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IIE Transactions (1998) 30, 705±713

Make-to-order versus make-to-stock in a


production±inventory system with general production times

ANTONIO ARREOLA-RISA1 and GREGORY A. DeCROIX2


1
Department of Information & Operations Management, Lowry Mays College & Graduate School of Business,
Texas A&M University, College Station, Texas 77843-4217, USA
E-mail: Tarreola@tamu.edu
2
Fuqua School of Business, Duke University, Durham, NC 27708-0120, USA
E-mail: decroix@mail.duke.edu

Received October 1996 and accepted September 1997

We study the optimality of make-to-order (MTO) versus make-to-stock (MTS) policies for a company producing multiple
heterogeneous products at a shared manufacturing facility. Manufacturing times are general i.i.d. random variables, and di€erent
products may have di€erent manufacturing-time distributions. Demands for the products are independent Poisson processes with
di€erent arrival rates. The costs of managing the production-inventory system are stationary and include inventory holding and
backordering costs. Backordering costs may be $ per unit or $ per unit per unit time. We derive optimality conditions for MTO and
MTS policies. We also study the impact of several managerial considerations on the MTO versus MTS decision.

1. Introduction base-stock (order-up-to) inventory policy has been shown


to be optimal in a similar system under periodic review
Competitive pressures and continuous improvement [1]. Also, the base-stock inventory policy has commonly
e€orts have led many ®rms to review their production± been used in previous work analyzing other aspects of
inventory practices. In particular, given the push toward systems similar to the one considered here [2±9]. For these
a ``zero-inventory'' goal, world-class companies have reasons we adopt a base-stock inventory policy for our
begun a search for conditions that determine when it is system. The other element that de®nes the production±
optimal to hold a ®nished goods inventory and when it is inventory policy is the scheduling rule ± i.e., if multiple
not. If a ®nished goods inventory is held for a product, we products are waiting to be manufactured, which product
say that the product is produced make-to-stock (MTS); should be produced ®rst? Some recent work [3±9] suggests
otherwise, we say that the product is produced make- that dynamic scheduling rules may outperform the ®rst-
to-order (MTO). Note that our designation of a product come ®rst-served (FCFS) rule. However, analysis of the
as MTO merely indicates stockless production, and does MTO/MTS decision for dynamic scheduling rules be-
not mean that the product is made to order due to custom comes intractable due to complex interactions among
speci®cations. products. Furthermore, the additional information and
To address the optimality of MTS and MTO policies, coordination required at the production facility by dy-
we consider a company that produces multiple products namic scheduling rules may counter the inventory savings
facing random demands. A single manufacturing facility over the FCFS rule. As a result and given that FCFS is
produces the products one at a time, and successive common in practice, we will adopt FCFS as the sched-
manufacturing times for each product comprise a se- uling rule for our system. We believe that the insights
quence of general i.i.d. random variables. Di€erent regarding the MTO/MTS decision obtained under the
products may have di€erent manufacturing-time distri- FCFS scheduling rule should be suggestive of the be-
butions. Demands for the products are independent havior of systems with more general scheduling rules, and
Poisson processes with di€erent arrival rates. The costs of in fact, we will show that this is the case for a number of
managing the production±inventory system are station- our results.
ary and include inventory holding and backordering The paper makes several contributions. Optimality
costs. conditions for MTO and MTS policies are established.
Although the form of the optimal production±inven- These conditions are derived for two backorder-cost
tory policy for this system has not been established, a cases: $ per unit and $ per unit per unit time. The opti-

0740-817X Ó 1998 ``IIE''


