European Journal of Operational Research 174 (2006) 16511663 www.elsevier.

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Production, Manufacturing and Logistics

Price uctuations, information sharing, and supply chain performance

Srinagesh Gavirneni
*
Johnson Graduate School of Management, Cornell University, Ithaca, NY 14850, United States Received 13 June 2000; accepted 27 April 2005 Available online 10 August 2005

Abstract We consider a supply chain consisting of one supplier with nite production capacity and a retailer facing independent and identically distributed demands from end-customers. Existing research advocates that, in a decentralized setting, the retailer and the supplier using stationary order up to policies is ecient. We show that in the presence of information sharing, the supply chain performance can be improved by the supplier oering uctuating prices. We study two specic settings: (1) the supplier only knows the parameters of the retailers inventory policy; and (2) the supplier knows the day-to-day inventory levels at the retailer as well. After establishing structure of optimal policies and developing ecient solution procedures, we perform an extensive computational study to determine the extent of the improvements realizable in the supply chain. We observed that for setting 1, an improvement was realized only when the end-customer demands were highly variable. Even then, the improvement in supply chain performance was less than 1%. Whereas, for setting 2, the improvement in supply chain performance averaged around 5.0% with a maximum of 16.3%. 2005 Elsevier B.V. All rights reserved.
Keywords: Supply chain management; Information sharing; Price uctuations; Inventory control

1. Introduction This paper describes the eect of price uctuations on the performance of capacitated supply chains with information sharing. Recent studies have indicated that price uctuations are one of
*

Tel.: +1 607 254 6776. E-mail address: sg337@cornell.edu

the principal reasons for the bullwhip eect and the associated ineciencies. As a result many suppliers have resorted to an every day low price (EDLP) strategy in order to reduce the uctuations in demand. That would certainly be a reasonable step if there is a lack of transparency in the supply. However, supply chains have lately become information intensive and the participants are operating in a cooperative fashion for the

0377-2217/$ - see front matter 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.ejor.2005.04.037

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benet of the whole supply chain. This paper establishes that, if there is information sharing in the supply chain, price uctuations (such as HILO pricing) can in fact lead to improved supply chain performance. We analyze a capacitated supply chain with a setup similar to the one in Cachon and Zipkin [7]. There is a single supplier with nite production capacity, C, supplying a single product to a retailer who is in turn facing independent and identically distributed demands (with cdf W() and pdf w()) from end-customers. The holding and penalty costs at the retailer are hr and pr, respectively. They are hs and ps at the supplier. The costs and the demand distributions are known to both parties. There are no xed ordering costs or leadtimes either at the retailer or the supplier. The unsatised demands at the retailer are backlogged and the unsatised demands at the supplier are sent to the retailer using an expediting strategy and ps represents the cost of expediting. Thus, if needed, the retailer can order and receive an innite quantity of the product in a period. All these assumptions are common in inventory control literature and most of them except the one on ordering costs can be relaxed without signicantly changing the general behavior of the system. We study this supply chain under a periodic setting and the sequence of events in every period is as follows: (1) the supplier decides (restricted by her capacity) how much to produce. The product is available immediately; (2) the retailer faces the end-customer demand and satises it to the best of his abilities. Unsatised demands are backlogged; (3) the retailer decides how much to order from the supplier; (4) the supplier satises the retailers demand to the best of her abilities. Unsatised demands are supplied through the expedited source. The product is available to the retailer at the beginning of the next period; and (5) the holding and penalty costs at both the retailer and the supplier are computed and the problem goes to the next period. We measure the performance of this supply chain using the total holding and penalty costs at both the retailer and the supplier. Since the purchase costs between the retailer and the supplier are internal to the supply chain, they are not explicitly included in the total supply

chain cost. Our objective is to show that a supply chain with a constant price, whatever that price may be, between the supplier and the retailer can often be made more ecient by the supplier moving to a strategy that oers uctuating prices. We have kept the models simple so that we can clearly identify the relationships between price uctuations, information sharing, and supply chain performance. Since optimal procedures for these models are known, the eects of these relationships can be computed accurately. The principal objective here is to gain insights on the interactions between these strategies in the hope that these may lead us to better manage more complex supply chains. We analyze a decentralized setting since we believe a large number of the supply chains operate in this manner. Many times the supplier and the retailer belong to two dierent companies or even if they are in the same company, they operate as two distinct prot centers. In addition, we believe that a decentralized system allows us to better relate these results to settings that contain multiple retailers and/or products. We study the interaction between these strategies in this supply chain by formulating and analyzing the retailer and supplier behavior in two dierent models. In Model 1, the supplier charges the retailer the same price (c dollars per unit) in every period. In this setting, it is optimal for the retailer to use a stationary order up to policy with the order up to level z in every period. Thus the endcustomer demands at the retailer are transmitted to the supplier without any change and the supplier sees i.i.d. demands in every period. In every period, the supplier is completely aware of the inventory level at the retailer and there is no need for the retailer to provide additional information. Since the cost, c, is constant and internal to the supply chain, its magnitude does not impact the total supply chain cost. In Model 2, the supplier alternates the selling price between c 0 and c 0  from one period to the next. This leads to the retailer using an ordering pattern that repeats every two periods. In every cycle of two periods, the rst period has an order up to level z 0 while the second period has the order up to level z 0 + d. Under this retailer inventory policy, the demands seen by the supplier are no longer i.i.d. We characterize the information

