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Cost Allocation

DOI: 10.1016/S0377-2217(99)00431-2

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Universidad del Valle (Colombia) Georgia Institute of Technology

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All content following this page was uploaded by Carlos J. Vidal on 25 April 2016.

European Journal of Operational Research 129 (2001) 134±158

www.elsevier.com/locate/dsw

transportation cost allocation

Carlos J. Vidal a, Marc Goetschalckx b,*

a

Universidad del Valle, Cali, Colombia

b

School of Industrial and Systems Engineering, 765 Ferst Drive, Georgia Institute of Technology, Atlanta, GA 30332-0205, USA

Received 1 April 1998; accepted 1 October 1999

Abstract

We present a model for the optimization of a global supply that maximizes the after tax pro®ts of a multinational

corporation and that includes transfer prices and the allocation of transportation costs as explicit decision variables.

The resulting mathematical formulation is a non-convex optimization problem with a linear objective function, a set of

linear constraints, and a set of bilinear constraints. We develop a heuristic solution algorithm that applies successive

linear programming based on the reformulation and the relaxation of the original problem. Our computational ex-

periments investigate the impact of using dierent starting points. The algorithm produces feasible solutions with very

small gaps between the solutions and their upper bound (UB). Ó 2001 Elsevier Science B.V. All rights reserved.

Keywords: Distribution; Modeling; Production; Global supply chain optimization; Transfer pricing

1. Introduction

The design and management of global supply chains are nowadays one of the most active research topics

in global logistics. Vidal and Goetschalckx (1997) identify several lacking features and opportunities for

research in the methodology for the strategic and tactical design of global logistics systems. Much of the

research ignores relevant international factors such as transportation mode selection, the allocation of

transportation cost among subsidiaries, the inclusion of inventory costs as part of the decision problem, the

explicit inclusion of suppliers, and the nonlinear eects of international taxation. Additionally, many global

supply chain models assume that transfer prices are ®xed and given.

A transfer price is the price that a selling department, division or subsidiary of a company charges for a

product or service supplied to a buying department, division, or subsidiary of the same ®rm (Abdallah,

*

Corresponding author. Tel.: +1-404-894-2300/2317; fax: +1-404-894-2301.

E-mail address: marc.goetschalckx@isye.gatech.edu (M. Goetschalckx).

0377-2217/01/$ - see front matter Ó 2001 Elsevier Science B.V. All rights reserved.

PII: S 0 3 7 7 - 2 2 1 7 ( 9 9 ) 0 0 4 3 1 - 2

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 135

1989). Transfer Pricing (TP) is one of the most controversial topics for multinational companies (MNCs).

According to O'Connor (1997), ``TP is the most important international tax issue facing multinationals

today, and is expected to remain so for the near future.'' In his survey of over 200 MNCs, 80% of them

identi®ed TP as the number one issue they have to face. Most researchers on global logistics have con-

sidered TP a typical accounting problem rather than an important decision opportunity that signi®cantly

aects the design and management of a global supply chain. In general, when a logistics analyst attempts to

determine the optimal ¯ows of products among facilities, the price of a product is almost always considered

a given parameter. However, this is not the case in real global logistics systems since management can

determine the transfer price with some degree of ¯exibility within given limits.

Undoubtedly, the TP problem is much more than an accounting problem. TP policies have signi®cant

eects on performance evaluation and motivation of subsidiary managers. Abdallah (1989) remarks that

making TP decisions for MNCs is an important, complex, ¯exible, and complicated task because it aects

other major functions of the ®rm such as marketing, production, location, transportation, and ®nance.

The impact of TP policies on taxable income, duties, and management performance is signi®cant. Ac-

cording to Nieckels (1976), small changes in transfer prices may lead to signi®cant dierences in the after-

tax pro®t of a company. On the other hand, the arbitrary manipulation of transfer prices (as presented by

Cohen et al., 1989) is currently under careful observation by tax authorities and is strictly penalized. De-

spite these limitations and based on current regulations, in most of the cases, companies have some range of

values for their transfer prices. According to Stitt (1995), the Organization for the Economic Cooperation

and Development (OECD) de®nes a range of an acceptable transfer price rather than a single `correct'

transfer price. Abdallah (1989) comments on the diculty of using market prices as the selected TP policy

in an international environment, mainly because of the diversity of economic environments and trans-

portation costs. Moreover, there will always exist a tradeo between the low transfer price desired by the

buyer division, and the high transfer price desired by the seller division.

Several researchers have addressed the TP problem as an integral component of the optimization of a

global supply chain. Nieckels (1976) presents a nonlinear mathematical model to determine optimal

transfer prices and resource allocation in a multinational textile ®rm. His formulation includes transfer

prices as decision variables and a linear objective function for maximizing the global net income after taxes.

One limitation of this model is that it assumes that the company has a central distribution center from

which all products are distributed to the sales subsidiaries. A second shortcoming of this model is that it

does not include Bill of Materials (BOM) constraints, although these are signi®cant to the real system.

Instead, the problem is formulated as a raw material based model using some transformations of products

into raw materials. Finally, the author does not address the decision of allocating transportation costs since

they are always charged to the destination subsidiary.

Nieckel's solution approach begins with a heuristic procedure that assigns initial values to the transfer

prices, equal to either their lower or their upper bound (UB). The remaining program is a linear program

that is solved for the optimal ¯ows. Given these ¯ows, the set of transfer prices becomes variable again. To

®nd the new set of transfer prices, a systematic heuristic procedure based on the sign of the derivative of the

objective function with respect to the transfer prices is then applied. The solution method iterates between

the optimization of the linear program and the heuristic procedure to change transfer prices until no further

increase in the objective function is possible. According to the author, when the solution procedure stops, a

local optimum is found. Although mentioned for further research, Nieckels does not attempt to calculate an

UB on the solution to the problem in order to test the performance of his heuristic.

Cohen et al. (1989) present a preliminary formulation of a normative model that is a dynamic, nonlinear

mixed integer programming formulation. The model is nonlinear due to the inclusion of transfer prices and

decision variables to allocate overhead costs to plants. The objective function considers the maximization of

the ®rm's after tax pro®t. Transfer prices are treated as a markup for each product, applied on the pro-

duction cost plus the shipping cost, which includes taris. This constitutes a shortcoming of this model since

136 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

in most cases the taris depend on the value of the transferred products and in the paper they are con-

sidered given as a part of the shipping cost per unit. The solution approach is a hierarchical process that

iterates between solving mixed integer programs to determine optimal ¯ows and supplier contracts, and

optimal markups. This process is repeated until a local optimum has been reached. Since the markups do

not have an upper bound, the resulting solution may generate a strong reduction of taxes that would not be

acceptable to tax authorities.

