtosolveanyofthefollowingtwoproblems:
?
1. Given ,whatis
2. Given
,whatis ?
Examples
Let
1.64. We look up the value in the table in the row with header 1.6 and column with
header0.04tofind
1.6611
0.0075. In the table, we identify this value at the row with value 2.4 and in
Let
betweenthecolumnswithvalues0.04and0.05.Hencez=2.445isthevalueobtainedfromlinear
interpolation.Inpractise,wearehappywithtakingeitherz=2.44orz=2.45.
106
107
108
109
5.2.5
Exercises
1.Eachyear,acomputerstoresellsanaverageof1000boxesofdisks.Annualdemandforboxesofdisks
is normally distributed with a standard deviation of 40.8 boxes. The store orders disks from a regional
distributor.Eachorderisfilledintwoweeks.Thecostofplacingeachorderis$50,andtheannualcostof
holdingoneboxofdisksininventoryis$10.Theperunitstockoutcost(becauseoflossofgoodwilland
thecostofplacingaspecialorder)isassumedtobe$20.Thestoreiswillingtoassumethatalldemandis
backlogged.Determineforthecomputerstoretheproper
a)orderquantity
b)reorderpoint
c)safetystocklevel
d)Whatistheprobabilitythatstockoutoccursduringleadtime?
Additionalquestions:
e) If the leadtime increases to 4 weeks, investigate how this affects your answers to the previous
questions,atod?
f)Whatistheexpectednumberofboxesperyearthatarenotdeliveredontimefromavailablestock
whenimplementingthereorderpointyoucalculatedinpartb?
g)Whatisthepercentage ofannualdemandmetontimefromavailablestock whenimplementing
thereorderpointcalculatedinpartb?
2. The same computer store as in Question 1 now doubts whether shortages result in backorders.
Supposethateachboxofdiskssellsfor$50andcoststhestore$30.Answerthesamequestionsatod,
forthecasethatshortagesallresultinlostsales!<Hint:youneedtoestimateavalueyouwillneedtouse
fortheshortagecost .>
3.Again,thesamecomputerstoreasinQuestion1andQuestion2.Itnowdoubtswhetherthevaluesfor
shortage cost used were realistic! Answer the same questions, a to d, for the case that the computer
storewantstheaveragenumberofstockoutcyclesperyeartobeatmostequalto3.
4.Yep,thesamecomputerstoreasinQuestion1,2,and3.Thestoremanagernowthinksitmightbe
besttoaimforsatisfyingatleast95%ofannualdemand.Answerthesamequestions,atod.<Note:this
exampleillustratesthatanegativesafetystockvalueispossible.>
5.Ahospitalordersitsbloodfromaregionalbloodbank.Eachyear,thehospitalusesanaverageof1040
pintsoftypeOblood.Eachorderplacedwiththeregionalbloodbankincursacostof$20.Theleadtime
foreachorderisoneweek.Itcoststhehospital$20tohold1pintofbloodininventoryforayear.The
perpintstockoutcostisestimatedtobe$50.AnnualdemandfortypeObloodisnormallydistributed
withstandarddeviationof43.26pints.Assumethat52weeks=1yearandthatalldemandisbacklogged.
a)Determinetheoptimalorderquantity,reorderpoint,andsafetystocklevel.
b)Tousethetwobinsystemwithbackorders,whatunrealisticassumptionsmustbemade?
6. Furnco sells secretarial chairs. Annual demand is normally distributed with mean of 1040 chairs and
standarddeviationof50.99chairs.Furncoordersitschairsfromitsflagshipstore.Itcosts$100toplace
anorderandtheleadtimeistwoweeks.Furncoestimatesthateachstockoutcausesaloss of$50in
futuregoodwill.Furncopays$60foreachchairandsellsitfor$100.Theannualcostofholdingachairin
inventoryis30%ofitspurchaseprice.
a)Assumingthatalldemandisbacklogged,whatarethereorderpointandthesafetystocklevel?
b)Assumingthatallstockoutsresultinlostsales,determinetheoptimalreorderpointandthesafety
stocklevel.
110
7.FOOTDInc.sellsanaverageof1000foodprocessorseachyear.Eachorderforfoodprocessorsplaced
byFOOTDcosts$50.Theleadtimeisonemonth.Itcosts$10toholdafoodprocessorininventoryfor
oneyear.Annualdemandforfoodprocessorsisnormallydistributedwithastandarddeviationof69.28.
Determinethereorderpointforeachofthefollowingvaluesoftheservicelevel:
a)95%ofannualdemandmetontime
b)99%
c)99.9%
5.3 News vendor problems

Inthissection,weconsidersingleperiodorstaticinventoryproblems.Theseareproblemsinwhichone
orderingdecisionhastobemadeatonemomentintime.
Such problems are often called news vendor problems. Consider a vendor who must decide how
manynewspapersshouldbeorderedeachdayfromthenewspaperplant.Ifthevendororderstoomany
papers,heorshewillbeleftwithmanyworthlessnewspapersattheendoftheday.Ontheotherhand,
thevendorwhoorderstoofewnewspaperswilllooseprofit(anddisappointcustomers)thatcouldhave
beenearnedifenoughnewspaperstomeetcustomerdemandhadbeenordered.Thenewsvendormust
orderthenumberofpapersthatproperlybalancesthesetwocosts.
More formally, a decision maker is faced with the problem of determining the order quantity q to
purchase an item based on estimates of some future demand for that item. Only after q has been
determinedandtheorderhasbeenplaced,therealvalueofthedemandDbecomesknown.Depending
onthevaluesofqandD,thedecisionmakerincursarevenueR(q,D),acost(q,D),andaprofitP=R
.
5.3.1
Example
A student has obtained the concession for picnic lunches at local football games. Records indicate the
followingdemanddistributionforlunches(Table2):
Table 2: Demand distribution for lunches at the local football club
Demand
Pr(x) = Probability that demand = X
X
0
0.00
1
0.10
2
0.10
3
0.30
4
0.30
5
0.10
6
0.10
Thelunchescost3andaresoldat5.Anylunchesleftovercanbedisposedoffor0.5.Theproblem
istodeterminetheorderquantity.
Threedifferentapproachestosolvethisproblemwillbegiveninthefollowingsections.
5.3.2
Cost minimisation
Oncethedecisionhasbeenmadetoplaceanorder,thefixedprocurementcosts donotinfluencethe
orderingdecision.Fixedcostsperorderarethereforeirrelevantinthiscase.Thecashflowsinfluencedby
theorderquantitydecisionarethecostsoforderingtoolessorthecostoforderingtoomuch.
Thecostoforderingtoomuchmayincludethepurchasepriceoftheitemplusthecostofdisposing
anyunsolditems.Thecostoforderingtoolessincludesthepurchasepriceoftheitemandthecostoflost
sales.
111
Letqrepresenttheorderquantityandxtherealisationofthedemand,ptheunitpurchasepriceof
theitem,wthesalvagevalueperunitfordisposingofit,andrtheunitsellingpriceforsellinganitemto
ourcustomers.Wecanthenwrite:
pq w(q x)
q, x
pq r(x q)
(x q)
(x q)
wherep=3/unit,w=0.5/unit,andr=5/unit.
Theexpectedcost,foragivenorderquantityq,isthengivenby:
x 0
x 1
E (q, x) q, x Pr(x) q, x Pr(x)
wherePr(x)istheprobabilitythatademandofxunitsmaterialises.
Wewanttoselectthisorderquantityqthatwillminimisetheexpectedcost.Itishelpfultoshowthe
calculationsinamatrix,aspresentedinTable3.Itcanbeseenthatthebestdecisionwouldbetoorder3
picniclunches,withanexpectedcostof128.5.
Table 3: Conditional cost matrix
Order
quantity q
Demand x
3
Expected
5
cost
E(
(q,x))
1
30
80
130
180
230
280
155.0
55
60
110
160
210
260
139.5
80
85
90
140
190
240
128.5
105
110
115
120
170
220
131.0
130
135
140
145
150
200
147.0
155
160
165
170
175
180
167.5
Pr(x)
0.10
0.10
0.30
0.30
0.10
0.10
5.3.3
Profit maximisation
Forproblemsinvolvingmajorchangesinrevenueinwhichprofitmaximisationistheobjective,profits
maybeusedasameasureofperformanceratherthancosts.Profitequalsrevenueminuscost.
Incaseoforderingtoomuch,theprofitcomesfromthesalesofunitsbutthereisacostrelatedtothe
disposalofunsolditems.Incaseoforderingtoofewunits,thesoleprofitsarise fromsales.LetP(q,x)
denotetheprofit,then:
(r p)x (p w )(q x)
P(q, x)
(r p)q
(x q)
(x q)
Theexpectedprofit,foragivenorderquantityq,is:
112
x 0
x 1
E P(q, x) P q, x Pr( x) P q, x Pr(x)
Weliketoselectthisorderquantitytomaximisetheexpectedprofit.ResultsaredisplayedinTable4.
Theoptimalorderquantityisagain3units.
Table 4: Conditional profit matrix

Order
Demand x
Expected
quantity q
profit
E(P(q,x))
20
20
20
20
20
20
20.0
-5
40
40
40
40
40
35.5
-30
15
60
60
60
60
46.5
-55
-10
35
80
80
80
44.0
-80
-35
10
55
100
100
28.0
-105
-60
-15
30
75
120
7.5
Pr(x)
0.10
0.10
0.30
0.30
0.10
0.10
5.3.4
Regret minimisation
A third approach to the example utilises the same basic methodology for decision making, but the
measure of performance can no longer be obtained simply by examining the relevant cash flows
associatedwithagivenorderquantityanddemandlevel.Theregretmeasureisobtainedbyreplacingthe
outcomeineachcellbythevalueobtainedbysubtractingtheprofitofthecellfromthemaximumprofit
foranycellinthatcellscolumn.Thissimpleconceptisintuitivelyevident.Foreachstateofnature(i.e.
realised demand level), there is an optimum decision (yielding the maximum profit). The regret
associated with making the best decision for a given state of nature is zero. The regret of each of the
othercellsinthecolumnsimplyindicatesthedifferenceinprofitsbetweenthedecisionindicatedandthe
bestdecisionforthestateofnaturethatoccurred.Theregretmatrixwithrespecttoourexampleisgiven
inTable5.
Table 5: Conditional regret matrix (in 0.1)

Order
Demand x
quantity q
Expected
regret
20
40
60
80
100
50.5
25
20
40
60
80
34.5
50
25
20
40
60
23.5
75
50
25
20
40
26.0
100
75
50
25
20
42.0
125
100
75
50
25
62.5
Pr(x)
0.10
0.10
0.30
0.30
0.10
0.10
113
Notethatexpectedregretplusexpectedprofitsumto7foreachorderquantity.Sincethisistruefor
eachorderquantity(q=1,2,6),selectingthealternativethatminimisesregretisidenticaltoselecting
thealternativethatmaximisesprofit.Thesumofthetwoexpectedvalues(inthiscase7)representsthe
expected profit if demand x were known before making decisions. That is, it is the sum of the highest
profit outcome for each state of nature times the probability of the state. The expected profit given
perfectknowledgeis:
x 0
x 1
E P(q, x) P q, x Pr( x) P q, x Pr(x)

2(0.1) 4(0.1) 6(0.3) 8(0.3) 10(0.1) 12(0.1) 7
Theexpectedregretcanthereforebeinterpretedasthecostofuncertainty.
The cost of uncertainty of the optimal decision represents the maximum value of perfect forecast
informationtothedecisionmaker.Forthisexample,themaximumpricethedecisionmakerwouldpay
forperfectinformationis2.35.
5.3.5
Exercises
1. In August, Walton Bookstore must decide how many of next years nature calendars should be
ordered.Eachcalendarcoststhebookstore$2andissoldfor$4.50.AfterJanuary1,anyunsoldcalendars
are returned to the publisher for a refund of $0.75 per calendar. Walton believes that the number of
calendarssoldbyJanuary1followstheprobabilitydistributionshownintheTablebelow.Waltonwants
to maximise the expected net profit from calendar sales. How many calendars should the bookstore
orderinAugust?
5.3.5.1.1 No.
of
Calendars
sold
100
150
200
250
300
Probabili
ty
.3
.2
.3
.15
.05
2. Every four years, Blockbuster Publishers revises its textbooks. It has been three years since the
bestsellingbook,TheJoyofOR,hasbeenrevised.Atpresent,2000copiesofthebookareinstock,and
Blockbustermustdeterminehowmanycopiesofthebookshouldbeprintedforthenextyear.Thesales
departmentbelievesthatsalesduringthenextyeararegovernedbythedistributionintheTablebelow.
Eachcopyofthebookduringthenextbringsthepublisher$35inrevenues.Anycopiesleftattheendof
the next year cannot be sold at full price but can be sold for $5 to Bonds Ennoble and Gitanos
Bookstores.Thecostofaprintingofthebookis$50000plus$15perbookprinted.Howmanycopiesof
TheJoyshouldbeprinted?Wouldtheanswerchangeif4000copieswerecurrentlyinstock?
Copies Demanded
5000
6000
7000
8000
Probability
.3
.2
.4
.1

