FORSCHUNGSERGEBNISSE DER

W I R T S C H A F T S U N I V E R S I TÄT W I E N

Rainer Quante

Management of
Stochastic Demand
in Make-to-Stock
Manufacturing

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FORSCHUNGSERGEBNISSE DER
W I R T S C H A F T S U N I V E R S I TÄT W I E N

Rainer Quante

Management of Stochastic Demand in

Make-to-Stock Manufacturing
Up to now, demand fulfillment in make-to-stock manufacturing is usually handled
by advanced planning systems. Orders are fulfilled on the basis of simple rules or
deterministic planning approaches not taking into account demand fluctuations.
The consideration of different customer classes as it is often done today requires
more sophisticated approaches explicitly considering stochastic influences. This
book reviews current literature, presents a framework that addresses revenue
management and demand fulfillment at once and introduces new stochastic
approaches for demand fulfillment in make-to-stock manufacturing based on the
ideas of the revenue management literature.

Rainer Quante, 2000–2005 Study of Business Computing at the University of

Paderborn; 2004–2005 Diploma student at a car manufacturer in Ulm; 2005–
2008 Doctoral student at the Vienna University of Economics and Business
Administration; 2008 to present Supply Chain Controller at an Austrian Airline in
Vienna.

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Management of Stochastic Demand
in Make-to-Stock Manufacturing

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 Forschungsergebnisse der
Wirtschaftsuniversitat Wien

Band 37

~
PETER LANG
Frankfurt am Main· Berlin· Bern· Bruxelles· New York· Oxford · Wien
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 Rainer Quante

Management of Stochastic Demand

in Make-to-Stock Manufacturing

~
PETER LANG
lnternationaler Verlag der Wissenschatten
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ISSN 1613-3056
ISBN 978-3-631-59409-4
ISBN 978-3-631-75386-6 (eBook)
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 Fi.ir meine Eltern

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Contents

List of Figures 9

List of Tables 11

Xomenclature 13

1 Introduction 15
1.1 Research Topic and Motivation . . . . . . . 15
1.2 Organization, Objectives and Contributions 18

2 Demand Fulfillment in Make-to-Stock Manufacturing 21

2.1 Make-to-Stock and the Customer Order Decoupling Point . 21
2.2 Structure of Advanced Planning Systems 22
2.3 Available-to-Promise . . . 24
2.3.1 Definition . . . . . 24
2.3.2 Dimensions of ATP 25

3 A Framework for Demand Management 29

3.1 Demand Management Defined . . . . . . . . . . . 29
3.2 General Model Types for DM . . . . . . . . . . . 30
3.2.1 Classifying Demand Management Models . 30
3.2.2 Single-Class Exogenous Demand Models 31
3.2.3 Price-Based Demand Models . . . 32
3.2.4 Quantity-Based Demand Models . . . . . 33
3.3 General Software Types for DM . . . . . . . . . 35
3.3.1 Classifying Demand Management Software 35
3.3.2 Single-Class Exogenous Demand Solutions 37
3.3.3 Price-Based Solutions . . . 37
3.3.4 Quantity-Based Solutions . . . . . . . . 38

4 Demand Management Models in MTS Manufacturing 41

4.1 Matching of Model and Software Types . 41
4.2 Quantity-Based DM in Manufacturing . 43
4.2.1 Traditional Revenue Management 44
4.2.2 Allocated Available-to-Promise 47
4.2.3 Inventory Rationing . . . . . . . 48
4.3 A Selected Allocation and Order Promising Model . 51
4.3.1 Models Without Customer Segmentation 51
4.3.2 Models With Customer Rainer
Segmentation . . . .
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 4.3.3 Search Rules for ATP Consumption . 59
4.4 Summary . . . . . . . . . . . . . . . . . . . 62

5 !\ew Demand Management Approaches 65

5.1 A Revenue Management Approach 65
5.1.1 Model formulation . . . . . 65
5.1.2 Structural properties and optimal policy 68
5.1.3 A Xumerical Example . . . . . . . . . . 71
5.2 Approximations Based on Linear Programming 72
5.2.1 Deterministic Linear Programming 73
5.2.2 Randomized Linear Programming 75

6 Simulation Environment 77
6.1 Technical Settings and Implementation Issues 77
6.1.1 Test Environment . . . 77
6.1.2 Implementation Issues 77
6.2 Simulation Issues . . . . . 79
6.2.1 Data Generation .. . 79
6.2.2 Simulation Options . . 81
6.2.3 Output and Key Performance Indicators 83
7 Xumerical Analysis 87
7.1 SOPA in Stochastic Environments . 87
7.1.1 Base Case Analysis . . . . . 88
7.1.2 Impact of Customer Classes 90
7.1.3 Impact of Customer Heterogeneity 91
7.1.4 Impact of Forecast Errors . . . . . 93
7.1.5 Impact of Backlogging Costs . . . . 94
7.2 Analysis of the Revenue Management Approach 95
7.2.1 Base Case Analysis . . . . . . . . . 96
7.2.2 Impact of Demand Variability .. . 97
7.2.3 Impact of Customer Heterogeneity 98
7.2.4 Impact of Supply Shortage . . . . . 99
7.3 Analysis of Randomized Linear Programming . 101
7.4 Summary . . . . . . . . . . . . . . . . . . . . . 104

8 Conclusion 105

Appendix 106

A Proofs of the Structural Properties of the RM approach 107

B Data Tables 113

Bibliography 121
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List of Figures

2.1 Customer Order Decoupling Point . . . . . . . . . . . . . . . . . . . 21

2.2 Structure of Advanced Planning Systems . . . . . . . . . . . . . . . 22
2.3 Exemplary Structure of an Advanced Planning System for MTS
Manufacturing . . . . . . . . . . . . . 23
3.1 Supply Chain Elements . . . . . . . . . 29
3.2 Types of Demand Management Models 31
3.3 Types of Demand Management Software 36
4.1 Quantity-Based Demand Management Models 43
4.2 Modeling Environment . . . . . . . . . . . . . 51
4.3 Illustration of the Inventory Balance Constraint 55
4.4 Rule-Based Order Processing (Disaggregated) 60
4.5 Rule-Based Order Processing (Aggregated) . 61
5.1 Non-Increasing Protection Levels 71
5.2 Concave Value Function . . . . 72
5.3 DLP and the Optimal Solution . 74
6.1 Simulation Horizon, Window and Frequency 82
7.1 Base Case Service Rates I . . . . . . . . . . 89
7.2 Base Case Service Rates II . . . . . . . . . . 90
7.3 Average Profits with Varying Number of Classes . 90
7.4 Average Relative Profits with Varying Number of Classes 91
7.5 Variation of Customer Heterogeneity 92
7.6 Variation of Forecast Errors . . . . . . . . 94
7. 7 Variation of Backlogging Costs . . . . . . 95
7.8 Customer Service Levels in the Base Case 97
7.9 Average Profits for Different Levels of Demand Variability 98
7.10 Varied Customer Heterogeneity for Different Levels of Demand Vari-
ability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
7.11 Impact of Shortage Rate on Average Profit Deviation from GOP
for Different Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . 100
7.12 RLP with Different Forecast Errors and Varied Customer Hetero-
geneity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
7.13 RLP and SOPA with Non-Nested Order Consumption . . . . . . . 103

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List of Tables

4.1 Overview of Publications on TRM in Manufacturing 44

4.2 Overview of Publications on aATP in Manufacturing 47
4.3 Overview of Publications on IR in Manufacturing . 49
4.4 Notation of the Basic Order Promising Model 52
4.5 Notation of the Network Flow Model . . . . 54
4.6 Notation of the Allocation Planning Model 56
4.7 Notation of the SOPA Model . . . . . . . . 58
4.8 Classification of Search Rules . . . . . . . . 62
5.1 Notation of the Revenue Management Approach 68
6.1 Data Stream Options . . . . . . . . . . . . . . . 80
6.2 Simulation Options . . . . . . . . . . . . . . . . . 81
7.1 Base Case Average Profits for Different Approaches . 88
7.2 Base Case Average Profits for Different Approaches . 96
B.1 Data of Fig. 7.1 . . 113
B.2 Data of Fig. 7.2 . . 113
B.3 Data of Fig. 7.3. . 114
B.4 Data of Fig. 7.4 . . 114
B.5 Data of Fig. 7.5 . . 114
B.6 Data of Fig. 7.6 . . 116
B.7 Data of Fig. 7.7. . 117
B.8 Data of Fig. 7.8 . . 117
B.9 Data of Fig. 7.9 . . 118
B.10 Data of Fig. 7.10 . 118
B.11 Data of Fig. 7.11 . 119
B.12 Data of Fig. 7.12 . 119
B.13 Data of Fig. 7.13 . 120

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Nomenclature
aATP Allocated Available-to-Promise
AP Allocation Planning
APS Advanced Planning Systems
ATO Assemble-to-Order
ATP Available-to-Promise
BOP Batch Order Processing
CDF Cummulative Distribution Function
cf. confer, compare
CODP Customer Order Decoupling Point
CPU Central Processing Unit
CTP Capable-to-Promise
CV Coefficient of Variation
DLP Deterministic Linear Programming
DM Demand Management
EPO Enterprise Profit Optimization
ERP Enterprise Resource Planning
FCFS First-Come-First-Served
GHz Gigahertz
GLPK GNU Linear Programming Kit
GOP Global Order Processing
GSL GNU Scientific Library
IP Integrated Pricing
IR Inventory Rationing
KPI Key Performance Indicator
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LP Linear Programming
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14 NOMENCLATURE

MB Megabyte
MRP Material Resource Planning
MTO Make-to-Order
NB Negative Binomial Distribution
ODF Origin-Destination-Fare
PC Personal Computer
PTP Profitable-to-Promise
RLP Randomized Linear Programming
RM Revenue Management
SIC Stochastic Inventory Control
SOPA Single Order Processing After Allocation Planning
SOPA A Aggregated SOPA
SOPA D Disaggregated SOPA
TRM Traditional Revenue Management
uATP Unallocated Available-to-Promise

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Chapter 1

Introduction

1.1 Research Topic and Motivation

"The theory of inventory control tells us how much safety stock is necessary
for fulfilling 99% of the orders in time, but not how to select the 1%, maybe
some tens of orders per day, which are postponed or cancelled." (Fleischmann
and Meyr, 2004, p. 14)
Although not explicitly stated, the authors indicate that there is more to
demand management than just achieving a high service level. Rejection or
postponement of orders are decisions that should be properly considered, since
they play a critical role for any enterprise. Hill (2000) concisely sums it up
when stating that "the most important orders are the ones that you turn down".
A number of concepts and methods emerged in the past decades addressing
this issue by trying to more actively manage demand. One prominent example
for successful demand management is the emergence of revenue management,
which was first applied in the pricing strategies of airline tickets.
In the late 1970s, deregulation of the American airline market allowed new
airlines to enter the market. Specialized only on the most profitable routes, the
new airlines were highly successful and gained substantial market shares, so
that the established airlines had to react to the increased competition. As most
of them operated a large network with manifold destinations, they could not
compete in a conventional manner against the highly-specialized new-comers
able to offer much lower prices: due to specialization, the new airlines had
less infrastructure costs, less maintenance costs and by focusing on the most
popular destinations they reached a high seat utilization. In contrast, on many
flights of the established airlines, seats were not completely sold-especially
on the less popular routes and on weekends.
American Airlines was the first player to react to the new market conditions
by an innovative pricing strategy. Instead of a cost-covering pricing of seats,
they set the prices for some tickets on the less-utilized flights on the basis of
marginal costs. Since marginal costs of an additional passenger are close to
zero, American Airlines realized that it is better to sell the seat for a very low
price, instead of leaving it empty.
Looking back, the new ticket pricing strategy developed by American Air-
lines sounds intuitive, but at that time Rainer
it was Quante - 978-3-631-75386-6
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16 CHAPTER 1 INTRODUCTION

