Computers & Industrial Engineering 61 (2011) 10861097

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Computers & Industrial Engineering

journal homepage: www.elsevier.com/locate/caie

Developing a two stage stochastic programming model of the price

and lead-time decision problem in the multi-class make-to-order rm q
S. Kamal Chaharsooghi a,1, Mahboobeh Honarvar a,, M. Modarres b,2, Isa Nakhai Kamalabadi a,3
a
b

Department of Industrial Engineering, School of engineering, Tarbiat Modares University, P.O. Box 14115-11, Tehran, Iran
Department of Industrial Engineering, Sharif University of Technology, P.O. Box 14588-89694, Tehran, Iran

a r t i c l e

i n f o

Article history:
Received 13 March 2010
Received in revised form 15 May 2011
Accepted 27 June 2011
Available online 3 July 2011
Keywords:
Pricing
Lead-time
Production
Two-stage stochastic programming

a b s t r a c t
Pricing coordination and due-date management are managerial challenges in todays competitive marketplace. Segmenting orders into classes and allocating resources based on their sensitivity to time
and price can increase a rms prot and its capacity utilization. In addition, other parameters such as
production policy, inventory holding and delivery system should be considered in pricing and due-date
decisions. In this paper, we consider the role of exibility in price, lead-time and delivery in the make-toorder environment, where limited production capacity under a stochastic demand function is allowed.
We develop a two-stage stochastic programming model to determine the price, lead-time and production
amount jointly in each period. The difculty of continuous distributions is avoided by using a scenariobased approach for stochastic demand. Through numerical analyses, we indicate the benets of exibility
in delivery, price and lead-time in various environments.
2011 Elsevier Ltd. All rights reserved.

1. Introduction
In todays competitive marketplace, pricing policies and revenue management techniques are the effective components that
inuence market demand and balance supply and demand. Revenue management can be dened as the art of maximizing the prot
generated from a limited capacity of a product over a nite horizon
by selling each product to the right customer at the right time for
the right price (Talluri & van Ryzin, 2004). Revenue management is
most effective when the demand can be segmented and price sensitivity varies across market segments.
While revenue management techniques and dynamic pricing
policies have been used widely in the airline and hotel industries,
retail and manufacturing companies are also employing pricing
strategies such as dynamic pricing and target pricing for their different classes of customers. In revenue management system, segmentation of orders is based on their sensitivity to price.
Moreover, the segmentation and quoting lead-times based on an
orders time sensitivity is a managerial challenge in make-to-order
environment.
q

This manuscript was processed by Area Editor Joseph Geunes.

Corresponding author. Tel.: +98 21 82883345.

E-mail addresses: skch@modares.ac.ir (S.K. Chaharsooghi), mahboobeh_

honarvar@yahoo.com (M. Honarvar), Modarres@sharif.edu (M. Modarres),
nakhai@modares.ac.ir (I.N. Kamalabadi).
1
Tel.: +98 21 44209944.
2
Tel.: +98 21 66165719.
3
Tel.: +98 21 82884387.
0360-8352/$ - see front matter 2011 Elsevier Ltd. All rights reserved.
doi:10.1016/j.cie.2011.06.022

In make-to-order environments, various attributes of the product, such as its price and lead-time, are evaluated by the buyer.
Therefore, for each new customer, the rm should determine a
due-date and price based on the customers preferences, the available capacity, and other potential orders that could demand those
resources. Companies such as Dell Computers and Amazon.com are
examples of rms that separate their customers into different classes and change their prices based on parameters such as demand
variation, inventory levels, or production schedules (Biller, Chan,
Simchi-levi, & Swann, 2005).
Based on price and scheduling decisions as proposed by
Charnsirisakskul, Grifn, and Keskinocak (2006), this paper proposes an extended model that incorporates joint pricing and
lead-time control problems in a production environment with stochastic demand. Customers are classied into different segments,
based on their reservation price and sensitivity to delivery time.
We model a MTO (make-to-order) production system, where
stochastic demand is a function of both price and lead-time and
the rm should determine these parameters for upcoming orders,
based upon its available capacity, the operating costs associated
with the production of the order, holding costs and tardiness penalties incurred for the orders that are completed in advance of their
due-dates and orders shipped after the preferred due-date,
respectively.
We assume prices and due-dates (lead-times) are set at the
beginning of the horizon. However, the production decision is
made after the arrival of customer orders as well as more denitive
information becomes available. As a real world case of this

S.K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

problem, one can name the internet-based retail system of car

industry. Automotive industry is pushed towards producing
customized cars. Thus, they have adopted make-to-order system.
Potential customers make their purchase decisions by optimally
consider both non-negotiable price and delivery dates. Then, they
optimize their objective by trading off between price and delivery
date.
Stochastic programming can be an appropriate approach to
model this problem, in which decisions need to be made prior to
obtaining complete information. This motivated us to use stochastic programming approach to formulate the integrated problem of
pricing and lead-time quotation.
This paper is organized as follows. We discuss the related literature in Section 2. In Section 3, we describe the pricing and leadtime quotation problem. In Section 4, we explain the algorithm
used to approximate the stochastic demand process and reformulate our problem in scenario representation. Section 5 presents the
numerical examples and sensitivity analysis for our model. Finally,
Section 6 is the conclusion of the paper.