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(retailer inventory policy parameters in setting 1 and retailer inventory levels in setting 2) available to the supplier and formulate the resulting non-stationary inventory control problem she faces. Though the variance of demands seen by the supplier is increased, the benets realized from the associated information ow will result in lower costs at her location. In addition, we will show that this reduction in costs at the supplier far outweighs the increase in the retailers costs. Thus, if the supplier is willing to share some of the benet she realizes with the retailer, the retailer may be willing to provide the inventory information and the whole supply chain will be more ecient. While the ways in which the prices at the supplier can be made to uctuate are numerous, we restrict our attention to uctuations that repeat every two periods. This is very similar to the HILO pricing popular among many suppliers. As will be seen later in our section on the computational results, we further assume that these uctuations are symmetric around the price oered in the constant pricing scheme. Under these assumptions, to determine the optimal uctuating pricing scheme, one needs only to search over the possible values of the  value. We develop an ecient procedure to determine the optimal supplier and retailer behavior for a given value of  and use that to search over the set of the possible  values to determine the optimal uctuating pricing scheme. We also present results from a computational study that is aimed at determining the extent of the reduction in supply chain costs that can be realized. We observe that such a reduction is in fact possible and is especially large when the demand variance, the supplier capacity, and the supplier penalty cost are all high. This is counterintuitive since we are saving money by using non-stationary policies both at the retailer and at the supplier even though the end-customer demand is i.i.d. While these reductions are seen to be small (less than 1%) when the supplier only knows the retailer inventory policy parameters, they are as large as 16.3% (with an average of 5%) when the supplier is aware of the retailer inventory levels. This is only possible because we are taking into consideration the information ows enabled by the price uctuations at the sup-

plier. By analyzing and understanding the interaction between price uctuations and information sharing we develop a strategy that results in a reduction in the total supply chain costs. The models we study are discrete time periodic review non-stationary capacitated inventory control problems. The capacitated stationary inventory control problems were analyzed by Federgruen and Zipkin [10,11] and solution procedures for it were presented by Tayur [26] and Glasserman and Tayur [15,16]. The capacitated nonstationary inventory control problem was the focus of articles by Kapuscinski and Tayur [18], Gavirneni et al. [12], and Scheller-Wolf and Tayur [24]. These three articles use innitesimal perturbation analysis (IPA) to solve these problems. We will use this approach as well and details on this method can be found in Glasserman [14]. Information ow in supply chains is the focus of many recent articles. Chen [8] studied the benets of information ow in a multi-echelon serial inventory system by computing the dierence between the costs of using echelon reorder points and installation reorder points. He observed that information sharing reduced costs by as much as 9%, but averaged only 1.75%. Cachon and Fisher [6] and Aviv and Fedegruen [3] studied the benets of information ow in one warehouse multi-retailer systems. They assumed innite capacity and the presence of batch sizes (or xed ordering costs) and found that the benets of information sharing under these settings were quite small, averaging about 2% in the case of Aviv and Fedegruen and about 2.2% in the case of Cachon and Fisher. Gavirneni et al. [12] computed the benets of information ow in a two-stage capacitated supply chain when the retailer is using an (s, S) policy. They noticed signicantly higher benets averaging around 14% and ranging from 1% to 35%. Designing ecient supply contracts has recently been a favorite topic of many in the supply chain management research community. Anupindi and Bassok [1], Cachon [5], and Lariviere [20] are excellent sources of information on this topic. It is not surprising that pricing plays an important role in designing good supply contracts. Pasternack [23] and Lee et al. [22] showed that price protection (a method for compensating the retailer for excess