It was a simple idea that enabled American Airlines to offer competitive and
even lower prices than the competing low-cost airlines. The only problem was
to identify which seats could be sold for normal prices and which seats to sell
for low prices because they would stay empty otherwise. American Airlines
tied the availability of low-price tickets to conditions which were fulfilled only
by leisure customers usually not willing to pay the normal prices. For exam-
ple, low-price tickets had to be bought 30 days in advance, preventing business
travelers from buying these tickets. Thus, the introduction of specialized tick-
ets designed for a specific customer class enabled American Airlines to skim
much more revenues from the total possible market potential.
In the last decades, revenue management (RM) has become a very popular
method of managing demand to increase profitability. This is not astonish-
ing given the high revenue increasing potentials of RM. Boyd (1998, p. 29)
for instance states that "revenue improvements from implementing a revenue
management system can range from 2-8 percent (or more) depending on the
carrier". The German airline Lufthansa AG reported an increase in revenues
of€ 715 Mio. in 1997 (Klophaus, 1998, p. 150)-approximately equal to the
result of normal operations in this year (Kimms and Klein, 2005, p. 2). As
seen in the case of American Airlines, the success of RM essentially relies on
identifying and exploiting differences in the customers' willingness to pay.
However, RM is mainly deployed in service industries-as for example air-
lines, car rentals, or hotels. It has not (yet) proven to be as successful in
other domains of application as, e.g., in manufacturing. In those industries,
different demand management concepts evolved in the past (for an overview
see Fleischmann and Meyr, 2004). Demand management in manufacturing is
often handled by a demand fulfillment module of the so-called advanced plan-
ning systems (APS). This module takes into account production quantities
determined by a mid-term master planning module and short-term production
planning. Based on these quantities, the demand fulfillment module decides
on the basis of simple rules which customer to fulfill at which time, e.g. rules
such as the first-come-first-served (FCFS) principle. As these rules are rather
simple and created with a focus on general applicability, the results of demand
fulfillment in APS leave space for improvements. Therefore, demand manage-
ment in manufacturing might learn from the experiences gained in the service
industries during the last decades.
Accordingly, practitioners as well as researchers put more and more effort in
exploring ways to adapt RM concepts to the specific needs of manufacturing
(Harris and Pinder, 1995, Swann, 1999, Arslan et al., 2007, Gupta and Wang,
2007). The core idea is that customer differentiation is beneficial also in a
manufacturing environment. Additionally, the building block of RM in the
service industries-perishable assets-corresponds to perishable capacity in
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1.1 RESEARCH TOPIC AND MOTIVATION 17

manufacturing industries. For instance, an empty seat in an airplane can be

compared to a machine standing still due to an insufficient number of orders.
However, the majority of scientific research focuses on adapting RM con-
cepts to make-to-order environments because of the mentioned correspondence
of perishable assets and perishable capacities in make-to-order manufactur-
ing. In make-to-stock manufacturing environments, this correspondence does
not apply as the machines schedules are based on forecasts instead of specific
customer orders. The aim of this thesis is thus to analyze the current state-
of-the-art in demand management (irrespective of a specific industry), and
then relating the ideas found in the literature to make-to-stock manufacturing
environments.
Our starting point is the current process of demand fulfillment in APS for
make-to-stock manufacturing. In the case of make-to-stock, production plan-
ning is done on the basis of demand forecasts: when a customer order arrives,
it can be either fulfilled from on-hand inventory or postponed to later arriv-
ing supply. The basic question to be answered in this thesis is to decide if it
pays off to refuse a low margin customer order in expectancy of future more
profitable orders.
The analysis relies on a number of assumptions as summarized in the fol-
lowing:
• Make-to-stock manufacturing environment with scarce capacities
• Deterministic future incoming supply
• Customers with different priorities
• Immediate order confirmation required
• Customers are willing to accept a late delivery under a price discount
In the short-term, it is assumed that the later arriving supply quantities are
known and can be promised to arriving customers. Additionally, we assume
a setting of scarce capacities, because the case of oversupply in make-to-stock
manufacturing reduces to simply accepting and fulfilling all arriving customers
orders. A further assumption in this work is that customers can be segmented
according to their different willingness to pay, different costs of fulfillment,
or different strategic importance. The first case typically applies to airlines
when they charge different prices according to the remaining booking time
and other factors like remaining capacity. In the second case, the costs of
serving a customer order can be used as a differentiator. Note that only those
costs which can still be influenced when accepting the order are relevant here.
This includes, for example, transportation costs, taxes, and any variable costs
of downstream production. The third case, the discrimination according to the
go beyond
strategic importance of customers may Rainer immediate costs and rev-
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enues. For example, loyal customers may be extremely important
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18 CHAPTER 1 INTRODUCTION

be given more favorable terms than occasional customers (see Quante et al.
(2009b, Sect. 3.1.5) for a further discussion). In addition, customers are as-
sumed to require an immediate response to their order, but are willing to
accept a late delivery under a price discount. Note that these assumptions are
equivalent to those in the work of Meyr (2009).

1.2 Organization, Objectives and Contributions

The idea of this thesis originates from the current state of the art of demand
fulfillment in make-to-stock manufacturing. where in general APS are used as
supporting tools. Therefore, this work starts in Chapter 2 with a description of
the current state-of-the-art in demand fulfillment and introduces the required
terms and definitions.
In order to search the literature for alternative approaches and concepts
suitable for make-to-stock manufacturing, we decided to systematically classify
the literature dealing with demand management. The focus was explicitly also
beyond manufacturing when reviewing the literature, since we want to search
in other disciplines for further ideas. We start introducing a framework for
demand management (DM) in Chapter 3 and identify generic model types. In
addition, a classification of commercial software solutions is presented in order
to get an idea of how these solutions work.
Subsequently, based on the framework of Chapter 3, the general types are
aligned to the specific requirements of make-to-stock manufacturing at the
beginning of Chapter 4 and shortcomings of the respective model types are
identified. A detailed analysis of specific models follows with a focus on man-
ufacturing environments, but without concentrating on make-to-stock systems
at this point.
Based on the literature review, Chapter 5 presents new models that reflect
important characteristics of order fulfillment in make-to-stock production envi-
ronments, namely customer heterogeneity, limited short-term supply flexibility,
and short-term allocation flexibility. Previous literature has not addressed the
interplay between these factors. The presented models are primarily based
on the ideas of revenue management. We prove structural properties of the
models and derive an optimal demand fulfillment policy. The result links order
fulfillment in make-to-stock manufacturing to revenue management concepts.
By this, we provide a way to unite the currently distinct concepts.
As these models of Chapter 5 explicitly take into account stochastic demand,
we compare the developed models with existing deterministic ones described
in Section 4.3. Before we conduct an extensive numerical study assessing the
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1.2 ORGANIZATION, OBJECTIVES AND CONTRIBUTIONS 19

tion environment in Chapter 6. We show the superiority of the developed

approaches in stochastic environments over the simple FCFS policy and the
deterministic models of Section 4.3. Additionally, we identify which key influ-
ence factors drive the potential benefits.
This work concludes in Chapter 8 with a discussion of the results and issues
for future research.

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Chapter 2
Demand Fulfillment 1n Make-to-Stock
Man ufact uring
In this chapter, we provide a description of the current state of demand ful-
fillment in make-to-stock manufacturing. In order to do this, we start with an
introduction of basic concepts as the customer order decoupling point. Subse-
quently, we discuss the structure of advanced planning systems and show the
activities involved in an exemplary demand fulfillment process in make-to-stock
manufacturing. Additionally, we explain the notion of available-to-promise.

2.1 Make-to-Stock and the Customer Order Decoupling

Point
In the work of Fleischmann and Meyr (2004) it is shown that demand ful-
fillment is strongly related to the position of the customer order decoupling
point (CODP). Therefore-before we explain demand fulfillment and advanced
planning systems in more detail-we give a short explanation of the CODP.
As seen in Fig. 2.1, the CODP divides the supply chain into forecast-driven
and order-driven processes (Sharman, 1984, Hoekstra and Romme, 1992).
The CODP holds the inventory that is needed to hedge against forecast
errors and replenishment uncertainty. The CODP plays a pivotal role in our
analysis since many decisions upstream of the CODP are dependent on the
available inventory and on future replenishment orders. For a more detailed
discussion of the CODP concept and its impact in different production en-
vironments (including make-to-order (MTO), assemble-to-order (ATO) and

Make-to-Order - - - - 6 -·-·-·-·-·---·-·-·-·-·-·-·-·-·-·-·-·-·••·-·-·-·-·-·--·····•·•·-·•·•···-·•·-·····-·-··•
Assemble-to-Order --------+ D ··-·-·····•·---·-·-·-·-···-·-·-·-·---·-·-···-·-·-·-·-·-·-·-·-·---·+
Make-to-Stock - - - - - - - - - 6 ·········•·-·-·····-·•·•·-·-·•·-·•·-·-·-·-·•

!::,. Customer Order Decoupling Point - forecast-driven -·····-• order-driven

Figure 2.1: Customer Order Decoupling Point

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22 CHAPTER 2 DEMAND FULFILLMENT IN MTS MANUFACTURING

make-to-stock (MTS)) we refer to Fleischmann and Meyr (2004). Note that

the supply chain may contain additional production processes downstream of
the CODP, but this is not the case for MTS production, since the CODP holds
already the final product.

2.2 Structure of Advanced Planning Systems

Tasks of demand management are well-established in make-to-stock manufac-
turing companies and are usually supported by modern information systems,
in particular advanced planning systems. These systems provide support for
the entire planning tasks along the supply chain, from long-term strategic
decision making to short-term operational decisions. Rohde et al. (2000) clas-
sify the supply chain decisions in a two-dimensional matrix (Fig. 2.2). This
matrix is vertically structured according to the planning horizon and horizon-
tally structured according to the sequence of planning tasks-from upstream

•------I
to downstream in the supply chain.

liiiiiiiiiiiiil
long-tenn
I Strategic Network Planning

I Master Planning
I Demand
Planning
Production Distribution
Purchasing Planning Planning r-·-·-·-···-·-·-·-·-•-·- - - -·
;
;
& ;
MRP
; Demand
short-tenn Transport !
Scheduling Fulfillment
Planning

Figure 2.2: Structure of Advanced Planning Systems (Rohde et al., 2000)

The planning tasks in the supply chain extend from procurement of raw ma-
terials over production and distribution towards selling of final products. Since
all these tasks are interrelated, a consecutive processing will not lead to opti-
mal plans. For instance, selling of products can only be done with information
about production and distribution in order to generate reliable due dates. On
the other hand, the production task requires reliable demand forecasts in order
to decide about lot-sizes and working times. To be able to support all these
tasks, APS usually have several modules structured according to planning hori-
zon and forecast accuracy. In order to cope with the interdependencies, the
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2.2 STRUCTURE OF ADVANCED PLANNING SYSTEMS 23

low forecast accuracy provide the limits of the lower tasks which are done on
the basis of better information. In order to do so, the upper tasks anticipate
decision making in lower levels (Schneeweilb, 2003, Sect. 2.1). From top to
down, the decisions become more accurate. Fig. 2.2 illustrates that on the top
level, the strategic network planning is responsible for coordinating the entire
supply chain. One the levels below, the tasks become more specialized.
The planning tasks associated with this thesis are located in the lower-right
corner and are supported from the so-called demand fulfillment module. In
order to illustrate how demand fulfillment for make-to-stock manufacturing

•llllt----
is supported by advanced planning systems, Fig. 2.3 illustrates the involved
supply chain activities and information flow in an exemplary consumer goods
MTS supply chain.

Fiiifiifiifil
mid-term
Master Planning

-
worl<ing time e.g. setup times Demand
Planning
net
demand
Simultaneous
Lot sizing
and
,. ,r-:---- _customer orders ..
short-term Scheduling ~stock j
; Demand Fulfillment
;

Figure 2.3: Exemplary Structure of an Advanced Planning System for Make-

to-Stock Manufacturing (Fleischmann et al., 2008, p. 97)

In the mid-term, the demand planning activity is responsible for generat-

ing aggregate demand forecasts which are handed over to the master planning
activity. It receives deterministic demand forecasts and prices as inputs from
the demand planning (Kilger and Wagner, 2008) and then determines the best
combinations of sales, production and replenishment quantities and the corre-
sponding inventories under given capacity constraints. The planning horizon
usually ranges from a few weeks up to several months. Therefore, data accu-
racy is low and the planning can only be done on the basis of aggregated data,
i.e., products and customers are aggregated to groups or classes, respectively.
In order to be able to balance supply with demand, the master planning ac-
tivity basically determines the extent of seasonal stocks and possible changes
of working times. A detailed descriptionRainer
of theQuante
master planning activity can
- 978-3-631-75386-6
be found in the work of Rohde and Wagner (2008).
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24 CHAPTER 2 DEMAND FULFILLMENT IN MTS MANUFACTURING

The generated master plan is handed over to the short-term activities. As

demand forecasts usually become more accurate on the short-term, the planned
stocks (from the master plan) and the current inventory are matched with
the short-term demand forecasts. The result of this planning step is the net
demand, which serves as input for the lot-sizing and scheduling task. This step
additionally considers the working time restrictions from the master plan and
computes the lot-sizes of the anticipated production quantities. Note, as this
is a make-to-stock environment, all planning tasks up to here are performed
on the basis of forecasts.
The last activity-which is the essential one in the scope of this work-is
demand fulfillment. This activity takes into account the planned production
quantities and quotes incoming customer orders according to their desired
delivery date. This activity is the only one considered so far that is not based
on forecasts but on the actual customer orders. In traditional material resource
planning systems (MRP), order quotes are generated on the basis of available
inventory. If there is no stock on-hand, the orders are quoted against the
production lead-time. Kilger and Meyr (2008, p. 182) give a simple example
that illustrates the weakness of such an order promising mechanism: it is not
guaranteed that capacity constraints are not violated and a feasible plan is
generated. Therefore, modern APS make use of more sophisticated methods.
The inner logic of these methods is based on the notion of available-to-promise
(ATP). In the following section, we introduce this key functionality of modern
APS demand fulfillment solutions.