2. Literature review
Joint pricing and inventory control strategies in a single period
(newsvendor) manufacturing environment were rst stated by
Whitin (1955). Whitins work was later extended by Mills (1959)
who studied effect of uncertainty on a pricing policy under a
linear-additive functional form for demand. Static pricing with
multiplicative form of demand was formulated by Zabel (1970)
and Karlin and Carr (1962). In addition, Petruzzi and Dada (1999)
examined an extension of the newsvendor problem in which
demand depends on both price and inventory level. Some other
researchers have considered multi-period, nite-horizon pricing
models (e.g., see Thomas, 1970; Thowsen, 1975; Zabel, 1972).
The retail industry has also used dynamic pricing techniques to
match demand with capacity, maximize revenue or achieve other
strategic goals, as shown by several authors (Chen & Simchi-Levi,
2004; Federgruen & Heching, 1999; Gallego & van Ryzin, 1994,
1997, and others). Elmaghraby and Keskinocak (2003) and Chan,
Shen, Simchi-Levi, and Swann (2004) provided a thorough review
of both single and multi-period models combining pricing and
inventory strategies. Most prior research on integrating pricing
strategies with inventory control policies has ignored production
capacity limitations.
The second body of research related to our paper focuses on
due-date management in which the key decisions are due-date setting and scheduling (e.g., Bertrand, 1983; Chen, Zhao, & Ball, 2001;
Hegedus & Hopp, 2001; Moses, Grant, Gruenwald, & Pulat, 2004;
Sawik, 2009; Seidmann & Smith, 1981; Wein, 1991; Wein &
Chevalier, 1992; Zorzini, Corti, & Pozzetti, 2008). The research on
due-date management is reviewed by Keskinocak and Tayur
(2004). They categorized all due-date assignment methods into
two categories: exogenous (determined by the sales department,
without knowing the actual production schedule) and endogenous
(assigned internally by the scheduling model). Some researchers
have used mathematical programming in solving the due-date setting problem. For example, Chen et al. (2001) developed mixedinteger programming models for quantity and due-date quotation
to customer orders that arrive within a pre-determined time interval. Sawik (2009) proposed a dual-objective problem of due-date
setting over a rolling planning horizon in make-to-order manufacturing. They considered the total number of delayed products as a
primary optimality criterion, and the total or maximum delay of
orders as a secondary criterion. The results in the papers cited
above indicate that proper due-date management offers a much
larger improvement in performance than priority sequencing.

1087

In the papers reviewed above, they all assume that the demand
process is independent of any price and/or lead-time quoted to
customers. Some researchers have considered whether the quoted
lead-times (or due-dates) and price affect customers decisions on
placing an order. Duenyas and Hopp (1995) were the rst to analyze a queueing model in which lead-time quotation affects the demand rate. They developed queueing models that allow customers
to leave if the due-date offered by the rm is too late. The objective
is to maximize prot by making the optimal decisions on sequencing and due-date setting. Duenyas (1995) also developed an effective heuristic for quoting due-dates and sequencing orders.
Palaka, Erlebacher, and Kropp (1998), So and Song (1998) and
Webster (2002) studied the optimal selection of price and delivery
time assuming a xed scheduling rule, and formulate the problem
as a steady state queueing model.
Keskinocak, Ravi, and Tayur (2001) proposed several online and
ofine algorithms for quoting lead-times to different customer
classes to maximize revenue, subject to the constraint that quoted
lead-times are 100% reliable when the processing time per customer is known. Moodie (1999) considered the negotiation process
in price and due-date setting, where the number of quotations
from customer is dependent on past delivery service level. Easton
and Moodie (1999) developed a probabilistic model to determine
optimal pricing and due-date setting decisions with contingent
orders. In their model, the probability that the customer will accept
a quoted price/due-date pair follows an S-shaped logit model.
Watanapa and Techanitisawad (2005) extended Easton and
Moodies model proposing a model that incorporates the market
segmentability, in which different policies can be applied to different demand classes. In their model, price and lead-time are dened
for a single job in a single-period production system. Extending
previous research, Charnsirisakskul et al. (2006) formulated a
deterministic mixed-integer programming model for the problem
of order selection, due-date setting and production scheduling in
multiple nite periods with customers arriving at different times.
In this paper, we extend the model of Charnsirisakskul et al.
(2006) in which the demand function is assumed to be deterministic. Therefore, all production lot sizes are deterministic. Due to
uncertainty of data, we consider the case of multiple classes of
orders with stochastic demand.
Substituting the uncertain demand by an expected value can be
considered a modeling error that cause an increase in cost and
result in lost sale and unsatised customers. Therefore, we assume
that demand is stochastic and function of both price and lead-time.
We consider a linear-additive form dened as D(p, l, n) =
d(p, l) + n for demand, where D(p, l, n) is the demand and n is a random variable that does not depend on the price and lead-time; in
this case the mean demand is d(p, l), and the noise term n shifts the
demand randomly about this mean (Talluri & van Ryzin, 2004).
Whitin (1955) was the rst to examine a linear-additive functional
demand form. Other related works that considered this form of demand include (Chen & Simchi-Levi, 2004; Dana & Petruzzi, 2001;
Federgruen & Heching, 1999; Mills, 1959; Yin & Rajaram, 2007;
Zabel, 1972).
An alternative way to incorporate more information about the
demand uncertainty into the model is by formulating a stochastic
linear program.
Stochastic programming (SP) models were originated by
Dantzig (1955) and Beale (1955). They proposed a stochastic view
to replace the deterministic one, where the unknown coefcients
or parameters are random, with assumed probability distribution
that is independent of the decision variables. Advances in computational methods to solve large scale problems made SP techniques
applicable to real-world problems. Stochastic programming has
been successfully applied to several optimization problems, such
as assetliability management (Consigli & Dempster, 1998; Sodhi,

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S. K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

2005), supply chain planning (Azaron, Brown, Tarim, & Modarres,

2008; El-Sayed, Aa, & El-Kharbotly, 2010; Santoso, Ahmed,
Goetschalckx, & Shapiro, 2005), capacity planning (Ahmed et al.,
2003; Chen, Li, & Tirupati, 2002), production planning (Fleten &
Kristoffersen, 2008; Gupta, Maranas, & McDonald, 2000), etc.
Within the stochastic programming, the nature of the decisional
process suggests that we consider a two-stage paradigm. Here, the
decision variables are partitioned into two different subsets: the
rst-stage decisions that are made before the random variables
are observed, and the second-stage decisions that depend on the
realization of the rst-stage random vector. In our problem, decisions on the price and lead-time represent rst-stage actions,
whereas decisions on production planning and order scheduling
are second-stage decisions since they are inuenced by the uncertain demands. We refer the reader to Kall and Wallace (1994),
Birge and Louveaux (1997) and Ruszczynski and Shapiro (2003)
for basic references on stochastic programming with recourse.
A standard approach to solve the stochastic models is by using a
nite number of scenarios to model uncertainty of relevant data.
The scenarios and their probabilities represent an approximation
of the probability distribution given by the random data and also
avoid the difculty of continuous distributions. In the present paper, we investigate a scenario tree-based stochastic programming
approach to the pricing and due-date management problem. In this
method, a scenario tree consisting of a nite number of scenarios
approximates the stochastic demand process.
There are several ways to generate scenario trees for stochastic
programs. Heitsch and Rmisch (2009) categorized them as (i)
bound-based constructions, (ii) Monte Carlo-based schemes or
Quasi Monte Carlo-based methods, (iii) EVPI-based (expected value of perfect information) sampling and reduction within decomposition schemes, (iv) the moment-matching principle, (v)
probability metric-based approximations.
In this paper, the scenario tree construction approach developed by Dupacova, Growe-Kuska, and Rmisch (2003) and Heitsch
and Rmisch (2003) is used. Given an initial set of discrete probability distribution, they determined a scenario subset of prescribed
cardinality and a probability measure based on this set that is the
closest to the initial distribution in terms of a natural (or canonical)
probability metric. Mller, Rmisch, and Weber (2004, 2008) also
considered their algorithm to approximate the evolution of passenger demand and the cancellation process in a multistage stochastic
program for revenue management model.
To the best of our knowledge from a review of the literature, there
is no existing joint pricing and lead-time decision model based upon
stochastic programming and scenario generation method.