No computational experience is presented in this paper, but the authors state that some variants of the

model have been successfully developed by them and/or other researchers. One of these is the work by

Cohen and Lee (1989), who describe a single-period multicommodity model that analyzes resource de-

ployment decisions faced by a personal computer manufacturer. It is important to note that this is the only

model that considers the decision of allocating transportation costs to either the origin or the destination by

formulating binary variables. However, in the presented solution process, this decision is made externally

and the corresponding binary variables are ®xed in the model.

In one of the most comprehensive models to date, Arntzen et al. (1995) present a multi-period, multi-

commodity mixed integer program to optimize the global supply chain at the Digital Equipment Corpo-

ration. The objective function considers the minimization of variable production costs, inventory costs,

shipping costs, ®xed production and production `style' costs, minus the savings from duty drawbacks and

duty relieves. All these terms are weighted by a factor a. The objective function also contains production

time and transportation time terms, weighted by a factor
1 ÿ a. It is not clear how the model manages two

dierent units of measure in the objective function beyond a user assigned weight. The TP decision problem

is not included in the formulation. In addition, taxes are only indirectly considered as a part of variable

production costs. The authors report on the use of `nontraditional methods', such as elastic constraints,

row factorization, cascaded problem solution, and constraint-branching enumeration. However, it is not

clear from the paper exactly which solution method has been applied.

More recently, Canel and Khumawala (1997) propose a mixed-integer single-product model for the

optimization of a global supply chain. The authors include TP decisions in their analysis, but they ®x the

transfer prices to either their lower or UB before solving the model. Additionally, transportation costs are

allocated to the destination subsidiary. As a consequence, this model does not include the TP problem and

the allocation of transportation costs as part of the decision process.

The explicit inclusion of global suppliers is ignored in most of the models described above. Furthermore,

inventory costs and their impact on the decision of selecting a transportation mode, which is very important

in an international scenario, are not considered in most of them.

This paper presents a tactical global supply chain model that extends previous research by simulta-

neously considering TP, transportation cost allocation, inventory costs, and their impact on the selection of

international transportation modes. Additionally, we provide an integrated and ecient procedure to

obtain near-optimal solutions and their UB to realistic cases. In Section 2 we present some general con-

siderations about TP. In Section 3 we describe the basic characteristics of the model, and in Section 4 we

illustrate the solution approach. Section 5 contains some computational experiments, and ®nally, in Section

6 we present some conclusions and insights for further research.

The determination of transfer prices is one of the most dicult problems that MNCs have to face. The

problem is to ®nd adequate transfer prices so that the global corporate goals are satis®ed and the per-

formance measures are fair for all the ®rm's subsidiaries and divisions (Eccles, 1985). According to

O'Connor (1997), the problem originates from the con¯icts between the general goals of the global cor-

poration and the internal goals of its subsidiaries, and from the constraints imposed by the legal envi-

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 137

ronment involving taxes and taris. The utilization of the arm's length principle, which establishes the use

of transfer prices as if the involved parties did not belong to the same corporation, is widely accepted.

Accordingly, Mueller et al. (1997) state that most current TP policies are based on either external market

prices or internal costs. Both have the advantage of being acceptable to tax authorities. The discussion of

the methods used by MNCs to determine their transfer prices is beyond the scope of this paper. For a

comprehensive explanation, see Belkaoui (1985), Eccles (1985), Abdallah (1989), and/or O'Connor (1997).

MNCs seek diverse objectives when setting their transfer prices. O'Connor (1997) presents the results of

several surveys concerning the key goals that MNCs try to achieve through their TP policies. In general, the

results of these surveys are not consistent since some of them give more importance to some objectives,

while others disregard the same goals. In summary, these objectives are to:

· Satisfy tax and other legal requirements;

· Produce pro®t maximization by minimizing worldwide taxes and duties;

· Produce a fair framework for performance evaluation and motivation of all related parties;

· Move funds internationally;

· Minimize exchange rate risk;

· Avoid exchange controls and quotas; and

· Increase pro®t share from joint ventures.

One of the most controversial objectives of TP policies is pro®t maximization by minimizing worldwide

taxes and duties. O'Connor (1997) states that although many companies argue that tax minimization is not

their main goal, in reality many ®rms appear to design TP policies to take advantage of dierential tax

structures among countries. In spite of the current regulations imposed by most countries intended to avoid

the arbitrary manipulation of transfer prices, there exist signi®cant opportunities for pro®t maximization

that are not illegal. Very likely, the ¯exibility is decreasing each day, but the impact of small changes in

transfer prices on the global pro®t of a company may be substantial. Therefore, designing TP policies to

minimize taxes legally should not be ignored by MNCs that prefer to design policies consistent with the

corporate strategy and organizational structure of the company. Probably the only way to analyze such an

impact is using mathematical models like the one described in this paper.

This example illustrates the fundamental ideas for the further development of the model. Fig. 1 shows

the system under consideration. Subsidiary A, the producer and seller, located in country A, manufactures

a single product that sells to subsidiary B, located in a dierent country B.

The following notation will be used in this example and in the next section (for the sake of simplicity, we

always use capital letters for parameters and lower case letters for decision variables):

Parameters

C transportation cost ($/unit)

D import duty charged in country B based on the value of the transferred product 12%

FA ®xed costs (other expenses) at subsidiary A $20,000/unit of time

FB ®xed costs (other expenses) at subsidiary B $120,000/unit of time

M market price of the product in country B $20/unit

Tl lower bound (LB) on the transfer price $11/unit

Tu UB on the transfer price $13/unit

TAXA corporate tax rate in country A 34%

TAXB Corporate tax rate in country B 50%

138 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

XMAX maximum volume (or demand) of the product 20,000 units/unit of time

Variables

p the proportion of transportation costs allocated to subsidiary A 0 6 p 6 1

t the transfer price of the product between the two subsidiaries [$/unit]

x the ¯ow of the product between the two subsidiaries [units/unit of time]

Table 1 presents typical calculations to determine the net income after tax (NIAT) for each of the

subsidiaries, and for the global corporation as a whole. Abdallah (1989) and O'Connor (1997) present

similar tables for analyzing the impact of the change of a transfer price on the NIAT of a company. Note

that when the transfer price is increased by $1/unit to $12/unit, the NIAT increases. However, an additional

increase in the transfer price of $1/unit to $13/unit reduces the NIAT since subsidiary B loses money.

Evidently, there exists an optimal transfer price between $11/unit and $13/unit.

Fig. 2 illustrates the corporate tax rate function we consider for all countries in this paper. No tax credit

for losses is included in the initial analysis. However, the model can handle tax credits if they are assumed to

occur in the same time period under analysis. When the corporate tax rate function is more complex, that is,

when it has more `steps' and breakpoint values, additional analysis is necessary. However, for large

companies the function considered here is realistic and valid in most countries.