2.3 Available-to-Promise
2.3.1 Definition
The notion of available-to-promise is strongly related to advanced planning
systems, and, with the success of APS solutions in the past years, is facing
increasing attention. Nevertheless, it is not a very new concept. Fischer (2001)
and Kilger and Meyr (2008) mention the work of Schwendinger (1979) as the
earliest reference to available-to-promise. Since there is already a detailed
analysis and literature review of ATP (see Fischer, 2001), we will not cite any
references before the year 2001 and put an emphasis on the years thereafter.
Kilger and Meyr (2008) define ATP as" ... the current and future availability
of supply and capacity that can be used to accept new customer orders". A
different definition of ATP is provided in the work of Ball et al. (2004), in
which ATP is defined as " . .. a business function [... ] directly linking customer
orders with enterprise resources". The commercial software vendor SAP defines
Rainer Quante - 978-3-631-75386-6
ATP quantity as the" ..Downloaded available
. quantity from to MRP for new sales
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2.3 AVAILABLE-TO-PROMISE 25

ATP check as a" ... function used to check [... ] if a product can be confirmed"
(SAP Help Portal, 2008).
Throughout this work, we follow the definition of Kilger and Meyr (2008)
when referring to the term ATP and see it as a quantity rather than a func-
tionality. It is important to note that a positive ATP quantity does not mean
that there is stock on-hand, because ATP takes also future available quantities
into account that are still to be produced. In the work of Fischer (2001), four
different functions associated with the notion of ATP are identified:
• Availability check of products and evaluation of alternative solutions
• Order confirmation and due date assignment
• Steps taken in case of temporary inability to deliver
• Due date monitoring and order repromising
In the first step, the ATP quantities are used to check the availability of
products. In cases when the product is currently not available, the next time
the product will be available can directly be derived from the ATP quantities
(as future supplies are considered). The availability check allows for a di-
rect confirmation of customer orders including the determination of due dates.
These two functions are essential for this work. The other two functions in-
volve more activities as demand fulfillment and are beyond the scope of this
work. For example, in case of temporary inability to deliver, a re-planning of
the production (lot-sizing and scheduling) has to be done.

2.3.2 Dimensions of ATP

As seen before, the master planning activity calculates aggregated plans struc-
tured according to certain categories, e.g., product or customer groups. As the
master plan is generally the basis for calculating ATP quantities, ATP exhibits
a similar structure. Kilger and Meyr (2008, p. 184) mention several alternative
possibilities to structure ATP quantities, e.g., location, sourcing type, region,
market etc. but refer to product, time and customer as the most important
ones. In the following, we give a short description of these three dimensions.
The level of detail of the ATP quantities in the product dimension cor-
responds to the location of the CODP. In case of MTO/ATO, products are
customer specific and production/assembly is driven by incoming customer or-
ders. The current and future supply and capacity that is taken into account
to accept new customer orders is represented by the production capacity after
the CODP and the inventory of semi-finished goods stored at the CODP. In
the case of MTS manufacturing, the production is entirely based on forecasts.
The current and future supply taken into account when the customer order
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26 CHAPTER 2 DEMAND FULFILLMENT IN MTS MANUFACTURING

The master plan is generally created for a few weeks up to a few months.
Accordingly, the granularity of the time dimension ranges from days to
months, mostly depending on the forecast accuracy. The ATP quantities are
therefore also structured according to certain time buckets, from which the
customer orders are fulfilled.
The third important dimension is the customer dimension. Kilger and
Meyr (2008) distinguish this dimension according to a supply- or demand con-
straint mode. Since the motivation of this thesis is driven by the problem
to decide which customer to fulfill first when capacity is scarce, the supply
constraint mode is the important one in this thesis. In this mode, not all or-
ders can be fulfilled and the ATP functionality has to provide means to decide
about customer priorities. Thus, APS assign customers to certain classes in
order to have a customer hierarchy.
The allocation of the quantities from the master plan to customer hierarchies
is usually done in APS on the basis of simple rules. Kilger and Meyr (2008,
Sect. 9.4.3) distinguishes three important rules:
• Rank based: Allocation of quantities according to predefined ranks. The
customer with the highest rank gets the forecasted quantities, the lower
ranks the remaining quantities.
• Per committed: The quantities are allocated proportionally to the fore-
casts of the different customers. If customer A has forecasted 100, and B
200, then B gets twice as much as A irrespective of the actual ·available
quantities.
• Fixed split: This rule is independent of the demand forecasts. Quantities
are allocated according to a predefined fixed ratio, e.g., customer A gets
60%, B gets 40%.
The process of determining the available quantities is called allocation plan-
ning (AP).
To find a reliable due date for a customer order, it is searched through
demand fulfillment alternatives in the mentioned dimensions. This means,
e.g., to search in the time dimension, checking for ATP back- or forwards in
time, in the product dimension, checking for substitute products, and in the
customer dimension, checking for availability in other priority classes (Kilger
and Meyr, 2008). This process is called order promising. Usually, simple rules
are defined as search strategies for the different dimensions (Meyr et al., 2008a,
Sect. 18.3.1). Profitability of different fulfillment alternatives is generally not
taken into account during this search. However, recent software systems do
not only consider available-to-promise (ATP) quantities (available inventory)
or capable-to-promise (CTP) quantities (available capacity), but also follow
a profitable-to-promise (PTP) logic that enables them to compare customer
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orders and fulfillment alternatives according to their priority. CTP quantities
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2.3 AVAILABLE-TO-PROMISE 27

are defined as" ... the remaining capacity of the assembly lines, if this capacity
is a potential bottleneck" (Fleischmann and Meyr, 2004). As they are only
applicable in MTO and ATO production systems, CTP is not relevant here.

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 Rainer Quante - 978-3-631-75386-6
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Chapter 3
A Framework for Demand Management
In this chapter, we propose a classification framework for demand manage-
ment. This framework is subsequently used to identify general types of models
and software in relation to the most important key-decision variables in sup-
ply chain management. To demonstrate the correspondence of the identified
general types of models with current scientific research, we present and dis-
cuss important review papers for each of the identified types. In contrast to
the subsequent Chapter 4, we will not discuss single research papers in this
chapter.
We start this chapter with a definition of demand management as it is un-
derstood in this work, following by a detailed description of the framework.
Once the framework is introduced, we discuss the identified model types sup-
plemented by references to important review papers.

3.1 Demand Management Defined

Demand management as it is understood in this work is closely related to
the previously described demand fulfillment in APS. As we have seen, the
notion of demand fulfillment is common in manufacturing, but similar concepts
exist in other industries, e.g., the earlier mentioned revenue management in
the service industries. Therefore-as we do not solely build on the notion of
demand fulfillment-we refer to the concepts developed in this work as demand
management concepts.

Forecast-driven (Demand Planning) Order-driven (Demand Fulfillment & Revenue Management)

Figure 3.1: Supply Chain Elements

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30 CHAPTER 3 A FRAMEWORK FOR DEMAND MANAGEMENT

In order to define demand management in the following, we adopt the supply

chain framework of Quante et al. (2009b) as shown in Fig. 3.1. Relevant in
this work are the processes in the supply chain downstream of the CODP
(order-driven processes). The framework shows the analogy between demand
fulfillment and revenue management as it extends elements like the CODP
(which is important for demand fulfillment) with elements representing revenue
management concepts. For instance, pricing decisions can be linked to the item
final product and capacity allocation decisions are linked to the item demand.
Demand management is closely tied to decisions in the depicted supply chain
and therefore depends on its specific characteristics. For example, the current
inventory at the CODP or the remaining production capacity may influence
pricing decisions or promised due dates. By capturing these characteristics,
the depicted elements of the supply chain framework provide a systematic basis
for identifying demand management models and software.

3.2 General Model Types for Demand Management

3.2.1 Classifying Demand Management Models

This section introduces a framework for generic demand management types de-
veloped to classify different literature streams. The structure of the framework
follows the work of Quante et al. (2009b). The authors distinguish demand
management models according to demand or price decisions, and control over
the replenishment quantity (as shown in Fig. 3.2). With these two dimensions,
distinct model types corresponding to common research streams are identified.
Quante et al. (2009b) note that these two dimensions are the "key decision
variables regarding demand and supply". Before reviewing each model type in
detail, the two dimensions are described in the following. Models in the first
row of Fig. 3.2 take demand as entirely exogenous. They satisfy demand first-
come-first-served (FCFS) at a given price. In particular, these models do not
consider a segmentation of customers. The middle and bottom row of Fig. 3.2
represent a more active management of demand. The models in the second row
influence the demand by adjusting prices. Like in the first row, the customers
are not segmented into specific classes and treated all equal just distinguished
according to their willingness to pay. The bottom row entails models that ex-
plicitly consider heterogeneous customers. In response to a customer request,
these models face a trade-off between accepting a current, low-priority cus-
tomer now versus reserving the resources for high-priority customers expected
in the future. The distinction between the middle and bottom row in Fig. 3.2
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corresponds with the classification of RM models
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3.2 GENERAL MODEL TYPES FOR DM 31

Replenishment consideration
None Data Decision variable
C
0 Stochastic
Order
!.g Data - Promising
Inventory
Control
'iii
C
8 Markdown/

.
Trade Integrated
1 Pricing/
Auctions
Promotions Pricing
Q.
,,C
~ Quantity-based Inventory
Traditional RM aATP
Rationing
~

Figure 3.2: Types of Demand Management Models (Quante et al., 2009b)

(2004). In order to follow their terminology, models are labeled as price-based

or quantity-based.
The columns in Fig. 3.2 reflect the way models decide about inventory re-
plenishment at the CODP. In the first column, models do not consider re-
plenishments. As for example, in airline revenue management, the seats in
an airplane can not be replenished when sold out. In the middle column, in-
ventory replenishments are considered but not actively influenced. The right
column entails models that actively decide about the quantities they want to
replenish.
In the following, we briefly discuss each of the aforementioned model types.
We will refer to available review papers for each of the model types. A detailed
discussion of individual articles relevant in this work is following in Chapter 4.

3.2.2 Single-Class Exogenous Demand Models

No models were found fitting in the upper left cell of Fig. 3.2. This is not sur-
prising since models with a given price and no consideration of replenishment
or inventory, respectively, have nothing to decide on, neither on the demand
nor on the replenishment side of the supply chain.
In the next cell to the right, the si>-called order promising models consider
price (i.e. demand), current inventory, and future replenishment quantities as
given. This results in information about product availability and delivery
times. For each incoming customer order the model decides real-time on the
due date. The decision is made in a greedy fashion, based on availability of
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32 CHAPTER 3 A FRAMEWORK FOR DEMAND MANAGEMENT

this category. An introduction and overview of this so-called "real-time mode"

or "single-order-processing" models is given in Ball et al. (2004), Chen et al.
(2001), and Fleischmann and Meyr (2004). Additionally, a broad overview
of due date management models with an emphasis on stochastic models is
included in the work of Keskinocak and Tayur (2004).
The upper right cell of Fig. 3.2 holds the vast class of stochastic inven-
tory control (SIC) models, which focus on optimal inventory replenishment.
Some of these models primarily address the structure of optimal replenishment
policies, as for example the famous (s, S)-policy proven by Scarf (1960). Other
models seek to determine optimal control parameters of such policies, such as
the optimal ordering time, order quantity and inventory review intervals. Many
SIC models build on the classical newsvendor model, which seeks to determine
the optimal order quantity for a perishable product under stochastic demand.
An overview of single-period newsvendor problems is given by Khouja (1999).
Silver (1981) provides an overview and typology of many standard inventory
problems, such as the ones mentioned above. General up-to-date overviews of
inventory models can be found in the textbooks by Silver et al. (1998), Porteus
(2002) and Tempelmeier (2006).