3. Problem description: Notation and assumptions

We model the MTO manufacturing facility as a single machine,
which may be the bottleneck in a system with negligible setup
times (and costs), where order preemption is allowed.
The planning horizon is divided into periods of equal length,
and the capacity in each period may differ. The rm denes a price
and lead-time for each customer class at the beginning of the planning horizon, and customer classes arrive with a stochastic demand that is a function of the price and quoted lead-time. The
manufacturer has the option of not presenting price and lead-time
for some customer classes. The accepted order (the order that price
and lead-time is presented for him) must be shipped to the customer between the commitment due-date and the end of the planning horizon. For accepted orders, after the realization of the
stochastic demand, the manufacturer decides on a production
schedule in a nite horizon, which, in turn, affects the due-dates.
Production scheduling must occur after the release time. The re-

lease time is the earliest time the production can be started. A produced order can be shipped to customer between the commitment
due-date and the end of the planning horizon. If an order is scheduled in any period prior to its commitment and negotiated duedate, it is stored in a third party warehousing facility and incurs
holding costs. An order shipped after the commitment due-date
is considered late and incurs a tardiness penalty proportional to
the number of periods and the quantity delay. Shortages are allowed, and unmet demands are lost.
The manufacturers objective is to maximize the net prot,
which is the sum of revenues from accepted orders minus production, holding, tardiness and shortage costs, subject to capacity,
delivery time, and demand constraints.
3.1. Notation
In the rest of this paper, we shall use the following notation.

W = {1, . . . , N} set of customer classes classied based on

sensitivity to price and lead-time,
T = {1, . . . , T} set of planning periods,
Pi fpi1 ; . . . ; pij ; . . . ; pini g set of prices (per unit) the manufacturer can charge for customer class i e W, where ni is the number of prices offered to customer class i,
e(i) earliest start time for producing customer class i e W,
i
i
i
Dui fl1 ; . . . ; lj ; . . . ; lLi g set of due-dates the manufacturer
i
can charge for customer class i e W, where ei  l1 <
i
i
l2 ; . . . ; < lLi  T and Li is the number of due-dates offered to customer class i,
Chi third party holding cost per time period per unit of customer class i e W,
Cai tardiness penalty per period per unit of customer class
i e W,
Csi shortage penalty per unit of customer class i e W
Cpit production cost per unit of customer class i e W in period
t e T,
Kt units of production capacity available in period t e T,
Di,j,k demand for customer class i e W corresponding to price
i
pij 2 Pi and due-date lk 2 Dui, expressed in units of production capacity required.
Note:
We consider a linear additive demand function Di;j;k Ai 
i
Bi pij  C i lk  ei 1 ni ; Ai ; Bi ; C i > 0, where Ai, Bi and Ci represent the market size, customer price and lead-time sensitivity for
customer class i, respectively, and ni is a random variable with
PDF (probability density function) f() and CDF (cumulative distrii
bution function) F(). As we can see, lk  ei 1, is the time interval
between the arrival time of the customer and the quoted due-date,
which we called the lead-time. The vector n = (n1, . . . , nN) represents the random data vector, where ni is the stochastic input
parameter in the demand function for customer class i e W.
We will formulate this problem as a two-stage stochastic recourse model. Such model is characterized by an initial rst stage
decision corresponding to the price and lead-time quoted to each
class of customer, after which the true values of the random events
are realized, and a second-stage or recourse decision is made. The
second stage decisions correspond to future compensation or recourse actions of scheduling and production planning in each time
period. The rst and second stage decision variables are as follows:
 First stage decision variables:
i

Zi,j,k 1 if price pij 2 Pi and due-date lk 2 Dui are selected

(quoted) for customer class i, 0, otherwise (j = 1, . . . , ni, k =
1, . . . , Li, i e W),

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S.K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

 Second stage decision variables:

The second stage decision variables are the following stochastic
variables:
xi;j;t;t0 quantity produced (in units of capacity) for customer class i
in period t and delivered in period t0 if price pij 2 Pi is selected
i
t ei; . . . ; t 0 ; t0 l1 ; . . . ; T; i 2 W.
Ui total quantity produced for customer class i, (i e W).
Hi total quantity-period inventory of customer class i, (i e W).
Vi,k total quantity-period tardiness of customer class i with
i
quoted due-date lk , (k = 1, . . . , Li, i e W).
The above bold face letters are used to denote random variables
(random vectors), in order to distinguish them from their particular realizations.
3.2. Stochastic model
The two-stage stochastic programming problem with random
recourse for pricing and lead-time decisions is formulated as
follows:

Max Q Z
ni X
Li
X

3:1

Z i;j;k  1 8i 2 W

3:2

j1 k1

Z i;j;k 2 f0; 1g 8i 2 W; j 1; . . . ; ni ; k 1; . . . ; Li ;

3:3

where Constraints (3.2) ensure that each order is either rejected or

accepted and only one price and one lead-time are chosen for the
order, Q(Z) is the expected second-stage recourse function dened
as Q(Z) = EnQ(Z, n), and Q(Z, n) is the optimal value of the following
model:
00
Max@@

ni
N X
X

pij

i1 j1

N
X

N
X

1
xi;j;t;t0 A 

t0 li1 tei

Hi  Chi 

Li
N X
X

i1

T
t0
X
X

ni X
N X
T
t0
X
X

4. A scenario representation of the stochastic model

To solve the stochastic recourse model, assume a random vector
n = (n1, . . . , nN) is given, with a nite number of scenarios
ns ns1 ; . . . ; nsN some Euclidean space RN with probabilities ps,
P
s = 1, . . . , S. In this case Q Z En Q Z; n s ps Q Z; ns . So we
can express the expected value as weighted sum (4.1), where variables xsi;j;t;t0 ; Hsi ; V si;k ; U si are production quantity, total quantityperiod inventory, total quantity-period tardiness, total quantity
produced under scenario s, respectively.

xi;j;t;t0  Cpit

i1 j1 t0 li tei
1

Max@

V i;k  Cai

ni X
Li
X
i
Ai  Bi pij  C i lk  ei 1 ni  Z i;j;k

!!