114
1.Solution:Expectedprofitismaximisedforq*=250items/run.
profit maximisation
acquisition cost
salvage value
revenue
p
w
r
order quantity
q
demand x
0
0
-125
-187.5
-250
-312.5
-375
0
0
0
100
150
200
250
300
0
p(x)
2
0.75
4.5
profit per unit sold

loss per unit unsold
2.5
1.25
expected profit
100
0
250
187.5
125
62.5
0
0
0.3
150
0
250
375
312.5
250
187.5
0
0.2
200
0
250
375
500
437.5
375
0
0.3
250
0
250
375
500
625
562.5
0
0.15
300
0
250
375
500
625
750
0
0.05
0
0
-125
-187.5
-250
-312.5
-375
0
0
0
231.25
328.125
387.5
390.625
346.875
0
2.Answer:Orderoneprintrunfor5000unitsofthebook,estimatedprofitis6550050000=$15500.
profit maximisation
acquisition cost
salvage value
revenue
p
w
r
order quantity
q
demand x
0
0
-30000
-40000
-50000
-60000
0
0
0
0
3000
4000
5000
6000
0
0
p(x)
15
5
35

20
10
expected profit
3000
0
60000
50000
40000
30000
0
0
0.3
4000
0
60000
80000
70000
60000
0
0
0.2
5000
0
60000
80000
100000
90000
0
0
0.4
6000
0
60000
80000
100000
120000
0
0
0.1
0
0
-30000
-40000
-50000
-60000
0
0
0
0
0
-30000
-40000
-50000
-60000
0
0
0
0
46500
59000
65500
63000
0
0
If4000booksinstock,thenitdoesnotseemworthwhiletoprintanothereditionasshownbelow.
acquisition cost
salvage value
revenue
p
w
r
order quantity
q
demand x
0
0
-10000
-20000
-30000
-40000
0
0
0
0
1000
2000
3000
4000
0
0
p(x)
15
5
35

20
10
expected profit
1000
0
20000
10000
0
-10000
0
0
0.3
2000
0
20000
40000
30000
20000
0
0
0.2
3000
0
20000
40000
60000
50000
0
0
0.4
4000
0
20000
40000
60000
80000
0
0
0.1
0
0
-10000
-20000
-30000
-40000
0
0
0
0
0
-10000
-20000
-30000
-40000
0
0
0
0
15500
28000
34500
32000
0
0
115
6 MRP, JIT, and Bottlenecks
6.1 Materials Requirements Planning

MaterialsRequirementsPlanning(MRP)isacomputerbasedproductionplanningandinventorycontrol
system. It is also known as timephased requirements planning, as it recognises the time needed to
produce (or purchase) items. MRP also recognises the relationship between the demand for the final
productandthecomponentstomakeit.Theserelationshipsarethenusedtodeterminetheamountthat
shouldbeproduced(orpurchased)ofeachfinalproduct,assembly,subassembly,andcomponentduring
eachperiodofaplanninghorizon.
6.1.1
MRP inputs
ThethreemajorinputsofanMRPsystemarethemasterproductionschedule,theproductionstructure
records,andtheinventorystatusrecords(Figure17).
Customerorders
Bills
ofmaterials
Purchaseorders
Master
Production
Schedule
Forecast
demand
Inventory
records
MRP
Materialsplans
Workorders
Figure 17. MRP environment
Master Production Schedule (MPS)

TheMasterProductionSchedule(MPS)outlinestheproductionplanforallenditems.Itexpresseshow
muchofeachenditemiswantedandwhenitiswanted.Typically,theMPSworkswithtimebucketsof
oneweek(month)andtheplanninghorizonoftheMPScoversforthenext16months(12years).
TheMPSisdevelopedfromenditemcustomerordersandforecasts.
Theenditemcustomerordersorsalesordersrepresentsomecontractualcommitmentonbehalfof
thecustomer.Customers,however,maychangetheirmindsaboutwhattheyrequireafterhavingplaced
their orders. Considering that each of several hundred customers may make changes to their sales
orders,notonce,butpossiblyseveraltimesafterorderplacement,itisevidentthatmanagingthesales
orderbookisacomplexanddynamicprocess.Anorganisationmayhavetomakedecisionsabouthow
muchflexibilitytheywillaffordtocustomersandatwhatstagetheircustomershavetoacceptliabilityfor
theimplicationsoftheirchanges.
Notalloperationshavethesamedegreeofforwardvisibilityintermsofknowncustomerorders.
Supermarkets,forexample,havenoadvancenoticewhenacustomerwillarriveandwhatandhowmuch
will be purchased. Many businesses also do not have sufficient time to respond justintime when
116
customers place orders, because there would be insufficient time left to buy the required materials,
performtherequiredmanufacturingoperationsonthosematerials,andthendelivertheproducttothe
customer. Many businesses therefore have to rely on forecasts, i.e. predictions about likely future end
item demands to ensure they have all raw materials, components, assemblies and end item products
availabletomeetdeliverytimesonceasalesorderisreceived.
Acombinationofknownordersandforecastedordersisusedtorepresentenditemdemandinmany
businesses.Importanttonoteisthatforecastedordersdonotequalsalestargets.Salestargetsaregiven
to the sales force and to give them some incentive, these are typically set optimistically high. The
forecasted orders should be the best estimate available at any time of what reasonably could be
expectedtohappen.
Acharacteristicofdemandmanagementisthatthefurtheraheadyoulookintothefuture,theless
certaintythereisaboutdemand.Intheshortterm,typically,thedemandwilllargelybebasedonplaced
orders.However,asfewcustomerordersareplacedwellintothefuture,thedemandinthelongerterm
willbelargelybasedonforecastsi.e.marketinformationfromsalesoperativesaswellashistoricalsales
figures.Astimegoesby,thefractionofforecastdemandforacertainfutureperiodwilldiminishandbe
replacedbynewlyarrivingsalesorders.
The mix of known orders and forecast orders will also be determined by the type of operation. A
conceptsometimesusedhereistheOrderPenetrationPoint(OPP).TheOPPisthatstoragepointinthe
supply chain where downstream operations are largely triggered by maketoorder demand and
upstreamoperationslargelybymaketostockdecisions.Forexample,theOPPforasupermarketliesat
theretailpointitself,whileforajobbingbuildertheOPPliesupstreamasmaterials(andotherresources)
willonlybeacquiredwhenthebuilderhasbeenawardedaspecificcontract.Manybusinesseshaveto
operate in a context where the OPP is located somewhere within their operations or downstream the
supply chain. In that case they need to operate mainly using forecasts. In general, the information of
sales orders combined with forecast demand of end items forms the major input to the Master
ProductionSchedule.
Note that MPS and MRP can also be applied to a service environment. For example, in a hospital
theatre there is an MPS which contains statements of which operations are planned and when. This
drives provisioning of materials for the operations, such as sterile instruments, blood and dressings. It
also governs the scheduling of staff for operations, including anaesthetists, nurses, and surgeons, and
otherfacilitiessuchasrecoveryroomsandbeds.
AnexampleofaMPSisgiveninTable1.Enditemdemandforthenext9weeksisgiven.Westartby
having30unitsoftheitemonhandatthebeginningofweek1,ofwhich10canbeusedtofulfildemand
forweek1,and20remainavailableinventory.Attheendofweek2,availableinventoryisreducedto10
units,justsufficienttosatisfydemandforweek3.Therefore,theMPSscheduleneedstomakeavailable
atleast10unitsattheendofweek3tosatisfydemandforweek4.
Table 6. Example of MPS chase strategy.
Weeknumber
1
2
3
4
5
6
7
8
9
Demand
10 10 10
10
15
15
15
20
20
Available 30 20 10 0
0
0
0
0
0
MPS
0
0
10
15
15
15
20
20
The chase strategy used in Table 1 is to make available only those amounts needed to satisfy
immediatefuturedemand.Asaresult,inventorylevelsareeventuallyreducedtozero.Chasingdemand
involves adjusting the provision of resources, which may not always be desirable or possible. Level
scheduling,ontheotherhand,(seeTable2)involvesaveragingtheamountrequiredtobecompletedto
smoothoutpeaksandtroughs.Theaverageprojectedinventoryoftheenditem,however,isnowmuch
higher.Inpractice,companiesmayusestrategieswhichfallbetweenthechaseandthelevelstrategy.
Table 7. Example of MPS level strategy.
Week number
1
2
3
117
Demand
10
10
10
10
15
15
15
20
20
Available 30
33
36
39
42
40
38
36
29
MPS
13
13
13
13
13
13
13
13
Whilethedemandfortheenditemsneedstobederivedfromprojectedsalesordersandforecasts,
the demand for all components necessary to produce these end items can be calculated by the MRP
systemfromtheMPSdata.
Bill of Material (BOM)

Toworkoutthevolumeandtimingofassemblies,subassembliesandmaterialsrequiredtomeetthe
MPS, we need information about the list of assemblies, subassemblies and components needed to
producetheenditems.ThisisprovidedbytheproductstructurerecordsorBillsofMaterials(BOMs).
ABillofMaterial(BOM)containstheinformationoneveryitemrequiredtoproduceanenditem:it
listsallinformationnecessary,inparticularthepartidentificationandthequantityneededperassembly.
AnexampleofasimpleBOMisdisplayedinFigure18.
A
B(1)
E(1)
Level0
C(3)
F(2)
J(1)
D(1)
G(2)
K(1)
H(1)
Level1
I(1)
Level2
Level3
Figure 18 Typical BOM. The letters represent assemblies, subassemblies and parts. The numbers in
parentheses are the quantities required for assembly.
InFigure18,itemAistheenditemanditrequires1subassemblyB,1subassemblyD,and3partsC.
OnepartEand2subassembliesFmakeup1subassemblyB.OnepartI,1partH,and2partsGmakeup
thesubassemblyD.OnepartJand1partKmakeup1subassemblyF.
ABOMshoulddisplayallcomponents,assembliesandsubassembliesinlevelsrepresentingtheway
in which they are actually manufactured: from raw materials to components to subassemblies to
assembliestoenditems.TheBOMforMRPmaybedifferentfromaproductstructureplanconstructed
bydesignengineers,asaproductmaynotbeassembledthewayitwasdesigned.
Inventory status records
These records contain the status of all items in inventory. All inventory items must be uniquely
identified. These records must be kept up to date, with each receipt, disbursement, or withdrawal
documentedtomaintainrecordintegrity.Theyshouldalsocontaininformationonleadtimes,lotsizes,or
otheritempeculiarities.
Quantitiesofitemsininventoryavailableforthenextperiodarereferredtoasonhand;quantities
thatareexpectedtobecomeavailablearescheduledreceipts.
6.1.2
MRP outputs
MRPtakestheMPSforenditems,BOMandinventorystatusrecords,anddetermineswhatcomponents
andsubassembliesarerequired,howmany,andwhenworkordersforsubassembliesshouldbereleased
tothemanufacturingoperationandwhenordersforpartsshouldbeplacedwithsuppliers.
For purchased components, the lead time is the time interval between placement of the purchase
order and the availability of these components in inventory. After such an order has been placed, it
changesfromplannedordertoopenoronorder.
118
Formanufacturedsubassemblies,theleadtimeistheintervalbetweenreleaseoftheworkorderto
themanufacturingoperationandtheavailabilityoftheproducedsubassembliesaftercompletion.
Theactualorderquantityreleasedtoeitherthemanufacturingfloororthesuppliermaybethenet
requirementsoradjustedtoanysuitablelotsize.
Example 1: simplified MRP
Question:Youaretoproduce100unitsofproductAinperiod8.Ifnostockisonhandorscheduledto
arrive,determinewhentoreleaseordersforeachcomponentandthesizeofeachorder.TheBOMand
LeadtimeinformationisdisplayedinFigure19.
Solution:ProductAismadefromcomponentsBandC;CismadefromcomponentsDandE.Bysimple
computationwecalculatequantitiesrequired:
ComponentB:(1)(numberofAs)=1(100)=100;
ComponentC:(2)(numberofAs)=2(100)=200;
ComponentD:(1)(numberofCs)=1(200)=200;
ComponentE:(2)(numberofCs)=2(200)=400.
Now we must consider the time element for all the items. Table 8 below create a simplified MRP
based on the demand for A, the knowledge of how A is made, and the time needed to obtain each
component.
A
Leadtime=4
B(1)
Leadtime=3
C(2)
Leadtime=2
D(1)
Leadtime=1
E(2)
Leadtime=1
Figure 19. BOM/Lead time information of example 1