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inventory at her location) is a strategy that the supplier can use to achieve channel coordination. Chen et al. [9] have shown that in order to achieve channel coordination in a supply chain with non-identical retailers, a discounting scheme based on three quantities (namely annual sales volume, order quantity, and order frequency) is necessary. Munson and Rosenblatt [21] explored the benets of using quantity discounts in a three level supply chain and showed that savings can be signicant. However, few researchers have specically looked at price uctuations and the role they play in improving supply chain performance. Iyer and Ye [17] studied price uctuations at the retailer and their eect on grocery supply chains. They observed that if the supplier obtains information about the price uctuations at the retailer, in some cases he can use that information to improve his performance. In this paper, we focus on the eect of price uctuations at the supplier and their impact on the performance of the whole supply chain. The rest of this paper is organized as follows. In the next section, we describe the two models we study and determine the corresponding optimal retailer and supplier inventory policies. In addition, we also briey describe ecient solution procedures for the optimal retailer and supplier parameters. In Section 3, we present the results from a large computational study and study the role that various supply chain parameters (such as supplier capacity, holding and penalty costs, and end-customer demand variance) play in determining the improvement in supply chain performance.

(the product is available to the retailer at the start of the next period) the retailer demands to the best of his abilities and (5) if there is inventory left at the supplier, he incurs holding costs and on the other hand if there is some unsatised demand, it is supplied by expediting and the costs of expediting are incurred. 2.1. Model 1 In this model the supplier charges the retailer c dollars per unit in every period. Under this setting, it is optimal for the retailer to use a stationary order up to policy with the order up to level z. Based on our assumption of expediting at the supplier, z is the newsvendor solution for the retailer. Thus   pr z W1 . hr p r Under this retailer ordering policy the demands seen by the supplier are i.i.d. with the distribution (with cdf U() and pdf /()). In addition, the distribution U() is exactly equal to the distribution W(). Based on Federgruen and Zipkin [10,11] a modied order up to policy is optimal for the supplier. The optimal order up to level, y, while not available in closed form, can be computed using IPA. Details on IPA validation and implementation can be found in Glasserman and Tayur [15,16]. When the retailer uses a stationary order up to policy, it presents a stable environment for the supplier. Since the retailer starts at her optimal up to level in every period and the end-customer demand is transmitted unaltered to the supplier, the supplier is fully aware of the inventory position at the retailer. There is no additional information that can be exchanged between the two. In addition, since the retailer and supplier optimal order up to levels (and the resulting costs) are independent of the supplier oer price, the supply chain performance will not be aected by its magnitude. 2.2. Model 2 In this section, we model the case in which the supplier charges the retailer uctuating prices from one period to the next. Specically, we will assume that the supplier alternates the selling price between

2. The Models In this section, we study two inventory control problems which dier in the way the supplier prices the product for the retailer. Recall from the previous section that in both these models, the sequence of events is as follows: (1) the supplier decides on his inventory level restricted by his production capacity; (2) the end-customer demands at the retailer are observed and the holding or penalty costs are incurred at the retailer; (3) the retailer places an order with the supplier to reach her desired inventory level; (4) the supplier satises

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c 0 and c 0  from one period to the next. Under this setting we will study the optimal retailer and supplier behavior. From the upcoming discussion, it will be evident that, in this HILO pricing scheme, the supply chain performance is only aected by the dierence between the HILO prices and is independent of the values of either price. Thus, to identify the optimal uctuating prices, one needs to only search over the values of . 2.3. Retailer behavior: Model 2 From Kapuscinski and Tayur [18] and Aviv and Fedegruen [2], we know the following result. Property 1. When the unit selling price at the supplier alternates between c 0 and c 0 , the retailer optimal order up to level alternates between z 0 and z 0 + d. Proof. Follows, as a special case of cycle length equal to 2, from Karlin [19] and Zipkin [27]. h When the retailer uses this ordering policy, the demands seen by the supplier are no longer i.i.d. In the next section we formulate the corresponding non-stationary inventory control model at the supplier and determine his optimal policy. 2.4. Supplier behavior: Model 2 For this model, we will analyze the supplier behavior for two specic settings. In setting 1, the supplier is only aware of the retailer inventory policy parameters (namely z 0 and z 0 + d) and in setting 2, in addition to knowing the retailer policy parameters, the supplier obtains information about the day-to-day inventory levels at the retailer. 2.5. Setting 1: Information on retailer policy parameters Since the retailer ordering policy follows a two period pattern, the demands at the supplier also will exhibit a cyclic pattern with a cycle time of two periods. In the rst period, the demand, d, at the supplier is either zero (if n1 is less than d) or n1 d (if n1 is greater than d) where n1 is the