To derive the general function of the global NIAT in this example, we should consider four disjoint

regions for the net income before tax (NIBT): both subsidiaries make a pro®t, only subsidiary A makes a

loss, only subsidiary B makes a loss, and both subsidiaries make a loss. The way to obtain these expressions

is to constrain NIBT for both subsidiaries. The general expression obtained for the NIAT of the global

corporation is shown below.

Global NIAT

8

>

> 0:1tx 5:38x ÿ 73; 200 if
t ÿ 7x ÿ 20; 000 P 0 and
20 ÿ 1:12tx ÿ 120; 000 P 0;

>

>

>

< ÿ0:46tx 15:38x ÿ 133; 200 if
t ÿ 7x ÿ 20; 000 P 0 and
20 ÿ 1:12tx ÿ 120; 000 < 0;

>

> 0:44tx 3x ÿ 80; 000 if
t ÿ 7x ÿ 20; 000 < 0 and
20 ÿ 1:12tx ÿ 120; 000 P 0;

>

>

>

:

ÿ0:12tx 13x ÿ 140; 000 if
t ÿ 7x ÿ 20; 000 < 0 and
20 ÿ 1:12tx ÿ 120; 000 < 0:

Fig. 3 shows the global NIAT vs. the transfer price t for dierent values of ¯ow x. Obviously, for the NIAT

to be bounded, there must exist an UB on the ¯ow x from A to B. This bound is determined by a limited

capacity of one or the two subsidiaries, by a limited demand, and/or by other ¯ow constraints imposed on

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 139

Table 1

Net income after tax for the basic example

Detail Subsidiary A Subsidiary B Global corporation

(Transfer price t $11/unit)

Sales

20,000 @ $11/unit 220,000

20,000 @ $20/unit 400,000 400,000

Variable costs ($7/unit) 140,000 140,000

Procurement costs 220,000

Import duties (12%) 26,400 26,400

Fixed costs 20,000 120,000 140,000

Net Income Before Tax (NIBT) 60,000 33,600 93,600

Taxes (34% and 50%) 20,400 16,800 37,200

Net Income After Tax
NIAT 39,600 16,800 56,400

Sales

20,000 @ $12/unit 240,000

20,000 @ $20/unit 400,000 400,000

Variable costs ($7/unit) 140,000 140,000

Procurement costs 240,000

Import duties (12%) 28,800 28,800

Fixed costs 20,000 120,000 140,000

Net Income Before Tax (NIBT) 80,000 11,200 91,200

Taxes (34% and 50%) 27,200 5,600 32,800

Net Income After Tax NIAT 52,800 5,600 58,400

Sales

20,000 @ $13/unit 260,000

20,000 @ $20/unit 400,000 400,000

Variable costs ($7/unit) 140,000 140,000

Procurement costs 260,000

Import duties (12%) 31,200 31,200

Fixed costs 20,000 120,000 140,000

Net Income Before Tax (NIBT) 100,000 ÿ11,200 88,800

Taxes (34% and 50%) 34,000 0 34,000

Net Income After Tax NIAT 66,000 ÿ11,200 54,800

140 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

the system. Notice that the optimal solution to the problem depends on both, the ¯ow and the bounds on

the transfer price: It may be equal to the LB, or to the UB, or may lie in between them.

Since the NIAT depends on the ¯ow and on the transfer price, it is not practical to develop a model

based on the functions shown in Fig. 3. A more general approach that considers all the disjoint regions,

similar to the method presented by Nieckels (1976) and Cohen et al. (1989), is the following. We de®ne two

new variables:

B Net income before tax subsidiary B $=unit of time:

The NIBT may take a negative (loss), zero, or a positive (pro®t) value. Therefore, A and B are free vari-

ables, that can be substituted by:

A A ÿ A ÿ ; where A P 0 and Aÿ P 0;

B B ÿ Bÿ ; where B P 0 and Bÿ P 0:

Note that the NIAT of the global corporation is the sum of the remainder after taxes of the NIBT of all

subsidiaries, minus the sum of the losses of all subsidiaries, provided
A ; Aÿ and
B ; Bÿ are not positive

at the same time. For the model developed here, this is true and will be shown below. Therefore, we can

formulate the following optimization problem:

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 141

subject to

tx ÿ 7x ÿ A Aÿ 20; 000;

ÿ 1:12tx 20x ÿ B Bÿ 120; 000;

11 6 t 6 13;

0 6 x 6 20; 000;

A ; Aÿ ; B ; Bÿ P 0:

It is very important to note that the pairs of variables
A ; Aÿ and
B ; Bÿ cannot be positive at the same

time in any optimal solution. To show this, suppose there exists an optimal solution such that A k1 > 0,

and Aÿ k2 > 0. There are three possible cases: (a) Suppose k1 > k2 . Since there is only one constraint in

which A and Aÿ appear, it is possible to rede®ne a new feasible solution with A k1 ÿ k2 > 0, and

Aÿ 0, and all other variables the same as before. It is easy to observe that the new value of the objective

function is greater than the original one as long as there is a non-negative tax rate for the subsidiary.

Therefore, the original solution cannot be optimal, which is a contradiction. For the case (b) k1 k2 and (c)

k1 < k2 , the proof is similar, by de®ning new feasible solutions with A 0; Aÿ 0, and with

A 0; Aÿ k2 ÿ k1 > 0, respectively. Hence, this property avoids the contradiction of having a pro®t and

a loss in a subsidiary at the same time.

Problem (P1) can be linearized by de®ning a new variable y tx, which represents the amount in dollars

transferred from subsidiary A to subsidiary B through the ¯ow x, using the transfer price t. With this

substitution, we obtain the following problem:

P2 Maximize NIAT 0:66A ÿ Aÿ 0:5B ÿ Bÿ

subject to

y ÿ 7x ÿ A Aÿ 20; 000;

ÿ 1:12y 20x ÿ B Bÿ 120; 000;

11x 6 y 6 13x;

0 6 x 6 20; 000;

A ; Aÿ ; B ; Bÿ P 0:

Evidently an optimal solution to Problem (P2) will also be optimal to Problem (P1). This is so since

given optimal values y and x , we can always ®nd an optimal transfer price t y =x , provided x > 0. In

the general case x may be equal to zero, but the transfer price here is meaningless since there is no ¯ow

from A to B, and it will not be calculated by the algorithm developed below. The unique optimal solution to

Problems (P1) and (P2) is the following (see Fig. 3):

y $250; 000=unit of time;

x 20; 000=units=unit of time;

t y =x $12:5=unit;

A $90; 000=unit of time

all other variables are equal to zero:

142 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

In this paper, the transfer price ± called `basic' transfer price ± is considered to be independent of the

transportation cost. The basic transfer price depends on the technique being used. For example, a cost-plus

method is appropriate to determine the set of transfer prices of components between internal suppliers and

manufacturing plants. Market prices can be adequate for the set of transfer prices of ®nished products

shipped from manufacturing plants to distribution centers (DCs). In any case, the transportation cost al-

location can be modeled independently of the basic transfer price. The transportation cost allocation re-

¯ects the terms of the transaction, which are more precisely de®ned as INCOTERMS. Some of these are,

for example, free on board (FOB), free alongside ship (FAS), and cost, insurance and freight (CIF).

