Analysis of supply contracts with quantity flexibility
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Production,Manufacturing and LogisticsAnalysis of supply contracts with quantity flexibilityZhaotong Lian a,*,Abhijit Deshmukh ba Faculty of Business Administration,University of Macau,Macau SAR,ChinabDepartment of Industrial and Systems Engineering,Texas A&M University,TX 77843-3131,USAa r t i c l e i n f o Article history:Received 7February 2005Accepted 5February 2008Available online 15April 2008Keywords:Supply contract InventoryRolling horizon Quantity flexibilityDynamic programminga b s t r a c tThis paper explores a class of supply contracts under which a buyer receives discounts for committing to purchases in advance.The further in advance the commitment is made,the larger the discount.As time rolls forward,the buyer can increase the order quantities for future periods of the rolling horizon based on updated demand forecast information and inventory status.However,the buyer pays a higher per-unit cost for the incremental units.Such contracts are used by automobile and contract manufacturers,and are quite common in fuel oil and natural gas delivery markets.We develop a finite-horizon dynamic pro-gramming model to characterize the structure of the optimal replenishment strategy for the buyer.We present heuristic approaches to calculate the order volume in each period of the rolling horizon.Finally,we numerically evaluate the heuristic approaches and draw some managerial insights based on the findings.Ó2008Published by Elsevier B.V.1.IntroductionThis paper studies ordering policies for a specific supply con-tract model in which a buyer receives discounts for committing to purchases in advance.The buyer places orders for products for each period in a finite horizon at the beginning of the horizon.The supplier provides price discounts to the buyer for future time period orders placed at the beginning of the horizon.As time pro-gresses,the buyer is allowed to increase the order amount in future time periods on a rolling horizon basis.However,the buyer has to pay an extra cost for the increased units.We call this type of supply contracts the Rolling Horizon Planning (RHP)contracts.We explain the RHP contracts using a simple example (see Table 1).The buyer places orders for the first 4weeks (planning horizon)at the beginning,and the supplier provides the ordered product quantities each week.The buyer may adjust (increase)the orders for the future 4weeks at the beginning of each week.Assume that the regular unit cost of a product is $10.00.The sup-plier sets the unit costs of $10.00,$9.50,$9.00,$8.50for orders placed in the upcoming 4weeks,respectively.If the buyer orders 10,10,10,10items for these 4weeks,the weekly costs are $100.00,$95.00,$90.00,$85.00.Now,if the buyer adjusts the order to 11,12,11for the 2nd,3rd and 4th weeks at the beginning of the second week,he will have to pay the extra cost ð11À10ÞÂ10:00,ð12À10ÞÂ9:50and ð11À10ÞÂ9:00dollars for the 2nd,the 3rd and the 4th week,respectively.Note that the additional units aremore expensive than those ordered in the earlier period (see Table 2).This study was motivated by the supply contracts used by major automobile manufacturers and their component suppliers,where the ordering quantities are determined and updated based on the forecast demands in a rolling horizon.Moreover,such contracts are common in heating oil and natural gas delivery markets in the US,where the buyers can lock-in a lower rate if they place an order (pre-pay)at the beginning of the winter season,and have the option of buying more than the order quantity,if needed,at a higher cost.Another important application area for this work is in contract manufacturing.According to Technology Forecasters Inc.,the worldwide contract manufacturing market is