 Ui

j1 k1

i1

S
X

t0
X

ni
N X
X
i1

 Cai 
Li
X

t0 li1 tei

Z i;j;k Di;j;k 8i 2 W; j 1;. . . ; ni

ps

i;j;t;t0

6 K t t 1; . . .; T

lk 1 t 0
ni X
X
X

xi;j;t;t0 6 M1 1 

ni
X

j1 t0 1 t1

!
Z i;j;k

8i 2 W; k 1; . . . ; Li

j1
ni
X

t0 lik

t  txi;j;t;t0 8i 2 W

T
X

i
 lk xi;j;t;t0

M2

tei

t0
X

ps

N
X
i1

ni X
N X
T
X

s1

t0 li1 tei
S
X

ps

Hsi  Chi 

S
X
s1

i1

ps

j1 t 0 li
1

Li
N X
X

V si;k

i1 k1

Csi




i
Ai  Bi pij  C i lk  ei 1 nsi  Z i;j;k

!
 U si
4:1

After rewriting the stochastic programming model (3.2)(3.11), our

scenario-based constraints are as follows:
ni X
Li
X

3:8

j1 t0 li tei
1

V i;k P

3:7

ni X
T X
t0
X

S
X

i1

ni X
Li 
X

3:6

j1

ni X
T X
t0
X

N
X

1
xsi;j;t;t0 A

j1 k1

T
X

i2Wjei6t j1 t0 maxft;li g
1

Hi P

3:5

k1

ni
X

j1

T
t0
X
X

s1
S
X
s1

xi;j;t;t0 6

tei

S.t.
T X
t0
X

pij

xsi;j;t;t0  Cpit 

3:4

Ui

s1

i1 k1

Csi 

The ve terms in (3.4) correspond to the total revenue, production cost, holding cost, tardiness penalty and shortage penalty,
respectively. Constraint (3.5) ensures that if price pij and due-date
i
lk are selected for customer class i, at most Di,j,k units must be
produced and delivered for customer class i. Constraint (3.6) is
a capacity constraint that ensures that the production capacity
in each period is not exceeded. An order can be delivered between the quoted due-date and the end of the planning horizon,
but only if the order is accepted. So, we have Constraint (3.7), in
i
which customer class i cannot be delivered before lk if lead-time
i
lk is selected.
The total quantity-period inventory, total quantity-period tardiness and total quantity produced of each order are dened by Constraints (3.8)(3.10), respectively. The parameters M1 and M2 are
sufciently large numbers.
As we can see, the model has so-called complete xed recourse;
that is, for any feasible rst-stage solution, the second-stage problem
^
is feasible (the recourse function is nite), since ^
x 0; ^I 0; H
^ 0 is always a feasible second-stage solution. We assume that
0; A
the possible realizations of demand are sufciently high such that
the lowerbound LB for Q(Z) is 0 (Q(Z, n) > 1) and accordingto the demand and capacity constraints, Q(Z, n) < 1 for all Z and n. So, Q(Z, n) is
nitevaluedforallZ e {0, 1}andallpossiblerealizationsoftherandom
data.

ni
X

Z i;j;k  1

8i 2 W; k 1;. . . ; Li

3:9

j1

T
t0
X
X

8i 2 W

xsi;j;t;t0 6

tei

3:10
0

xi;j;t;t0 P 0 8i 2 W; j 1; . . . ;ni ; t ei; .. . ; t ; t

i
l1 ; . . . ; T; Hi

P 0 8i 2 W;
3:11

Li
X

Z i;j;k Dsi;j;k

8i 2 W and j 1; . . . ; ni ; s

k1

1; . . . S

j1 t0 li tei
1

V i;k P 0 8i 2 W; k 1;. . . ; Li

4:2

t0 li1

xi;j;t;t0

Z i;j;k 6 1 8i 2 W

j1 k1

ni
X

T
X

i2Wjei6t j1 t 0 maxft;li g
1

xsi;j;t;t0 6 K t

4:3
t 1; . . . ; T

4:4

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S. K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

i

lk 1 t 0
ni X
X
X

xsi;j;t;t0 6 M 1 1 

j1 t 0 1 t1

ni
X

Z i;j;k 8i 2 W; k

j1

1; . . . ; Li ; s 1; . . . ; S
Hsi P

ni X
T
t0
X
X

t 0  txsi;j;t;t0

4:5

8i 2 W; s 1; . . . ; S

4:6

j1 t 0 li tei
1

V si;k P

ni X
T
t0
X
X

t 0  lk xsi;j;t;t0 M 2

j1 t0 li tei
k

ni
X

Z i;j;k  1 8i

j1

2 W; k 1; . . . ; Li ; s 1; . . . ; S
U si

ni X
T
t0
X
X

xsi;j;t;t0

integer program and is NP-hard. The simultaneous backward

reduction algorithm is approximated by Heitsch and Rmisch
(2003) to determine a reduced probability distribution Q of n such
that the set of deleted scenarios has maximal cardinality and that
l^ r P; Q 6 e holds.
Using their backward reduction algorithm, we determine a reduced probability distribution of the random vector ~
n ~
n1 ; . . . ; ~
nN
and use it in the stochastic programming model ((4.1)(4.9)). The
details for backward reduction algorithm and a small instance of
constructing the scenario tree by this algorithm are given in
Appendix A.