3.2.3 Price-Based Demand Models

The model types in the middle row of Fig. 3.2 treat price as a decision, which
influences the demand. Pure pricing models aim to determine an optimal
selling price, without considering replenishments. For example, given a price-
demand relation, the goal is to find the price which maximizes total revenues.
Mild et al. (2006) review factors influencing demand and show how to find
optimal prices.
Markdown models determine the right price path for inventory clearance
for a given amount of inventory, which cannot be replenished during the plan-
ning horizon. Elmaghraby and Keskinocak (2003) classify several dynamic
pricing models with and without replenishment decisions, the latter ones in-
cluding markdown models.
Auctions, as discussed for example by Talluri and van Ryzin (2004, Sect.
6), take a fundamentally different approach to pricing. They provide a price-
discovery mechanism and thereby an alternative to posting fixed prices. This
approach is particularly valuable if little demand information is available. The
aforementioned authors discuss the close connection between auctions and dy-
namic pricing.
Trade promotion models represent aRainer type of pricing models that consider
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3.2 GENERAL MODEL TYPES FOR DM 33

of Fig. 3.2. Neslin (2002) provides an overview and discusses the reasons for
promotions.
Research in integrated pricing (IP) models dates back to Whitin (1955)
who extends the EOQ-formula as well as the classical newsvendor model with
price decisions. This field has seen extensive research in the last decades,
which is summarized, for example, by Petruzzi and Dada (1999). Recent
research focuses on multiple period models, which are discussed in the well-
known literature reviews of Chan et al. (2004), Elmaghraby and Keskinocak
(2003) and Yano and Gilbert (2003). Few models exist for environments in
which replenishment, prices and due dates are set simultaneously. Some models
of this type and other models dealing with due date setting can be found, for
example, in the previously mentioned review paper by Keskinocak and Tayur
(2004).
From an application-oriented perspective it is worthwhile comparing IP and
a successive application of pricing & SIC models. While IP models recognize
the interdependence between pricing and replenishment and therefore deter-
mine decisions simultaneously, they do so at the cost of a more simplified
demand and supply representation. Pure pricing models may include sophis-
ticated demand functions, including reference price effects, promotion effects,
and competition (Mild et al., 2006). Similarly, SIC models consider factors
such as multiple suppliers and quantity-discounts. IP models typically cannot
deal with these factors due to tractability (Elmaghraby and Keskinocak, 2003,
Sect. 4).

3.2.4 Quantity-Based Demand Models

Models in the bottom row of Fig. 3.2 take prices as exogenous but manage
demand by means of rationing strategies. In contrast to the models of the top
and middle row, the models distinguish multiple customer classes and prioritize
them rather than fulfilling orders in an FCFS manner.
The type traditional revenue management (TRM) in the first cell of
the third row refers to models that are common in airline applications. In
these models, given units of a perishable product (e.g., seats on a flight on
a specific day) are allocated to customers with different priorities or different
willingness to pay. The basic question is whether to accept a given order or to
reserve capacity in anticipation of more profitable future orders. McGill and
van Ryzin (1999) and Pak and Piersma (2002) provide an overview and a short
history of research in traditional revenue management with a focus on airline
applications. Boyd and Bilegan (2003) discuss models focusing on e-commerce
applications. The recent review by Chiang et al. (2007) includes an overview
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34 CHAPTER 3 A FRAMEWORK FOR DEMAND MANAGEMENT

Models of the type Allocated available-to-promise ( aATP) are similar to the

order promising type of the top row except for differentiating between multi-
ple customer classes. Scarce resources (inventory on hand, planned stock at
the COOP or capacity downstream of the DP) are allocated to these classes
according to customer profitability or other priority measures. Within each
class, customer requests are usually handled FCFS, just as in traditional order
promising. Examples of these type have been discussed before in Sect. 4.3.2.
Guerrero and Kern (1988) introduce the general problem of accepting and re-
fusing orders and discuss the requirements and implications of order promising
mechanisms. For reviews of the mostly deterministic models of this type the
reader is referred to Kilger and Meyr (2008) and Pibernik (2005).
If customer requests do not have to be answered instantaneously, several cus-
tomer orders can be collected and jointly promised in a batch, thereby creating
higher degrees of freedom for selecting the most important or profitable or-
ders within a simultaneous optimization process. Overviews of these so-called
"batch order promising models" can again be found in the work of Ball et al.
(2004), Chen et al. (2001) or Fleischmann and Meyr (2004).
A review of integrated due-date management and job-scheduling models with
deterministic orders is provided by Gordon et al. (2002). The article considers
batch-models in which due dates are determined according to current capacity
and the desired delivery date. Keskinocak and Tayur (2004) give a general
overview of due-date setting models.
aATP and TRM models are similar in that they decide about demand fulfill-
ment with respect to different customer classes. The most significant difference
concerns the perishability of resources. TRM considers "perishable" products,
e.g., empty seats on a specific flight, which are lost after the departure date,
whereas the ATP quantities managed in aATP models are generally storable.
Another difference concerns the time horizon. TRM models typically consider
a fixed day of capacity availability, e.g., the departure date of a flight. In con-
trast, aATP models consider multiple periods linked through the storability
of excess inventory. Furthermore, aATP models usually assume deterministic
demand whereas demand in TRM models is stochastic.
The last model type within the grid concerns inventory rationing (IR)
models. Similar to the relationship between aATP and order promising, IR
models extend SIC models by distinguishing and prioritizing multiple customer
classes. For an early review refer to Kleijn and Dekker (1998). As traditional
SIC models, IR models may consider deterministic or stochastic replenishment
lead times. A further distinction within this class of models concerns the
number of demand classes considered, which may be general or limited to two
classes.
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3.3 GENERAL SOFTWARE TYPES FOR DM 35

IR and aATP models differ in terms of exogenous versus endogenous replen-

ishment. Specifically, IR models consider replenishment decisions with station-
ary deterministic or stochastic lead times. In contrast, aATP typically consid-
ers capacitated, dynamic and deterministic arrivals of push-based production
(==replenishment) quantities. To this end, aATP usually assumes deterministic
and dynamic demand forecasts whereas IR models assume stochastic demand.
In addition to the model types captured in Fig. 3.2, a few recent research
streams aim to combine several types by simultaneously considering multiple
attributes. For example, Kocab1y1koglu and Popescu (2005) jointly analyze
price and allocation decisions with two customer classes. Since most quantity-
based models assume exogenous prices, this seems to be a promising direction
for future research. Bitran and Caldentey (2003) formulate a general model
of this problem and review the current state of research. Another approach is
pursued in Ding et al. (2006) in which trade promotion models are combined
with inventory rationing models. The authors denote the resulting new prob-
lem type by ADP, referring to the allocation of available stock, discounting
and prioritization of customers.

3.3 General Software Types for Demand Management

3.3.1 Classifying Demand Management Software

The software market for demand and supply chain solutions has changed in
recent years. For many years the focus was on the supply side. The inter-
est is now, however, turning to end-to-end solutions including the demand
side. Big supply chain solution providers like Oracle and SAP are investing
large amounts in the acquisition of demand-related know-how. For example,
in 2005 SAP took over Khimetrics, a leading vendor of markdown, price, and
promotion-optimization solutions. Oracle-after taking over one of its largest
competitors in supply chain solutions, Peoplesoft, in 2005-simultaneously in-
vested in the demand solutions of Demantra (2006), ProfitLogic (2005) and
Retek (2005), all of them leading vendors of retail revenue management soft-
ware. Another big consolidation occurred in 2006 when JDA Software-a
provider of specialized retail solutions-took over Manugistics, a supply chain
solution provider focusing on profit optimization in the consumer goods indus-
try.
The scope of our current analysis is restricted to software supporting short-
term decision making in DM. These solutions draw data from other software
systems, such as Customer Relationship Rainer
Management systems on the demand
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36 CHAPTER 3 A FRAMEWORK FOR DEMAND MANAGEMENT

Kilger, 2008) on the supply side. Since these systems themselves do not focus
on decision making we do not include them in our analysis.
As discussed in the previous section, scientific optimization models are fairly
well described in the literature. One can easily identify data, decision variables,
restrictions and solution strategies. Moreover, the solution quality is often an-
alyzed in detailed numerical studies. This is different for commercial software
solutions. Usually, available information is scarce and reveals little of the un-
derlying technology. Software users can only assess the supported input data,
available options, and the resulting output that is automatically calculated.
The solution quality can hardly be evaluated objectively and is usually judged
by user experience.
Our analysis of software modules reflects this limited availability of objective
information. We build our characterization of software types and functional-
ities primarily on available software reviews and whitepapers. As a starting
point we use essentially the same dimensions as for the scientific models. Model
data and decisions roughly correspond with software input and output, respec-
tively.
Fig. 3.3 structures software types along the same axes as the model types
of Section 3.2. We choose names according to the functionality of commercial
software modules on the market. The remainder of this section briefly reviews
each of these software types.
Replenlshment consideration

None Data Decision variable

C Purchasing &
0
!G)
Data -
Traditional
Order Promising
Materials
Requirements
"ti Planning
"iii
C
0 Markdown-/
()
Pricing-/ Promotion Enterprise Profit
Price-based
~ Auction- Optimization Optimization
·c Management
a.
"ti
; Demand
i Quantity-based
Revenue
Management
Fulfillment &
ATP
Master
Planning
C

Figure 3.3: Types of Demand Management Software (Quante et al., 2009b)

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3.3 GENERAL SOFTWARE TYPES FOR DM 37

3.3.2 Single-Class Exogenous Demand Solutions

The mid upper cell of Fig. 3.3 denoted by traditional order promising
contains traditional software modules for short-term order promising under
known inventory availability. When a customer order arrives, the software
simply determines whether the order can be satisfied out of available inventory.
If not, the order is backlogged according to a standard lead time without
considering future capacity or additional incoming supply. It is easy to see
that this approach can lead to an order peak after the standard lead time
and thus to severe capacity problems in the future. Kilger and Meyr (2008)
illustrate this situation in a simple example.
Refilling of inventory is usually left to purchasing & materials require-
ments planning modules, which are part of enterprise resource planning
(ERP) systems. Essentially, these systems support refilling of non-bottleneck
material and components from a single vendor. An overview of these classical
systems can be found, for example, in the textbook of Vollmann et al. (2005).
Since these classical systems provide sufficient solution quality only for very
simple settings, specialized inventory modules consider extensions such as ca-
pacitated replenishment, stochastic demand, and multiple suppliers (Stadtler,
2008). Such modules usually are part of larger advanced planning and sup-
ply chain planning software suites. Additionally, there are specialized vendors
of supply-chain wide inventory optimization tools, such as Optiant (Optiant,
2007) with its inventory suite Powerchain and Smartops (Smartops, 2007).

3.3.3 Price-Based Solutions

Markdown management systems are mainly used in retail, for example for
end-of-season stock clearance. An example of markdown management systems
is B_Line, described by Mantrala and Rao (2001) under the name MARK.
The system takes possible prices and corresponding demand probability dis-
tributions for each period as inputs and can find both markdown and markup
price paths. The output consists of a specific price in each period. Further-
more, MARK is capable of finding a suitable amount of initial inventory by
iterating through a discrete set of possible inventory levels. Elmaghraby and
Keskinocak (2003, Sect. 3.2) describe the capability of markdown solutions.
Software systems of the type pricing management are relatively new.
This is due to improvements in computing power and increased availability of
past sales data. The rise of data warehouses and cheap computing power has
recently allowed the use of automated pricing systems for many applications.
Pricing management systems are based on complex price-demand functions
for which suitable parameters have to be estimated, a process requiring vast
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38 CHAPTER 3 A FRAMEWORK FOR DEMAND MANAGEMENT

data must include a certain degree of diversity, corresponding with at least

a few past price changes. Capacity or inventory restrictions are usually not
considered in these types of software (see for example Mild et al., 2006).
The quick expansion of e-commerce applications has boosted the use of
auction systems. The large number of different systems merits a review
in its own right and exceeds the scope of our analysis. We refer to Kambil
and van Heck (2002) for a systematic introduction to this field. Vakali et al.
(2001) discuss the characteristics of internet-based auction systems and present
a short survey of popular applications.
Similar to the previously described markdown systems, promotion opti-
mization is also used in retail environments, as described by Elmaghraby and
Keskinocak (2003, Sect. 3.2). Very detailed information about the capability
of such systems can be found on-line, for example from the vendors mentioned
at the beginning of this section.
The term enterprise profit optimization (EPO) was coined by the soft-
ware company Manugistics, who claims to be the first vendor offering an
integrated pricing and supply solution (Manugistics, 2002). Furthermore,
Manugistics software is meant to be able to allocate scarce resources to the
most profitable customers, thus simultaneously applying ideas of quantity-
based DM. Demand and supply planning is realized in many solutions, but
not in an integrated way and not including price decisions. Most APS forecast
demand for different price levels and then successively analyze-within the
context of mid-term planning-several what-if scenarios and their effects on
the total supply chain.