Table 8. Simplified MRP matrix with solution for example 1.
Item: A
Lead time = 4
Period
1
2
Gross requirements
Planned order releases
Item: B
Lead time = 3
Gross requirements
Item: C
Lead time = 2
Gross requirements
8
100
100
100
100
Gross requirements
Item: D
Lead time = 1
Gross requirements
Item: E
Lead time = 1
200
200
200
200
400
400
119
Plannedorderreleasesofaparentitemareusedtodeterminegrossrequirementsforitscomponent
items.Plannedorderreleasesofaparentitemgenerateagrossrequirementinthesametimeperiodfor
its lower level components. Planned order release dates of the components are simply obtained by
offsettingtheleadtimes.
The MRP in Table 8 shows which items are needed, how many are needed, and when they are
needed;inordertocomplete100unitsofproductAinperiod8,itisnecessarytoreleaseorderfor100
unitsofBinperiod1,200unitsofCinperiod2,200unitsofDinperiod1,and400unitsofEinperiod1.
MRP Matrix
The previous example was a simplified case. In a typical MRP table, we will instead encounter the
followingentries(seeTable9):
I. Grossrequirements:thetotalanticipateddemandfortheitem.Forenditemsthequantityis
obtainedfromtheMPS;forcomponentsandsubassembliesitisderivedfromtheplanned
orderreleasesofitsparents;
II. Scheduled receipts: material that has been ordered previously and is expected to arrive in
thisperiod;
III. Projected on hand: expected quantity in inventory at the end of the period, available for
demand in subsequent periods. It is calculated by subtracting the gross requirements for
theperiodfromthescheduledreceiptsandplannedorderreceiptsforthesameperiodas
wellastheprojectedonhandfromthepreviousperiod.Whensafetystockismaintained
and/or units are allocated to future orders, these amounts must be added to the gross
requirementsbeforecalculatingtheprojectedonhand;
IV. Netrequirements:thereductionofgrossrequirementsbythescheduledreceiptsinthe
periodplustheprojectedonhandinthepreviousperiod.Thisindicatesthenetnumberof
itemsthatmustbeprovidedtosatisfytheparentormasterschedulerequirements;
V. Plannedorderreceipts:thesizeoftheplannedorder(theorderhasnotyetbeenplaced)and
when it is needed. This appears in the same period as net requirements, but its size is
modifiedbytheappropriatelotsizingpolicy(seealsonextsection).Ifthelotsizingpolicyis
notlotforlot,theplannedorderquantitywillgenerallyexceedthenetrequirements.Any
excessbeyondthenetrequirementsgoesintoprojectedonhandinventory.Withlotfor
lotordering,theplannedorderreceiptsisalwaysthesameasthenetrequirements;
VI. Planned order releases: when the order should be placed (released) so the items are
availablewhenneededbytheparent.Thisisthesameastheplannedorderreceiptsoffset
for lead times. Planned order releases at level j generate material requirements are the
lower levels j + 1, etc. When the order is placed, it is removed from the planned order
receipts and planned order releases rows and entered in the scheduled receipts row.
Plannedorderreleasesshowthewhat,howmany,andwhenofMRP.
Table 9. Typical MRP matrix.
Item:
Level:
Lead time =
On hand =
Period
PD
Safety stock =
Allocated =
Lot
sizing policy =
Gross requirements
Scheduled receipts
Projected on hand
Net requirements
Planned order receipts
Example 2: MRP
Given:Thereareordersfor103unitsofproductAinperiod8and200unitsofproductQinperiod7.The
onhandinventorylevelsforeachitemareA=18,Q=6,B=10,C=20,D=0,andE=30.Asafetystockof
five units is maintained on product A and six units on product Q with no safety stock on other
components. Additionally, ten units of the 18 units on hand of product A are already allocated to
particularcustomers.Therearenoopenorders(scheduledreceipts)onanyitem.ThelotsizeforitemsA,
120
Q,B,andCisthesameasthenetrequirements(lotforlotordering),whilethelotsizeforDis200units
andforEis500units.
Question:DevelopanMRPplanforproductsAandQwiththeproductstructures(BOM)givenbelow.
Whatshouldbethesizeoftheordersforeachitem,andwhenshouldordersbereleased?
EnditemA
Leadtime=4
B(1)
C(2)
Leadtime=3
Leadtime=2
D(1)
E(2)
Leadtime=1
Leadtime=1
EnditemQ
Leadtime=2
E(1)
C(1)
Leadtime=1
Leadtime=2
D(1)
E(2)
Leadtime=1
Leadtime=1
Figure 20. BOM/Lead time information for example 2.
Solution
SinceitemEappearsatlevel1andlevel2inproductQandalsoatlevel2inproductA,itisbesttoassign
itthelowestlevelof2inordertoavoidthatwewillcalculateamaterialrequirementsplanforitmore
than once. The MRP plan for 103 product A and 200 product Q is shown in Table 10. The table was
developedinthefollowingmanner:
ThefirststepistoestablishthegrossrequirementsforitemsAandQ,whicharegivenas103and200
units,respectively.
TheplannedorderreleasesforAandQinperiods4and5areexploded(multipliedbyusequantities
ofitemsB,C,andE)andaccumulatedasgrossrequirementsforitemsB,C,andE.OnlyitemsBandCare
thencalculated.
TheplannedorderreleasesforBandCinperiods1,2,and3areexplodedandaccumulatedasgross
requirements for items D and E. Item E already has a gross requirement of 200 units in period 5 from
itemQsexplosion.
Notethatwehaveintroducedinexample2safetystocks.SafetystockscanbeusedwithinMRP,butit
doesnotconsiderthemavailableforregularuse.Safetystockisrecommendedattheenditemlevelbut
notthecomponentlevelinMRP.TheneedforsafetystocksofcomponentsisreducedbyMRPsinceit
calculatesthequantitiesofcomponentsneededandwhentheyareneeded.
WithMRPlogic,itispossibletohavelowlevelitemsscheduledinaperiodthatisnolongerfeasible,
i.e.itshould havehappenedinthepast.Itisthenneededtoeitherrevisethe MPSandshiftenditem
demandtolaterperiods,orotherwisetocompressleadtimebyexpeditingtheitem,ortoreducelead
timeforthelotbyallowingovertimeinthemanufacturingshop.
121
Table 10. MPR plan for example 2.

Item:A Level:0
lot-for-lot
Lead time =4
PD
On hand =18
1
Safety stock =5
3
Gross requirements
Scheduled receipts
Projected on hand
3
3
3
3
3
Net requirements
100
Item:Q Level:0 Lead time =2 On hand =6 Safety stock =6
lot-for-lot
PD
1
2
3
4
Gross requirements
Scheduled receipts
Projected on hand
0
0
0
0
0
Net requirements
Item:B Level:1 Lead time =3 On hand =10 Safety stock =
lot-for-lot
PD
1
2
3
4
Gross requirements
Scheduled receipts
Projected on hand
10
Net requirements
Item:C Level:1
Lead time =2
policy: lot-for-lot
PD
Gross requirements
Scheduled receipts
Projected on hand
20
Net requirements
Item:D Level:2 Lead time =1
policy: 200
PD
Gross requirements
Scheduled receipts
Projected on hand
0
Net requirements
Item:E Level:2
Lead time =1
policy: 500
PD
Gross requirements
Scheduled receipts
Projected on hand
Net requirements
6.1.3
30
Allocated =10 Lot sizing policy:

5
8
103
Allocated =0
5
0
100
100
Lot sizing policy:

7
200
0
200
Allocated = 0
5
0
200
200
Lot sizing policy:
7
100
10
10
90
On hand =20
1
20
20
10
0
90
90
Safety stock =0
3
20
200
200
0
180
180
0
200
200
180
On hand =0
200
Safety stock =0
180
200
20
180
200
200
200
On hand =30
20
180
200
360
400
170
330
500
500
270
230
500
30
500
Safety stock =0
4
Allocated =0
6
Allocated =0
6
Allocated =0
6
Lot sizing
8
Lot sizing
8
Lot sizing
8
200
270
70
Lot sizing policies
Severalmethodscalledlotsizingpoliciesarecommonlyusedtodeterminetheplannedorderreleases
for each period. We have already encountered the simple (and widely used) lotforlot policy, which
basicallysaysthatplannedorderreceiptsaresetequaltonetrequirements.Wenowdiscusssomeother
oftenusedlotsizingpolicies:periodorderquantity(POQ),economicorderquantity(EOQ),andthepart
periodbalancingmethod(PBB).
122
Toillustratethevariousmethods,weassumethattheaveragedemandforacomponentXis225units
perperiod,thesetupcostsofproducing(orpurchasing)thecomponentXis225,andthecostofholding
oneunitofXininventoryforoneperiodis0.5.WeuseTable11asthebasecase,inwhichthelotforlot
approachisused.
Table 11. Example to illustrate various lot sizing policies.
Item:X Level:
Lead time =2
On hand =150
policy: lot-for-lot
PD
1
2
3
Gross reqrmnts
Scheduled rcpts
Projected on hand
Net requirements
Pl. order rcpts
Pl. order relses
150
100
50
100
150
140
Safety stock =0
4
Allocated =0
Lot sizing
10
11
12
240
100
340
100
240
100
340
140
140
100
100
340
340
340
100
100
100
100
240
240
100
100
340
340
340
100
240
Thetotalcostisthesumofholdingcostsandsetupcosts:
Holdingcosts=0.5(150+150+100)=200
Setupcosts=7(225)=1575
Totalcosts=200+1575=1775
POQ method
Thismethodsimplysets,inaperiodinwhichproductionisscheduled(nonzeroplannedorderreleases)
theproductionquantityequaltothesumofPpositivenetrequirements,wherePisafixednumber.
Table 12. Example using POQ lot sizing method.
Item:X Level:..
policy: POQ
Lead time =2
PD
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
150
On hand =150
240
100
150
100
50
100
440
140
580
340
580
Safety stock =0
6
340
340
440
Allocated =0
10
100
240
100
340
100
440
100
Lot sizing
11
12
340
340
340
340
Table 12 illustrates POQ applied to the example of Table 11 assuming P = 3. Note that we must
produce in period 1 to meet period 3s net requirements. Since P = 3, out planned order releases for
period1shouldmeettotalnetrequirementsforperiods3,4,and6.Tomeetnetrequirementsinperiod
8,weneedtoproduceinperiod6,andthequantityproducedequalstotalnetrequirementsofperiods8,
9,and10.
Thetotalcostisthesumofholdingcostsandsetupcosts:
Holdingcosts=0.5(150+100+440+340+340+340+100)=905
EOQ method
Inthismethod,thebatchsizeissetequaltothewellknowneconomicorderquantityEOQ=
2 (setup cost)(average demand per period)
Lot size
(unit holding cost per period)
22
Ifthisresultsinafailuretomeetanyperiodsnetrequirement,wethenproducethesmallestmultiple
oftheEOQ(i.e.lotsize=2EOQ,or3EOQ,andsoon)thatwillavoidashortage.
ThisgivesintheexampleofTable11:
123
Lot size
23
2 (225)(225)
450 units
(0.5)
Table 13. Example using EOQ as lot sizing method.

Item: X Level:..
policy: EOQ
Lead time =2
PD
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
150
On hand =150
240
100
150
100
50
100
310
140
450
210
450
Safety stock =0
5
340
210
320
130
450
450
320
Allocated = 0
8
10
100
240
100
220
430
20
450
330
450
Lot sizing
11
12
340
330
440
10
450
450
We begin by producing 450 units during period 1; this will arrive in time to meet period 3
requirements.These450unitswillenableustomeetallrequirementsthroughtoperiod5,soournext
productionof450unitswillbeduringperiod4.Inperiod9,wewillneedmoreunitsofX,soweproduce
450unitsduringperiod7.Finally,weneedtoproduce450unitsduringperiod10.
Thetotalcostincurred:
Holdingcosts=0.5(150+100++440)=1685
Manycompaniesadoptafixedorderquantitylotsizingpolicy.Withthismethod,eachproductionrun
(orpurchaseorder)isofthesamesize,notnecessarilytheEOQ.
PBB method
Inthismethod,wemakeeachlotsizingdecisionbyproducingthenumberofperiodsofnetrequirements
thatmakestheholdingcostassociatedwiththeproductionbatchascloseaspossibletothesetupcost
forproducing(purchasing)thebatch.ThisideaisbasedonthefactthattheEOQminimisescostsatan
orderquantityforwhichsetupandholdingcostsareequal.
ThecalculationswhenappliedtoourexamplefromTable11areshowninthefollowingthreetables.
Wefirstneedtodeterminethelotsizeforthefirstproductionrunwhichistoproducegoodforperiod3
atleast.WeseefromTable14thattheholdingcostswillbeclosesttosetupcostswhenproducingfor
periods3and4.
Table 14. Determining the lot size for the first production run.
Produced for periods
Setup costs ()
Holding costs ()
3
3,4
3,4,6
225
225
225
0
0.5(100) = 50*
0.5(3(340)+100) = 560
As we produce in the first batch for periods 3 and 4, we need to start producing the next batch in
period4tomeet(atleast)requirementsofperiod6.CalculationsarethenshowninTable15.Thisgives
as solution to produce for periods 6 and 8. The next production run therefore needs to start with
producingforperiod9atleast;calculationsareshowninTable16.
Table 15. Determining the lot size for the second production run.
Setup costs ()
Holding costs ()
6
6,8
6,8,9
225
225
225
0
2(0.5)(100) = 100*
2(0.5)(100) +3(0.5)(240) = 460
124
Table 16. Determining the lot size for the third production run.
Setup costs ()
Holding costs ()
9
9, 10
9,10,12
225
225
225
0
0.5(100) = 50*
0.5(3(340)+100) = 560
Thelastbatchtoproduceisinperiod10tomeetperiod12srequirements.Thecompletesolutionis
displayedinTable17.
Table 17. Example using PPB as lot sizing method.