end-customer demand seen at the retailer. Let us call the state supplier is in as state 1. In the next period, he is in one of two possible states. We will say that he is in state 2 if the demand from the retailer was zero in the previous period. On the other hand, if the retailer order in the previous period was non-zero, then we will say that the supplier is in state 3. In state 2, the demand seen by supplier is n1 + n2 where both n1 and n2 are end-customer demands from the distribution W() and n1 is less than d. In state 3, the supplier sees demand n2 + d. For ease of presentation, we will say that Ui() (/i()) is the cdf (pdf) of the distribution of demand seen by the supplier in state i. Clearly U1() 6st U2() 6st U3(). From states 2 and 3, the supplier transitions into state 1 in the next period. The transition probability from state 1 to 2 is W(d) and the transition probability from state 1 to 3 is 1 W(d). We present some structural properties for this problem and also discuss ways for computing the optimal solutions. Most of the properties can be established using standard techniques such as dynamic programming, convexity, and induction similar to the arguments presented in Federgruen and Zipkin [10,11], Kapuscinski and Tayur [18], and Glasserman and Tayur [15,16]. 2.5.1. Structural properties: Setting 1 Property 2. For nite horizon and innite horizon (discounted and average cost) a modied order up-to policy is optimal. Proof. Let Li(y) be the one-period cost in state i with inventory level y. It can be computed as follows: Z y Z 1 Li y hs y t/i tdt ps t y/i tdt.
0 y

Let V in x be the optimal cost of an n-period problem starting in state i with inventory level (before production) x. V in x miny2x;xC J in y where J 1 y L1 y WdV 2 y n n1 Z 1 V 3 y t d wtdt; n1
d

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J 2 y L2 y n J 3 y L3 y n

V 1 y t /2 tdt; n1 V 1 y t /3 tdt. n1

Z0 1
0

Since there are no salvage costs at the end of horizon, we have V i0  0 for all i. Since Li(y) is convex in y, it is easy to establish (see [18,24]) via induction that for all values of n and i: 1. 2. and 3. a modied order up to policy is optimal. Let zin denote the optimal order up to level for an n-period problem starting in state i. Based on these convexity properties and using results from pages 210212 (for the discounted case) and pages 310313 (for the average case) of Bertsekas [4], we can establish that for each state i, the innite horizon optimal policy is modied order up-to yi. h As dened in Federgruen and Zipkin [10,11], a modied order up to policy with level y is one in which if the inventory level is less than y, we raise it to y; if this level cannot be reached, we exhaust the available capacity; if the inventory level is above y, we produce nothing. Let zin be the optimal order up-to level for an n-period problem starting in state i. In the innite horizon the optimal order up to level in a period depends only on the state of the system in that period. Let yi be the innite horizon optimal order up-to level in state i. Property 3. The order up to levels are ordered as follows: (1) y1 6 y3, and (2) y2 6 y3. Proof. We use 0 , 0 0 to denote rst and second derivatives, respectively. J 01 y L01 y WdV 02 y n n1 Z yd 03 V n1 y t d wtdt d Z y V 01 y t/2 tdt J 02 y L02 y n n1 Z0 y V 01 y t/3 tdt J 03 y L03 y n n1
0

Since U1() 6st U2() 6st U3(), we know that L01 y P L02 y P L03 y for all values y. Using this relation and starting from the initial condition V 0i 0 8i, via induction we can show that 0 V 01 x P V 03 x and V 02 x P V 03 x for all values n n n n of n and x. This leads us to conclude that z1 6 z3 n n and z2 6 z3 for all n. This ordering must also hold n n for innite horizon order up to levels. h Let y C be the optimal order up to level in state i i when the supplier capacity is C. At lower capacities, the order up to levels will be higher. Property 4. For two different capacities C1 and C2 such that C 1 6 C 2 ; y C1 P y C2 for all i in i i {1, 2, 3}. Proof. Let C1 J in ; C1 V in ; C1 zin and C2 J in ; V in ; C2 zin be the quantities dened above when the capacities are C1 and C2, respectively. First we prove that if C1 6 C2 then (a) (b) (c)
C 1 0i J n x 6 C2 J 0i x; n C 1 0i V n x 6 C2 V 0i x; n C1 i zn P C2 zin .