3.3.4 Quantity-Based Solutions

APS software modules that support mid-term, aggregated supply and demand
decisions are known as master planning modules (Meyr et al., 2008b) as pre-
viously mentioned in Sect. 2.2. They receive deterministic demand forecasts
and prices as inputs from the demand planning module of APS (Kilger and
Wagner, 2008) and then determine the best combinations of sales, production
and replenishment quantities and the corresponding inventories under given
capacity constraints. Quantities can be allocated to different customer classes.
In terms of the supply chain framework in Fig. 3.1, master planning modules
deal with forecast-driven planning activities (e.g., push-based replenishment of
the CODP) and therefore fall outside the scope of our definition of DM. How-
ever, we feel that they deserve mention since their resulting allocations serve
as the primary input for the short-term, capacity-checked order promising, ex-
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3.3 GENERAL SOFTWARE TYPES FOR DM 39

of options considered in master planning modules can be found in the work of

Rohde and Wagner (2008).
The type in the lower middle cell takes capacity and inventory replenish-
ments into account and corresponds to the demand fulfillment & ATP
modules of APS previously described in Chapter 2. These modules extend the
aforementioned traditional order promising and determine due dates for incom-
ing customer orders, which promise to be more reliable than simple standard
lead times. In addition, if ATP quantities are allocated to customer priority
classes-in the usually implemented aggregated way-order promising differ-
entiates with respect to customer importance, based on customer profitability
or strategic impact.
Revenue management software is widely used by airlines, hotel chains,
and car rental agencies. RM software systems basically take the given capacity
and offered tariffs as input and decide on acceptance or rejection of customer
orders. One of the main differences with demand fulfillment & ATP is that
RM software focuses on revenues rather than costs. Furthermore, RM systems
usually forecast demand in much more detail than demand fulfillment modules,
e.g., for each flight, on each day, and for each customer class. These forecasts
require a large amount of historical sales data in order to be reliable. Modern
revenue management systems can handle many additional industry-specific
issues, such as overbooking and connecting flights in the airline context (Talluri
and van Ryzin, 2004, Sect. 10.1.3, 11.2).

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Chapter 4
Demand Management Models 1n MTS
Manufacturing
In this chapter, we align the identified general types of demand management
described in Chapter 3 with the characteristics of manufacturing environments.
By this, we can further narrow the domain of demand management models by
excluding those ones that appear hardly suitable for MTS production systems.
After identification of the most suitable models, we complement the general
review from the previous chapter by a more detailed review of specialized
papers taking into account the characteristics of manufacturing environments.

4.1 Matching of Model and Software Types to the

Requirements of MTS Manufacturing
In this section, we identify alignments and misalignments between models and
software within the domain of MTS manufacturing. Specifically, the goal of
this section is to identify the most appropriate models and software types
for DM decisions in MTS manufacturing. We also seek to highlight remaining
research needs and provide the motivation for the models presented in Chapter
5.
We build our discussion around the structure of Figures 3.2 and 3.3. Specif-
ically, we compare the supply flexibility in MTS manufacturing with the way
that replenishment decisions are supported by different model and software
types. Similarly, the demand flexibility is tied to the supported demand man-
agement. In this way, we identify the most appropriate cell(s) in Figures 3.2
and 3.3. This allows us to recognize empty spots and future research needs.
In manufacturing, production processes are the most important-and usu-
ally most costly-process steps. The customer order decoupling point as the
interface between forecast-driven demand planning and customer-oriented de-
mand fulfillment describes whether a certain production process is operated
under demand (un)certainty, what type of stocks (raw material, components,
final products) have to be held, where the main bottlenecks (stocks, production
capacity) can be expected, and how longRainer Quante - 978-3-631-75386-6
customer service times will be.
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42 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

In MTS environments, all production processes are executed in a forecast-

based way. Due to upstream capacity limitations, production planning decides
on short-term replenishment of CODP inventories in a push-based, "vendor-
driven" manner. Thus, models including replenishment decisions (third column
of Fig. 3.2) can only support the mid-term, forecast-based demand planning,
but not the short-term demand fulfillment. In order to make use of the (un-
certain) information on future CODP inventory replenishments, as implied by
the production plans, demand fulfillment models of the second column appear
the most appropriate.
Because of the MTS market conditions and contracting practice, pricing
decisions typically have to be taken on a mid-term basis. For example, the
Demand Planning module of an APS forecasts several price-demand scenar-
ios, including different alternatives for price discounts or promotions. These
scenarios are passed on to a master planning module, which checks each of
them with respect to supply chain constraints, selects the most profitable one,
and generates directives for the (forecast-based) short-term production plan-
ning. Thus, short-term pricing flexibility is rather limited, which rules out the
models on the second row of Fig. 3.2. Price-based approaches appear mainly
applicable on the mid-term planning level, e.g. to determine demand forecasts
in conjunction with optimal prices.
The remaining models are order promising and aATP models as the most
applicable ones for DM in MTS manufacturing. Both of them consider the
current level of CODP inventory. Order promising in an MTS environment
searches through the ATP quantities in an FCFS manner to be able to ful-
fill a customer order. Newer approaches process several customer orders in a
batch and allocate ATP to the most profitable customer orders. aATP models
overcome the disadvantage of batch order promising, namely not providing a
real-time order promise and forcing the customer to wait. However, they are
dependent on forecast-based information on CODP inventories that is provided
by the master and production plans, and on the possibility of customer seg-
mentation. The ATP search rules that are used to consume the allocated ATP
quantities of the different customer classes follow similar ideas as traditional
RM methods. However, since products in MTS manufacturing are durable
and can be stored, they also have to be able to "search over time", i.e. to take
future inventory replenishments into account.
The results of this section can be summarized as follows: Replenishment
decisions are not relevant for short-term demand fulfillment in MTS manu-
facturing, which rules out the third column in Fig. 3.2. The second row is
also not appropriate for short-term applications due to the low pricing flexi-
bility. Traditional RM methods do not consider storability of inventory. The
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4.2 QUANTITY-BASED DM IN MANUFACTURING 43

Replenishment consideration

None Data Decision variable

Traditional RM aATP Inventory Rationing

Quantity-based + storability + stochastics + deterministic

+ several supplies
replenishments + no ordering

Figure 4.1: Quantity-Based Demand Management Models

matching of the generalized model and software types of Chap. 3 to the specific
characteristics of MTS manufacturing leads to the following research questions:
How can demand management models be adapted to the specific needs of
make-to-stock manufacturing? Unlike in service environments, order promising
in manufacturing industries is a multi-period problem, i.e. production earlier
or deliveries later than the customers' requested date are possible. Therefore,
traditional RM techniques typically cannot be applied as is in MTS manu-
facturing industries. They have to be adapted to deal with the holding and
(future) replenishment of CODP inventory and costs. The allocation and ATP
consumption rules currently used in APS serve this purpose, but are very basic.
Furthermore, stochastic influences from the demand side are usually ignored.
Inventory rationing models cannot be applied as is to MTS manufacturing due
to their short-term replenishment decisions. Excluding replenishment deci-
sions from IR models and using the "remaining'' rationing policies for demand
fulfillment seems to be a way of adapting such models. Fig. 4.1 summarizes
the match of models and software to the requirements of MTS manufacturing.
Subsequently, such new models are shown in Chap. 5.
Since it is not clear how different models perform under realistic conditions,
a comprehensive performance analysis considering the specific characteristics
of MTS manufacturing will be made in Chap. 7. The analysis should help to
assess the different models and rules taken from commercial software solutions
and should determine the main influence factors on the performance.

4.2 Quantity-Based Demand Management m

Manufacturing
We will discuss the literature of the three identified types in more detail, as
basically review papers have been mentioned before. Additionally, we take
into account the characteristics of MTSRainer
manufacturing when reviewing the
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44 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

Table 4.1: Overview of Publications on TRM in Manufacturing (Method:

C=Conceptual, M=Simulation/analytical models, R=Review,
S=Case study)

Publication CODP Classes Method

Harris and Pinder (1995) ATO 2 C,M
Kalyan (2002) MTO/ATO/MTS C
Kuhn and Defregger (2004) MTO 2 s
Rehkopf and Spengler (2004) MTO several C,M
Barut and Sridharan (2005) MTO several M
Kimms and Klein (2005) MTO C
Jalora (2006) MTO several M
Kolisch and Zatta (2006) MTO C
Rehkopf (2006) MTO C,M,R
Kumar and Frederick (2007) MTO/MTS 3 s
Spengler et al. (2007) MTO several M
Chiang et al. (2007) R
Specht and Gruf.l, (2007) ATO c,s

4.2.1 Traditional Revenue Management

Overviews of TRM and its applications in different industries (including man-
ufacturing) are provided by Kimms and Klein (2005) and Chiang et al. (2007).
These overviews reveal that the literature on quantity-based RM in manufac-
turing is basically limited to MTO and ATO production environments. This
can be explained by the correspondence of production capacities and perishable
assets which are the building blocks of RM in the service industries (Weath-
erford and Bodily, 1992). Usually, TRM papers for manufacturing determine
optimal protection levels for production capacities (located downstream of the
CODP).
Table 4.1 shows important papers on TRM in manufacturing classified ac-
cording to the CODP, the number of customer classes considered and the
methodology applied in the paper. We distinguish between four methodolo-
gies: conceptual (C), simulation/analytical models (M), review (R), and case
studies (S). Conceptual papers are understood as those describing and devel-
oping new concepts and ideas without defining a specific model. This is done
in the next methodology of defining simulation- or analytical models. Review
papers focus on providing a comprehensive state-of-the-art of the literature
within a special field of research. They are often combined with conceptual
work, e.g., the development of a classification framework. Finally, case studies
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focus on a detailed description of real-world applications.
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4.2 QUANTITY-BASED DM IN MANUFACTURING 45

A seminal paper for the adoption of RM concepts in manufacturing is the one

from Harris and Pinder (1995). The authors describe the analogies between
ATO production and the service industries and proposes a TRM model for
a repair facility and a sports apparel manufacturer. Unlike many papers in
TRM, the author describes not only how to determine protection levels for a
two-class problem, but also how to determine the optimal selling prices.
Similar to the previous paper, Kalyan (2002) establishes a relationship be-
tween airline revenue management and its counterparts in manufacturing. The
author introduces the notion of MAV (minimal acceptable value) and shows
how MAV can be used in many different applications. MAV is understood as
the value of a resource and is known in revenue management as the bid-price,
a threshold for accepting those orders that generate higher revenues than the
bid-price. The basic idea of the paper is that all assets or resources are asso-
ciated with a certain value (MAV). If this value is known, it can be compared
to any incoming order. If the price of the order is higher than the MAV, the
order is accepted, and rejected otherwise. The paper gives many examples and
shows how MAV can be calculated in manufacturing applications.
Kuhn and Defregger (2004) discuss a case of a paper production company
with a fixed capacity on the short-term. Production is triggered by incoming
orders (MTO) and customers are divided into two classes differentiated in
resulting revenues (€ 50,000 vs. € 10,000) and required lead times (2 days vs.
3 days). If a customer order is accepted, the paper machine is busy for two
days. The problem is to decide which of the low-margin customers to reject
in anticipation of later arriving high-margin customers. The authors propose
a Markov decision process solved by means of a linear program. A numerical
study shows a profit increase of 5.4% compared to a simple FCFS policy.
The work of Rehkopf and Spengler (2004) is a further paper identifying
the characteristics between the service industries and MTO manufacturing
according to the application of revenue management. The authors focus on
the iron and steel industry and show how a network revenue management
problem (Talluri and van Ryzin, 2004) can be solved with a linear program
in order to allocate capacity. This conceptual work is deepened in the later
released paper of Spengler et al. (2007) which is discussed further below.
The work of Barut and Sridharan (2005) is selected as a representative of
an entire line of research in scheduling and accepting orders in an MTO man-
ufacturing setting. Rather than to focus just on the acceptance decisions, the
authors-in contrast to the previously mentioned papers-take into account
the scheduling and exact due date determination of incoming orders. They
propose a heuristic procedure (called DCAP) that is able to process orders in
distinct lots and handles more than two customer classes. The results indicate
that DCAP performs better than an FCFS Rainerpolicy.
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46 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

similar model as shown in Barut and Sridharan (2005) but extends their work
by showing a dynamic order acceptance and scheduling policy evolving over
time when the exact demand realizations are known.
Kolisch and Zatta (2006) present a short introduction into revenue manage-
ment for the process industry. Their work includes an empirical study over 124
companies of the process industry. The large majority of companies confirmed
that revenue management is a suitable method to cope with overcapacities
and increasing competition. 80% of the surveyed companies currently apply
methods of revenue management, the majority of them (74%) for capacity
management and 15% price management.
Kumar and Frederick (2007) show the case of Andersen, an American win-
dow manufacturer. The case describes a simplified decision problem Andersen
is facing. The company sells its products over three distinct distribution chan-
nels. In two of the three channels, Andersen produces windows upon order
placement and generates only low or medium margins due to long lead times.
In the third channel, the customer buys the window directly in a warehouse
and pays a surplus due to the short lead times. Andersen is producing on-stock
in this third channel. The aim is to find an optimal amount of inventory stored
in the warehouse. A closed-form solution is presented in this study resembling
the famous newsvendor problem.
Spengler et al. (2007) propose a model for the iron and steel industry in
an MTO setting. The authors define a stochastic dynamic program based on
a vector of CTP quantities. The optimal policy is to accept an order if its
current contribution margin exceeds the expected marginal profits. As the
problem size is too large to be solved directly with dynamic programming,
the authors approximate the expected marginal profits by a multi-dimensional
knapsack formulation. In numerical tests the proposed method results in in-
creased contribution margins of 5.3% compared to a simple FCFS rule. This
work as well as the previous mentioned work of Rehkopf and Spengler (2004)
is included in the dissertation of Rehkopf (2006).
Specht and Grul5 (2007) describe the successful application of a revenue man-
agement system in the Ford Motor Company. The described system consists
of three distinct tools: (1) a package optimizer to create bundles of promising
car accessories, (2) a price optimizer to generate incentive schemes, and (3)
a decision support tool for car dealers that provides information about what
cars to order. Additionally to this case study, Specht and Grulb (2007) discuss
the requirements of future revenue management systems in the automotive
industry. The authors mention that such a system should generate buying
alternatives based on the current capacity utilization in the supply chain and
acceptable lead times.
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4.2 QUANTITY-BASED DM IN MANUFACTURING 47