The transportation cost allocation may be de®ned as p the proportion of transportation costs allo-

cated to the origin (subsidiary A for the basic example), where 0 6 p 6 1. If p 0, then the destination

subsidiary pays for all the transportation costs. On the other hand, if p 1, then the origin subsidiary

assumes all the transportation costs. It is possible to obtain unique optimal solutions with 0 < p < 1, and

therefore it is appropriate to model p as a continuous variable. As an illustration and following the same

notation as in the basic example, Table 2 shows general expressions for the NIAT for the case when duties

are paid on the CIF value, assuming both subsidiaries are pro®table.

3. The model

Fig. 4 illustrates the system under consideration. The suppliers are classi®ed into two groups: internal

suppliers and external suppliers. For the external suppliers there is no possible decision with respect to

transfer prices since they sell directly to the company using market prices. For the internal suppliers a set of

optimal transfer prices for the period under consideration is to be determined by the model. The manu-

facturing plants receive components and raw materials from the suppliers, and perform assembly opera-

tions to obtain ®nished products. Then, the plants send ®nished products to DCs using a second set of

transfer prices, which also is to be determined by the model. Finally, the ®nished products are distributed

worldwide from the DCs to retailers and/or ®nal customers.

The complete formulation of the model is very detailed and lengthy, since it requires the de®nition of sets

for all the logistics objects (suppliers, manufacturing plants, DCs, and customers), transportation channels

between the logistics objects, capacity constraints, ¯ow conservation constraints, and cost de®nitions.

Many of the constraints are common in supply chain models and therefore the complete model has not

been included in this paper but it is given in Vidal and Goetschalckx (1998). A verbal formulation, as-

sumptions, and constraints which are unique to this model are given next.

The assumptions of the proposed model can be divided into two classes. The ®rst class contains standard

supply chain modeling assumptions. The detailed list of these assumptions can be found in Vidal and

Goetschalckx (1998) and they are not repeated here. The second class of assumptions deals with transfer

prices and taxation. These assumptions of the model are the following:

· All internal suppliers, plants and DCs are considered to be subsidiaries of the US parent company and

are supposed to be actively involved in manufacturing, selling, shipping, and servicing activities. There-

fore, the Subpart F income of the Internal Revenue Code does not apply here, since all the income of the

subsidiaries is considered active income (for a more detailed description of these concepts, see Glautier

and Bassinger, 1987; Radebaugh and Gray, 1993; Bodner, 1997). As a consequence, the deferral principle

applies, that is, the income is not taxed to the parent company until the dividends are received by the

shareholders.

· Each internal supplier, plant, and distribution center is assumed to be taxed on their local-source income,

except for the parent company, which is subject to tax on its worldwide income. The company attempts to

Table 2

General expression for the NIAT when duties are paid on the CIF valuea

Detail Subsidiary A Subsidiary B Global corporation

Sales

x @ $t/unit tx

x @ $M/unit Mx Mx

Procurement costs tx

Transp. cost Cpx C
1 ÿ px Cx

Other variable costs Vx Vx

Import duties D
t Cx D
t Cx

Fixed costs FA FB FA FB

NIBT
t ÿ Cp ÿ V x ÿ FA fM ÿ
1 DC ÿ
1 Dt Cpgx ÿFB M ÿ C ÿ V ÿ D
t Cx ÿ
FA FB

Taxes
TAXA
t ÿ Cp ÿ V x
TAXB fM ÿ
1 DC ÿ
1 Dt Cpgx
TAXA
t ÿ Cp ÿ V x

ÿTAXA FA ÿTAXB FB
TAXB fM ÿ
1 DC ÿ
1 Dt Cpgx

ÿ
TAXA FA TAXB FB

NIAT
1 ÿ TAXA
t ÿ Cp ÿ V x
1 ÿ TAXB fM ÿ
1 DC ÿ
1 Dt Cpgx
1 ÿ TAXA
t ÿ Cp ÿ V x

ÿ
1 ÿ TAXA FA ÿ
1 ÿ TAXB FB
1 ÿ TAXB fM ÿ
1 DC ÿ
1 Dt Cpgx

ÿ
1 ÿ TAXA FA
1 ÿ TAXB FB

a

It is assumed in the above table that both subsidiaries make a pro®t.

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

143

144 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

maximize the total pro®t after tax in all the countries where it operates, but no income is remitted as a

dividend to the shareholders, and therefore the parent company is only taxed on its local income. Further

re®nements of the model may consider withholding taxes and the reception of dividends from subsidiaries.

· The structure of the organization and its degree of vertical integration allow for the centralization of de-

cisions about the transfer prices.

· Customer demand may or may not be completely satis®ed. This may generate positive slack demand

variables in an optimal solution, especially when the company wants to analyze the impact of the unex-

pected absence of key internal suppliers and/or the impact of producing and selling non-pro®table prod-

ucts.

· All transfer price variables have a lower and an upper bound, which re¯ect feasible markups for produc-

tion costs and a pro®t margin, or for possible discounts from market prices.

· As a requirement for the justi®cation of transfer prices to tax authorities, all the transfer prices from a

given origin and for a given component (or ®nished product) must be the same for all the destinations.

The transfer price, of course, does not include the transportation cost, which is modeled separately. This

can be thought of as the transfer price being determined based on production costs, and therefore there is

no reason to allow it to be dierent for dierent buyers. The allocation of the transportation cost to the

origin or destination is a decision variable that is considered independently of the transfer price. If trans-

fer prices are allowed to be dierent, the problem is easier to solve as we show below.

· Import duties are paid by the importing country, based on the FOB value of the transferred products, or

based on the CIF value, as appropriate. No export duties are considered.

MODEL P
x; t; v; p

Maximize global after tax pro®t (given in dollars for the time period under analysis)

After tax pro®t of internal suppliers

+After tax pro®t plants

+After tax pro®t of DCs

Subject to Expressions for the NIBT of internal suppliers, plants, and DCs

Suppliers' capacity (internal and external suppliers)

Production capacity at plants

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 145

Bill of materials at plants and balance constraints at DCs

Minimum pro®t for internal suppliers, plants and DCs (optional)

Bounds on transfer prices and general bounds on decision variables

The after tax pro®t of suppliers, plants and distribution centers are included in the objective function

with the following generic form

X

1 ÿ TAXi ibts ÿ

i ÿ ibtsi :

i

Here TAXi is the corporate tax rate (%) of the home country of logistics object i; ibtsi is the net income

before tax of logistics object i, which can be a supplier, manufacturing plant, or distribution center. The

dimensions are ($/unit of time).