Item: X Level: ..
sizing policy: PPB
PD
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
150
Lead time = 2
On hand = 150
Safety stock =
7
240
100
150
100
50
100
240
100
140
240
6
340
100
340
440
440
100
340
Allocated = 0
10
100
240
100
11
100
240
340
Lot
12
340
340
340
Thetotalcostincurred:
Holdingcosts=0.5(150+100++100)=325
Totalcosts=1225
Inthisexample,PPBproducedthelowesttotalcost.Forotherexamples,however,POQorEOQmight
outperformPPB.Theonlymethodguaranteedtoyieldalotsizingsolutionthatminimisestotalcostsis
the WagnerWhitin method. Unfortunately, the WagnerWhitin method is more complex than most
practitionerswouldlike,soitisrarelyused.Anothermethodthatgivesagoodperformanceinpractiseis
called the SilverMeal method. Both the WagnerWhitin optimal method and the SilverMeal
approximatemethodisdescribedinWinston(1994).
6.1.4
Remarks on MRP
MRPhasbeencomeintousewiththeriseofcomputersinthelate1970s.
Evenaslightchangeintherequirementsforanenditemmaycausesubstantialchangesinthetiming
and lot sizes for subassemblies, components, and parts. This phenomenon is known as the
nervousnessoftheMRPsystem.
AnimportantdecisionisthefrequencywithwhichMRPrecordsareupdated.InaregenerativeMPR
system,theentirerecordforeachenditem,subassembly,component,etcisupdatedperiodically.In
ourexamples,therecordmightbeupdatedeveryperiod.Everyperiod,weonlyplaceordersforthe
firstperiod.Theapproachissometimesalsoreferredtoasarollingplanninghorizon.
TheMPSshouldberealisticintermsofwhattheproductionfacilitycanachieve.MRPandMPSdo
nottakecapacityrestrictionsexplicitlyintoaccountandthismaycausepracticalproblems,overtime,
etc.
Assuming everything works as planned, the MRP will result in no shortages or stock outs.
Unfortunately,fourtypesofuncertaintymaycauseshortagestooccur:
Leadtimeuncertainty.
Enditemdemandtimeuncertainty.
Enditemdemandsizeuncertainty.
Productionyielduncertainty.
Twoapproachesareusedtoavoidshortagescausesbythesefourtypesofuncertainty:
125
Planorderssotheyarriveearlierthanneeded.Thisiscalledthesafetyleadtimeapproach.
Thisworksbestfordealingwithleadtimeanddemandtimeuncertainty.
Keepmoreenditemsininventorythanwhatisneeded(andincreaseproductionbatchesin
casethisinventoryisbeingdepleted).Thisisthesafetystockapproach.Thisworksbestfor
demandsizeandproductionyielduncertainty.
References
Winston, W.L. 1994. Operations Research: Applications and Algorithms, 3th edition. Duxbury Press. See Chapter 20:
Deterministic Dynamic Programming.
Winston, L.W. 1994. Operations Research: Applications and Algorithms (3rd ed.). Duxbury Press, California. ISBN 0534209718.
Chapter 18, Section 1.
Exercises
1.Given:Table18givesgrossrequirementsforfinalproductsAandBduringthenextsixweeks.Eachunit
of A uses two units of C, and each unit of B uses three units of C. Each unit of C uses four units of D.
AssumethatAandBcanbeproducedinzerotimeonceenoughCisavailable.TheleadtimeforbothC
andDisoneweek.Atthebeginningofweek1,120unitsofCand160unitsofDareonhand.Fiftyunits
of C and 80 units of D are scheduled to be received at the beginning of week 2. The average weekly
demandis100units.Thecostperproductionrunis200,andthecostofholdingoneunitininventory
foraweekis4.
Questions:
1. Usingthelotforlotmethod,determinetheMRPrecordsforCandD.
2. DeterminetheMRPrecordforCifPOC(P=2)isused.
3. DeterminetheMRPrecordforCiftheEOQlotsizingmethodisused.
4. DeterminetheMRPrecordforCifthePPBlotsizingmethodisused.
Table 18. Data for question 1.

Week
1
20
10
A
B
2
0
30
3
30
0
4
10
10
5
20
5
6
0
10
2.Given:EnditemAconsistsof3unitsB,1unitC,and2unitsD.Bconsistsof2unitsEand1unitsD.
Cisassembledfrom1unitBand2unitsE.EveryunitEconsistsofaunitF.ComponentsB,C,EandFhave
aleadtimeof1week.AandDsleadtimeis2weeks.A,B,andFareproducedlotforlot.ForC,D,andE,
afixedorderquantityisusedof50,100,and250units,respectively.ComponentsC,E,andFhave10,
150, and 300 units on hand, respectively. All other components have no on hand inventory. The
scheduledreceiptsforAare10inweek6,50unitsofEandFinweek4,and100unitsDinweek1and
againinweek2.Therearenootherscheduledreceipts.TheMPSstatesagrossrequirementof30unitsA
inweek5and30unitsAinweek8.
Question:DeterminetheMRPplanforallitems.
3.Wepresentlyhave18unitsofproductAonhand.Ittakes2weektoproduceaunitofproductA;
POQ(P=4weeks)isbeingusedtodetermineplannedproduction.ThegrossrequirementsforproductA
forthenextsevenweeksareshowninthetablebelow.
Questions:
I. Determineplannedproductionforeachweek.
II. Suppose week 2s gross requirements is reduced by 1 (to 13 units). How does the planned
productionforeachweekchange?Howdoesthisillustratenervousness?
126

Week
1
2
2
14
3
3
4
6
5
2
6
1
7
45
Solutions
1.i.Usingthelotforlotmethod,weobtainthefollowingMRPrecordsforCandD:
Item: C Level: 1
Lead time = 1
sizing policy: lot-for-lot
PD
1
Gr.reqrmnts
70
Sched.rcpts
Proj.on hand
120
50
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
Item: D Level: 2
Lead time = 1
PD
1
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
160
160
On hand =
120
Safety stock = 0
90
50
10
60
50
55
30
50
50
55
Safety
55
30
55
30
30
stock = 0
50
50
50
50
On hand = 160
2
200
80
40
200
220
120
160
160
220
220
220
120
120
120
160
Allocated =0
Lot
Allocated =0
Lot
Allocated =0
Lot
ii.UsingthePOQ(P=2)method,weobtainthefollowingMRPrecordforC:
Item: C Level: 1
Lead time = 1
sizing policy: POQ (P=2)
PD
1
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
70
120
50
On hand =
120
Safety stock = 0
90
50
10
60
50
55
30
50
50
100
(50)
30
55
85
(30)
100
85
iii. The EOQ for C, assuming that the average weekly demand of 100 units is related to C items, is
equalto(2(200)100/4)=100units.WeobtainthefollowingMRPrecordforC:
Item: C Level: 1
sizing policy: EOQ
Lead time = 1
PD
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
120
On hand =
120
Safety stock = 0
70
90
50
10
60
50
55
30
50
50
100
(50)
45
55
100
15
(30)
50
100
Allocated =0
Lot
100
iv. Using PPB, we first have to calculate the lot sizes to be used. The first period for which a net
requirementarisesisperiod3.Therefore:
Produced for weeks