J in y is convex in y; V in x is convex in x;

C2

and

We rst prove (a) and (b) by induction. They are obviously true for n = 0. Assume they are true for n 1. After comparing C1 J 0i x and C2 J 0i x, n n and using (b) for n 1, it is easily established that C1 J 0i x 6 C2 J 0i x. Furthermore from the n n convexity of Jn and inductional assumption C1 J 0i x C 1 6 C1 J 0i x C 2 6 C2 J 0i x C 2 . n n n Using the expression for V 0i x given above and n the observation that if A P B then min(0, A) P min(0, B) and max(0, A) P max(0, B), it is easily established that C1 V 0i x 6 C2 V 0i x. So, by n n induction parts (a) and (b) of the property are true for all n. Since both C1 V in x and C2 V in x are convex and C1 V 0i x 6 C2 V 0i x, we have C1 zin P n n C2 i zn . This proves part (c). This relation will be valid for the innite horizon order up to levels as well. h Let yi(d) be the optimal order up to level in state i when the retailer ordering policy is {z 0 , z 0 + d}. Property 5. For values d1 and d2 such that d1 6 d2, yi(d1) 6 yi(d2) for i 2 {2, 3}, and y1(d1) P y1(d2).

V 0i x maxfJ 0i x; minf0; J 0i x Cgg. n n n

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d1 i Proof. Let U ; d1 Li ; d1 J in ; d1 V in ; d1 zin d2 i d2 and U ; Li ; d2 J in ; d2 V in ; d2 zin be the quantities dened above corresponding to two dierent values d1 and d2 such that d1 6 d2. It is easy to establish that d1 U1 Pst d2 U1 and d1 i U 6st d2 Ui for i 2 {2, 3}. It follows that d1 0 L1 6 d2 L01 and d1 L0i P d2 L0i for i 2 {2, 3}. Starting with the initial condition d1 V i0 d2 i V n 0, and using induction we can establish that d1 V 01 6 d2 V 01 and d1 V 0i P d2 V 0i for n n n n i 2 {2, 3}. This leads us to conclude that d1 z1 n P d2 z1 and d1 zin 6 d2 z0i for i 2 {2, 3}. Since n n these relations hold for all n, they must hold for the innite horizon order up to levels as well. h

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always be reached leading to the relation V in 0 0 for all i 2 {2, 3}. Combining this with the fact that L01 0 P 0 will lead us to conclude that V 01 0 P 0. Thus the optimal order up to level n in state 1, z1 , must be at most zero. Given that it n cannot be smaller than zero, it must be equal to zero. h These properties will be useful in developing solution procedures for computing the optimal order up to levels. 2.5.2. Solution procedures: Setting 1 In this section, we propose ecient solution procedures for this non-stationary inventory control problem. We do this in two stages. First, we develop a procedure for the uncapacitated situation. This procedure while not applicable for the capacitated case, will be helpful in providing starting solutions and developing heuristic procedures. 2.5.2.1. Uncapacitated situation. When the production capacity is innite and the demand distribution is stationary, the optimal order up to level is given by the newsvendor formula. When the demands are non-stationary, the optimal order up to levels are generally not available in closed form. However, ecient procedures for computing them are available. Song and Zipkin [25] present solution procedures for the continuous time non-stationary problem under the additional assumption of Poisson demands. Karlin [19] and Zipkin [27] present solution procedures for the discrete time problem when the demands are cyclic. However, these solution procedures are not useful here since the state in a period sometimes is dependent on the demand observed in the previous period. Gavirneni and Tayur [13] have a solution procedure that is applicable here. Their approach is based on recursively estimating the derivatives of the cost function and has been shown to be very ecient. We will use their procedure for the uncapacitated situation. 2.5.2.2. Capacitated situation. Capacitated inventory control problems are hard to solve even when demands are stationary. In the presence of nonstationarities, they are particularly hard, and

In states 2 and 3, myopic order up to levels that minimize the cost of a single period are upper bounds on the optimal order up to levels. Since   d W1 hsps is the myopic solution for state 3, p
s

based on Property 2, we can say that Property  For all states i 2 f1; 2; 3g; y i 6 d 6.  ps 1 W hs ps .   Proof. Observe that L0i d W1 hsps P 0 for all p
s

i. This leads, via induction, to the fact that   V 0i d W1 hsps P 0 for all i implying that zin n ps   must be smaller than d W1 hsps for all values p
s

of n and i. Thus the innite order up to levels yi   must be smaller than d W1 hsps . h p
s

Since the unsatised demands at the supplier are lost (due to expediting), when the supplier   capacity is greater than d W1 hsps , we can asp
s

sume that the supplier is uncapacitated.   Property 7. When C P d W1 hsps , there ps   exists du W1 hsps such that for all values of p
s

d P du ; y 1 d 0. Proof. Dene du such that Wdu hsps which will ps result in the fact that for any d P du ; L01 0 P 0.   Since C P d W1 hsps , based on Property 5 ps we know that the optimal order up to level can