The net income variables are free variables, since the net income before tax may be negative, zero, or

positive. Therefore, each of these variables is replaced by the dierence between a ``plus'' non-negative

variable (pro®t variable) and a ``minus'' non-negative variable (loss variable).

The net income before tax of logistics objects such as plants and DCs is computed similarly to the net

income before tax of DCs located in countries where duties are charged on the CIF value, which is given in

the following constraint:

X X X 1 X X X 1

MPRICElp wklmp ÿ HANDCkp TRCWMklm Wp wklmp

l2C
k m2T
k;l p2P

El l2C
k m2T
k;l p2P

Ek

X X X VPkp H h

p i

ÿ TTWMklm
CSF SHIPFREQklm SSFWkp TTWMklm wklmp

l2C
k m2T
k;l p2P

Ek

X X X 1

ÿ tppldcjp
1 DUTYjkp
1 ÿ propwjkm DUTYjkp TRCPWjkm Wp xjkmp

j2M m2T
j;k p2P
j

Ej

1

ÿ FIXDCk ibtwc ÿ

k ÿ ibtwck ; k 2 W c:

Ek

The net income before tax of logistics objects is computed similarly to the net income before tax of DCs

located in countries where duties are charged on the FOB value, which is given by:

X X X 1 X X X 1

MPRICElp wklmp ÿ HANDCkp TRCWMklm Wp wklmp

l2C
k m2T
k;l p2P

El l2C
k m2T
k;l p2P

Ek

h

X X X VPkp H p i

ÿ TTWMklm
CSF SHIPFREQklm SSFWkp TTWMklm wklmp

l2C
k m2T
k;l p2P

Ek

X X X 1

ÿ tppldcjp
1 DUTYjkp
1 ÿ propwjkm TRCPWjkm Wp xjkmp

j2M m2T
j;k p2P
j

Ej

1

ÿ FIXDCk ibtwfk ÿ ibtwfkÿ ; k 2 W f :

Ek

The minimum reasonable pro®t of logistics object k can have a LB dictated by external factors and this is

modeled by the following type of constraint:

ibtwc

k P MINPROn :

146 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

The upper and LBs on transfer prices are modeled by the following type of constraints:

l u

TPPLDCjp 6 tppldcjp 6 TPPLDCjp ; j 2 M; p 2 P
j:

Bounds on the proportions for allocating transportation costs are modeled by the following type of con-

straints:

For the sake of clarity, we present the sets, indexes, parameters, and decision variables next.

C set of market zones, indexed by l

C k set of market zones that can be served by distribution center k 2 W

M set of manufacturing plants, indexed by j

P set of ®nished products, indexed by p

P j set of products that can be produced in manufacturing plant j; P j P

T set of transportation modes, indexed by m

T j; k set of available transportation modes between plant j 2 M and distribution center

k 2 W ; T j; k T

T k; l Set of available transportation modes between distribution center k 2 W and

market zone l 2 C k; T k; l T

W set of DCs, indexed by k

Wc set of DCs located in countries where duties are charged on the CIF value of

imported products; W c W

Wf set of DCs located in countries where duties are charged on the FOB value of

imported products; W f W ; W c [ W f W ; W c \ W f ;

Parameters (Note: For convenience and ease of reading, all parameters are de®ned using capital letters)

DUTYjkp import duty rate on the value of ®nished product p 2 P j, shipped from plant

j 2 M to distribution center k 2 W

Ek exchange rate of country of distribution center k 2 W [monetary units of the

respective country/dollar]

FIXDCk ®xed cost of distribution center k 2 W [monetary units country of distribution

center k per unit of time]

H holding cost given in $/($. units of time) (units of time consistent with those of the

average transportation time parameters de®ned below) [in general, given in $/$. year]

HANDCkp handling cost of ®nished product p 2 P in distribution center k 2 W [monetary

units country of distribution center k/unit of p]

MINPROn minimum ``reasonable'' pro®t of subsidiary n (internal supplier, plant, or

distribution center) [monetary units of the corresponding country/unit of time]

(These parameters are to be used judiciously by management)

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 147

[monetary units country of market zone l/unit of p]

SHIPFREQijm frequency of shipments of raw materials from internal supplier i 2 S 0 to plant

j 2 M i, using transportation mode m 2 T i; j [units of time (in general, days)]

SHIPFREQklm frequency of shipments from distribution center k 2 W to customer zone l 2 C k,

using transportion mode m 2 T k; l [units of time (in general, days)]

SSFWkp safety stock factor of ®nished product p 2 P at distribution center k 2 W

l u

TPPLDCjp ; TPPLDCjp LB and UB on the transfer price of ®nished product p 2 P j, shipped from

plant j 2 M to any distribution center in W [monetary units country of plant j/

unit of p]

TPSUPLlir ; TPSUPLuir LB and UB on the transfer price of raw material r 2 R i, shipped from internal

supplier i 2 S' to any plant in M i [monetary units country of supplier i/units of r]

TRCPWjkm transportion cost per weight unit (not including duties) of ®nished products

shipped from plant j 2 M to distribution center k 2 W , using transportion mode

m 2 T j; k [monetary units country of plant j/weight unit]

TRCWMklm transportion cost per weight unit (not including duties) of ®nished products

shipped from distribution center k 2 W to market zone l 2 C k, using transpor-

tation mode m 2 T k; l [monetary units country of distribution center k/weight

unit]

TTPWjkm average transportation time from plant j 2 M to distribution center k 2 W , using

transportion mode m 2 T j; k [units of time]

TTWMklm average transportation time from distribution center k 2 W to market zone

l 2 C k, using transportation mode m 2 T k; l [units of time]

VPkp inventory value of ®nished product p 2 P , given in monetary units of the country of

distribution center k 2 W per unit of p

Wp weight of a unit ®nished product p 2 P [weight units/unit of p]

Decision variables (Note: For convenience and ease of reading, all decision variables are de®ned using small

letters.)

ibtwck net income before tax of distribution center k 2 W c [$/unit of time]

ibtwfk net income before tax of distribution center k 2 W f [$/unit of time]

Note: The above ®ve sets of variables are free variables, since the net income before tax may be

negative, zero, or positive. Therefore, each of these variables is replaced by the dierence

between a plus non-negative variable (pro®t variable) and a minus non-negative variable (loss

variable). For example, the set of free variable ibtwcj
j 2 M c generates the sets of

non-negative variables ibtwc c ÿ c

j
j 2 M and ibtwcj
j 2 M ].