3
3,4
3,4,5
Produced for weeks
5
5,6
Setup cost
200
200
200
Setup cost
200
200
Holding cost
0
4(50)=200*
4(50 + 2 (55))=640
Holding cost
0
4(30)=120*
127
TheMRPrecordthereforeis:
Item: C Level: 1
sizing policy: PPB
Lead time = 1
PD
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
120
On hand =
120
Safety stock = 0
70
90
50
10
60
50
55
30
50
50
100
(50)
30
55
85
(30)
50
100
Allocated =0
Lot
85
Bycoincidence,thisrecordisequaltotherecordobtainedwiththePOQ(P=2)method.
2.TheBOMcanbedrawnasfollows:
A
B(3)
Level0
E(2)
D(2)
Level1
Level2
E(2)
Level3
F
E(2)
F
Level4
NoticethatitemsofthesametypeariseonmorethanonelevelintheBOM.Indeed,Bisonlevel1as
wellaslevel2,Eonlevel2andlevel3,Donlevel1and3,andFonlevel3and4.Theeasiestapproachis
tofirstbringallitemsdowntotheirlowestlevelbeforetheMRPcalculationsstart.Thereforewemodify
theBOMto:
A
Level0
C
Level1
B(3)
E(2)
Level2
E(2)
E(2)
D(2)
Level3
Level4
128
Item: A Level: 0
Lead time = 2
PD
1
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
Item: C Level: 1
sizing policy: 50
Allocated =0
6
Lead time = 1
1
50
Lead time = 2
30
10
3
30
20
50
50
On hand =
10
30
30
10
Safety stock = 0
60
50
90
50
90
90
On hand = 0
60
60
90
100
60
60
On hand =
2
100
150
3
250
10
10
Allocated =0
90
50
100
50
Lot
20
50
50
Gr.reqrmnts
100
280
Sched.rcpts
Proj.on hand
150
50
20
20
Net reqrmnts
230
Pl.ord.rcpts
250
Pl.ord.relses
250
Item: F Level: 4
Lead time = 1
On hand = 300
PD
1
2
3
300
20
20
30
10
20
Safety stock = 0
Allocated =0
4
Lead time = 1
PD
On hand =
Lot
30
30
30
PD
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
Safety stock = 0
10
10
Gr.reqrmnts
Sched.rcpts
Proj.on hand
10
10
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
Item: B Level: 2
Lead time = 1
PD
1
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
Item: E Level: 3
sizing policy: 250
30
PD
Gr.reqrmnts
Sched.rcpts
Proj.on hand
Net reqrmnts
Pl.ord.rcpts
Pl.ord.relses
Item: D Level: 3
sizing policy: 100
On hand =
60
Safety stock = 0
4
60
40
40
60
100
(40)
Safety stock = 0
4
Allocated =0
Lot
Lot
Allocated =0
200
200
200
Lot
120
50
70
200
50
250
250
Safety stock = 0
4
Allocated =0
7
Lot
250
50
50
50
150
150
150
3.
i.
129
Item: A Level: 0
Lead time = 2
PD
1
Gross requirements
Scheduled receipts
Projected on hand
Net requirements
18
On hand =
18
Safety stock = 0
Allocated =0
14
45
16
9
1
10
3
6
1
2
45
45
10
Lot
45
ii.
Item: A Level: 0
Lead time = 2
PD
1
Gross requirements
Scheduled receipts
Projected on hand
Net requirements
18
On hand =
18
Safety stock = 0
Allocated =0
13
45
16
48
6
54
46
2
45
1
45
Lot
54
A slight change in gross requirements results in a large change in production levels as well as
inventory levels! Small changes on MPS data may therefore result in large changes down the MRP
explosion.
Theamplificationarisesespeciallyfromthelotsizingtechniqueused,whichcombinesthepositivenet
requirementsfrom4futureperiods.Ifwewoulduselotforlotinstead,theresultingMRPwouldshow
muchlessnervousness:
Item: A Level: 0
Lead time = 2
PD
1
Gross requirements
Scheduled receipts
Projected on hand
Net requirements
18
Safety stock = 0
Allocated =0
14
45
16
2
1
1
2
6
6
1
2
2
45
1
1
45
45
18
18
Item: A Level: 0
Lead time = 2
PD
1
Gross requirements
Scheduled receipts
Projected on hand
Net requirements
On hand =
6
On hand =
18
Safety stock = 0
Allocated =0
13
45
16
3
2
2
45
1
1
45
45
6
6
1
Lot
Lot
6.2 JustInTime
BasedontheexampleofmanysuccessfulJapanesecompanies(mostnotablyToyota),manycompanies
worldwidehaveattemptedtoreduceinventorylevelsbyimplementingaJustInTime(JIT)approachto
productionandpurchasing.TheJITapproachconsistsofproducingproductsorobtainingproductsfrom
suppliersatthemomenttheyarerequired.SinceJITstrivestoreduceinventorylevels,JITisalsoknown
asstocklessproductionorzeroinventories.
130
6.2.1
Motivation
The main motivation behind JIT is that inventory represents inefficiency. Just as high water levels in a
riverhidedangerousrocks,highinventorylevelsinacompanyhidesourcesofinefficiencyandcausesof
poorproductquality.
Advocates of JIT believe that companies often underestimate the holding cost ch used in the
traditional inventory models such as the Economic Order Quantity (EOQ) model. The advocates of JIT
argue that in the long run, the fixed costs of a warehouse and the cost of shop storage should be
consideredasavariablecostandthereforeincludedinthevalueoftheholding costch.This would,of
course,reduceoptimallotsizeandaverageinventorylevels.
Another important parameter in inventory models is the replenishment cost cp. Often a major
componentofitisthetimerequiredtosetupamachineforaproductionrun.Areductionofsetupcostcp
will typically increase optimal replenishment frequency, reduce optimal lot size, and reduce inventory
levels.MuchofthesuccessofimplementingJITcomesfromthesuccesswithwhichonecanachievea
reductioninsetuptimes.
Anothertraditionalargumenttoholdinventoryisthatsafetystockmustbeheldtoreduceshortages
causedbydemanduncertaintyandsupplyuncertainty(suchasvariabilityinleadtimes).JITreducesthe
impactofdemanduncertaintyoninventorylevelsbylevellingtheproductionschedule.Forexample,if
2000carsand1000lorriespermonthmustbeproducedandaplantisopen20dayspermonth,theplant
shouldaimforproducing2000/20=100carsperdayand1000/20=50lorriesperday,andthesequence
inwhichthevehiclesrollfromtheproductionlineshouldalsoreflecttherelativedemand:car,lorry,car,
car,lorry,car,car,lorry,etc.ForJITtosucceed,itiscriticalthatthequantityofaproductproducedeach
dayvariesbyatmost10%fromtheaveragedailyproductionlevel.
Byreducingsafetystocklevels,thecausesofsupplyvariability(suchasunreliablesuppliers,frequent
machine breakdowns, product quality problems) are exposed. By reducing or eliminating thecauses of
supplyvariability,thereislessneedtokeeplargeamountsofsafetystocks.
6.2.2
Push and pull systems
To understand how JIT differs from the traditional approach, we must understand the difference
betweenpushandpull(production)systems.Consideramanufacturingprocessinwhichaproductmust
passthroughfourworkstationsbeforebeingcompleted,beginningatstation1andendingat4.Thinkof
the product as flowing down a river. Then the first workstation 1 is farthest upstream and station 4 is
farthestdownstream.
In a push system, materials push their way through the system from station 1 to 4. When, for
example,100unitsofaproductarecompletedatstation1,theyarepushedtowardstation2,causing
work for the employees at station 2. Once 20 units, for example, are finished on station 2, they are
pushed to station 3, and so on. Traditional production systems are often push systems, with relatively
large setup costs, so large production lot sizes. This can cause large workinprocess inventories to
accumulate.Furthermore,ifforexampleatsomemomentintimestation3breaksdown,thenstation1
and2maystillproducewithstockaccumulatingbeforestation3,unlesssomeonetellsthemtostop.
In contrast, JIT is a pull system, a system in which an upstream station does not produce anything
unlessproductionisauthorisedbytheimmediatelysucceedingdownstreamstation.Forexample,station
2cannotworkonanymaterialunlessauthorisedbystation3.Thisalsomeansthatifatsomepointin
timestation3breaksdown,allstationsupstreamwillsoonalsostopandthebuildupofextrainventory
isavoided.
6.2.3
The Kanban System
ThebestknownmethodusedtoimplementJITisToyotasKanbansystem.Thefollowingthreetypesof
itemsarevitaltoimplementingJITthroughtheKanbansystem:
I. Containers.Eachcontainerholdsastandardnumberofpartsusuallylessthan10%ofthedaily
requirementforthepart.Thiskeepslotsizesrelativelysmall.
131
II. Movecards(alsoknownaswithdrawalorconveyancecards).Movecardsareusedtoauthorise
movementofacontainerbetweentwoconsecutiveoperationsforexample,fromstation4to
station3andbacktostation4.Acontainercannotmoveunlessamovecardisattachedtoit.
III. Production cards. A production card is used to authorise production of a container of parts.
Workerscannotproducethepartsneededtofillacontainerunlessauthorisedbyaproduction
card.
There is a separate set of containers, move cards, and production cards for each possible flow of
material.Forexample,thereisonesetofcontainers,movecards,andproductioncardsformovement
betweenworkstation3and4,oneothersetformovementbetween2and3,andyetoneothersetfor
movementbetween1and2.
Forexample,letsfocusonthemovementbetweenstation3and4.Supposewearestartingtowork
on a container of parts that arrived at station 4. This container will have a move card attached to it.
Removethatcardandattachittoanemptycontaineratstation4(callthiscontainer1).Nowcontainer1
(withitsmovecard)canbetransportedbacktostation3.Atstation3,findafullcontainerofparts(callit
container2).Container2willstillhaveitsproductioncardattachedtoit.Removethatproductioncard
and put it in station 3s production card file box. Replace the production card on container 2 with the
movecardfromcontainer1.Youcannowtransportcontainer2tostation4.Productionworkersfrom
station3canusetheproductioncardthatyouhavejustplacedinthefileboxtoattachittotheempty
container1andcanthereforestartproductiontofillupthiscontainer.
This shows how station 4 pulls material downstream through the system. The beauty of the
approachisitssimplicity:unlikeMRP,forexample,nocomplicatedpaperworkorcomputerprintoutsare
neededtokeeptrackoftheinventorystatusateachstation.Thecardsdothejobautomatically.Ifwe
reduce the number of cards between two workstations, we will automatically reduce the inventory
betweenthetwostations.Ifwehavetoofewcards,however,shortagesmayoccurfrequently.Onlytrial
anderrorcandeterminetherightnumberofcards.
TherulesoftheKanbansystemcanbesummarisedasfollows:
I.
II.
III.
IV.
Atalltimes,eachcontainermusthaveacard(eitheramoveoraproductioncard)attachedtoit.
Nevermoveacontainerunlessithasamovecardattachedtoit.
Neverbeginproducingacontainerwithoutaproductioncard.
Acontainershouldalwayscontainastandardnumberofparts.
If station 4 breaks down, for example, then this will eventually result in production stopping at all
upstreamstations(13).Atfirstglance,thismightappeartoreducetheplantsproductivity.Inreality,
however,frequentplantshutdownsforceworkerstoconcentratemoreonqualityandplantefficiency.In
the long term, the shutdown will become less frequent, and a more efficient (and higher quality)
productionprocesswillresult.
6.2.4
How many cards?
Heresawayhowtocalculate(intheory)howmanymoveandproductioncardsareneededtoenablethe
plant to meet daily demand without holding unnecessary inventory. Let us again consider the material
movementbetweenstation3and4.Define:
c =numberofpartsineachcontainer(lessthan10%ofdailyrequirement);
Tm =time(indays)forworkertogofromstation4togetacontaineratstation3andreturnwithit
tostation4;
Tp =time(indays)requiredtoproduceacontainerwithcpartsatstation3;
D =dailydemandforpartsproducedatstation3;
M =numberofmovecards;
P =numberofproductioncards.
132
Howmanymovecardsareneeded?Wecanmake1/Tmtripsperdaytogetcontainers,andoneach
tripwecangetMcontainerswithcpartspercontainer.SinceweneedDpartsperday,intheorywecan
meetdailyrequirementswithoutaccumulatingexcessinventoryif:
1
M c D
Tm
or
DTm
c
Howmanyproductioncardsareneeded?WithPcards,wecanproduceuptoPcontainers(eachwith
cparts)andthis1/Tptimesperday.SincewemustproduceDunitsperday,wecanintheorymeetdaily
requirementswithoutaccumulatingexcessinventoryif
1
P c
Tp
or
DTp
c
Fortheseformulastobevalid,wemustassumethatthereisnovariabilityinmoveandproduction
times.Thevalidityoftheformulasalsorequiresthatthecontainerswillbereadytopickupwhenevera
workerfromstation4arrivesatstation3.Toallowforsomeslackinthesystem,thefollowingformulas
areoftenusedtodeterminetherequirednumberofmoveandproductioncards:
DTm (1 k)
c
D Tp (1 k)
c
wherekisasafetyfactor.IfJITisworkingwell,kshouldbenear0.Toyotastrivestokeepkascloseas
possibleto0.10.Inreality,acompanymaybeginwithk=0.50.Ifshortagesareinfrequent,acardmaybe
removedfromthesystem.Thiswillreduceinventorylevels.Ifshortagesarestillrare,anothercardmay
beremoved.Thisprocesscontinuesuntilsatisfactoryresults,i.e.infrequentshortagesandlowinventory
levels,havebeenobtained.
Example
Assumek=0.Station4mustobtain200partsperdayfromstation3.Eachcontainercontains10parts,
andittakesTp=0.10dayatstation3tofillacontainer.Goingfromstation4tostation3withanempty
container,pickupafullcontaineratstation3andreturntostation4takesatotalofTm=0.05day.Then:
M=200(0.05)(1+0)/10=1movecard
P=200(0.10)(1+0)/10=2productioncards
Themaximuminventorylevelis(M+P)c=30items.
Letusseehow1movecardand2productioncardswouldenablethesystemtokeepupwithdemand
without accumulating excess inventories. Observe that station 4 will use up a container in 0.05 day.
133
Supposethatattime0(thebeginningofaworkday)station4hasonefullandoneemptycontainer,and
station3hastwofullcontainers.Attime0,webeginusingpartsatstation4,andsoaworkertakesthe
emptycontainer(withamovecard)tostation3.Theworkerarrivesatstation3attime0.025.There,the
workerpicksupafullcontainerandremovestheproductioncard.Atstation3,thedetachedproduction
cardisusedtostartproductionforfillingtheemptycontainer.Afterattachingthemovecardtothefull
container,theworkerheadsbacktostation4andarrivesattime0.05,justintimeforthefullcontainer
of parts to be used when the full container already at station 4 is used up at time 0.05. At time 0.05,
another worker leaves station 4 and arrives at station 3 at 0.075. Production begins at station 3 on
anothercontainer.(Thisisokay,becausewehavetwoproductioncards).Wearrivebackatstation4with
afullcontainer(again,justintime)attime0.10.Attime0.10,aworkeragainleavesforstation3,anda
time0.125,theworkerarrivesatstation3andcanpickupthefullcontainerwhoseproductionbeganat
time0.25.Insummary:
1. Attimes0;0.5;0.10;0.15;,aworkerleavesstation4forstation3.
2. Attimes0.25;0.75;0.125;.,aworkerarrivesatstation3andpicksupafullcontainer.Station3
alsosimultaneouslybeginsproducingacontaineraparts.
3. Attimes0.05;0.10;0.15,aworkerarrivesatstation4withafullcontainer(justintime)
Themaximuminventorylevelwillbe30parts.Withmorecards,themaximuminventorylevelwould
increase,buttherewouldbeslackinthesystemtohandleunexpectedshutdowns,shortages,ordelays.
Also note that a levelled production schedule (i.e. always producing 200 parts per day, for example) is
criticaltothesuccessofJIT.Section5describeshowToyotadealswithfluctuationsindemand.
6.2.5
Subcontractors
WhenacompanysuchasToyotaimplementsJIT,thesubcontractorsalsohavetoadoptJITdeliverytothe
Toyota plants. It is usually the subcontractor who delivers its products to the company. As JIT implies
frequentdeliveriesinsmalllotsizes,theinventorylevelsatboththeToyotaplantandthesubcontractors
canremainlow.However,thedistributioncostswillrise.
Tocounterthehighdistributioncosts,thesesuppliersoftencollaboratewitheachotherandusethe
socalled roundtour mixedloading transportation system. Suppose, for example, that four
subcontractedcompaniesA,B,C,andDarealllocatedintheeasternareaoftheToyotaplant.Suppose
furtherthattheyhavetobringtheirproductsfourtimesduringthedayshiftinsmalllotsizes.Thefirst
deliveryat9amcouldbemadebysubcontractorA,alsopickinguponthewayproductsforcompaniesB,
C,andDinAstruck.Theseconddeliveryat11amcouldbemadebycompanyBsimilarlypickingupthe
products of A, C, and D on the way. The third delivery at 2pm would be made by company C and the
fourthdeliveryat4amwouldbemadebycompanyD.
The subcontractors themselves would also adopt the JIT system in their production plants to keep
inventorylevelsofworkinprocessdown,toincreaseproductandprocessquality,andlowercosts.This
willbebeneficialtoToyotaasthesuppliescanbeofferedatlowerprices,andultimatelybenefitthefinal
customersaswell.
6.2.6
Fluctuations in demand
TheJITsystemworksonlyifproductionissmoothed(orlevelled,seealsoSection1)andthereforeif
demandisfairlyconstant.Withinreasonablelimits,however,theJITproductionsystemofToyotaisable
todealwithvariousfluctuationsindemand.Therearethreetypesofdemandchangespossible:
Case1:Nochangeindailytotalproductionload,theonlychangesareinthekindsofendproducts(for
example,carsintheToyotasituation),theirdeliverydates,andtheirquantities.
ThesolutionadoptedbyToyotaistoonlyrevisetheproductionscheduleforthefinalproductionline
where the cars are finalised. Then the schedules for all the preceding processes will be automatically
revisedbytransferringtheKanbans.
134
Case2:Shorttermsmallfluctuationsinthedailyproductionload,althoughthemonthlytotalloadis
thesame.
Forthiscase,ToyotadoesnotincreasetheordecreasethenumberofKanbans,butsimplyincreases
ordecreasesthenumberofKanbanmovements.TheassemblylineofToyotahasatwoshiftsystem.The
day shift is from 8am to 6pm, and the night shift starts at 9pm, ending at 6am. By inserting early
attendanceandovertimebeforeandaftertheseshifts,thelinealwayshasthesamenumberofworkers
atanytimethelineisinoperation.Itistherebyabletoproduceasmanyunitsasathreeshiftsystemif
necessary.If,ontheotherhand,demandislower,thefrequencyofKanbanmovementsisreducedwhich
resultsinidlecapacityoridletimefortheworkers. Simultaneously,timespentincarryinginventoryis
prolonged.Iftheleadtimeisshort,however,thelossassociatedwithcarryinginventorywillnotbevery
large.
Case3:Seasonalchangesindemand,orwhentheactualmonthlydemandislargerorsmallerthanthe
predeterminedloadortheprecedingmonthsload.
Inthiscase,thenumberofKanbansmustbedecreasedorincreased,andatthesametime,allthe
productionlinesmustberearranged.
To better understand what to do in Case 3, we first introduce the concept of cycle time. Take the
exampleofSection1.If2000carsand1000lorriespermonthmustbeproducedandaplantisopen20
dayspermonth,theplantshouldaimforproducing2000/20=100carsperdayand1000/20=50lorries
per day, and the sequence in which the vehicles roll from the production line should also reflect the
relative demand: car, lorry, car, car, lorry, car, car, lorry, etc. The cycle time is the time between two
vehiclesleavingtheproductionline:
cycle time
operating hours per day
necessary output per day
21
150
0.14 hours/vehicle
Therefore every 0.14 hours = 8.4 minutes a vehicle should leave the production line. If the total
numberofvehiclesneededpermonthisnowdecreasedfrom3000to2500,forexample,thenthedaily
outputnecessaryis2500/20=125andthecycletimebecomes:
cycle time
operating hours per day
necessary output per day
21
125
0.168 hours/vehicle
orevery10.08minutesavehicleshouldleavetheproductionline.
How to best achieve this change? The basic idea is to lower the production rate by reducing the
numberofoperatorsnecessarytodothework.Theproductionlayoutthatisfoundtobemostflexibleto
allowforsuchadjustmentistheUturnformat,asdepictedinthefiguresbelow.Thetopfigureshows,for
example, the configuration under high monthly demand: five operators are used, each operating two
machines.
135
entrance
1
exit
entrance
1
exit
Figure 21. U-form layout and worker allocation under high (top) and low (bottom) monthly demand.
The bottom figure would then be the configuration used when monthly demand is lower: three
operators,twoofthemoperatingtheemachinesandonefourmachines.Theworkoneachmachinewill
goslowerasanoperatornowhasmoremachinesundercontrol.Asaresult,theoutputwillbereduced.
Inorderforthistowork,operatorshavetobemultiskilledworkers,astheymayhavetochangework
fromtimetotime.Eachjoboneachmachinehastobeperfectlystandardisedsothatdifferentworkers
willalwaysfollowthesameproceduresoneachmachinesothatproductqualityremainsconstant.
6.2.7
Comparison JIT and MRP
Experience with JIT and MRP has shown, not surprisingly, that MRP tends to outperform JIT when
demandishighlyvariableandsetupcostsarehighorsetuptimesarelong.JITtendstooutperformMRP
whendemandisstableandsetuptimesaresmall.
Clearly,thesmallerlotsizesassociatedwithJITwillincreasethenumberofsetupsrequired.Consider
acompanyproducingmanydifferentproducts.IfsuchacompanyusesJIT,highsetupcostswillprobably
beincurredbecauseitmustfrequentlychangefromproducingoneproducttoanother,duetosmalllot
sizeofJIT.ThisexplainswhyJITismostcommonlyusedinarepetitivemanufacturingenvironmentwhere
mostsetuptimesaresmallandveryfewproductsaremade.
Exercises
1.Given:InaKanbanproductionenvironment,100partsperdayarerequired,5partspercontainerare
used,andTm=Tp=0.20days.Assumethatmaterialisbeingtransportedfromstation1tostation2.
Questions:
a. Determinethenumberofmoveandproductioncardsneeded.
136
b. Atwhatinstantswillapersonarriveatstation2withfullcontainers?
c. Atwhatinstantswillproductiononcontainersbeginatstation1?
d. Whatisthemaximumnumberofpartsininventory?
2.Given:InaKanbanproductionenvironment,200partsperdayareneeded,20partspercontainer
areused,andTm=0.10daysandTp=0.30days.Assumethatmaterialisbeingtransportedfromstation1
tostation2.
Questions:
a. Determinethenumberofmoveandproductioncardsneeded.
b. Atwhatinstantswillapersonarriveatstation2withfullcontainers?
c. Atwhatinstantswillproductiononcontainersbeginatstation1?
d. Whatisthemaximumnumberofpartsininventory?
e. Whatisthecycletime?
3.Given:ConsideraBOMasdisplayedinFigure22.
A
B(2)
Figure 22. BOM for question 3.
A,B,andCareproducedatourownfactory.Aisassembledinstation2,andcomponentsBandCare
bothproducedinstation1.Thesetuptimesforthemachineinstation1aredisplayedinTable20.