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closed form solutions do not exist for these order up to levels. So we resort to Innitesimal Perturbation Analysis (IPA). IPA is a simulation based solution procedure. During the simulation run while computing the costs of the system, IPA also computes the derivatives of the costs with respect to the order up to levels. Using these derivatives in a gradient based search procedure, we can iteratively compute the optimal order up to levels. Glasserman [14] provides a good introduction to this technique. For its application in multi-echelon inventory control models, the reader is referred to Glasserman and Tayur [15,16]. To use the IPA procedure we need to establish that the derivatives estimated from the simulation are in fact valid. This validation can be achieved here by using arguments similar to those found in Kapuscinski and Tayur [18] and Scheller-Wolf and Tayur [24]. 2.5.3. Setting 2: Information on retailer inventory levels In this section, we consider the situation when, in a period if the retailer orders nothing (i.e. if endcustomer demand is less than d), she provides information about her inventory level to the supplier. This information can be used by the supplier to better predict his demand. He now knows that in the next period the demand he sees will be n1 + n2 where n1 is known and n2 is from the distribution W(). Using this information, he can further reduce his costs (we know for sure that his costs cannot increase) while the costs at the retailer, when compared to those in setting 1, are not aected. Thus the supply chain will probably be more ecient in setting 2 than in setting 1. The non-stationarity of the demands at the supplier can be formulated as follows. In the rst period, the demand, d, at the supplier is either zero (if n1 is less than d) or n1 d (if n1 is greater than d) where n1 is the end-customer demand seen at the retailer. Let us call this state 0 for the supplier. In the next period, he is in one of d possible states. We will say that he is in state n1 (which is known to the supplier) if the demand from the retailer was zero in the previous period. In this case we know that n1 is less than d. On the other hand, if the retailer order in the previous period was non-zero, then we will say that the supplier is in state d. In

state i, the demand seen by supplier is i + n2 where n2 is an end-customer demand from the distribution W(). For convenience in notation we have assumed that the end-customer demands have been discretized and are strictly positive. We will say that Ui() (/i()) is the cdf (pdf) of the distribution of demand seen by the supplier in state i. Clearly Ui() 6st Ui+1() for all values of i in {0, 1, 2, . . ., d}. From a state i > 0, the supplier transitions into state 0 in the next period. The transition probabilities from state 0 to other states can also be appropriately determined. Using arguments of convexity and induction, we can show that Property 8. For nite horizon and innite horizon (discounted and average cost) a modied order up to policy is optimal. The structural properties established for setting 1 can be appropriately extended to cover setting 2. In addition, the optimal policy parameters can be computed eciently using IPA. Once the optimal solutions have been characterized, and ecient solution procedures have been determined, it is time to determine the extent of the benets that are realizable by these strategies. To achieve that, we performed a detailed computational study and the results are presented in the next section.

3. Computational results The experimental setup for our study is as follows. The holding cost at the supplier is 1 while the penalty cost is allowed to take values 5, 8, and 11. The end-customer demand is assumed to have a mean of 20 and was sampled from distributions Exponential(20), Erlang(10, 2), Erlang(5, 4), and Erlang(2.5, 8). Thus the standard deviations of the end-customer demand were 20, 14.1, 10, and 7.1, respectively. The production capacity at the supplier was allowed to take values 25, 45, and 65. So, the capacity was always greater than the mean demand. For model 1, the cost at the supplier was kept constant at ve dollars per unit. In model 2, we let the cost at the supplier alternate between 5.0 + K * 0.25 and 5.0 K * 0.25. We

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computed the total supply chain costs for values of K ranging from 0 to 5 and chose the value of K that resulted in the lowest total supply chain costs. Since the case K = 0 represents the case of stationary policies, we know that this optimization can never result in increased supply chain costs. But, it was interesting to note that, in many cases it was possible to reduce the total costs in the supply chain. It is also possible to use a ner grid for the purchasing costs by changing the factor 0.25 to 0.1. Since the key factor here is the dierence in costs, the fact that we only consider symmetric uctuations in selling prices does not signicantly aect the results. The dierence between the costs of these two models can be attributed to price uctuations and information sharing. For each case, we computed the percentage benet of these strategies as follows: model 1 cost model 2 cost % benefit 100. model 1 cost Our observations from this computational study are detailed below. 3.1. Relationship between d and  In an innite horizon inventory control problem, the relationship between  and d is independent of c 0 as long as it is greater than . Clearly, when  = 0, d corresponding to it is also zero. As  increases, the d value increases (see Fig. 1). For end-customer demand distributions that are reasonably well behaved (continuous and dierentiable), this relationship between  and d is also well behaved (see Fig. 1) and for a given value of , we can easily determine the corresponding d. For the experiments that resulted in Fig. 1, we assumed that the holding and penalty costs (hr and pr) at the retailer were 1 and 5, respectively. 3.2. Cost per period We observed that, for both the settings, the cost per period increased with increase in demand variance, increased with increase in penalty cost, and decreased with increase in capacity. This behavior of the costs has been well documented in inventory