Table 4.2: Overview of Publications on aATP in Manufacturing (Method:

C=Conceptual, M=Simulation/analytical models, R=Review,
S=Case study)

Publication CODP Classes Method

Chen et al. (2001) MTS M
Fischer (2001) MTS several C,M,R
Chen et al. (2002) MTS M
Gordon et al. (2002) MTO R
Ball et al. (2004) C,R
Fleischmann et al. (2004) C,R
Keskinocak and Tayur (2004) MTO R
Pibernik (2005) C,R
Lee (2006) MTO/ATO 4 to 8 M,S
Pibernik (2006) MTS several C,M
Pibernik and Yadav (2009) MTS 2 M
Kilger and Meyr (2008) C,R
Meyr (2009) MTS several C,M

4.2.2 Allocated Available-to-Promise

Models of the type aATP allocate capacity /inventory to customers according
to their profitability. These models are usually found in manufacturing envi-
ronments and are often directly applicable in APS to be used in real-world
applications. In this section, we complement the review of aATP models by
discussing important examples of this type of models.
The most relevant paper in this thesis is the one by Meyr (2009). The model
presented here follows a two-step approach: In a first step, quotas are assigned
to customer classes (Allocation Planning) which are consumed later on in real-
time by the incoming orders (ATP consumption). Due to the importance of
this paper, we give a detailed description of the presented model and research
approach in the subsequent Section 4.3.
In contrast to the two-step approach of Meyr (2009), batch order promising
models use batch intervals to be able to select the most profitable orders.
Examples of batch models can be found in the work by Chen et al. (2001),
Chen et al. (2002), and Fischer (2001). As shown in these articles, the general
drawback of batch models-the long response time to customer requests-is
usually handled by first answering the request with an approximative due date
and then refining this date in a subsequent step.
Lee (2006) describes a simulation toolRainer
developed for IBM's hardware busi-
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48 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

activities-from calculating ATP quantities over scheduling of orders up to

due date promising. The author claims that this is one of only a few works
considering the entire process, including ATP generation. The considered di-
mensions of ATP are the type of product, demand classes, supply classes and
time buckets. ATP quantities are calculated according to information about
component availability, current inventory, work-in-process, the master plan,
supplier commitments and production capacity. When a customer order ar-
rives, the model searches through the ATP dimensions according to predefined
search rules. The aim of the study is to show the change in key performance
indicators when shifting from an MTO to a configure-to-order (CTO) busi-
ness. The study reveals that customer service increases dramatically in the
CTO setting.
Pibernik (2006) discusses order fulfillment strategies in case of stock out
situations. This work is one of the few papers taking deterministic future
replenishments into account. The author proposes a model to allocate a set of
orders to ATP quantities when the costs of short- and long-term consequences
of delaying or rejecting an order can be quantified. Similar to the work of
Meyr (2009), the author describes a way to pre-allocate ATP quantities to
customer classes in order to increase profitability. The author also mentions
the rank-based allocation strategy as earlier mentioned in Section 2.3.2. It
starts allocating all available quantities to the highest customer class. Then, it
iterates in descending order through the lower classes allocating the remaining
quantities.
Together with the previous described work, the paper of Pibernik and Yadav
(2009) is the second paper found considering customer classes and deterministic
future replenishments . The authors propose a model that selects among two
customer classes under a service-level constraint. The described model in this
paper is closely linked to our setting, but reveals some distinctive features.
The most prominent distinction is the service-level objective as we maximize
the expected profit. Furthermore, the model assumes stochastic due dates,
two customer classes and lost sales where we allow more than two classes and
both, lost sales and backlogging.

4.2.3 Inventory Rationing

There are two broad research streams within the type ofIR models. Ha (1997a)
and De Vericourt et al. (2002) propose models with multiple demand classes
and stochastic replenishment times, thus assuming limited production (=re-
plenishment) capacities. In contrast, Melchiors et al. (2000) and Arslan et al.
(2007) model deterministic replenishmentRainer
lead times and unbounded replenish-
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4.2 QUANTITY-BASED DM IN MANUFACTURING 49

Table 4.3: Overview of Publications on IR in Manufacturing (Method:

C=Conceptual, M=Simulation/analytical models, R=Review,
S=Case study)

Publication CODP Classes Method

Ha (1997b) MTS 2 M
Ha (1997a) MTS several M
Kleijn and Dekker (1998) R
Melchiors et al. (2000) MTS 2 M
De Vericourt et al. (2002) MTS several M
Arslan et al. (2007) MTS several M
Gupta and Wang (2007) MTO/MTS 2 M
Mc.mering and Thonemann (2007) MTS 2 M
Defregger and Kuhn (2007) MT0 several M
Teunter and Klein Haneveld (2008) MTS 2 M,R

levels, which are typically expressed in policies like (s, S, R) where s is the
reorder point, S the order-up-to level, and R the protection level between cus-
tomer classes. When inventory falls below s, it is filled up to S. In a two-class
setting, demand from the low margin class is fulfilled as long as the inventory
is above the protection level R.
Although some of the following work is also linked to revenue management,
we classify all models deciding about replenishments as IR models. Defregger
and Kuhn (2007) propose a model in an MTO setting using a Markov decision
process. The authors consider a decision maker who has to decide whether to
accept an order-taking into account the order specific profit and the orders
maximum lead time-and whether to raise the inventory level by additional
production. In contrast to the conventional approaches in MTO settings, the
authors include a finished goods inventory in their model in order to be able to
fulfill high-margin orders with a short lead-time. However, it is still an MTO
setting since production is triggered by incoming customer orders.
Gupta and Wang (2007) study a setting with two customer classes, distin-
guished in transactional and more valuable contractual orders. The manu-
facturer can choose which transactional orders to fulfill but has to meet the
demand of contractual orders at a short notice. The authors study two scenar-
ios, one in which the contractual orders are produced-to-stock and one with
make-to-order production. In the MTS scenario, the manufacturers decision is
twofold: (1) how many units to accept from the transactional orders (contrac-
tual have to be fulfilled) and (2) how much to produce to raise finished goods
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50 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

Mollering and Thonemann (2007) focus on analyzing optimal backorder

clearing in critical level policies. In contrast to models assuming lost sales,
backorder models have to decide about which backorders to fulfill under dif-
ferent inventory levels. In the more realistic setting of order sizes greater than
one, the authors prove an optimal way of backorder clearing.
The work ofTeunter and Klein Haneveld (2008) includes an up-to-date liter-
ature review and classification of inventory rationing models. Additionally, the
authors propose a dynamic rationing model with two customer classes taking
into account the remaining time until the next customer order arrives. The
authors mention the easy implementation of their approach as rationing levels
are provided in charts and lookup-tables.
Table 4.3 gives an overview about models on IR. Although the mentioned
papers in the table are not exhaustive, it represents an overview about current
research in this field. The papers in the table suggest that there is a further
distinction in research between papers considering two customer classes and
papers considering more than two classes. Ha (1997b) explains this when he
states "as the number of customer classes increases, the optimal policy will be
difficult to compute because of the curse of dimensionality and will be even
more difficult to implement". For practical applications, many of these models
are tailored to a specific problem and usually not applicable in general settings
considered by APS.

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4.3 A SELECTED ALLOCATION AND ORDER PROMISING MODEL 51

4.3 A Selected Deterministic Allocation and Order

Promising Model
In this section we discuss the work of Meyr (2009) in which an LP model
for demand fulfillment is presented which is the building block for the later
developed stochastic models of Chapter 5. The author distinguishes between
two different types of models: models with customer segmentation and models
without customer segmentation. The models support the demand fulfillment
functionality of APS as described in Sect. 2.2. They receive the ATP informa-
tion from a production planning module and promise due dates to incoming
customer orders as shown in Fig. 4.2. In the following, we provide a mathe-
matical formulation of these models. In addition, we propose a classification
of search rules for ATP consumption which consume allocated ATP quantities.
Due to an aggregated or disaggregated consumption of aATP quantities, we
analyze how far these rules are applicable in stochastic environments.

without customer segmentation with customer segmentation

~:;;:;:,T
once for supply planning
(e.g. production planning)
onca I supply planning 11 demand planning I
ATP\ j,orecasts
r ------ I

ATP allocation :

l
once
GOP.BOP ATP consumption
("allocation planning". AP) i
I
FCFS ("order promising") allocated ATP !
(=quotas for :
customer ]
order(s) ( ) commitment(s) classes k) :

rea~time I "customer" I
real-time ___ ATP consumption (SOPA) _ I
J

GOP:
BOP:
once for all orders of the planning horizon T
several times for all orders of a batching
:~~~ ( )oo~~~ent
horizon B<T
FCFS: in real-time for each single order real-time I"customer" I
Figure 4.2: Modeling Environment (Meyr, 2009)

4.3.1 Models Without Customer Segmentation

The following basic order promising model without customer segmentation
assigns customer orders to ATP quantities according to profitability. In order
to model the successive arrival of customer orders the proposed LP formulation
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52 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

orders in iteration s and distinguishes accordingly between three different cases:

(1) if the model is executed after each order, i.e., J• contains only the new
order, the model resembles an FCFS policy. One can imagine that this model
does not lead to an optimal profit as customers with a low level of profitability
might buy units better kept for later arriving high margin customers. (2)
If the model is executed after a certain reasonable amount of time, i.e., J•
contains all orders arrived in that certain time period, the approach is called
batch order processing (BOP) referring to a batching horizon B in which the
orders are collected to be processed in the next run. (3) If the batching horizon
equals the total planning horizon, the model is not executed until all orders
are known. This approach results in an optimal solution and is therefore called
global order processing (GOP). The following equations show the basic order
promising model:
T+l
max LL Pit oft (4.1)
iEI' t=l

subject to
T+l
Loft = q; 'vi E /" (4.2)
t=l

L oft s; AT Pt" Vt = 1, ... , T. (4.3)

iEI'

The objective function 4.1 maximizes the profit over the planning horizon
when satisfying the orders of set /8. The profit Pit includes the revenues Pi
generated by the customer i minus optional backlogging costs b; or holding
costs h, i.e., Pit= Pi - h(di - t) if the required delivery date di of the order is
after the fulfillment date t and Pit = Pi - bi(t - di) in case of a late delivery
(and Pit = Pi otherwise).
The model includes two constraints. 4.2 guarantees that the total quantity
q; of each order is fulfilled (either from real supply or from the infinite supply
of period T + 1). 4.3 guarantees that, in each period, not more than the total
supply AT Pt is assigned to all orders.
In the cases of BOP or FCFS where several iterations are executed, the ATP
quantity has to be updated after each iteration in order to cope for already
assigned demand quantities. This step corresponds to the previously described
Netting activity (see Sect. 2.2). Formally, the ATP quantities are updated
after iteration s with the following formula: ATPt+ 1 = AT Pt" - I::iEI' oft Vt =
1, ... , T. Table 4.4 summarizes the used symbols and notation.
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4.3 A SELECTED ALLOCATION AND ORDER PROMISING MODEL 53