projected to grow from a revenue of $118billion in 2001to $288billion in 2005,rep-resenting a penetration of nearly 30%of the total available market for electronics manufacturing (see [12]).As a consequence,con-tract manufacturers are also exposed to the risk due to uncertain demands.However,contract manufacturers want to smooth the production process and reduce fluctuation as much as possible.Therefore,high-technology firms that use these contract manufac-turers are frequently required to place advanced orders based on forecast demand instead of realized demand.One can easily see that the rolling horizon planning contracts are ideally suited for this situation,and are indeed standard operational management tools used by these companies to incorporate forecast information in the decision process.In the situations discussed above,Tsay [13]state that quantity flexibility (QF)contracts under rolling horizon planning are efficient coordination schemes to balance the risk of each side.The objective of this paper is to present an analytical model for these contracts,characterize the structure of the optimal0377-2217/$-see front matter Ó2008Published by Elsevier B.V.doi:10.1016/j.ejor.2008.02.043*Corresponding author.Tel.:+853********;fax:+853********.E-mail address:lianzt@umac.mo (Z.Lian).European Journal of Operational Research 196(2009)526–533Contents lists available at ScienceDirectEuropean Journal of Operational Researchj o u r n a l h o m e p a g e :w w w.e l s e v i e r.c o m /l o c a t e /e j orpolicies for buyers,and develop solution methodologies that allow buyers to determine ordering quantities which minimize their ex-pected total cost per period.There is significant prior work in the general area of supply con-tracts.Bassok and Anupindi[2]provide an early study of supply contracts with quantityflexibility.Under their commitment con-tract,there exists a minimum total ordering quantity that the buyer must purchase by the end of afinite contract horizon.The focus of their work is on how the buyer makes the ordering deci-sion in each period.In Bassok et al.[3]’s quantityflexibility con-tract,the demand forecast for each period of the entire contract horizon is given and the buyer needs to place an(initial)order for every period at the beginning of thefirst period.As time goes on,the buyer updates orders from the current period to the last period according to the current inventory level and the pre-fixed adjustment limits.Henig et al.[7]consider a different minimum ordering quantity contract under which the buyer decides whether to order the pre-fixed contract amount or order more than this amount at the begin-ning of each period.The buyer will be charged an incremental cost for the excess amount ordered.The authors show that the optimal policy is a modified order-up-to policy under the assumption that the demands are independent and identically distributed.Tsay [13]models the incentives of both the supplier and the buyer in a setting in which the buyerfirst estimates a purchase quantity for a given selling season,the supplier then commits to production,and finally the buyer makes the actual purchase based on the updated information of an uncertain demand.Tsay and Lovejoy[14]consider the quantity commitment contract in a multi-echelon setting, allowing for non-stationary demand with information updating.Other literature dealing with quantity commitment contracts can be found in Anupindi and Bassok[1],Lariviere[8],Corbett and Tang[5],and the review paper by Tsay et al.[15].Differing from Bassok et al.