706 Arreola-Risa and DeCroix
Pn
mality conditions turn out to be independent of manu- k iˆ1 ki = average arrival rate of orders at the
facturing times in the ®rst backorder-cost case but not in manufacturing facility;
the second case. We identify special circumstances for the di  ki =k = fraction of orders at the manufacturing
second backorder-cost case where the MTO versus MTS facility coming from product i;
decision can be made entirely based on the ®rst moments qi  P
ki E‰Mi Š = load o€ered by product i;
of the manufacturing-time distributions. We o€er evi- q  niˆ1 qi = capacity utilization of the manufacturing
dence that manufacturing-time diversity may or may not process;
favor a MTO policy, depending on how diversity is Mi = unit manufacturing time for product i;
conceptualized. Finally, these results are used to provide hi = unit inventory holding cost rate;
insights into the impact of manufacturing-time random- OHi = on-hand inventory for product i;
ness reductions e€orts on the MTO versus MTS decision. K = average inventory holding and backor-
A search of the inventory literature reveals that ana- dering cost per unit time;
lytical treatments of the MTO versus MTS decision are Ri = base-stock level for item i;
limited to Li [10] and Arreola-Risa [2]. Li has looked at Ri = the value (or values) of Ri ; i ˆ 1; 2; . . . ; n,
the optimality of MTO/MTS in a multi-®rm market which minimize K.
where companies compete for customers based on deliv-
Inventory backordering costs may be incurred in a
ery time of orders. He considered the one-product case
variety of ways. For a discussion of backorder costing
and assumed that unit manufacturing times are expo-
the reader may consult, for example, Silver and Peterson
nentially distributed. The inventory cost function is a
[11]. In this paper we will consider the following two
present value where the interest rate is compounded
types of backorder costs: $ per unit, and $ per unit per
continuously. Arreola-Risa has considered a production-
unit time. If inventory backordering costs are incurred $
inventory system similar to the one in this paper, but
per unit, for each product i, let pi denote the unit
where manufacturing times for the di€erent products are
backordering cost and BRi denote the backorders rate
identical and gamma distributed, and backorder costs are
(number of backorders per unit time).Then from basic
incurred $ per unit per unit time. He determined the value
principles:
of the squared coecient of variation of manufacturing
time at which the ®rm is indi€erent to produce a product X
n

MTO or MTS. K …p† …R1 ; R2 ; . . . ; Rn † ˆ f hi E‰OHi Š ‡ pi E‰BRi Šg;


The contents of the paper are organized as follows. iˆ1

Section 2 contains a derivation of the cost model. In …p†


where K …† is the average cost per unit time under $ per
Sections 3±5 we establish MTO/MTS optimality condi- unit backorder costs.
tions and also explore several factors that may a€ect the If inventory backordering costs are incurred $ per unit
MTO versus MTS decision. Section 3 deals with $ per per unit time, for each product i, let pi denote the unit
unit backorder costs and Sections 4 and 5 deal with $ per backordering cost rate and BLi denote the backorder
unit per unit time backorder costs. In turn, Section 4 level. Again from basic principles:
considers homogeneous manufacturing times while Sec-
tion 5 looks at the more general case of heterogeneous X
n
K …p† …R1 ; R2 ; . . . ; Rn † ˆ f hi E‰OHi Š ‡ pi E‰BLi Šg;
manufacturing times. Conclusions and directions for iˆ1
further research are summarized in Section 6.
…p†
where K …† is the average cost per unit time under $ per
unit per unit time backorder costs.
Under a FCFS scheduling rule, the quantities E‰OHi Š,
2. The cost model E‰BRi Š, and E‰BLi Š are independent of Rj , for j 6ˆ i. This
independence also holds for any scheduling rule that is
In this section we develop the cost model and note some independent of the base-stock levels. (The ``lowest-in-
of its basic properties to be used for optimization pur- ventory-level-®rst'' scheduling rule for homogeneous
poses. Let: products with equal base-stock levels [4,8,9] is an exam-
E‰Š = expected value operator; ple of such a rule.) Thus we can minimize K …p† …† or
…p† …p†
fA …† = probability function of random variable K …p† …† by minimizing Ki …Ri † or Ki …Ri †, respectively,
A; for each i, where:
FA …† = distribution function of random variable …p†
A; Ki …Ri † ˆ hi E‰OHi Š ‡ pi E‰BRi Š;
n = number of di€erent products; …p†
Ki …Ri † ˆ hi E‰OHi Š ‡ pi E‰BLi Š:
Di = demand per unit time for product i;
ki  E‰Di Š = average demand per unit time for Let OOi denote the number of orders outstanding for
product i; product i. It is not dicult to show that E‰OHi Š ˆ