Table 4.4: Notation of the Basic Order Promising Model

Indices:
s = 1, ... , S Iterations
t = 1, ... , T + 1 Periods of the planning horizon (T +1: dummy period)
i = 1, ... , I Customer orders
J• Set of orders that are promised in iteration s
Decision variables:
oft ? 0 Part of order i which is served by ATP of period t and
promised during iteration s
Data:
ATPt" Not yet assigned supply that becomes available in pe-
riod t and can still be promised to customers during
iteration s
q; Requested order quantity of order i
Pit Per unit profit of order i if satisfied by ATP of period
t
Pi Per unit revenue of order i
d; Requested delivery date of order i
b; Per unit and period backlogging costs of order i
h Per unit and time holding costs

For the sake of comparability with the ongoing development of stochastic mod-
els, we slightly reformulate the basic order promising model. In the current
formulation, holding and backlogging costs are part of the profit term Pit· This
leads to the situation that the costs are only charged when a customer order
is fulfilled. In case of backlogging, this seems intuitive, but not for holding
costs. Therefore, we introduce a fictitious order ¢ with a delivery date d<I> = T
where all remaining quantities of ATP are assigned to. The profit term P<t>t
only includes the holding cost term, i.e., P<t>t = -h(T - t). The adapted order
promising model can be stated as

L
T+l
max LPitOf1 (4.4)
iE/'U<f> t=l

subject to
T+l
Loft = q; Vi E /" (4.5)

L
t=l

oft = ATPt" Vt = 1, ... , T. (4.6)

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54 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

Table 4.5: Notation of the Network Flow Model

Indices:
I/ Set of orders i with a desired delivery date in period t
Decision variables:
Downstream flow of inventory in period t and iteration
s
Yl ~ 0 Upstream flow of inventory in period t and iteration s
zf ~ 0 Lost sales quantity of order i and iteration s
Data:
b Per unit and period backlogging costs (independent of
order i)

Note that the original and the adapted formulation result in equal profits
in case of high scarcity (for which the model was intended). Even if large
LP models can be solved with modern LP solvers, calculation time increases
rapidly when solving the GOP model. Especially in the rolling horizon simula-
tions of Chapter 7, the problem size gets very large. We propose a network flow
formulation of the above adapted order promising model that can be solved for
larger instances within a reasonable time. However, this model comes with the
disadvantage that the backlogging costs are not order dependent and, there-
fore, have to be changed to b. Additionally, this model is not able to show
from which ATP quantity a certain order is fulfilled.
For the mathematical model formulation, we define a subset It ~ I" with
It:= {i E I"jd; = t} as the set all orders i EI• with a desired delivery date in
period t. The network flow order promising model is henceforth given as
T+I
max LP;(q; - zt) - L (hx: + by:) (4.7)
t=l

subject to

x:+i - Yf+ 1 - x: + Yt = ATP/ - L (q; - zt) Vt= 1, ... , T (4.8)

iEit

zf ~ q; Vi= 1, ... ,I" (4.9)

xf = 0, yf = 0, Yr+i = 0. (4.10)

The symbols and notation of the network flow problem are shown in Table 4.5.

The objective function 4.7 maximizes the profit

Rainer resulting
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4.3 A SELECTED ALLOCATION AND ORDER PROMISING MODEL 55

ties flow downwards (i.e., to later periods) holding costs are charged. If the
flow goes to the opposite direction, backlogging costs are charged. The inven-
tory balance constraint 4.8 controls the flow between the periods. Incoming
quantities are consisting of the current period's ATP quantities (ATPt), the
downstream flow from the previous period ( x:) and the upstream flow from the
next period (Yt+1)- Outgoing quantities are consisting of the downstream flow
to the next period (xf+ 1 ), the upstream flow to the previous period (y:) and the
flow to the orders arriving in this period (minus lost sales) O:::iel'I (q; - z:)).
Fig. 4.3 illustrates the flow of quantities. The further constraints in 4.10 set
the initial quantities of the first and last period. x! can also be used to set the
initial inventory.

Figure 4.3: Illustration of the Inventory Balance Constraint

4.3.2 Models With Customer Segmentation

The models with customer segmentation try to overcome the disadvantages of
the previous models. In case of FCFS, it is not guaranteed that a reasonable
solution is reached. BOP models overcome this drawback but result in longer
waiting times for the customer (as due dates are not determined until the
end of the batch interval is reached). The general structure of models with
customer segmentation is shown on the right side in Fig. 4.2. These models
usually follow a two-step approach: in a first step ( allocation planning), quotas
are assigned to a given number of customer classes based on ATP quantities
and demand forecasts. In a second step (ATP consumption), the quotas are
consumed in real-time by incoming customer orders.
In the following, we present an approach by Meyr (2009) based on an LP
model. Instead of a rule-based approach to determine the quotas (as described
in Section 2.3.2), the author proposes a model allocating ATP quantities ac-
cording to the profitability of customer classes. The determined quotas in the
AP step are subsequently called aATP. Rainer Meyr Quante
(2009) -uses the acronym SOPA
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56 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

Table 4.6: Notation of the Allocation Planning Model

Decision variables:
Zktr z O Part of demand of priority class k in period r which is
satisfied by ATP of period t
ft ~ 0 Still unallocated part of ATP of period t
Data:
dmin
kT Lower bound on sales to priority class k in period t
dmax
kr Upper bound on sales to priority class kin period t
Pktr Per unit profit if ATP of period t satisfies demand of
priority class k in period r

With the symbols and notation of Table 4.6 we can formulate the allocation
planning model as
K T+l T
max LL L PktrZktr (4.11)
k=l t=l r=l

subject to

L
T+l
d'l:,/:n ::; Zktr ::; df:/x Vk, T = l, ... , T (4.12)
t=l
K T
LL Zktr + ft = ATP/ Vt = 1, ... , T. (4.13)
k=l r=l

The profit resulting from allocating ATP quantities to customer classes is

maximized in the objective function 4.11. Differently to Pit in the basic or-
der promising model, the profit term Pktr represents the profit of a customer
class and not an individual order. Meyr (2009) suggests to calculate Pktr as
the average profit of all orders assigned to customer class k. Constraint 4.12
assures that not more than the maximum expected demand is allocated to a
customer class and period (or not less than the minimum, respectively). In this
constraint, the demand forecasts generated by the demand planning activity
are considered in the model. Constraint 4.13 restricts the allocated quantities
to the available ATP.
In the following, we show how the quotas or aATP quantities, respectively,
can be extracted from the optimal solution of the AP model, denoted by"*".
Meyr (2009) proposes two different granularities of aATP quantities. Firstly, a
fine granularity in which the aATP quantities are structured according to the
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4.3 A SELECTED ALLOCATION AND ORDER PROMISING MODEL 57

to a time slot T. The aATP in this granularity can directly be taken from the
optimal values of the decision variables Zkt-r as shown in 4.14.

aAT P1i., := zZt-r Vk, t, T. (4.14)

The second granularity represents an aggregated version of the aATP quan-

tities in which the time slots T are aggregated to one time period. Equation
4.15 shows how the aggregated aATP quantities are extracted from the opti-
mal values of the decision variables Zkt-r• This version especially makes sense
when forecast accuracy is low and the allocation of ATP to certain time slots
results in poor profits. The proposed aggregation provides a way to compen-
sate forecast errors. However, this aggregation allows customers to consume
ATP quantities far away from their desired delivery date.

L
T
aAT P1i := zZt-r Vk, t. (4.15)
-r=l

Additionally to the aATP quantities, the AP model might also result in unal-
located ATP, e.g., when the maximum expected demand is low in comparison
to available ATP. These quantities are henceforth called uATP as shown in
4.16.

uAT P/ := ft Vt. (4.16)

The second step of the SOPA approach processes the incoming customer
orders in real-time according to the aATP quantities. Let 2; be the set of
accessible priority classes from order i. Additionally, let i(s) denote the current
(and only) order processed in the iteration step s. Accordingly, we define the
order processing model as
T+l T
max L L Pi(s),tott + L Pi(s),tx: (4.17)
kE2:i(a) t=l t= 1

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58 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

Table 4.7: Notation of the SOPA Model

Indices:
Set of priority classes which can be consumed by order
i
Decision variables:
oj.t~ 0 Part of allocated ATP of period t for priority class k
which is in iteration s assigned to order i( s) showing a
desired delivery date d;(s)
X8 > 0
t -
Part of unallocated ATP of period t which is in itera-
tion s assigned to order i (s) showing a desired delivery
date d;(s)

ATP that becomes available in period t and has been

allocated to orders in priority class k with a requested
delivery date in period r
uATP/ ATP that becomes available in period t but has not yet
been allocated to any priority class or planned delivery
date
i(s) The (single) order considered in iteration s

subject to
T
LL
T+l
0 i.t + Lxf = qi(s) (4.18)
kE3;(,) t=l t=l

oi.t S aAT pktd;(,) Vk E 3i(s)' t = 1, ... , T (4.19)

xf s uATP/ Vt= 1, ... , T. (4.20)

Table 4. 7 summarizes the symbols and notation of the above model. 4.17
maximizes the profit of the quantities assigned to order i(s). 4.18 guarantees
that the assigned quantities to order i(s) are equal to the demand (if not
enough supply is available, the order is fulfilled from the fictitious supply of
period T + 1). 4.19 and 4.20 restrict the consumed quantities of order i(s) to
the available allocated and unallocated quantities. The SOPA model takes as
input a given number of customer classes and corresponding assignments of
orders to classes. The assignment of orders to classes has to be done before
the actual order arrives, otherwise the SOPA approach will not work. As this
seems to be confusing on the first sight, Meyr (2009) argues that not a single
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4.3 A SELECTED ALLOCATION AND ORDER PROMISING MODEL 59

order. Long-term relationships between vendors and their customers usually

make it possible for such an assignment to be done before the actual order
processing starts. All orders i of a customer assigned to class k are then also
part of this class. The set 3; of accessible classes of order i includes at least
the class of the customer posting the order i, but might be extended when
a customer is allowed to consume quantities of lower classes. Meyr (2009)
analyzes which approaches perform best.
As the above order processing model solves an LP for each single order
that arrives, it seems reasonable for practical implementations to mimic the
SOPA search process through the aATP quantities by using simple rules. A
description of such rules can be found in the following Section 4.3.3.
A remaining task is still to determine an appropriate number _of customer
classes k. As the number of classes gets larger, a finer determination of quotas
is possible. However, the demand forecast d'!:-rax becomes less accurate with
increasing k. As this is a medium-term planning task and is usually not part
of the short-term demand fulfillment, we will not focus on this trade-off but
nevertheless provide some insights to this problem in the numerical studies of
Chapter 7.
The benefits of SOPA result from the immediate response to customer re-
quests and the ability to increase profitability by selecting among customer
classes. The major drawback of this model is the negligence of demand vari-
ability as it assumes demand as deterministic.

4.3.3 Search Rules for ATP Consumption

This section builds on the model described in Sect. 4.3.2, but instead of using
an LP for the ATP consumption step, simple rules are proposed. The rules
take as input the aAT P quantities generated in the Allocation Planning step.
The presented rules emulate the order processing step for the disaggregated
aAT P quantities (cf. Equation 4.14) and for the aggregated quantities (cf.
Equation 4.15). Additionally, we show a modified rule adapted to the specifics
of stochastic environments.

Disaggregated Single Order Processing

The search rule presented in this section takes as input the disaggregated
quantities aAT PftT. When not otherwise stated, we use the notation of Section
4.3, hence i(s) denotes the currently processed order. The order is allowed to
consume aAT P quantities from its own and lower priority classes reserved for
the requested delivery date d;(s)· The search rule and the order of execution is
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60 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

7 = dI(s)

t T

Figure 4.4: Rule-Based Order Processing (Disaggregated)

in quantities reserved for the requested delivery date ( T = d;(s)) and moves
through the availability times starting at the delivery date (t = d;(,)) (cf. G)),
then before (t < d;(s)) (cf. ®) and then after the delivery date (t > d;(s))
(cf.®). Then it searches through all availability times in lower classes (cf. ©)
at the delivery date. If not all requested quantities can be fulfilled, it is searched
through the unallocated quantities available at the delivery date of the order,
then through quantities available prior to the delivery date and then through
the quantities available after the delivery date.