Setup time (days)
From B
From C
To B
0
0.02
To C
0.01
0
ProductiontimetoproduceoneBonstation1is0.01.ProductiontimetoproduceoneConstation1
is0.01.ProductioniscontrolledaccordingtotheJITapproachusingaKanbansystem.Containersused
betweenstation1andstation2store4Bitemsand2Citems.Thetimetobringanemptycontainerfrom
station2tostation1andbringafullcontainerbackis0.05days.
To produce one item B, one kit of parts D is needed. To produce one item C, one kit of parts E is
needed. D kits are produced by supplier 1, and E kits are produced by supplier 2. Containers used to
transportDkitsfromsupplier1tostation1contains16Dkitsatatime.Thesamecontainerscanbeused
totransport8Ekitsfromsupplier2tostation1.
Supplier1needsatimeof0.2daystoproduceacontainerofDkits.Supplierneedsatimeof0.15days
toproduceacontainerofEkits.Totransportafullcontainer,andbringanemptyoneback,supplier1
needs0.2days.Totransportafullcontainerandbringanemptycontainerback,supplier2alsoneeds0.2
days.Ifsupplier1andsupplier2wouldcooperateandadopttheroundtourmixedloadingsystemin
whichonecontainerfromeachispickedup,transporttimewouldbe0.25daysforoneroundtrip.The
dailyproductionrequirementis100Aitems.
Questions:
a. Determinethenumberofmoveandproductioncardsbetweenstation2andstation1.
b. Determine the number of move cards between supplier 1 and station 1 in case of separate
transport
c. Determine the number of move cards between supplier 2 and station 1 in case of separate
transport.
137
d. Determine the number of move cards between suppliers 1 and 2 and station 1 in case of the
roundtourmixedloadingapproach.
e. Determinethenumberofproductioncardsforeachsupplier.
f. Determinethemaximuminventorylevelinthesupplychainundertheseparatetransportoption
g. Determinethemaximuminventorylevelinthesupplychainundertheroundtourmixedloading
approach.
Solutions
1. Solution:
a. M=100(0.2)/5=4movecards;P=100(0.2)/5=4productioncards
b. Arriveat0.20;0.25;0.30;0.35;0.40;etc.(becausetherehavetobe4movementsinaperiodof0.2.)
Note:Analternativewaytocalculateb:cycletimeis1/100=0.01i.e.every0.01daysanitemhasto
rollfromtheproductionline,whichmeansthatanewcontainerof5partshastoarriveevery5(0.01)
=0.05days.Assumingthefirstwalkfromstation2tostation1startsat0.0,thepersonwillarriveat
station 4 with first container at time 0,20, and then every 0.05 days the following container has to
arriveatstation4.Hencethesequenceis:0.20;0.25;0.30;0.35;0.40;etc.
c. Begin at 0.1; 0.15; 0.20; 0.25; 0.30; etc (4 containers in production in a period of 0.2) Note: An
alternativewaytocalculatec:cycletimeis0.01daysand5partspercontainermeansevery0.05days
productiontofillanewcontainerhastocommence.Thefirstemptycontainerarrivesfromstation2
at0.1,whichisthetimetheproductiontofillthiscontainerstarts;thenattime0.15thenextempty
containersfromstation2arrivesandproductionstartsforthissecondcontainer;etc.
d. Beginwith4fullcontainersateachstation.Thenmaxinventorylevelis8(5)=40items.
2. Solution:
a. M=200(0.1)/20=1movecard;P=200(0.3)/20=3productioncards
b. Cycletimeis1/200=0.005daysbetweentwoitemsrollingfromtheproductionline.Acontainerhas
20 items, therefore a container needs to arrive at station 2 every 20(0.005) = 0.1 days. The first
containerwillarriveat0.1;thesecondat0.2;then0.3;etc.
c. Similarly,every0.1daysafullcontainerhastobereadyatstation1,andthereforeproductiontofilla
new container needs to start every 0.1 days. Production can beginat 0.05;thenproduction for the
nextcontainercanstartat0.15;thenat0.25,etc.Thefirstcontainerforwhichproductionstartedat
0.05willbereadyat0.35,justintimeforpickupbyaworkerfromstation4.
d. Cycletime=timeinaday/itemsneededperday=1/200=0.005days.Thisisthetimebetweentwo
itemsrollingfromtheproductionline.
3. Solution:(Note.Inreallife,onewillhaveuncertaintiesinleadtimessuchasthosecausedbytraffic
jamsandthereforeonehastointroducesafetyfactors)
a. Betweenstation2andstation1:Station1wouldhavetoproduceinthefollowingorder:B,B,C,B,B,
C,etc(seeBOM).Acontainerthereforecontains4Band2Citems.Totaldemandperdayinorderto
produce100Aitemsperdayistherefore200B+100C=300itemsperday.ThusM=300(0.05)/6=
2.5=>3movecards.Atstation1,thetimetofillonecontaineristhetimetoproduce:B,B,C,B,B,C
and set the machine back in a condition to start production on a B item. Total production time is
hence:
Productiontime:6(0.01)=0.06days
Setuptime:2(0.02)+2(0.01)=0.06days
Totalproductiontimetofillcontainer=0.06+0.06=0.12days
Therefore:P=300(0.12)/6=6productioncards.
b. M=200(0.2)/16=2.5=>3movecards.
c. M=100(0.2)/8=2.5=>3movecards.
d. M=300(0.25)/24=3.125=4movecards.
e. Forsupplier1:P=200(0.2)/16=2.5=>3productioncards.Forsupplier2:P=200(0.15)/8=1.875=>
2productioncards.
f. 32Bitemsand16Citemsincontainersinstation1orsomewherebetweenstation1andstation2;48
Dkitsatsupplier1;96Dkitssomewherebetweensupplier1andstation1;16Ekitsatsupplier2and
40Ekitssomewherebetweensupplier2andstation1;
138
g. Likeinf.,butonly64Dkitsand32Ekitssomewherebetweensupplier1or2andstation1.
References
See also e.g. Chapter 18, Section 2 of: Winston, L.W. 1994. Operations Research: Applications and Algorithms (3rd ed.).
Duxbury Press, California. ISBN 0534209718.
6.3 Bottleneck scheduling