[3],our model assumes that the sup-plier provides the buyer with discounts for committing to pur-chases in advance for the future periods.After knowing the updated inventory level and the updated demand information, the buyer can adjust the previously placed orders.However,the buyer will be charged an incremental cost for the additional order-ing quantities.Moreover,we assume that the time horizon keeps rolling and the demand information is updated at each decision epoch.Rolling horizon planning has been extensively applied to production scheduling in industrial practice,such as material requirement planning(MRP).Chand et al.[4]provide an extensive bibliography on the rolling horizon in operations management problems.The rest of the paper is organized as follows.We describe the RHP model in Section2.An objective function is formulated based on a dynamic programming model,which is difficult to handle when the number of planning periods is large.In Section3,we de-velop a frozen ordering planning(FOP)as a heuristic solution to the RHP contracts.We further develop a second-level frozen order-ing planning(FOPII)in Section4.In Section5,we derive the opti-mal solution of RHP when the number of planning periods is2and the number of information periods is3.In Section6,we conduct numerical studies and compare the results among order-up-to, FOP and FOPII policies.Findings and managerial insights are drawn from the numerical results.We summarize the results andfindings of this paper in thefinal section.2.RHP model descriptionConsider a quantityflexibility contract that has been negotiated between a supplier and a buyer for a single product.The contract works in a rolling-horizon fashion as follows:At the beginning of thefirst period,there is a confirmed order for current period and there are TÀ1committed orders for the next TÀ1planning peri-ods.With the latest demand and inventory information at the beginning of period2,the buyer will consider whether and how to modify the orders for current period(the second period)and the next TÀ2periods,and the same time,the buyer places a new advanced order for theðTþ1Þth period(that is the T th period if we count from the second period).This process proceeds period by period till the end of the contract lifespan.At the beginning of period n,n¼1;2;...,let Q n;i be the newly updated ordering quan-tity for the i th period,i¼n;...;nþTÀ1.The rolling horizon plan-ning can be showed as following when T¼3:Period123456ÁÁÁ1Q1;1Q1;2Q1;32Q2;2Q2;3Q2;43Q3;3Q3;4Q3;54Q4;4Q4;5Q4;6...ÁÁÁÁÁÁÁÁÁThe supplier offers discount prices to the buyer.We assume that the unit price is c1for current period,and c2;...;c T for the next TÀ1period,where c1P c2PÁÁÁP c T.For example,when T¼3, the total purchasing costs for the units received in period4is c3Q2;4þc2ðQ3;4ÀQ2;4Þþc1ðQ4;4ÀQ3;4Þ.The confirmed order for current period is delivered immedi-ately.Subsequently,the customer demand is satisfied by the stock on hand.Any excess demand is backordered.Table1An example of rolling horizon planning contractPeriod1234567110101010$370.00$100.00$95.00$90.00$85.00211121112$140.00$10.00$19.00$9.00$102.0031213128$87.00$0.00$19.000.00$68.0041312911 $102.50$0.00$0.00$9.00$93.50 Total$699.50Table2Comparison among order-up-to,FOP and FOPII for different T sStationary Wedge-shapeT Order-up-to FOP FOPII Order-up-to FOP FOPII261.7731.5129.9683.9340.0238.23365.9737.3735.8595.6248.5546.78466.6744.942.88105.4759.5956.59571.3452.1749.78114.4170.4666.88674.1858.7155.9117.6680.976.33Z.Lian,A.Deshmukh/European Journal of Operational Research196(2009)526–533527At the beginning of any period,the buyer only has the demand information in the coming N periods,T6N.The demands in differ-ent periods are independent.Let LðIÞ¼hIþþpIÀbe the expectation of the inventory cost within a time unit,where Iþ¼max f I;0g and IÀ¼max fÀI;0g. When I is positive,LðIÞ¼hI represents the holding cost which is increasing in I,and when I is negative,LðIÞ¼ÀpI represents the back-ordering cost which is decreasing in I.Because there are only N periods of demand information at the beginning of any period