45

- Exponential(20) - Erlang(5,4) - Erlang(2.5,8)

35

Delta value

25

15

Epsilon value
Fig. 1. The plot of d as a function of .

control literature and thus we will not elaborate on this here. 3.3. Supplier order up to levels: Setting 1 Fig. 2 contains the plot of the optimal supplier order up to levels (for the case Erlang(10, 2), C = 65, ps = 11) for the three states as a function of the d value. Notice that these order up to levels satisfy the properties 5, 6, and 7 established in the

90

- state 1 - state 2 - state 3

Order upto levels

70

50

30

10

10

20

30

40

50

60

Delta value
Fig. 2. Order up to levels as a function of d value.

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% Benefit

previous section. The order up to level for state 3 was always greater than the order up to levels for states 1 and 2. Order up to level for state 1 decreased with increase in the d value while the order up to levels for states 2 and 3 increased. At a large d value, the order up to level in state 1 drops to zero and remains there for all higher values. 3.4. Reduction in total supply chain costs In this section, we present the results on percentage benet gained when these strategies are implemented. First, we detail the results for setting 1 in which the supplier is only aware of the retail inventory policy parameters. 3.4.1. Setting 1: Information on retailer policy parameters We observed that while we were not able to reduce the total supply chain costs for the demand distributions of Erlang(10, 2), Erlang(5, 4), and Erlang(2.5, 8) we were able to reduce the total supply chain costs when the end-customer demand had the Exponential(20) distribution. The reasons for this were twofold: (1) the information ows associated with the uctuating prices were more benecial when the demand variance was high; and (2) the holding and penalty costs at the retailer are less sensitive to the inventory levels when the demands have higher variance. Thus when the end-customer demand variance is high, we are able to reduce the total supply chain costs by using price uctuations and the information ows associated with them. However, the reductions observed were quite small and ranged from 0.00% to 0.98%. Fig. 3 contains the plot of the percentage reduction in the total costs in the supply chain as a function of capacity for the Exponential(20) demand distribution. Notice that reductions were higher at higher capacities. The main reason for this behavior is that information ows are more benecial at higher capacities and thus at higher capacities the supplier realizes higher savings while the retailer costs are not aected. Fig. 4 illustrates relationship between the percentage reduction in the total costs and the penalty cost for the Exponential(20) demand distribution. Notice that reductions were higher at lower pen-

1.0

0.8

0.6

0.4

0.2 25 45 65

Capacity
Fig. 3. Percentage benets as a function of supplier capacity: setting 1.

1.0

0.8

% Benefit

0.6

0.4

0.2 5 8 11

Penalty cost
Fig. 4. Percentage benet as a function of supplier penalty cost: setting 1.

alty costs. The main reason for this behavior is that at higher penalty costs, the increased variability in the retailer ordering process increases the supplier costs dramatically and the little information that is available to him is not eective in reducing his costs. Thus the benet of these strategies is lower at lower penalty costs. Thus when the end-item demand distribution has very high variance, the supplier capacity is not restrictive, and the supplier penalty cost is

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low, we are able to reduce the total supply chain costs by considering non-stationary policies at the retailer even though the end-customer demand distribution is stationary and i.i.d. Admittedly, the reductions observed here are not large (<1%), but the most notable observation is that such a reduction is indeed possible. 3.4.2. Setting 2: Information on retailer inventory levels In this section, we report on the reduction in total supply chain costs when the supplier has information about the retailer inventory levels. In this setting, the total supply chain costs reduced by as much as 16.3% (average of 5.0%). Let us now study how the supplier capacity, supplier penalty cost, and end-customer demand variance aect these benets. 3.4.2.1. Eect of supplier capacity. Fig. 5 contains the plot of average percentage reduction as function of supplier capacity. Notice that, it is consistently increasing as the capacity increases. This is because, when his capacity is not restrictive, the supplier is able to react to the information ows from the retailer. This enables him to capture a high benet from these information ows, thus far eclipsing the ineciencies (at the retailer) caused by the price uctuations.

10

2 5 8 11

Penalty cost
Fig. 6. Percentage benet as a function of supplier penalty cost: setting 2.