OptimisedProductionTechnology(OPT)isatechniquethatderivesitsnamefromacomputersoftware
systemforplanningandschedulinginanoperationalfacilityinthecontextofvariability.Thefirstversions
ofthissystemwereintroducedasearlyas1979.
The internal algorithms of the OPT software are proprietary, but the general rules have been
explained in Goldratt and Coxs book The Goal, a book in which the message is presented as an
adventure story around a manager facing the closure of his factory unless a major improvement in
productivity(moreoutputatlowercosts)isobtainedwithinafewdays.Asatechnique,OPTprovidesyet
another perspective on planning and scheduling compared to MRP and JIT, although it is more a
philosophythanarealtechnique.
OPT is closely linked with TOC, yet another acronym which stands for the Theory of Constraints,
explainedinseveralotherbookswithagainGoldrattasoneoftheauthors.
Whatthesetwoapproachesleadtoistheviewthatmodellingcanhelptoidentifyproblemsand/orto
optimise the Supply Chain. The optimisation model of a Supply Chain is a successful approach
exemplifiedbyforexampletheacceptanceofLinearProgramming.
6.3.1
Optimised Production Technology (OPT)
ThebasicideaofOPTisthatinaproductionenvironmentinwhichdifferentmachinesorstationsshould
worktogethertoproduceendproducts,someofthesemachinesorstationsareheavilyusedandothers
arenot.Thefirstandmainattentionforplanningandschedulingshouldgotowardskeepingtheseheavily
usedmachines,thesocalledbottlenecks,workingathighutilisationlevels.Theplanningandscheduling
for the other stations, the nonbottlenecks stations, comes second. These noncritical resources are
scheduledbelowcapacitytoallowforasafetycapacitytoexistatalltimes.
ThegeneralrulesofOPTaresummarisedhereandwillbefurtherdiscussedinthesections:
1.
Donotbalancecapacitybalancetheflow.
2.
Thelevelofutilisationofanonbottleneckresourceisdeterminednotbyitsownpotentialbutby
someotherconstraintinthesystem.
3.
Activatingaresource(makingitwork)isnotsynonymouswithutilisingaresourceeffectively.
4.
Anhourlostatabottleneckisanhourlostfortheentiresystem.
5.
Anhoursavedatanonbottleneckisamirage.
6.
Bottlenecksgovernboththroughputandinventoryinthesystem.
7.
Thetransferbatchmaynotandmanytimesshouldnotbeequaltotheprocessbatch.
8.
Theprocessbatchshouldbevariablebothalongitsrouteandintime.
9.
Prioritiescanonlybesetbysimultaneouslyexaminingallofthesystemsconstraints.Leadtime
isaderivativeoftheschedule.
OPTinvestigatesfiveareasoftheproductionenvironment:variability,bottlenecks,setups,lotsizes,
andpriorities.
Variability
Most scheduling methods attempt to balance resources. The number of workers will be constantly
adjustedtobalancemachinecapacitywithworkercapacity,andtheplansforthesubsequentworkwill
utilise these resources at the capacity required to meet demand. It has been shown through
mathematical simulation that a balanced plant cannot exist in the presence of variability. Variability in
139
dependent work centres will cause schedules to be missed, resulting in a decreased throughput,
increasedinventory,andincreasedoperatingcosts.
OPT rules are based on the realisation that the constraints on an operation often exist outside the
operation. The variability within an operation not only affects that operation but all subsequent
operations,especiallywithbottleneckresources.Therefore,OPTsfirstruleis:1.Donotbalancecapacity
balancetheflow.
Bottlenecks and Nonbottlenecks
Abottleneckisarestrictionorconstraintintheflowofmaterialthrougharesource.Aresource,inthis
case,isanyelementneededtomakeaproduct,whetheritisamachine,aperson,orspace.Aresourceis
consideredabottleneckwhenitisrequiredtooperateat100%capacitytomeetthepresentschedule.
Astheschedulechangesortheproductmixchanges,differentresourcesmaybecomebottlenecks.
To illustrate the interaction between bottlenecks and nonbottlenecks, four different cases are
presented in Figure 23; they represent virtually all the possible combinations of interaction. In the
examples,acertainproductismanufacturedthatrequirestheuseoftworesources,XandY.Thisisthe
simplestcaseandcan,ofcourse,beexpandedformultipleresources.Demandforthisproductplaces
different time requirements on the two resources, and an imbalance occurs. X denotes a bottleneck
resourcethathasamarketdemandof100hoursperweek;italsohasacapacityof100hoursperweek.Y
denotesanonbottleneckresourcesthathasamarketdemandof75hoursperweekandacapacityof
100hoursperweek.Thesetworesourcescanonlyinteractinfourways.
Bottleneckresource
Capacity=100hours/week
Demand=100hours/week
Nonbottleneckresource
Capacity=100hours/week
Demand=75hours/week
Case1
Case2
Case3
Case4
Dependentdemand
Independentdemand
Customer
Figure 23. Interaction between resources
Incase1,allproductflowsfromXtoY.Inthiscase,resourceXhasarequirementof100hoursper
weekandisfullyutilised,butresourceYhasonly75hoursofworkandisthereforeunderutilised.The
outputfromXstarvesY.
Incase2,allproductflowsfromYtoXandXcanagainbeutilised100%ofthetime.IfY,however,is
activated100%ofthetime,toomuchproductwillbeproducedandflowtoresourceX;Xwillnotbeable
toprocessalltheseproducts.Thiswillincreaseworkinprocessinventory,consumeresources,andnot
increasethroughput.Tobalancetheflow,Yneedstobeactivatedonly75%ofthetime.
140
Incase3,XandYbothfeedacommonassembly.Havingworkedthroughcases1and2,wecansee
thatXwillbeutilised100%ofthetimetomeetmarketdemand;however,activatingY100%ofthetime
willexceedthedemandfor thisresourceandwillagainbuildworkinprocessinventoryinfrontofthe
assemblystation.
Incase4,XandYbothfeedindependentcustomerdemandandarenotinterrelated.ActivatingX100
%ofthetimewillexactlymeetcustomerdemand.ActivatingY100%ofthetimewillexceedcustomer
demand; this will build inventory and not increase throughput. Y needs only be activated 75 % of the
time.Notethatinthiscasethemarkethasbecometheconstraint.
In all four cases the same results were obtained. X was always active, a good indication of a
bottleneck. Y could not be activated more than 75% of the time, or one or more manufacturing goals
werecontravened.FromthisexamplecomesOPTssecondandthirdrules:2.Thelevelofutilisationofa
nonbottleneck resource is determined not by its own potential but by some other constraint in the
system;3.Activatingaresource(makingitwork)isnotsynonymouswithutilisingaresourceeffectively.
Allnonbottleneckresourcesmustthereforebeschedulednotonthebasisoftheirownconstraints
butonthebasisofthesystemsconstraints.
Setups
Theavailabletimeatabottleneckresourcecanbedividedintotwocategories:processingtimeandsetup
time.Ifanhourofsetupissavedatabottleneckresource,anhourofprocessingtimeisgained.Taking
thefourcaseexampleoftheprevioussection,resourceXscapacityhasincreasedto101hoursperweek.
Itmeansthattheentiresystemisnowabletosatisfyahigherdemandperweek,i.e.thethroughputof
thesystemhasincreased.ThisleadstoOPTsfourthrule:4.Anhourlostatabottleneckisanhourlost
fortheentiresystem.
At nonbottlenecks, however, there may be no gain at all in avoiding setups. Taking again the
examplesoftheXandYmachines,increasingYscapacityfrom100to101hoursperweekwouldnotgive
usanyincreaseinthroughput.Inparticular,incases13,wewouldnevergainfromhavingYatacapacity
of 101 hours per week, even if machine Xs capacity would be 101 hours per week and demand for X
would likewise have increased to 101 hours per week. We can realise a throughput equivalent to 101
hoursperweekofdemandforXwhetherYscapacityis100or101hoursperweek.Incase4,extending
machineYscapacitydoesalsomakenosensewithaweeklydemandthatrequiresonlyabout75%ofits
capacity.ThereforeOPTsfifthrulestates:5.Anhoursavedatanonbottleneckisamirage.
Lot sizes
Itisimportantthatsetupsbesavedatthebottlenecks,sincetimespentnotproducingaffectstheentire
system.OPTthereforeadvisestoproduceinlargerbatchesonthebottleneckresourcethantraditional
lot sizing methods (see e.g. Chapter 1, Section 3) would indicate. Indeed, the cost of a setup at a
bottleneck resource is not just the cost associated with the time and work required at this bottleneck
station,butitshouldbeassociatedwiththelossinthroughputforthewholesystemandthereforeitis
very high! Therefore, OPTs sixth rule reads as follows: 6. Bottlenecks govern both throughput and
inventoryinthesystem.
Since nonbottleneck resources have actually spare time available, it is possible to produce in
smaller lot sizes on such resources. Smaller lot sizes means more setups and setup time, but time is
availableandthecostofsuchsetupsmayonlyinvolvethedirectlabourcost:thereisnoopportunitycost
ofthroughputlossastheoneassociatedwithbottleneckresources.
141
Setup
time
X
Runtime
Bottleneckresource
Timesavedinsetupbecomesruntime
Additional run time results in additional hour of

throughputforthewholesystem
Setup
time
Y
Runtime
Idle
time
Nonbottleneckresource
Anytimesavedinsetupbecomesidletime
Anadditionalhourofidletimeisworthnothing
Figure24.Resourceactivities
Thebenefitofproducinginsmallerlotsizesonnonbottleneckstationsaresystemwideadvantagesin
thatsmallerlotsizesmayreduceleadtimesandcanhelptokeepbottleneckresourcesworkingallthe
time. Indeed, in case 2 of the examples presented before in which machine Y feeds the bottleneck X,
smaller lot sizes on Y may be better able to keep X working all the time. (This is especially relevant in
whenthereisvariabilityinthesystem).
Asabatchmovesthroughafacility,itencountersbothbottleneckandnonbottleneckresources,and
thequestionarisesastowhetherabatchshouldbesubdividedorremainasingleentity.Twodifferent
typesofbatchesmustbeconsidered:
Transferbatch:thelotsizeviewedfromthestandpointofthepart.
Processbatch:thelotsizeviewedfromthestandpointoftheresource.
TheEconomicOrderQuantity(EOQ)modelmaintainsabalancebetweenholdingandsetupcosts.In
thecaseofabottleneck,thesetupcostisviewedfromtheperspectivenotonlyoftheresourcebutofthe
entiresystem.Anhourlostatthebottleneckisanhourlostforthewholesystem.Oneshouldmakesure
the bottleneck station needs relatively few setups and has always a buffer inventory in front of it.
Therefore:7.Thetransferbatchmaynotandmanytimesshouldnotbeequaltotheprocessbatch.
Since a batch moving through manufacturing will encounter both bottleneck and nonbottleneck
operations,allwithvaryingsetupandprocessingtimes,theparametersusedinestablishinglotsizefor
the batch must be examined for validity. Typically, batches launched on the shop floor are split,
combined,andoverlappedtomeetthedemandsoftheschedules.ThesimplicityoftheEconomicOrder
Quantity(EOQ)formulacannotaccommodatethecomplexitiesandrealityofmultipleworkcentresina
manufacturing environment, and it should not be expected that one batch size for a product moving
through many work centres should always be the same: 8. The process batch should be variable both
alongitsrouteandintime.
Priorities
Many rules exist to determine the sequence in which orders should be processed. The most widely
acceptedrulesconsidertheamountoftimeremainingtocompletetheorderandthetimeavailableto
completetheorder,orthetimetoduedate.
142
MRPlogiclooksattheprioritiesofanitembasedontherequiredduedateandtheleadtimeoffsetof
components.Thisinitialroughcutdoesnotconsidercapacityconstraintsandmayresultinaplanthat
requiresreworkinguntilfeasible.Ineffect,MRPlooksatprioritiesandthenseesiftheyfitthecapacity.
Invariably,however,conflictingprioritiesresult,sincetwoormoredifferentjobswillrequireprocessing
atthesameworkcentreatthesametime.Tosatisfycapacityconstraints,onejobmustbeprocessedfirst
andthesubsequentjob(s)delayed.Sincedelayhasoccurred,theleadtimehasbeenaffected.
Theleadtimeofajobisthusaffectednotonlybythecapacityofthevariousworkcentresbutbythe
priority of the other jobs. This leads to the ninth and final rule: 9. Priorities can only be set by
simultaneouslyexaminingallofthesystemsconstraints.Leadtimeisaderivativeoftheschedule.
6.3.2
Theory Of Constraints (TOC)
Step1.Identifythesystemsconstraint(s).
Calculatetheprocessload.
Allforbreakdowns.
Determinethenumberofsetupsthatcanbedone.
Step2.Decidehowtoexploitthesystemsconstraint(s),
i.e.howtomakethebestuseoftheconstraint.
Ifnobottleneckexists,thenmakeapredeterminedschedulefortheconstraints.
Ifabottleneckdoesexist,thendecideontheproductmixbeforemaking
apredeterminedschedule.
=TheDrumConcept.
Step3.SubordinateeverythingelsetothedecisionsmadeinStep2.
Releasematerialintotheplantaccordingtotheneedsoftheconstraints,
allowingsufficienttimeforthematerialtoarrive.
=TheBufferandRopeConcept.
Step4.Elevatethesystemsconstraint(s).
Afterhavingmadethebestpossibleuseoftheexistingconstraint(s),
thenextstepistoreduceits(their)limitationsonthesystemsperformance.
Example
AssumeweoperateasimpleplantasdepictedinFigure1.WehaveaproductcalledPwhichsellsfor90
per unit, and the market will take 100 units per week. In order to make that product, we have to put
togetheranassembly.WehaveresourceD,whodoesallourassemblywork,anditrequires10minutes
tomakeoneproductP.Theassemblyoperationinvolvesputtingtogetherapurchasedpartthatcosts5
andputtingtogetherafewcoupleofmanufacturedparts.Thosemanufacturedparts,ofcourse,alsoare
madefromrawmaterials,andoneparticularpartgoesthroughdepartmentA,wheretheresourcetakes
15minutestoworkonit,andthenitgoesontodepartmentC,where10minutesaretaken.Anotherpart
startsindepartmentB,where15minutesarerequired,thenitgoestodepartmentC,where5minutes
arerequired.Finallyourassemblerputsthemtogether,andwehaveafinishedproduct.
Wehaveasecondproduct,productQ,whichsellsfor100perunit.Itispricedhigher,sowecansell
only 50 of them per week. It is also done by the assembly department, but the assembly only takes 5
143
minutes.Itusestwoparts,onemadefromrawmaterialcostingwhichgoesthroughdepartmentsAand
thenB,andtheotherpartisatypeofpartalsousedinproductP.
In this particular plant, we have one A, one B, one C, and one D, and they are all working 2400
minutesadaya40hourday.Itcostsus6000aweektorunthisplant.Whatisthemaximumamount
ofmoneywecanmakeinthisplant?
A,B,C,D:1each
Availabletime:
2400min/week
Operating
expenses:
6000/week
Q100/unit
50
P90/unit
100
D 5
D 10
Purcha
separt:
5/unit
C 10
C5min
B 15
A 15
B 15
A 10
RM1
20/
RM2
20/
RM3
20/
Figure1:Simpleplantexample.
Howmuchprofitcanwemake?Letusfirstcalculatewhatnetprofitperweekcanbe,i.e.whatthe
potentialoftheplantwouldbeiftherewerenocapacityconstraints.TheresultsareshownintheTable1
below.
Table 1: Net week profit potential for this plant
Product
Total
P
Q
Marketpotential
100
50
Sellingprice
90
100
Rawmaterialcosts
45
40
Contributionperunit
45
60
Totalcontribution
4500
3000
7500
Operatingexpenses
(6000)
Netprofitperweek
1500
However, we cannot be sure that we can produce everything. Let us check whether what the
workloadwouldbeonallofourresourcesifwewouldindeedtrytoproduce100Pproductsand50Q
products.ThesecalculationsareshownintheTable2.
144
Table 2: Process load assuming full market demand can be produced