4:7

8i 2 W; s 1; . . . ; S

4:8

j1 t 0 li tei
1

5. Numerical study
In this section, we investigate the benets of exibility in delivery, price and lead-time in various environments. Also, we illustrate the advantage of our modeling approach compared with the
expected value solution approach.

xsi;j;t;t0 P 0 8i 2 W; j 1; . . . ; ni ; t ei; . . . ; t0 ; t 0 l1 ; . . . ; T
Hsi P 0
V si;k P 0

5.1. Flexibility in delivery, price and lead-time

8i 2 W; s 1; . . . ; S
8i 2 W; k 1; . . . ; Li ; s 1; . . . ; S

Z i;j;k 2 f0; 1g 8i 2 W; j 1; . . . ; ni ; k 1; . . . ; Li
4:9
The constraints (4.3)(4.8) are demand constraint, capacity constraint, delivery constraint, total quantity-period inventory, total
quantity-period tardiness and total quantity produced for customer
classes under scenario s. The constraint (4.2) is non-anticipativity
constraint linking the separate scenarios.
Depending on the number of realizations of n, this linear program may become (very) large in scale. One way to overcome this
difculty is using decomposition methods that exploit special
structures of the model (Ruszczynski & Shapiro, 2003). Another
method is to reduce the model dimension; it might be desirable
to reduce the originally designed tree (Dupacova et al., 2003;
Heitsch & Rmisch, 2003). These approaches make use of probability metrics, i.e., of metric distances on spaces of probability measures, where the metrics are selected such that the optimal
values of the original and approximate stochastic programs are
close if the distance between the original probability distribution
and its approximation is small.
We will briey describe the approach of Heitsch and Rmisch
(2003), where the bundling and deletion process relies on comput^ r P; Q of the original
ing and bounding the Kantorovich distance l
probability distribution given by the individual scenarios
P
P Si1 pi dni and their weights, and the distributions of the
P
approximate trees Q Sj1;jRJ qj dnj . The Kantorovich distance
l^ r P; Q is given by (4.10), where P and Q are xed Borel probability
measures on a closed subset X of RN, i.e., P, Q e P(X), and a function
c: X  X ? R is given by (4.11).

8
9
>
>
>
>
S
S
S
<X
=
X
X
i j
^
lr P;Q Min
cr n ;n gij : gij P 0;
gij qj ; gij pi 4:10
>
>
>
>
i1
j1
:i;j1
;
jRJ
jRJ
n
o
4:11
cr n; ~n : Max 1;kn  n0 kr1 ;k~n  n0 kr1 k~n  nk; 8n; ~n 2 X
Also, J  {1, . . . , S}, and dn e P(X) denotes the Dirac measure placing
^ r ; r P 1, between the multivariate
unit mass at n. The distances l
probability distributions given by MongeKantorovich (mass)
transportation problems are relevant for the stability of two-stage
models (Heitsch & Rmisch, 2007; Rmisch, 2003).
The optimal choice of an index set J for scenario reduction
represents a set-covering problem. It may be formulated as a 01

In this section we perform a numerical study to compare how

three different types of exibility affect the protability of the
rm:
(1) Price exibility
(2) Lead-time exibility
(3) Delivery exibility
With price (lead-time) exibility, we quote different prices
(lead-times) to different customers. When there is no price (leadtime) exibility, a single (xed) price (lead-time) is quoted to all
customers (Charnsirisakskul et al., 2006). With delivery exibility,
we can ship orders after their quoted lead-time.
We consider different policies of price and lead-time exibility:
P1 (price exibility, lead-time exibility), P2 (price exibility, no
lead-time exibility), P3 (no price exibility, lead-time exibility),
and P4 (no price exibility, no lead-time exibility). These combinations are considered in two cases: delivery exibility (D1) and no
delivery exibility (D2).
Since the number of customer classes (N) and the number of
time periods (T) vary, we have divided the problems into six different groups to carry out this numerical study. For each group of
problems, the production capacity of each period (K) is categorized
as high, medium, and low capacity. Table 1 presents the characteristics of different groups of problems.
For each group of problems, we randomly generate the parameters, Ai, Bi and Ci, in demand functions, from a uniform distribution. The intervals are determined such that B1 P B2 P    P BN,
C1 6 C2 6    6 CN. Therefore, customer class 1 has the greatest sensitivity to price, and customer class N has the greatest sensitivity to
lead-time.
The other parameters are considered to be xed in all instances
as follows:
Without the loss of generality, we assume that all customers
arrive at the beginning of the time horizon. With this assumption,
the lead-time and the due-date will be equivalent. The holding and
tardiness costs per unit of time for each customer of class i are
Chi = 5, Cai = 20, and the production cost in each period t for each
customer of class i is Cpit 10. Prices are selected for each customer class from a bounded set of integer values, P(i) = {pi:
10 6 pi 6 60}. The due-date for all customers is chosen from set
Du(i) = {1, 2, . . ., T  1, T}.
The random perturbation nj in the demand function is exponentially distributed with a mean of ve. With the initial set consisting

S.K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

Table 1
Specications of different groups of problems.
Problem
number

N1-1
N1-2
N1-3
N2-1
N2-2
N2-3
N3-1
N3-2
N3-3
N4-1
N4-2
N4-3
N5-1
N5-2
N5-3
N6-1
N6-2
N6-3

6
6
6
6
6
6
5
5
5
12
12
12
6
6
6
4
4
4

4
4
4
3
3
3
3
3
3
5
5
5
6
6
6
3
3
3

400
100
50
400
100
50
400
100
50
400
100
50
600
100
50
400
100
50

of S = 2000 scenarios and the backward reduction algorithm

described in Heitsch and Rmisch (2003), a scenario set consisting
of 50 scenarios is generated for the stochastic process n by a proce^ r P; Q 5:7035
dure implemented in MATLAB software, where l
for problem with N = 6. This value will be reduced with a decrease
of N.

1091

We use the model ((4.1)(4.9)) to solve this pricing model. With

dened intervals for prices and a reduced scenario

tree, the model
contains 51NT binary variables and 2550N TT1
50NT 50N
2
non-negative variables. For the case of a 12-period time horizon
and 5-customer class problem, the number of binary decision
variables will be 3060 and the number of non-negative variables
will be 844,750. The total number of model constraints (excluding
non-negativity and binary constraints) is 2600N + 150NT
constraints. This corresponds to 22,000 constraints for a 12-period
time horizon and a 5-customer class problem.
The generated instances solved for all policies and inferences
are obtained based on the results. Our problem instances were
solved by ILOG CPLEX 9.0 on a PC Quad Core 2.83-GHz processor.
The maximum expected prot under each policy and three described capacity levels for generated instances are represented in
Figs. 1a1f.
To compare how the protability of the rm changes according
to different policies, we consider the base case in which there is no
exibility of price, lead-time or delivery and compare the percentage of prot increases over base case policy (P4-D2) for other
policies. The results are summarized in Table 2.
Also, we use the average value of prices and lead-times obtained from eighteen generated instances in Figs. 2 and 3. In these
Figures, we only present the prices and lead-times for two classes
of customers: customer class 1 has the greatest sensitivity to price
and customer class N has the greatest sensitivity to lead-time.
The main conclusions one can draw from Table 2 and Figs.
1a1f, 2 and 3 are as follows.