propwjkm proportion of transportation costs of ®nished products shipped from plant j 2 M to

distribution center k 2 W , using transportation mode m 2 T
j; k, allocated to plant j

prospijm proportion of transportion costs of raw materials shipped from internal supplier i 2 S 0 to

plant j 2 M
i, using transportation mode m 2 T
i; j, allocated to internal supplier i

tppldcjp transfer price of ®nished product p 2 P
j,shipped from plant j 2 M to any distribution

center in W (not including transportation costs) [monetary units country of plant j/unit of p]

wklmp amount of ®nished product of p 2 P shipped from distribution center k 2 W to market zone

l 2 C
k, using transportation mode m 2 T
k; l [units of p/unit of time]

xjkmp amount of ®nished product p 2 P
j, produced at plant j 2 M and shipped to distribution

center k 2 W , using transportation mode m 2 T
j; k [units of p/unit of time]

148 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

4. Solution approaches

Clearly, Problem P
x; t; v; p is a non-convex optimization problem with a linear objective function, a set

of linear constraints, and a set of bilinear equalities. The problem has the following general structure:

P x; t; v; p Maximize d T0 v

subject to

cTr x d Tr v xT Ar t xT B r p f r ; r 1; 2; . . . ; m;

Cx 6 b;

T l 6 t 6 T u;

0 6 p 6 1;

x P 0; t P 0; v P 0;

where Ar ; Br
r 1; 2; . . . ; m and C are the matrices of coecients; b the right-hand side vector of ¯ow-

related constraints; cr
r 1; 2; . . . ; m; d r
r 0; 1; 2; . . . ; m the vectors of coecients; f r
r 1; 2; . . . ; m

the ®xed costs at internal suppliers, plants, and DCs; p the vector of proportions to allocate transportation

costs; t vector of transfer prices; T l ; T u the LB and UBs on transfer prices; v vector of pro®t and loss

variables; x is the vector of material ¯ows.

Problem P
x; t; v; p can be transformed into an inde®nite quadratic problem with bilinear constraints by

replacing some variables from the bilinear equalities in the objective function. Therefore, according to

Pardalos and Vavasis (1991), it is NP-hard.

Speci®c variations of this problem have been widely studied. For example, the classic bilinear problem

has a bilinear objective function with linear constraints represented by two separable polyhedra in x and y

(Konno, 1976; Gallo and Ulk ucu, 1977; Vaish and Shetty, 1977; Sherali and Shetty, 1980; Al-Khayyal and

Falk, 1983; Judice and Faustino, 1991). The jointly constrained bilinear program is a variation of the latter,

in which the constraints are linear but cannot be separated into two disjoint polyhedra in x and y (Al-

Khayyal, 1990; Sherali and Alameddine, 1992). The more general case when the convexity of the feasible set

is relaxed is a more dicult problem to solve (Al-Khayyal, 1990). An example of this case is a general

bilinear problem having bilinear constraints, as shown in Al-Khayyal (1992). This problem has received less

attention in the literature, and has been more intensively studied for speci®c cases, namely the pooling

problem (Floudas and Visweswaran, 1990; Visweswaran and Floudas, 1990; Floudas and Aggarwal, 1990;

Visweswaran and Floudas, 1993), and some applications in farm management (Bloemhof-Ruwaard and

Hendrix, 1996). Other researchers have addressed the problem indirectly by analyzing more general

problems, such as polynomial programming problems (Sherali and Tuncbilek, 1992), general quardratic

programs (Al-Khayyal et al., 1995), and general constrained non-convex problems (Floudas and Vis-

weswaran, 1993; Ben-Tal et al., 1994; Androulakis et al., 1995).

To the best of our knowledge all the computational results reported in the above research correspond to

relatively small instances of the problems. However, in global supply chain models, we usually face medium

to large-scale optimization problems for which none of these global optimization approaches appear to

work satisfactorily. For this reason, and given the structure of the problem, an optimization-based heuristic

procedure using successive LP solutions has been developed. Its description is given next.

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 149

It is important to note the proportion of transportation costs, represented by the variables

propwjkm and prospijm , are allowed to be dierent from a speci®c origin to dierent destinations, using a

given transportation mode. There exists considerable ¯exibility to de®ne the fraction of the transportation

cost paid by the subsidiary and the terms of each transaction can be dierent. As a consequence, the bilinear

terms in x and p can be linearized by using the following substitutions:

X

prospijm Wr Sijmr zijm ; i 2 S 0 ; j 2 M
i; m 2 T
i; j;
1

r2R
i\R
j

X

propwjkm Wp xjkmp zjkm ; j 2 M; k 2 W ; m 2 T
j; k:
2

p2P
j

The rationale for the de®nition of these variables comes from the fact that the proportions to allocate

transportation costs do not depend on the speci®c component or ®nished product since these costs are

expressed per unit of weight. Using this substitution, we transform the problem into the following for-

mulation:

P x; t; v; z Maximize d T0 v

subject to

cTr x d Tr v xT Ar t gTr z f r ; r 1; 2; . . . ; m;

Cx 6 b;

T l 6 t 6 T u;

z ÿ Ex 6 0;

x P ; t P 0; v P 0; z P 0;

where the new set of constraints z ÿ Ex 6 0 corresponds to the transformed bounds on the proportions for

allocating transportation costs (see constraints 0 6 p 6 1 in Problem P
x; t; v; p, namely:

X

0 6 zijm 6 Wr sijmr ; i 2 S 0 ; j 2 M
i; m 2 T
i; j;
3

r2R
i\R
j

X

0 6 zjkm 6 Wp xjkmp ; j 2 M; k 2 W ; m 2 T
j; k:
4

p2P
j

We can relax the limitation that all transfer prices must be the same from each origin to all destinations

for a given raw material (or ®nished product) by rede®ning the transfer price decision variables as follows:

150 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

tpsuplijr transfer price of raw material r 2 R
i, shipped from internal supplier i 2 S 0 to plant j 2 M
i

(not including transportation costs) [monetary units country of supplier i/unit of r],

tppldcjkp transfer price ®nished product p 2 P
j shipped from plant j 2 M to distribution center k 2 W

(not including transportation costs) [monetary units country of plant j/unit of p].