n,we have no idea about the ordering quan-tities beyond these N periods.Therefore,it is very difficult,if is not impossible,to estimate the expected total cost in a whole contract lifespan.We here restrict the buyer’s objective to determine the ordering quantity Q n;n;Q n;nþ1;...;Q n;nþTÀ1by minimizing the ex-pected total cost within these N periods.The total cost includes the purchasing cost,holding cost and the back-ordering cost.Without loss of generality,we take the index of thefirst period to be zero.Denoted by Q0;0;Q0;1;...;Q0;TÀ1the committed ordering quantities for the coming T period at the beginning of the previous period,denoted by Q1;1;Q1;2;...;Q1;TÀ1the updated ordering quan-tities for the coming T periods,and denoted by Q1;T the newly com-mitted order quantity for the coming T th period.We further denote Q t;i as the updated ordering quantity for the coming i th period at the beginning of the coming t th period,t¼2;...;T,and t6i6N.For example,when T¼3and N¼6,at the beginning of period n,the ordering quantity matrix we need to deal with isPeriod n nþ1nþ2nþ3nþ4nþ5 nÀ1Q0;1Q0;2n Q1;1Q1;2Q1;3nþ1Q2;2Q2;3Q2;4nþ2Q3;3Q3;4Q3;5nþ3Q4;4Q4;5Q4;6 The buyer’s objective is to derive the updated ordering quanti-ties Q1;1;...;Q1;T by minimizing the total cost within the coming N periods on the condition that Q0;1;...;Q0;TÀ1are known.3.Dynamic programming formulationWe now formulate the problem as a dynamic program within an N-period horizon.At the beginning of the current period(could be any period n of the supply contract),we denote x t as the initial inventory level at the beginning of the coming t th period,and M t¼min f N;tþTÀ1g for t¼1;...;N.LetAðtÞðx t;Q t;t;...;Q t;Mt j Q tÀ1;t;...;Q tÀ1;MtÞbe the expected total cost from the coming t th period to the coming ðtþTÞth period,t¼1;...;N.VðtÞðx t;Q tÀ1;t;...;Q tÀ1;MtÞis the mini-mum value of AðtÞðÁjÁÞ,where Q0;1;...and Q0;TÀ1are obtained from the previous period.For convenience,we define Q tÀ1;tþTÀ1¼0when t¼0;...;T.Remark1.Q0;1¼Q0;2¼ÁÁÁ¼Q0;TÀ1¼0if the current period is thefirst period of the supply contract.The corresponding dynamic programming formulation can be written asAðtÞðx t;Q t;t;...;Q t;Mt j Q tÀ1;t;...;Q tÀ1;MtÞ¼X M ti¼t c iÀtþ1ðQ t;iÀQ tÀ1;iÞ"#þE½Lðx tþ1Þ þE½Vðtþ1Þðx tþ1;Q t;tþ1;...;Q t;MtÞ ;ð1ÞVðtÞðx t;Q tÀ1;t;...;Q tÀ1;MtÞ¼minQ t;t P Q tÀ1;t;...;Q t;MtP Q tÀ1;Mtf AðtÞðx t;Q t;t;...;Q t;Mtj Q tÀ1;t;...;Q tÀ1;MtÞg;t¼1;...;NÀ1;ð2ÞAðNÞðx N;Q N;N j Q NÀ1;NÞ¼c1ðQ N;NÀQ NÀ1;NÞþE½Lðx Nþ1Þ ÀsEðxþNþ1Þ;ð3ÞVðNÞðx N;Q NÀ1;NÞ¼minQ N;N P Q NÀ1;Nf AðNÞðx N;Q N;N j Q NÀ1;NÞg;ð4Þwhere x tþ1¼x tþQ t;tÀD t for16t6N and s is the salvage value per unit item.The solution of the above dynamic programming formulation gives the optimal ordering quantities Q1;1;...;Q1;T at the beginning of any period n.When the horizon is rolled to next period,the buyer obtains the beginning inventory level and the newly updated demand infor-mation.By evaluating the dynamic program(1)–(4)again,the buyer can obtain the new ordering quantities Q1;1;...;Q1;T.In the new rolling horizon,Q0;T¼0,and Q0;1;...;Q0;TÀ1are the old order-ing quantities Q1;2;...;Q1;T determined in the previous period.When T is large,the abovefinite-horizon dynamic programming formulation is extremely complex to solve directly.We shall devel-op some heuristic approaches to handle the RHP problem.4.FOP heuristicAs we can see that Q1;1;...;Q1;T are needed to be determined from the dynamic program at the beginning of the rolling horizon. Intuitively,the ordering quantities Q1;1;...;Q1;T,are not supposed to be revised too much because we do not have the update demand information yet,i.e.,Q i;j%Q1;j for26i6T and i6j6T.With the above idea,we can develop a heuristic approach to obtain the ordering quantities according to the frozen ordering planning (FOP)from Flynn and Garstka[6]and Lian et al.