Fig. 1a. Expected prot under different combinations of lead time, price and delivery exibility in generated instances 1-1, 1-2 and 1-3.

Fig. 1b. Expected prot under different combinations of lead time, price and delivery exibility in generated instances 2-1, 2-2 and 2-3.

Fig. 1c. Expected prot under different combinations of lead time, price and delivery exibility in generated instances 3-1, 3-2 and 3-3.

1092

S. K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

Fig. 1d. Expected prot under different combinations of lead time, price and delivery exibility in generated instances 4-1, 4-2 and 4-3.

Fig. 1e. Expected prot under different combinations of lead time, price and delivery exibility in generated instances 5-1, 5-2 and 5-3.

Fig. 1f. Expected prot under different combinations of lead time, price and delivery exibility in generated instances 6-1, 6-2 and 6-3.

Fig. 2. Average value of prices under different combinations of lead time, price and delivery exibility for each customer class in generated instances.

Fig. 3. Average value of lead times under different combinations of lead time, price and delivery exibility for each customer class in generated instances.

1093

S.K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

Table 2


D2
 100 .
The percentage of prot increases over base case policy (P4-D2) for other policies ValueP4
P4 D2
Problem number

P1-D1

P2-D1

P3-D1

P4-D1

P1-D2

P2-D2

P3-D2

N1-1
N1-2
N1-3
N2-1
N2-2
N2-3
N3-1
N3-2
N3-3
N4-1
N4-2
N4-3
N5-1
N5-2
N5-3
N6-1
N6-2
N6-3

17.677
99.926
125.854
22.928
70.191
72.828
12.538
83.371
84.62
23
113.417
135.07
35.792
117.879
155.102
12.569
84.434
101.811

9.652
13.739
22.577
22.928
70.186
72.828
12.538
12.347
12.785
5.269
18.857
31.236
30.106
18.857
31.236
12.569
11.865
19.170

4.218
44.933
62.454
13.015
70.191
66.959
0.476
30.925
31.966
8.196
52.826
78.15
22.048
57.581
78.15
0.339
34.363
37.053

0.827
11.797
21.517
13.015
66.571
66.959
0.476
4.138
6.15
2.114
16.386
28.333
19.61
16.386
28.333
0.339
5.319
9.793

16.638
87.848
83.965
21.907
44.253
40.041
12.347
79.641
71.49
20.03
106.722
122.948
34.534
107.825
121.007
12.095
81.932
90.065

8.265
4.169
1.06
3.239
2.312
1.811
12.347
10.578
5.191
3.294
5.888
4.031
29.257
5.887
4.031
12.095
7.770
1.119

3.331
42.469
44.169
13.195
26.578
27.191
0
28.312
22.419
8.564
44.493
59.737
21.978
57.581
59.737
0
29.801
36.623

20.75
94.87
112.548

15.51
24.309
31.639

8.049
48.47
59.122

6.063
20.099
26.847

19.592
84.704
88.253

11.416
6.101
2.874

7.845
38.206
41.646

Average

High capacity
Medium capacity
Low capacity

1. As we can see in Figs. 1a1f and Table 2, delivery exibility

leads to higher expected prot under all policies. This is also
obtained by Charnsirisakskul et al. (2006).
2. When the production capacity is high, the manufacturer can
determine a lead-time equal to 1 for all customers and
change the demand and its prot by changing the price.
Thus, under both delivery exibility and no delivery exibility, price exibility is more useful than lead-time exibility.
With decreasing the production capacity, the lead-time exibility is more benecial because the manufacturer cannot
produce all orders in the rst period and should determine
different lead-times for different customer classes.
3. In the medium and low production capacity, although under
exibility or with no exibility in delivery, the lead-time
exibility is more useful than the price exibility, but this
difference is more obvious in the no delivery exibility. In
the absence of delivery and lead-time exibility, all orders
must be held in the inventory and be delivered at once. This
leads to high holding cost that the price exibility cannot
compensate.
4. The average percentages of prot increase over the base case
for price, lead-time and delivery exibility, at medium production capacity, are 6.101%, 38.206%, and 20.099% in. These
values are changed to 2.874%, 41.646%, and 26.847% at low
production capacity. Thus, the manufacturer chooses leadtime, delivery and price exibility in decreasing order. These
orders may be changed due to the problems parameters.
The range of holding and tardiness costs for each customer
class considered in the problems is usually high relative to
the price ranges. Therefore, the manufacturer prefers not
to hold inventories. In delivery exibility, the orders made
after the quoted due-date, are delivered immediately. Thus,
delivery exibility is an advantage. This order changes to
price, lead-time and delivery exibility at a high production
capacity because the manufacturer can produce all orders in
the rst period and deliver them in the same period.
5. Under both medium and low production capacities, if the
manufacturer can choose two types of exibility, we can
rank the policies according to their percentage of prot
increases over the base case as follows:
(1) Price exibilitylead-time exibility,
(2) Lead-time exibilitydelivery exibility,

(3) Price exibilitydelivery exibility.

The two exceptions are examples N2-2 and N2-3 where the
above order was changed as follows:
(4) Price exibilitydelivery exibility,
(5) Lead-time exibilitydelivery exibility,
(6) Price exibilitylead-time exibility.
Unlike the other examples, the tardiness cost is considered to be
one in these examples which is low compared with other costs.
Thus, the manufacturer can determine a lead-time equal to that
of the rst period for all customers and deliver orders in the
next periods with a low tardiness cost. According to this
description, the exibility in delivery is more useful than the
other exibilities.
6. According to Figs. 2 and 3, if the base level of demand or
demand rate is high compared with the production capacity,
the sale price and lead-time for customers should be set
higher.
7. According to Fig. 2, under both delivery exibility and no
delivery exibility policies, when we have price exibility,
the price charges for customer class 1 (customers who are
sensitive to price) is less than that for other customer
classes.
8. With price or lead-time exibility, the manufacturer can
obtain more prot while charging lower prices to customer
class 1.
9. Comparing the two policies, P3 and P4, we can see that with
lead-time exibility, the manufacturer can obtain more
prot while charging lower prices to all customer classes.
10. According to Fig. 3, when there is high production capacity,
the manufacturer can assign a lead-time equal to one for
approximately all customer classes.
11. According to Fig. 3, under both delivery exibility and no
delivery exibility policies, when we have price exibility
(policies P1 and P2), the lead-time charges for customer
class N (customers who are sensitive to lead-time) are less
than the ones for the other customer class.
12. As we can see from Fig. 3, in some examples, when there is
no exibility in price (P3 policy), the lead-time charges for
customer class N are higher than the ones for other customer
class. Demand for customer class N is almost high due to low
common price in P3 policy. The high lead-time charged for
this customer class is for balancing the demand and supply.