By doing this, we are now able to make the following substitutions to linearize the remaining nonlinear

terms existing in the bilinear constraints of problem P
x; t; v; z:

X

tpsuplijr sijmr yijr ; i 2 S 0 ; j 2 M
i; r 2 R
i \ R
j;
5

m2T
i;j

X

tppldcjkp xjkmp yjkp ; j 2 M; k 2 W ; p 2 P
j:
6

m2T
j;k

The rationale for the de®nition of these variables is similar to that of the substitution of the proportion

variables, because the transfer prices ± as de®ned in this paper ± do not depend on the transportation mode

since the transportation costs are considered separately. Therefore, the summation may be made over all

available transportation modes. It is important to observe that the new lower and UBs on the transfer

prices also have three indexes according to this rede®nition. Since we are interested in developing a new

problem that is equivalent to the original Problem P
x; t; v; p, we need to rede®ne the bounds on transfer

prices as:

i l

TPPLDCjkp TPPLDCjp ; j 2 M; p 2 P j 8k 2 W ; 7

u u

TPPLDCjkp TPPLDCjp ; j 2 M; p 2 P j 8k 2 W :

Moreover, for the problem P
x; y; v; z to be equivalent to the original problem P
x; t; v; p, we need to add

constraint of the form xT F q y 0; q 1; 2; . . . ; h, which ensure that all transfer prices from a given origin to

all destinations for a given raw material (or ®nished product) are equal. More precisely, these constraints

are the following:

yijn r yijn1 r

P P ;

m2T
i;jn Sijn mr m2T
i;jn1 Sijn1 mr

8

yjkn p yjkn1 p

P P ;

m2T j;kn xjkn mp m2T j;kn1 xjkn1 mp

for all possible combinations of jn and jn1 , and kn and kn1 . These constraints are to be relaxed so that we

can obtain an UB on the original problem P
x; t; v; p. Hence, we obtain the following problem:

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 151

P x; y; v; z Maximize d T0 v

subject to

Cx 6 b;

Dl x 6 y 6 Du x;

z ÿ Ex 6 0;

xT F q y 0; q 1; 2; . . . ; h constraints to be relaxed

x P 0; y P 0; v P 0; z P 0:

The new constraints Dl x 6 y 6 Du x come from the original bounds on transfer prices in problem

P
x; t; v; z, and are given by:

X X

TPSUPLlijr Sijmr 6 yijr 6 TPSUPLuijr Sijmr ; i 2 S 0 ; j 2 M
i; r 2 R
i \ R
j;

m2T
i;j m2T
i;j

X X
9

l u

TPPLDCjkp xjkmp 6 yjkp 6 TPPLDCjkp xjkmp ; j 2 M; k 2 W ; p 2 P
j:

m2T
j;k m2T
j;k

The relaxation of problem P
x; y; v; z provides an UB on the original problem P
x; t; v; p. Let us call this

relaxed problem PR
x; y; v; z. This UB will be utilized for testing the performance of the overall procedure,

whose description is given next.

If we ®x the set of variables x in problem P x; t; v; z, then the problem becomes linear in t, and vice

versa. Thus, we can iterate by successively ®xing one set of variables and solving the remaining LP for the

other set. The process can be terminated when the change in the objective function value is negligible. Fig. 5

summarizes the overall procedure. We use the notation P x; t; v; z j x and P x; t; v; z j t to denote Problem

P x; t; v; z with ®xed ¯ows and with ®xed transfer prices, respectively. The diculty in solving the original

problem P x; t; v; p to optimality is due to its multi-extremality characteristic, that is, the existence of

multiple local optima. Consequently, the heuristic solution obtained by the procedure is highly dependent

on the starting point. In what follows, we test the performance of diverse starting points instances of the

problem.

5. Computational experience

The procedure described in the previous Section has been implemented using AMPL connected with

CPLEX. All the experiments have been done in an IBM RS6000 model 590 with 512 MB of RAM. We have

conducted extensive computational experiments using diverse starting points and two sets of instances of

dierent sizes. All instances have been carefully generated to approximate real instances as much as pos-

sible. The main characteristics of these instances are shown in Table 3. In what follows, we describe each of

the starting points we have tested.

152 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

Table 3

Main characteristics of the small and medium instances solved

Characteristics Small instances Medium instances

Total number of suppliers 11 50

Number of internal suppliers 3 12

Number of manufacturing plants 3 8

Number of distribution centers 8 10

Number of customer zones 20 80

Number of components 10 35

Number of ®nished products 5 12

Average transportation modes/arc 2.8 3.1

Number of decision variablesa 1544 10,100

Number of constraintsa 521 2926

a

The number of decision variables and constraints shown correspond to problem PR
x; y; v; z after preprocessing.

In this case we solve problem PR
x; y; v; z and take the optimal set of ¯ows as the starting point of the

procedure. It is important to note that these ¯ows are feasible to the original problem P
x; t; v; z and

therefore a good behavior is expected.

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 153

Assuming that the optimal solution to problem PR
x; y; v; z contains at least a set of transfer prices that

are not feasible, we use the following expressions to determine a suitable set of feasible transfer price to start

the process:

P

j2MMS
i:r2RRM
j ysuplijr

tpsuplir P P ; i 2 SINT ; r 2 RRS;
i

j2MMS
im2TSM
i;j:r2RRM
j Sijmr

P
10

k2w ypldcjkp

tppldcjp P P ; j 2 M; p 2 PPM
j

k2W m2TMW
j;k xjkmp

It is important to note that these expressions yield a weighted average of all dierent transfer prices, so that

the total amount transferred from the given origin remains constant. If there is no ¯ow from some origins,

then we select the LB on the transfer price to start the process.

Reducing the expression for the NIAT of the global corporation in Table 2, we ®nd that one of its terms

is equal to
1 ÿ TAXA ÿ
1 ÿ TAXB
1 Dtx. This suggests that if the expression in the brackets is

greater than zero, then the transfer price should be set to its UB; otherwise, it should be set to its LB.

Nieckels (1976) presents the same heuristic to start his solution procedure. Of course, the optimal value

depends on other factors such as ¯ows, but this simple rule is worth implementing in the general procedure.

Speci®cally, we apply the following rules for setting the starting transfer prices in this case:

X

For all i 2 SINT ; r 2 RRS
i : if
1 ÿ TAXi ÿ
1 DUTYijr
1 ÿ TAXj > 0;

j2MMS
i:r2RRM
j

X

For all j 2 M; p 2 PPM j : if 1 ÿ TAXj ÿ 1 DUTYjkp 1 ÿ TAXk > 0;

k2W

u l

then let tppldcjp TPPLDCjp ; otherwise let tppldcjp TPPLDCjp :

We have also examined the behavior of the procedure when setting all the transfer prices either to their

LB or to their UB. In addition, we allow the procedure to begin with all the transfer prices set to the middle

of the interval, that is, equal to (LB + UB)/2.

The procedure can also be implemented with any value of the initial ¯ows even using infeasible ¯ows.

This is so since we eliminate all constraints exclusively concerning ¯ows when we solve the problem

P
x; t; v; z j x (see Fig. 5). One case is when we set all the initial ¯ows to zero, but any initial value can be

used.