[9].4.1.Order-up-to policyUsing the FOP approach,we can obtain the ordering quantities Q1;1;...;Q1;T at the beginning of thefirst period.We now develop an order policy as below:We never update the ordering quantities in the future,but make an order for the new coming T th period with price c T.This policy is similar to an order-up-to policy except for thefirst period.The only difference is that,at each period,we make an order for the coming T th period,rather than the next per-iod.For example,the rolling horizon planning can be showed as following when T¼3:For convenience,we still call this policy the order-up-to policy.To simplify the model,we assume that the number of informa-tion periods is N¼Tþ1.At the beginning of the second period,we will derive the opti-mal value of Q2;Tþ1from the following program:minS U2;Q2;Tþ1f c T Q2;Tþ1þELðS U2ÀD2;TÞÀsEðS U2ÀD2;TÞþg;s:t:S U2P x2þX Ti¼2Q1;i;where S U2is the order-up-to level.528Z.Lian,A.Deshmukh/European Journal of Operational Research196(2009)526–533We first derive the optimal value of S U 2:S U 2¼max G À12;T þ1p Àc T p þh Às ;x 2þX T i ¼2Q 1;i ();ð5Þwhere G 2;T þ1ðÁÞis the cumulative distribution of P T þ2i ¼2D i .Since D 2;...;D T þ1are independent,G 2;T þ1ðÁÞis the convolution of G 2ðÁÞ;...;G T þ1ðÁÞ.Then the optimal value of Q 2;T þ1can be obtained fromQ 2;T þ1¼max S U2Àx 2ÀX T i ¼2Q 1;i ;0():ð6ÞWe can similarly derive the optimal value of the order-up-to le-vel S U n and the optimal value of the ordering quantity Q n ;n þT À1at the beginning of the n th period (n P 2).4.2.FOP policyNow,let’s improve the order-up-to policy as following:At the beginning of the first period,we obtain the ordering quantities Q 1;1;...;Q 1;T by using the FOP approach.When the horizon is rolled to next period,we have the information of the beginning inventory level and the newly updated demand.Then we calculate the new ordering quantities Q 1;1;...;Q 1;T by using the FOP ap-proach again (The old Q 1;1;...;Q 1;T become Q 0;0;...;Q 0;T À1).We call this improved heuristic policy the FOP policy.We define S 0¼x 1,S i ¼x 1þQ 1;1þÁÁÁþQ 1;i and D ði Þt ¼D t þÁÁÁþD i ,for 16t 6i 6T .To simplify the expression,we define Q 0¼ðQ 0;1;...;Q 0;T Þ.Let J 1ðS 1;...;S T j x 1;Q 0Þbe the expected total costs from period 1to period T .For convenience,we define S 0¼0.We haveJ 1ðS 1;...;S T j x 1;Q 0Þ¼X T i ¼1f c i ½S i ÀS i À1ÀQ 0;i þEL ðS i ÀD ði Þ1ÞgÀsE ðS T ÀD ðT Þ1Þþ:ð7ÞThe objective isminS 1;...;S TJ 1ðS 1;...;S T j x 1;Q 0Þ;ð8Þs :t :S i ÀS i À1P Q 0;i8i ¼1;...;T :ð9ÞConstraints (9)ensure that the ordering quantity in each period is non-negative and cannot be less than the ordering quantity made in last rolling horizon.As we show in the lemma below,J 1ðS 1;...;S T j x 1;Q 0Þis a con-vex function of S 1,...,S T ,which guarantees that the sum of first partial derivatives of J 1ðÁÞare monotone.Lemma 1.J 1ðS 1;...;S T j x 1;Q 0Þis a convex function with respect to S i ;i 6T.Proof.See Appendix A .hLet us introduce some notations in order to present the ordering quantities.Denotee S i ¼G À11;ip Àc i þc i þ1h þp ;i ¼1;...;T À1;ð10Þe S T ¼G À11;T p Àc T h þp Às :ð11ÞWe have the following theorem.Theorem 1.The optimal ordering policy of FOP,is defined by somedual thresholds,i.e.,S Ã1;...;S ÃT ,the optimal values of S 1;...;S T ,can be derived by the recursive procedure below:(a )S Ã1¼max f e S 1;x 1þQ 0;1g ;(b )For 26i 6T,S Ãi ¼max f e S i ;Q 0;i þS Ãi À1g .Proof.See Appendix B .hCorollary 1.Q Ã1;1;...;Q Ã1;T ,the optimal ordering quantities of FOP,aregiven by Q Ã1;i ¼S Ãi ÀS Ãi À1;i ¼1;...;T,where S Ã0¼x 1.Remark 2.The critical numbers e S 1;...;eS T are independent of the beginning inventory level x 1and Q 0;1;...;Q 0;T .Specially,in the sta-tionary-demand case,e S 1;...;eS T are constants,i.e.,we only need to calculate them once in the whole horizon.5.Second order