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S. K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

13. According to Fig. 3, under delivery exibility, the lead-time

charged for customers in each policy is lower than that with
no delivery exibility. With delivery exibility, the leadtime quoted to customers will be low and the orders can
be produced and delivered after the quoted due-date. With
no delivery exibility, the orders are delivered only at the
quoted due date. Thus, to compensate for the production
capacity, the higher lead-time (or due-date) is charged.

5.2. Value of the stochastic program

Stochastic programs are computationally difcult to solve.
Therefore, for real-world problems, people have a tendency to
solve much simpler versions. For example, researchers may solve
the deterministic program by replacing all random variables with
their expected values, or they may solve deterministic programs,
each corresponding to one particular scenario, and then combine
these different solutions with some heuristic rule. The accuracy
of such approaches can be evaluated by introducing two concepts,
the Expected Value of Perfect Information (EVPI) and the Value of the
Stochastic Solution (VSS), (Birge & Louveaux, 1997).
The Expected Value of Perfect Information (EVPI): The EVPI concept measures the maximum amount a decision maker would be
ready to pay in return for complete information about the future.
Let n be the random variable whose realizations correspond to
the various scenarios. Let Q 0 be the optimal value of the stochastic
 n be the optimal value for the deterministic
programming and Q
problem corresponding to one particular scenario n.
The wait and see value (WS), which corresponds to the expected
 n.
value of the optimal objective for each scenario is WS En Q

The expected value of perfect information (EVPI) is then dened

as EVPI WS  Q 0 .
The Value of the Stochastic Solution (VSS): The stochastic programming approach considers the entire range of uncertain scenarios. On this score, it may be better than its deterministic
correspondents. However, it also dramatically increases computational complexity. Therefore, the majority of people would solve
the deterministic problem by replacing the random variables with
their corresponding expected values. The concept of the value of
the stochastic programming solution (VSS) can be used to justify
whether the putting extra effort into modeling and solving sto 
chastic programming is worthwhile. Let Z
n be the optimal decision of the rst stage in deterministic problem where all random
variables are replaced by their expected values. The value of the
stochastic solution (VSS) is then dened as VSS Q 0  EEV, with
 
EEV En Q Z
n; n. In general, a bigger VSS indicates a higher
benet from using the stochastic programming approach.
In this section, we compute these two measures for problem
instances.
Table 3 shows the WS, EVPI, and VSS of 18 problem instances,
and the best objective value for the two-stage stochastic programming problem which was optimized with 50 scenarios. The last
column represents the lower bound for the true problem with
2000 scenarios and dened as LB En0 Q Z  n; n0 , where Z*(n)
is the optimal decision of the rst stage in a reduced stochastic
problem with 50 scenarios and n0 is the random variable consisting
of S = 2000 scenarios. We can obtain the optimality gap of the solution Z*(n) using the lower bound estimate and the objective function value estimate from the reduced stochastic program. A
smaller gap indicates a smaller error resulting from using the reduced stochastic programming approach.

Table 3
Computational results for wait-and-see and the stochastic programming solutions.
Problem number

Q 0

WS

EVPI

EEV

VSS

LB

Gap

N1-1
N1-2
N1-3
N2-1
N2-2
N2-3
N3-1
N3-2
N3-3
N4-1
N4-2
N4-3
N5-1
N5-2
N5-3
N6-1
N6-2
N6-3

11078.630
8717.539
5850.263
19343.57
16059.658
10503.853
5700.87
4660.653
3074.317
14044.294
9904.212
6127.792
15528.61
10111.321
6649.984
7204.229
5934.107
4145.437

11118.380
8823.588
5917.060
19694.66
16158.650
10708.37
5708.931
4768.656
3080.8
14079.25
10014.94
6321.719
15573.47
10200.56
6794.502
7263.448
6007.378
4280.57

39.750
106.049
66.797
351.094
98.992
204.517
8.061
108.003
6.483
34.96
110.728
193.927
44.85319
89.239
144.518
59.219
73.270
135.133

11076.88
8707
5809
19343.46
15984.14
10460.88
5695.365
4625.733
3021.947
14044.29
9801.78
6093
15527.81
10071.13
6613
7191.283
5903.011
4135.264

1.75
10.539
41.263
0.11
75.518
42.973
5.505
34.92
52.37
0.004
102.432
34.792
0.804
40.191
36.984
12.946
31.09639
10.173

11058.529
8696.896
5841.703
19337.32
16053.95
10499.03
5689.43
4649.061
3062.255
14035.8
9894.518
6120.316
15489.43
9993.639
6591.82
7195.814
5934.107
4142.677

20.1
20.643
8.56
6.25
5.713
4.103
11.44
11.592
12.062
8.494
9.694
7.476
39.184
117.682
58.164
8.415
0
2.76

Table 4
Computational results for VSS and the stochastic programming solutions with respect to different probability distributions (exponential distribution).
EXP(5)

N1-1
N1-2
N1-3
N2-1
N2-2
N2-3
N3-1
N3-2
N3-3

EXP(20)

Q 0

EEV

VSS

Q 0

EEV

VSS

11078.63
8717.539
5850.263
19343.57
16059.66
10503.85
5700.87
4660.653
3074.317

11076.88
8707
5831
19343.46
15984.14
10460.88
5695.365
4625.733
3021.947

1.749
10.539
19.263
0.11
75.518
42.973
5.505
34.9204
52.37

11877.1
8923.519
5544.539
20152.05
16110.6
9933.915
6155.888
4736.073
3111.648

11875.21
8847.576
4494.584
20150.05
15697.65
9824.367
6090.374
4698.346
2952.644

1.89
75.943
1049.955
1.998
412.951
109.548
65.514
37.727
159.004

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S.K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

Table 5
Computational results for VSS and the stochastic programming solutions with respect
to different probability distributions (uniform distribution).
U(20, 20)
Q 0

U(40, 40)
EEV

N1-1 10726.15
10666.16
N1-2
8279.43
8116.736
N1-3
5526.559
5236.163
N2-1 19095.85
19077.55
N2-2 15772.69
15136.06
N2-3 10059.6
9795.167
N3-1
5508.81
5468.66
N3-2
4408.073
4213.197
N3-3
2873.865
2828.401