154 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

Table 4

Computational results for small and medium instances

Starting % Gap from the Solution No. of

point upper bound time (s) iterationsb

Small

instances No.a

1 Opt_Flows 1.882 4.51 2

Opt_TP 1.028 4.56 2

Heu_TP 1.889 13.83 11

LB_TP 1.889 13.66 11

UB_TP 1.743 5.71 3

Mid_TP 1.306 452.28 506

Init_Flows 0 1.889 13.24 11

Init_Flows 50,000 0.756 19.70 >17

Opt_TP 0.008 4.44 2

Heu_TP 0.000 3.33 1

LB_TP 0.000 3.33 1

UB_TP 0.036 4.40 2

Mid_TP 0.045 4.41 2

Init_Flows 0 0.000 4.23 2

Opt_TP 0.183 8.39 6

Heu_TP 0.381 6.06 4

LB_TP 0.381 6.06 4

UB_TP 0.129 29.35 27

Mid_TP 0.154 12.03 10

Init_Flows 0 0.381 6.96 5

Opt_TP 1.095 4.64 2

Heu_TP 1.328 42.64 38

LB_TP 1.432 32.64 29

UB_TP 1.134 26.13 23

Mid_TP 1.386 41.09 36

Init_Flows 0 1.432 32.73 29

Opt_TP 1.707 820.29 737

Heu_TP 24.746 437.18 336

LB_TP 24.746 440.87 336

UB_TP 13.571 197.72 174

Mid_TP 19.242 1,030.37 889

Init_Flows 0 24.764 360.87 312

Medium

instances No.a

1 Opt_Flows 0.022 80.84 2

Opt_TP 0.022 96.55 3

Heu_TP 0.022 100.32 3

LB_TP 0.022 572.25 28

UB_TP 0.024 3,054.75 160

Mid_TP 0.023 348.50 17

Init_Flows 0 0.022 572.69 29

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 155

Table 4 (Continued)

Starting % Gap from the Solution No. of

point upper bound time (s) iterationsb

2 Opt_Flows 0.000 41.19 1

Opt_TP 0.000 40.53 1

Heu_TP 1.465 84.10 5

LB_TP 0.400 61.29 3

UB_TP 0.282 49.44 2

Mid_TP 0.470 46.69 2

Init_Flows 0 0.400 70.71 4

Opt_TP 0.400 423.10 13

Heu_TP 3.473 107.48 2

LB_TP 1.384 118.95 2

UB_TP 0.782 147.35 3

Mid_TP 0.614 140.41 3

Init_Flows 0 1.384 143.81 3

Opt_TP 0.525 117.22 2

Heu_TP 6.691 126.49 3

LB_TP 2.186 143.41 3

UB_TP 1.515 126.21 2

Mid_TP 1.965 239.12 7

Init_Flows 0 2.186 206.57 5

Opt_TP 0.504 21,836.41 793

Heu_TP 6.527 698.22 37

LB_TP 5.260 14,295.65 677

UB_TP 3.174 34,447.42 1,356

Mid_TP 4.829 26,312.53 1,177

Init_Flows 0 5.241 22,873.70 1,028

a

Instances of the same size have the same structure shown in Table 3, but they dier by demand, tax rate, and other parameters. Small

and medium instances 5 are de®ned with unconstrained transfer prices (LB 0 and UB A large number).

b

The number of iterations represents the number of times the convergence criterion is tested (see Fig. 5).

The procedure converges for all the cases we have tested, even when it starts with infeasible ¯ows. The

main results are summarized in Table 4. Note that the quality of the local solution obtained with the

procedure is highly dependent on the starting point. For most of the instances we have solved, the best

solutions have been obtained when the starting point is either the optimal ¯ows (Opt_Flows) or the optimal

transfer prices (Opt_TP) from the relaxed problem. A noticeable exception occurs in the small instance No.

1 for Init_Flows 50,000. It is important to note the behavior of the procedure in the small and medium

instances No. 5. These instances were created with a large ¯exibility for selecting all transfer prices. Of

course, these instances are not likely to be found in reality due to strict regulations of tax authorities, but

they provide a benchmark for the behavior of the procedure since we expect the gap between the local

solution and the UB to be larger when the transfer prices are less constrained. In instances No. 5 the

starting point with Opt_Flows and with Opt_TP from the relaxed problem signi®cantly outperforms the

other starting points.

It is also important to observe that the procedure converges very fast, especially when starting with

Opt_Flows or with Opt_TP. Even when the number of iterations is larger, the typical behavior of the

156 C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158

Fig. 6. Objective value progress for small instance No. 3 (starting point UB_TP).

procedure is characterized by very good solutions early on in the process (Fig. 6). In other less frequent

cases, the convergence is slower, but we have not observed this performance when starting with Opt_Flows

or Opt_Tp. This allows us to obtain very good solutions very fast.

Finally, concerning the characteristics of the solutions, all instances in Table 4 have been solved using

inequalities
6 for the customer demand constraints. This allows us to identify non-pro®table products

and costly customers to be served. The behavior of the procedure when satisfying total demand (equality

constraints for customer demand) is similar, although the gaps between the local solutions and their cor-

responding UBs are slightly larger. Most of the solutions show the transportation cost being totally allo-

cated to the origin or to the destination, with very few proportions lying in the interval (0, 1).

In this paper we have presented a global supply chain model that includes explicitly TP and transpor-

tation cost allocation as decision variables. The model also considers the selection of transportation modes

based on approximate expressions for the inventory costs generated by the utilization of each transpor-

tation mode. Since the resulting problem is NP-hard, we have developed a heuristic successive LP-solution

procedure and UBs to test its performance. Our computational experience shows satisfactory results with

C.J. Vidal, M. Goetschalckx / European Journal of Operational Research 129 (2001) 134±158 157

very close gaps between the local solutions found by the procedure and their corresponding UBs even for

instances presenting a high degree of ¯exibility in the transfer prices. In some cases the procedure provides

provably optimal solutions. Our ongoing research comprises the test of larger instances, and the application

of global optimization procedures to the original problem to obtain either optimal solutions or solutions

with a prescribed gap, at least for the small instances. This will provide additional benchmarks for the

developed procedure.

Further research should consider pro®t repatriation, withholding taxes, and cash ¯ows; the inclusion of

additional international features such as the rules of origin, duty drawbacks, and import quotas that may

exist in regional trading agreements; and the analysis of more complex corporate rate functions. The in-

clusion of location decisions, especially related to the opening of new DCs is also a fertile area for further

research.

Since the algorithm that we presented here can ®nd near-optimal solutions to medium instances in

acceptable computation time, the model described here can be useful in the optimization of global supply

chains. MNCs can apply these techniques to increase signi®cantly their global pro®ts after taxes.

Acknowledgements

This research was partially funded by the Instituto Colombiano para la Ciencia y la Tecnologia,

COLCIENCIAS; by the Universidad del Valle, Cali, Colombia; and by the Fulbright Commission, ad-

ministered by the Latin American Scholarship Program for the American Universities (LASPAU).

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