FOP heuristic (FOPII)In FOP,we derived Q 1;1;...;Q 1;T by assuming that the ordering quantities will not be modified.When N >T ,we further develop a heuristic by assuming that the ordering quantities can be modi-fied at the beginning of the second period but will not be modified after the second period,i.e.,Q i ;j %Q 2;j ,i ¼3;...;T ,i 6j 6T .For example,when T ¼3and N ¼4,the order-quantity matrix will be Q 1;1Q 1;2Q 1;3Q 2;2Q 2;3Q 2;4We then derive the optimal values of Q 1;1;...;Q 1;T by minimiz-ing the expected total cost in the finite horizon.We call this heu-ristic approach FOPII .By following this idea,we can developFOP-K approach where K 6N .We define Z 1¼x 2¼S 1ÀD 1,which is the beginning inventory of period 2.And we define Z i ¼Z i À1þQ 2;i for i P 2.Obviously,the inventory at the end of period i ,equals to Z i ÀD ði Þ2,i ¼2;...;T þ1.We represent the vector ðS 1;...;S T Þby S ,and let J 2ðZ 2;...;Z T þ1j x 2,S Þbe the total expected costs from the 2nd period to the (T +1)th period.We have J 2ðZ 2;...;Z T þ1j x 2;S Þ¼X T þ1i ¼2f c i À1ðZ i ÀZ i À1ÀS i þS i À1ÞþE ½L ðZ i ÀD ði Þ2Þ g ÀsE ðZ T þ1ÀD ðT þ1Þ2Þþ:s :t :Z i ÀZ i À1P S i ÀS i À18i ¼2;...;T þ1;ð12Þwhere we define S T þ1¼S T .Denote e Z i ¼G À12;i p Àc i À1þc i p þh for 26i 6T and e Z T þ1¼G À12;T þ1p Àc T p þh Às.By Theorem 1,we can easily obtain the optimal values ofZ 2;...;Z T þ1on the condition that S 1;...;S T and D 1are known:Z Ãi ¼max f e Z i ;S i ÀS i À1þZ Ãi À1g ;26i 6T þ1;ð13Þwhere Z Ã1¼x 2.Under FOPII policy,let AC ðS j x 1;Q 0Þbe the minimum expected total cost within the first T periods when the commitment quantity vector is S .That is,AC ðS j x 1;Q 0Þ¼XT i ¼1c i ðS i ÀS i À1ÀQ 0;i Þ"#þE ½L ðS 1ÀD 1Þ þE D 1min Z i ÀZ i À1P S i ÀS i À1;26i 6TJ 2ðZ 2;...;Z T þ1j x 2;S Þ¼XT i ¼1c i ðS i ÀS i À1ÀQ 0;i Þ"#þE ½L ðS 1ÀD 1Þ ;þZ1J 2ðZ Ã2;...;Z ÃT þ1j S 1Ày ;S Þd G 1ðy Þ;ð14Þwhere S i ÀS i À1P Q 0;i 8i ¼1;...;T .Lemma 2.AC ðS j x 1;Q 0Þis convex with respect to S .Z.Lian,A.Deshmukh /European Journal of Operational Research 196(2009)526–533529Proof.See Appendix C.hWe will use an iterative coordinate descendant(ICM)approach (see,for example,Luo and Tseng[11])to derive the optimal order-ing quantities S.Let e i be the unit vector in the i th coordinate,i.e.,e i¼ð0;...; 0;1;0;...;0Þ,i¼1;...;T.The Algorithm is below:Algorithm1Step I Set >0to be a small number.Choose a initial point Sð0Þ.To promote the computational speed,we can choose the opti-mal solution of FOP as Sð0Þ;Step II Starting from Sð0Þ,wefirst derive the optimal point Sð1Þalong with thefirst coordinate,i.e.,ACðSð1Þj x1;Q0Þ¼minzþSð0Þ1P Q0;1ACðSð0Þþz e1j x1;Q0Þ;ð15Þwhere z is a real parameter.Then we start from Sð1Þto derive the optimal point Sð2Þalong with the second coordinate,i.e.,ACðSð2Þj x1;Q0Þ¼minzþSð0Þ2ÀSð0Þ1P Q0;2ACðSð1Þþz e1j x1;Q0Þð16Þand so on so forth till we obtain SðTÞby optimizing all T coordi-nates.SðTÞsatisfiesACðSðTÞj x1;Q0Þ¼minzþSð0ÞT ÀSð0ÞTÀ1P Q0;2ACðSðTÀ1Þþz e1j x1;Q0Þ:ð17ÞStep III For any j P1,repeat Step II by considering SðjTÞas a new initial point,we obtain SðjTþ1Þ;...;Sððjþ1ÞTÞ.Step IV If j Sððjþ1ÞTÞÀSððjþ1ÞTÀ1Þj< ,stop,otherwise,go back to step III.The following theorem guarantees the convergence of Algo-rithm1.Theorem2.Algorithm1converges to the optimal solution of problem FOPII.Proof.See Appendix D.h6.RHP contract when T¼2and N¼3Obviously,when T¼2and N¼3,the solution of RHP con-tract is exactly the same as the solution of FOPII.In this section, we will directly derive the solution without using Approach1. We denoted RHPð2;3Þas the two-period RHP contracts with N¼3.Theorem3.The optimal ordering policy of RHPð2;3Þis defined by two dual thresholds,i.e.,the optimal value of S1and S2are given by SÃ1¼max f e S1;x1þQ0;1g¼max GÀ11pÀc1þc2pþh;x1þQ0;1ð18Þand SÃ2¼max f b S2;SÃ1þQ0;2g where b S2is the solution of the equationc2Àc1þðc1Àc2ÀpÞG1ðb