Reso
ProcessLoad
Available
Workload
urce
/week
time/week
/week
A
P:15x100=1500
2000
2400
83%
Q:10x50=500
B
P:15x100=1500
3000
2400
125%
Q:15x50+15x50=1500
C
P:10x100+5x100=1500
1750
2400
73%
Q:5x50=250
D
P:10x100=1000
1250
2400
52%
Q:5x50=250
Sothereisaproblem:wecannotmakeeverything.WorkloadsarefineforA,C,andD,butresourceB
shouldbeusedmorethan100%andthisisnotpossible.
Now we have a different kind of problem. Because we cannot make everything, what should we
make? Let us first approach this from an accounting perspective in which we wish to calculate the
profitabilityofaproduct,asshownintheTable3.
Table 3: Conventional approach based on product profitability
Product
P
Q
Marketpotential
100units
50units
Sellingprice
90
100
Rawmaterialcosts
45
40
Contributionperunit
45
60
Directlabourtimeperunit
55min
50min
Contributionperdirectlabourminute
0.82
1.20
=>ProductQispreferable
AsproductQisapparentlythemostprofitableproduct,wewillproduceall50productsQonresource
B,whichleavesuswith900minfreeonresourceBwhichwewillusetoproduce900/15=60productsP.
Thenetprofitswecanexpectfromtheplantperweekaretherefore:
Table 4: Net profit per week expected under the conventional approach
Product
Total
P
Q
Quantityproduced
60
50
Sellingprice
90
100
Rawmaterialcosts
45
40
Contributionperunit
45
60
Totalcontribution
2700
3000
5700
Operatingexpenses
(6000)
Netprofitperweek
(300)
Unfortunately,wewillmakealossof300perweek.Isthisreallythebestwecando?
WenowaregoingtoapplythephilosophyofTOC,andseeifleadstobetterresults.Weknowthat
resourceBisthebottleneckoftheplant.Whatwouldhappenifwetriedtoestablishhowtomakebest
useofthisbottleneckresource;whatwouldbethesolutionifwetriedtomakesurethateveryminuteof
processing time on the bottleneck will generate us the most profits? Would we then still prefer to
produceQ?ThetypeofcalculationsneededaredisplayedintheTable5.
145
Table 5: TOC approach based on bottleneck profitability
Product
P
Q
Marketpotential
100
50
Sellingprice
90
100
Rawmaterialcosts
45
40
Contributionperunit
45
60
Timeonbottleneckperunit
15min
30min
Contributionperbottleneckminute
3.00
2.00
=>ProductPispreferable!
ThistimeproductPispreferable.Ifwewouldproduceall100productsofP,wewouldhave900min
leftonresourceBtomake900/30=30productsQ.Thenetprofitexpectedisnow:
Table 6: Net profit per week expected under the TOC approach
Product
Total
P
Q
Quantityproduced
100
30
Sellingprice
90
100
Rawmaterialcosts
45
40
Contributionperunit
45
60
Totalcontribution
4500
1800
6300
Operatingexpenses
(6000)
Netprofitperweek
300
Wewouldmakeaprofitof300perweek!
Think about this: with theconventional method, weneed to have accurate estimates of how much
processing time is needed on all work stations to produce a unit of product (i.e. of the whole supply
chain). With the TOC method, we only need to know the time needed on the bottleneck resource. It
seemswecanachievebetterresultswithlesseffort.
Efficiencies
As a result of the plan to produce 100 products P and 30 products Q, we can calculate the actual
workloadsforeachresource.TheresultsaredisplayedinTable7below.
Table 7: Process load under the TOC planning schedule

Reso
ProcessLoad
Available
Workload
urce
/week
time/week
/week
A
P:15x100=1500
1800
2400
75%
Q:10x30=300
B
P:15x100=1500
2400
2400
100%
Q:15x30+15x30=900
C
P:10x100+5x100=1000
1150
2400
48%
Q:5x30=150
1150
2400
48%
D
P:10x100=1000
Q:5x30=150
WecanseethattheseresultsaresimilartotheexamplesdiscussedinSection1onOPT.Itisnouseto
runresourcesA,C,andDat100%efficiency,asthiswouldnotallowustosellanythingmorebutwould
justbuildupinventory.
146
Elevate the systems constraints

Supposeanengineerattheplantaskspermissiontospend5000intoolingandfixturesthatwillallow:
TheprocesstimeatresourceCtobeincreasedfrom5to7minutes;
TheprocesstimeatresourceBtobedecreasedfrom15to14minutes.
Wouldyousaythisisagoodproposal,ordoyouthinkweneedtofiretheengineer?
Atfirstsight,theideamayseemstrange.Remarkthatifwewouldimplementthisidea,theprocessing
time to make the part from raw material RM1 goes up from 25 to 27 minutes, the processing time to
makethepartfromrawmaterialRM2goesupfrom20to21minutes,andonlytheprocessingtimeto
makethepartfrommaterialRM3goesdownfrom25to23minutes.Allinall,wedonotseemtogaina
lotinprocessingtimes,andwehavetopay5000forit!
Letsexaminethesituation,however,fromtheviewpointofTOC.Theproposalhasonegoodaspect:
itreducesthetimeneededtoproduceonthebottleneckresource;processingtimegoesdownfrom15to
14minutesforPandfrom30to28minutesforQ.Thisgives:
Table 8: TOC approach based on bottleneck profitability
Product
P
Q
Marketpotential
100
50
Sellingprice
90
100
Rawmaterialcosts
45
40
Contributionperunit
45
60
Timeonbottleneckperunit
14min
28min
Contributionperbottleneckminute
3.21
2.14
=>ProductPisstillpreferable!
ThistimeproductPisstillpreferable.Ifwewouldproduceall100productsofP,wewouldhave1000
minleftonresourceBtomake1000/28=35.735productsQ.Thenetprofitexpectedisnow:
Table 9: Net profit per week expected under the TOC approach
Product
Total
P
Q
Quantityproduced
100
35
Sellingprice
90
100
Rawmaterialcosts
45
40
Contributionperunit
45
60
Totalcontribution
4500
2100
6600
Operatingexpenses
(6000)
Netprofitperweek
600
We would make a profit of 600 per week, an extra 300 per week! Therefore, the investment of
5000wouldpayitselfbackinlessthan5000/30017weeks,orinlessthan5months.
A new look at standard costing
OPT and TOC provide new perspectives on the standard approaches to production costing, measuring
productionefficiencyinworkcentres,makeorbuydecisions,andoverallonhowinvestorsshouldinvest
theirmoney.
147
Linear Programming
Oneofthemostpowerful developmentsistheuseofoperationalresearchmethods.Forexample,the
problem of the simple plant presented in previous section can be easily translated into a Linear
Programmingproblem:
Let xp be the units of P produced per week, and xq be the units Q produced per week. Then our
objectivefunction,tomaximiseprofits=revenuescosts,canbeexpressedas:
Max z 90 x p 100 x q 6000 5 x p 20 x p 20 x p 20 x q 20 x q
Theconstraintsinthemodelare:
1)DemandconstraintsforPandQ:
x p 100
x q 50
2)TimeconstraintsforA,B,C,andD:
15 x p 10 x q 2400
15( x p x q ) 15 x q 2400
10 x p 5( x p x q ) 2400
10 x p 5 x q 2400
3)Signrestrictions
x p , xq 0
Exercise
1.Acompanyproducestwotypesofproduct:XandY.ThemarketpotentialforXis50unitsperweek;
themarketpotentialforproductYis100unitsperweek.OneunitofXsellsfor$100,andoneunitofY
sellsfor$80.Thecompanyhasthreeexpensivemachines:A,B,andC.Eachmachinecanbeusedfor2400
minutesperweek.Thefixedcostsperweekare$4000.
OneunitofproductXismadefromoneunitofrawmaterialFandtwounitsofrawmaterialG;one
unit of product Y is made from one unit of raw material G and one unit of raw material H. The unit
purchasepriceofFis$20;ofGis$20;andofHis$30.
RawmaterialsFandHarefirstprocessedonmachineB;toprocessoneunitonBrequires10minutes.
RawmaterialGisfirstprocessedonmachineC;ittakes15minutestoprocessoneunit.Theprocessed
rawmaterialsthenflowtomachineAtomakethefinalproductsXandY.Ittakes10minutesonmachine
AtoproduceoneunitofXand15minutestoproduceoneunitofY.
a)UsetheTheoryOfConstraintsfourstepframeworktoproposeaproductionplanforthecompany
tomaximiseitsweeklyprofits(=revenuescosts).
b) Suppose it takes 20 minutes on resource B to process one unit. Which resource is now the
bottleneck?WriteanLPmodelofthisplanningproblem.
c)SolvetheLPproblemconstructedinb)withExcelSolver.
Answers:
a)
148
Table : Net week profit potential for this plant
X
Marketpotential
50
Sellingprice
$100
Rawmaterialcosts
$60
Contributionperunit
$40
Totalcontribution
$2000
Operatingexpenses
Netprofitperweek
Product
Y
100
$80
$50
$30
$3000
Total
$5000
$(4000)
$1000
Table : Process load assuming full market demand can be produced

Resour
ProcessLoad
Available
ce
/week
time/week
A
X:10x50=500
2000
2400
Y:15x100=1500
B
X:10x50=500
1500
2400
Y:10x100=1000
C
X:2x15x50=1500
3000
2400
Y:15x100=1500
Workload
/week
83.3%
62.5%
125%
Table : TOC approach based on bottleneck profitability
Product
X
Y
Marketpotential
50
100
Sellingprice
$100
$80
Rawmaterialcosts
$60
$50
Contributionperunit
$40
$30
TimeonbottleneckCperunit
30min
15min
ContributionperbottleneckCminute
$1.33
$2.00
=>ProductYispreferable!
Toproduce100Yproductscorrespondswith1500minutesonthebottleneckC,leaving900minutes
onCtoproduce900/30=30units
Table : Process load under the TOC planning schedule

Resour
ProcessLoad
ce
/week
A
X:10x3=30
130
Y:15x100=1500
B
X:10x3=30
1300
Y:10x100=1000
C
X:2x15x3=900
2400
Y:15x100=1500
Table : Net week profit potential for this plant
Product
Available
time/week
2400
Workload
/week
54.2%
2400
54.2%
2400
100%
Total
149
Marketpotential
Sellingprice
Rawmaterialcosts
Contributionperunit
Totalcontribution
Operatingexpenses
Netprofitperweek
X
30
$100
$60
$40
$1200
Y
100
$80
$50
$30
$3000
$4200
$(4000)
$200
b)
Table : Process load assuming full market demand can be produced
Resour
ProcessLoad
Available
ce
/week
time/week
A
X:10x50=500
2000
2400
Y:15x100=1500
B
X:20x50=1000
3000
2400
Y:20x100=2000
C
X:2x15x50=1500
3000
2400
Y:15x100=1500
Workload
/week
83.3%
125%
125%
References
Goldratt,E.,andJ.Cox.2004.TheGoal:aProcess of OngoingImprovement.GowerPublishingLtd.,
ISBN0566086654.
Goldratt, E.M., E. Schragenheim, and C.A. Ptak. 2000. Necessary But Not Sufficient: A Theory of
ConstraintsBusinessNovel.NorthRiverPress.ISBN0884271706.
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2015

4.3.1 Perfect coordination schemes: examples ................................................ 83

1.1 Defining Supply Chain Management

1.2 Understanding Supply Chain Management

1.3 Measuring Supply Chain Performance

1.4 What is Integrated Logistics?

2.1 Strategy and Finance

2.2 Time value of money

Net Present Value for discrete interest rates

Net Present Value for continuous interest rates

where istheinterestratepertainingtoaperiodoflength and isthecontinuousinterestrate

Example 1 A oneoff lump sum () received at future time L

Example 3 An infinite number of equal cash revenues received at equidistant moments

Example 4 A continuous cashflow at a rate of a (/year) received for eternity.

Linear approximations of NPV and AS

This can be used to derive linear or quadratic approximations in of NPV or AS functions, as

NPV and AS of a few useful cases

Case 1 A oneoff lump sum a () received at future moment L

2.3 Economic Order Quantity (EOQ) Harris (1913)

Figure 1. Lot-size model (EOQ).

(Q) h (Q) p (Q) s (Q)

Figure 2. Global cost function of the EOQ model.

Using the NPV framework to derive the optimal policy

Figure 3. Cash-flows representation of the EOQ model.

2.4 Economic Production Quantity (EPQ) Taft (1918)

The traditional approach to deriving the optimal policy

Figure 4. Manufacturing lot size system.

where *EOQ referstothecostobtainedinbasicEOQmodel.ItiseasytoshowthattheEOQmodelis

Using the NPV framework to derive the optimal policy

2.5 EOQ with batch demand Grubbstrm (1980)

The traditional approach to deriving the optimal policy

2.6 Lotforlot production at finite rate Monahan (1984)

and the holding cost is then

Thus we can take

Wefinishthissectionbyproviding some intuitionbehindthesuppliersreward. As shownabove,it

2.7 EOQ for batch demand Goyal (1976)

always satisfies the

2.9 Vending machine

t buyer paays at some time

ninstalmentss.Thebuyer maypay,forrexample,a fractionoft heamountd

will hencefortth assume th

2.11 Consignment arrangements

A buyersupplier model with consignment arrangements

Note that the holding cost for the buyer is based on

2.12 The profit function of the integrated supply chain

However,thisfunctionnowmakesuseoftwodifferentopportunitycostsofcapital, and .Would

2.13 Using the NPV framework to include other cost components

Onewaytosolvethisproblemistakingpartialderivativesto and andsolvethenonlinearsystem

Credit elastic demand functions

BEULLENS, P. 2014. REVISITING FOUNDATIONS IN LOT SIZING CONNECTIONS BETWEEN HARRIS,

3 IL in Buyer-Supplier Supply Chains

3.1 Onetoone shipping

Figure 5: One-to-one shipping (Direct shipping, line-haul shipping, FTL shipping)

Shortest Path Problem

Figure 6: A shortest path problem

Economic Transport Quantity (ETQ)

Figure 7: Inventory positions and cash-flows in the direct shipping model

Optimal threefirm solution

Determining the value of

since there are approximately 24 365

Maximum Economic Haulage Radius (MEHR)

Note that when

The righthand side

he maximum possible vallue of . Ho

Alternative solution method for Shapley Value *RECOMMENDED