VSS

Q 0

EEV

VSS

59.989 10608.65
10521.31
87.34
162.694
7884.611
7550.477
334.134
290.396
4922.105
3713.238 1208.867
18.3
19073.88
19050.15
23.73
636.634 15440.59
14113.05
1327.538
264.434
9412.807
9016.401
396.406
40.15
5445.64
5320.069
125.571
194.876
4144.49
3833.521
310.969
45.464
2676.009
2510.491
165.518

As we can see from Table 3, all instances except instances N3-1

and N3-3 have a high EVPI meaning that perfect information would
be helpful to substantially improve the objective function.
Instances N2-2, N3-3 and N4-2 have relatively a high VSS indicating that a stochastic programming approach is justied.
The optimality gaps for instances N5-2 and N5-3 are relatively
high indicating that a scenario reduction with more precision must
be done for these examples.
In almost all instances with a high production capacity, the VSS
is low indicating that decision making in these problems is based
on expected values of random variables.
To see how the above results are represented under different
probability distributions, a sensitivity analysis is performed with
respect to the random data. To this purpose, we solve the rst nine
examples described in Table 1 considering three new probability
distribution functions for random variable n in the demand function as follows:
1. Exponential distribution with a mean of 20: n EXP(20),
2. Uniform distribution on interval [20, 20]: n U(20, 20),
3. Uniform distribution on interval [40, 40]: n U(40, 40).

First, price and lead-time exibility lead to higher prots than

no exibility in price and lead-time under all the values considered
for the model parameters.
Second, the ranking of price, lead-time and delivery exibility
are dependent on our environment, and under some parameter
values lead-time exibility is more benecial than price exibility.
Third, with lead-time or price exibility, we can obtain more
benet by charging a lower price for some customer classes, than
we can in the case where we have no exibility in price or leadtime. The relatively large value for VSS and EVPI in some examples
justies the use of more sophisticated modeling techniques and
extra computational efforts.
There are several other results that suggest possible further research. First, we have considered static price and lead-time quotations where price and lead-time are determined for all customers
at the beginning of the time horizon. Dynamic pricing and leadtime quotations can be more benecial than static pricing in some
environments in which the demand function changes with time.
Second, the scenario representation of the pricing and lead-time
quotation problem corresponds to large scale mixed integer programming. Therefore, a future work will focus on using decomposition methods to solve the resulting large scale linear program.
Appendix A
A.1. Simultaneous backward reduction
Let P be a xed Borel probability measure on X, i.e., P e P(X)
with scenarios {n1, n2, . . . , nS} in some Euclidean space RN and probability weights {p1, p2, . . . , pS}. N is the number of customer classes.
Thus the simultaneous backward reduction algorithm according to
Heitsch and Rmisch (2003) is as follows:

step 1 : ckj : cni ; nj ;

1

cll : min clj ;

jl

As done in the last section, for each distribution, a scenario set

consisting of 50 scenarios is derived from the initial set consisting
of S = 2000 sample scenarios.
Tables 4 and 5 show the best objective value for the two-stage
stochastic programming problem and the VSS of rst nine problem
instances according to the considered probability distributions. As
we can see from Tables 4 and 5, the value of the stochastic programming increases with the mean of the exponential distribution or with
the coefcient of variation of demand when the demand is uniformly
distributed. In fact, the solutions given by the deterministic models
would not be able to dene the best price and lead-time for problem
instances that had enormous variance in demand function. This relatively large value for VSS justies the use of more sophisticated
modeling techniques and the extra computational effort.

j 1; . . . ; S;

Sorting of fckj : j 1; . . . ; Sg;

zl : pl cll ;

l 1; . . . ; S;
1

J 1
: fl1 g:

l1 2 argl2f1;...;Sg min zl ;
step i :

ckl

min ckj ;

jJ i1
[flg

zl :
k2J

i1

k 1; . . . ; S;

l 1; . . . ; S

pk ckl ;

lRJ

i1

; k2J

A:1
i1

[ flg

l R J i1
;

[flg
i

li 2 argjJi1
min zl ;

J i
: J i1
[ fli g:

Step S  s + 1: redistribution by (A.2)

where

j pj
q

pi ;

for each j R J

A:2

i2J j

J j : fi 2 J : j jig and ji 2 arg min cni ; nj for each i 2 J A:3

jRJ

6. Conclusion
We have presented a stochastic programming approach for
make-to-order rms with multiple customer classes to simultaneously determine the price and lead-time. We used an additive
form for the demand function, in which the stochastic parameter
is approximated by a scenario tree. The scenario tree is generated
by the backward reduction algorithm obtained by Heitsch and
Rmisch (2003). Through numerical examples and a sensitivity
analysis, we compared the benets of price, lead-time and delivery
exibility with changes in the values of the model parameters. As a
result from sensitivity analysis, we can summarize the following
ndings:

and the function c: X  X ? R is given by

cn; ~n maxf1; kn  n0 k; k~n  n0 kgr1 kn  ~nk;

8n; ~n 2 X

A:4

Table A.1
The scenarios nj and probabilities pj.

n1
n2
n3
n4
n5

Class 1

Class 2

Class 3

Probability

3.5
2
1
1
2

3.5
2.5
1.5
1
2.5

3.75
3
1.5
1.5
3

0.125
0.200
0.350
0.200
0.125

1096

S. K. Chaharsooghi et al. / Computers & Industrial Engineering 61 (2011) 10861097

Fig. A.1. Initial scenario tree consisting of ve scenarios.

Fig. A.2. Reduced scenario tree consisting of three scenarios.

To show how the backward reduction algorithm works, we consider

a small instance consisting of N = 3 customer classes. We consider a
scenario tree with the total number of scenarios S = 5. The scenarios
nj and probabilities pj are presented in Table A.1.
The initial generated scenario tree is presented in Fig. A.1
Substituting r = 1 in Eq. (A.3), the cost function cn; ~
n is determined by the following matrix:

Using the reduction algorithm, a scenario set consisting of three

scenarios is generated for the stochastic process n. The two scenarios n1 and n5 are deleted of which J = {1, 5}, j(1) = 2 and j(5) = 4. So,
the new probabilities for the remaining scenarios are q2 = p1 + p2 =
0.325, q3 = p3 = 0.35 and q4 = p4 + p5 = 0.325. The new scenario tree
is shown in (Fig. A.2).
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