S2Àe Z2ÞþðhþpÞZ b S2Àe Z2G2ðb S2ÀyÞd G1ðyÞ¼0:ð19ÞProof.See Appendix E.hRemark3.From Theorem3,we can see that RHPð2;3Þis also a dual-threshold policy.And critical points e S1and b S2are indepen-dent of e Z3and the salvage value putational studiesIn this section,we analyze the numerical results on FOP and FO-PII contracts.Here we assume that all demands involved are nor-mally distributed.The following parameters are used for the computations.Demands are assumed to be(i)Stationary normally distributed with a mean of100.0perperiod and a coefficient of variation of0.25by default;or (ii)Non-stationary with four possible patterns of the mean, which changes seasonally,viz.,decreasing(starting from 150.0down to100.0in steps of5.0);increasing(starting from100.0to150.0in steps of5.0);triangular(starting from100.0increasing to150and then decreasing to100.0 all in steps of5.0);wedge shape(starting from150.0and then decreasing to100.0and then increasing back to 100.0in steps of5.0).Since all these four possible patterns have the similar performance,we only illustrate the situa-tion when the demand is seasonal increasing and wedge shape.The unit purchase prices are c1¼$5:0,c i¼0:95c iÀ1,i¼2;...;T. The unit holding cost is$0.5.The unit shortage cost is$5.5.In most inventory models,the per-unit costs of purchasing are not included in order to evaluate an inventory policy.This is because the holding cost and the back-ordering cost are smal-ler comparing with the direct purchasing cost.While as the pur-chasing discounts involved in our model,it is hard to ignore the purchasing cost from the total.One way to handle this is to sub-tract out the fully discount of purchasing the expected amount of demand from the total costs.We call the remaining portion the controllable cost.Since FOP and FOPII only give us some ordering policies,in or-der to evaluate them,a sample path technique is used to generate the customer demand for each period,we can then generate the inventory level at the beginning of each period and calculate the controllable cost within the period.Without loss of generality, we assume that the initial inventory level x1is zero.We take20 different seeds,and run500replications for each seed,and run 60periods in each replication.We calculate the averages and the coefficients of the controllable costs.We found that the coefficients are about5%which is acceptable.In the following tables,we only present the average controllable costs and some samples of the ordering quantities for the stationary demand and the wedge-shape demand.We do not count the salvage costs in the total costs or the con-trollable costs when we run the simulation.The salvage value s is needed only when we determine the optimal order quantities at the beginning of each period.After we tried different values of s¼0;c T=2,and c T,we found that the total costs(or the controllable costs)are the lowest when s¼c T.It is reasonable because the buyer can still keep the unused units to next period without get-ting penalty(except the holding cost).Wefirst compare the controllable costs among order-up-to,FOP and FOPII policies.Table2,Figs.1and2illustrate the averages of the controllable costs given by order-up-to,FOP and FOPII Policies in thefirst60periods.Comparing with the cost given by order-up-to policy,we can see that the costs given by FOP and FOPII are much lower,while FOP and FOPII are not very different(the cost from FOPII is slightly lower than the cost from FOP).For example,when T¼5,in the stationary-demand case,the averages of the controllable costs per period in thefirst60periods given by order-up-to,FOP and FOPII are71.34,52.17and49.78,respectively;in the wedge-shape demand case,the costs are114.41,70.46and66.88,respec-tively.530Z.Lian,A.Deshmukh/European Journal of Operational Research196(2009)526–533。