3.4.2.2. Eect of supplier penalty cost. The average percentage reduction is plotted as a function of the supplier penalty cost in Fig. 6. It is clear that the percentage benet is higher at higher penalty costs. This in contrast to the behavior observed for setting 1 (see Fig. 4). The reason for that is as follows: when there is tighter cooperation between the supplier and the retailer, the expediting necessary at the supplier is drastically reduced. Such a reduction has a higher benet when the supplier penalty cost is high. 3.4.2.3. Eect of end-customer demand variance. The plot of average percentage reduction as a function of the standard deviation of end-customer demand is given in Fig. 7. It is evident that when the end-customer demand is more variable, the percentage reduction is higher. This is due to the fact that when the demand has a variance, the information ows from the retailer are more benecial. They are able to quickly alert the supplier of large swings in the end-customer demand. From the results of this computational study we can conclude that a signicant reduction in total supply chain costs can be realized when the supplier uctuates his selling price and the retailer is willing to provide information about her inventory levels. We further observed that these reductions

% Benefit

1 25 45 65

Capacity
Fig. 5. Percentage benet as a function of supplier capacity: setting 2.

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S. Gavirneni / European Journal of Operational Research 174 (2006) 16511663 [3] Y. Aviv, A. Federgruen, The operational benets of information sharing and vendor managed inventory (VMI) programs, Olin School of Business, Washington University, 1998. [4] D.P. Bertsekas, Dynamic programming: Deterministic and stochastic models, Prentice-Hall, Englewood Clis, NJ, 1988. [5] G. Cachon, Competitive supply chain inventory management, in: S. Tayur, R. Ganesham, M. Magazine (Eds.), Quantitative Models for Supply Chain Management, Kluwer Academic Publishers, Dordrecht, 1999. [6] G. Cachon, M. Fisher, Supply chain inventory management and the value of shared information, Management Science 46 (8) (2000) 10321048. [7] G. Cachon, P. Zipkin, Competitive and cooperative inventory policies in a two stage supply chain, Management Science 45 (7) (1999) 936953. [8] F. Chen, Echelon reorder points, installation reorder points, and the value of centralized demand information, Management Science 44 (12) (1998) 221234. [9] F. Chen, A. Federgruen, Y.S. Zheng, Coordination mechanisms for a distribution system with one supplier and multiple retailers, Management Science 47 (5) (2001) 693 708. [10] A. Federgruen, P. Zipkin, An inventory model with limited production capacity and uncertain demands I: The average-cost criterion, Mathematics of Operations Research 11 (2) (1986) 193207. [11] A. Federgruen, P. Zipkin, An inventory model with limited production capacity and uncertain demands II: The discounted-cost criterion, Mathematics of Operations Research 11 (2) (1986) 208215. [12] S. Gavirneni, R. Kapuscinski, S. Tayur, Value of information in capacitated supply chains, Management Science 45 (1) 1624. [13] S. Gavirneni, S. Tayur, An ecient procedure for nonstationary inventory control, IIE Transactions 33 (2) (2001) 8389. [14] P. Glasserman, Gradient estimation via perturbation analysis, Kluwer Academic Publishers, Boston, 1991. [15] P. Glasserman, S. Tayur, The stability of a capacitated, multi-echelon production-inventory system under a base-stock policy, Operations Research 42 (5) (1994) 913925. [16] P. Glasserman, S. Tayur, Sensitivity analysis for base-stock levels in multi-echelon production-inventory systems, Management Science 42 (5) (1995) 263281. [17] A. Iyer, J. Ye, Vendor managed inventory in a promotional retail environment, M&SOM 2 (2) (2000) 128143. [18] R. Kapuscinski, S. Tayur, A capacitated productioninventory model with periodic demand, Operations Research 46 (6) (1998) 899911. [19] S. Karlin, Optimal policy for dynamic inventory process with stochastic demands subject to seasonal variations, J. SIAM 8 (1960) 611629. [20] M. Lariviere, Supply chain contracting and coordination with stochastic demand, in: S. Tayur, R. Ganesham, M.

10

% Benefit

2 5 10 15 20

Standard deviation
Fig. 7. Percentage benet as a function of standard deviation of end-customer demand: setting 2.

are larger at higher supplier capacities, supplier penalty costs, and end-customer demand variance.

4. Conclusions In this paper, we have analyzed a simple yet representative capacitated supply chain in light of price uctuations at the supplier and information sharing between the supplier and retailer. After establishing optimal supplier and retailer behaviors and developing ecient solution procedures, we performed a detailed computational study to tabulate the eect of these strategies. We were able to show that it is possible to signicantly reduce the costs of the total supply chain using these strategies.

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