Aggregated Single Order Processing

In contrast to the disaggregated aAT P, the quantities reserved for a specific

period r are aggregated and can be consumed by all incoming orders. The
corresponding aggregated search rule hence merely searches in the dimensions
t (availability time of ATP) and k (customer class). Again, consumption of
quantities from lower classes is allowed. The search procedure is depicted in
Fig. 4.5. In order to prevent high backlogging costs, the search rule starts
searching through those quantities available at the requested delivery date
of the order (t = d;(s)) (cf. G) ). If there are no quantities available in the
orders own priority class, then the search moves to lower classes (cf. ®). If
the order is still not completely fulfilled, the search goes to ATP quantities
(of the orders own priority class) available before the delivery date ( t < d;(s))
(cf. ® ). The search is repeated for aAT P quantities reserved for lower classes
and available before the delivery date. If there are still quantities requested,
it is searched through the aAT P quantities available after the delivery date
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4.3 A SELECTED ALLOCATION AND ORDER PROMISING MODEL 61

t=l T

Figure 4.5: Rule-Based Order Processing (Aggregated)

classes. If not all requested quantities can be fulfilled, it is searched through

the unallocated quantities as described in the previous section.

A Classification of Search Rules

We have seen two different search rules that mimic the behavior of the order
processing model of Sect. 4.3.2. In order to classify different search rules and
their performance in stochastic environments, we propose a classification of
search rules according to the following set of attributes. All search rules are
based on the disaggregated aAT P quantities of Equation 4.14.
First, we distinguish search rules according to the attribute nested aATP. If
the search is nested, consumption of quantities from lower classes is allowed.
The second and third attributes concern the aggregation according to the
requested delivery date of the order. As in the case of the search rule described
4.3.3, an order is only allowed to consume quantities reserved for the order's
own delivery date. However, as backlogging of orders is usually much more
expensive than an early availability of goods (and associated holding costs),
we distinguish the aggregation according to quantities reserved for periods
after the delivery date of the current order and quantities reserved for periods
before the delivery date. These attributes are called aggregate future aAT P or
aggregate past aAT P, respectively. For instance, in case aggregate Ju.tu.re aATP
is not, but aggregate past aATP is allowed, an order is allowed to consume all
quantities reserved for periods at and prior to its delivery date. In this way,
the expensive backlogging of orders is limited to a minimum. If both attributes
are set to true, then the order is allowed to consume both quantities, prior to
and after the requested delivery date.
Since the allocation planning step might also result in unallocated ATP
quantities (uAT P), search rules have to define how these quantities are con-
sumed. Since uAT P is allocated to neither delivery dates nor customer classes,
the only way to differentiate it is the availability time. The attribute future
uATP available states whether uAT P available after the delivery date of the
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62 CHAPTER 4 DM MODELS IN MTS MANUFACTURING

Table 4.8: Classification of Search Rules

Attribute SOPA D SOPA A

nested aATP ✓ ✓
aggregate future aAT P ✓
aggregate past aAT P ✓
future uAT P available ✓ ✓

According to these attributes, we classify two different search rules. First, we

denote the search rule of Sect. 4.3.3 as SOPA_D, referring to a disaggregated
single order processing after allocation planning. As access to lower classes is
allowed, nested aATP is set to true. Accordingly, aggregate future/past aATP
both are set to false, as only the quantities reserved for the delivery date can
be consumed. Also, future uATP available is set to true as consumption of all
unallocated quantities is allowed.
Second, we denote an aggregated version of SOPA as SOPA_A. This rule
resembles the search rule described in Sect. 4.3.3, but is slightly different. In
contrast to Sect. 4.3.3, SOPA _ A takes as input the disaggregated aAT P quan-
tities (cf. 4.14), but is allowed to consume all quantities reserved for periods
prior and after the requested delivery date. The search proceeds as follows:
First, SOPA_A searches through the disaggregated quantities like the rule
SOPA_D. Then it moves to quantities reserved for periods prior to the deliv-
ery date (T < d;(s)). Afterwards, it searches through quantities reserved for
periods after the delivery date. An overview of the discussed search rules is
given in Table 4.8.

4.4 Summary

The discussion of selected papers revealed that only very little research exists
for the specific setting described in this work. When it comes to stochastic
approaches, nothing was found so far. The literature on TRM features many
papers with a manufacturing focus, but nearly all models are developed for an
MTO setting. There was only one paper considering stochastic demand and
a similar setting as ours (Pibernik and Yadav, 2009), but it differs in terms
of focusing on a service level objective. The manifold literature on inventory
rationing shows that there is much research in this field, but usually the ap-
proaches are adapted to very specific settings and not generally applicable.
This is-on the other hand-the advantage of aATP models, as they are de-
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4.4 SUMMARY 63

in order to preserve general applicability. Thus, these models still offer many
possibilities for further improvements.

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Chapter 5

New Demand Management Approaches

In this chapter, we address the identified shortcomings of the TRM, aATP and
IR models and show new approaches designed specifically for the characteristics
of MTS manufacturing. First, we show an approach based on revenue manage-
ment ideas and show the optimal demand fulfillment policy. However, for large
problem sizes this approach soon reaches its limits since it requires extensive
calculation time. In addition, we propose an approximative model based on
an adapted version of the SOPA approach which uses ideas from the network
revenue management literature, called randomized linear programming (RLP).
Due to the high applicability of LP models, randomized linear programming
combines a conventional LP with stochastic demand information.

5.1 A Revenue Management Approach

5.1.1 Model formulation

Recall our setting of a make-to-stock manufacturing system facing demand

from multiple customer classes. Customer classes differ in the price per unit
that they pay. Scheduled inventory replenishments are known. Given this in-
formation, the manufacturer decides for each order whether to satisfy it from
stock, backorder it at a penalty cost, or reject it. The objective is to maxi-
mize profit over a finite planning horizon, taking into account sales revenues,
inventory holding costs, and backorder penalties.
In order to achieve this goal the manufacturer has to make a trade-off for
each order whether to satisfy it or whether to save the supply for potentially
more profitable future orders. We make the following assumptions to model
this situation.

Assumption 5.1. Orders from a given customer class follow a compound

Poisson process. The order processes of different classes are mutually indepen-
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66 CHAPTER 5 NEW DEMAND MANAGEMENT APPROACHES

Let >. denote the expected number of orders of the Poisson process in a given
period, then the probability that exactly k orders arrive can be calculated with
>,.ke->.
J(k, >.) = ---,a-· (5.1)

The Poisson assumption is common in many RM models, specifically in so-

called dynamic demand models (see Talluri and van Ryzin (2004)). As Laut-
enbacher and Stidham (1999), we allow non-unit order sizes, which appears
appropriate in a manufacturing environment. In our analysis, we discretize
the planning horizon in such a way that the probability of receiving multiple
orders within a single period is negligible. Let T denote the length of the
planning horizon and t the period index. Moreover, let c = 1, ... C identify
the different customer classes.
Assumption 5.2. Inventory replenishments are exogenous and known.

This assumption reflects the APS planning hierarchy. Inventory replenish-

ments are determined in mid-term and short-term production planning and
then serve as input for order promising decisions. Let X; be the available sup-
ply arriving at the beginning of period i, i = 1, ... , T and let x. = (x 1 , ... , xr)
be the vector of all of these replenishments. Note that at time t, x; corresponds
with inventory on-hand if i ~ t and with a future scheduled replenishment oth-
erwise. In APS terminology, x denotes the ATP quantities.
Assumption 5.3. Order due dates are equal to order arrival times, but orders
can be backlogged at a price discount.

This assumption reflects the MTS context. Customers expect immediate

delivery, in principle. Late deliveries are only acceptable at a price discount.
Let re denote the unit revenue from satisfying an order of class c from stock.
Delaying an order gives rise to unit backorder costs b per period. Analogously,
holding costs h are incurred for all units of inventory on hand at the end of a
period. Note that unit backorder and holding costs are independent of time
and customer class.
Assumption 5.4. Partial order fulfillment is allowed.

This assumption includes splitting an order for partial delivery in different

periods. This is a technical assumption, which we need for tractability. We
discuss its impact and potential relaxations later on. Let d denote the order
quantity, u; the amount of supply arriving in period i used to satisfy a given
customer order, and let fl = (u 1 , ... , ur). Note that for an order arriving in
period t, u; corresponds with delivery from stock if i ~ t and with backlogging
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5.1 A REVENUE MANAGEMENT APPROACH 67

Table 5.1 summarizes the above notation. We can now formulate our prob-
lem as a stochastic dynamic program with state variable x and decision variable
u. In principle, one can drop all entries from these vectors, for which x; = 0.
I.e., the dimension of the state space corresponds with the number of sched-
uled replenishments. However, for ease of notation we use x and il as defined
above.
The profit Fi(x, d, c, u) earned in period t depends on the available supply,
order size, customer class, and fulfillment decision as follows

L Uj - b L u;(i - t)(l - 8it) - h L(X; - U;)8it,

T T T
Fi(x, d, c, u) = Tc (5.2)
i=l i=l i=l

where 8;t is defined as 1 if i ~ t and 0 otherwise, and il has to satisfy u; ~ x;

for all i and L; u; ~ d.
The first term in Equation 5.2 calculates the revenues received from satisfy-
ing the current order of class c. The second term computes backlogging costs
that occur when using supply that arrives later than the customer order, i.e.
when 8it = 0. These costs are computed for the total length of the delay (i-t).
The third term represents holding costs that are charged for the on-hand in-
ventory at the end of period t. Note that unlike the backlogging costs, which
are charged for the total customer waiting time, holding costs only cover the
current period t. To simplify subsequent calculations, we define Pi(i, c) as the
incremental profit per unit of supply i used to satisfy one unit of an order of
class c in period t. Collecting the terms in Equation 5.2 that depend on u;
yields

Pt(i, c) = Tc - b(i - t)(l - 8it) + h8;t (5.3)

and

= L Pt(i, c)u; - L x;8it.

T T
Fi(x, d, c, u) h (5.4)
i=l i=l

In addition to the current period's profit, we also have to take into account
the impact of a fulfillment decision il on future profits. The state transition is
given by x .- x-il = (x 1 -u1, ... , xr-ur ). Letting ½(x) denote the maximum

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68 CHAPTER 5 NEW DEMAND MANAGEMENT APPROACHES

Table 5.1: Notation of the Revenue Management Approach

Indices:
t = 1, .. . ,T Periods of the planning horizon
i = 1, ... ,T Period of inventory replenishment
State variables:
x=(x1, ... ,xr) Vector of available supply quantities
Decision variables:
ii=(u1, ... ,ur) Vector of supply quantities used to fulfill a given order
Random variables:
C Customer class
d Order quantity
F(c, d) Joint CDF of customer class c and order quantity d
Data:
re Unit revenue from customer class c
b Unit backorder costs per period
h Unit holding cost per period

expected profit-to-go from period t to the end of the planning horizon T for a
given supply vector x we then obtain the following Bellman recursion

with the boundary condition Vr+ 1 (x) = 0.

5.1.2 Structural properties and optimal policy

We now analyze structural properties of the value function of the dynamic
program defined in the previous section. This will then allow us to character-
ize the optimal fulfillment policy. All proofs of this section are given in the
appendix. We start by defining marginal profits:

Definition 5.1. ~;½(x) := ½(x) - ½(x - e;) for x; 2: 1,

where e; denotes the i-th unit vector. Rainer

Definition 5.1 concerns the expected
Quante - 978-3-631-75386-6
marginal value of a unit of supply arriving in period i or, 05:39:20AM
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5.1 A REVENUE MANAGEMENT APPROACH 69

opportunity costs of selling this unit. Using this definition, we can rewrite the
Bellman recursion of Equation 5.5 as follows.

V,(X) - E,,, 0 L.,,:i;'., ~" { t,(u,P,(i, c) - hx;O;,) + v,., (X -U)}]

- E,, 0 [".,,:;!;'., .,,, {t,(u,P,(i, c) - hx;O;,)

+Vi+1(x) - t f: ~;Vi+1 (x - e;(z - 1) - f (eiui)) }]

ht,
1=1 z=l J=l

- V,.,(x) - x; + E,_ 0 ["<.,,.:[, t, (t.(

••<' { P,(i, c)

-~;l/i+ 1 (x - ei(z - 1) - ~(eiui)))}] · (5.6)

Note that this formulation decomposes ii, into single-unit steps. In this way,
the maximization in Equation 5.6 reflects the trade-off between the profit of
selling a unit of supply now and the corresponding opportunity cost. Also
note that a similar decomposition is well-known for the classical single-leg
airline yield management problem (see Talluri and van Ryzin (2004), page 59).
What is different in Equation 5.6 is the summation over i, which introduces
an additional dimension into the problem.
We now identify properties of the value function that help us evaluate the
above maximization expression. The first step is to compare the marginal
values of supplies arriving in different periods.

Proposition 5.1. For all m < n and for all x with Xm, Xn 2". 1 the value
function satisfies:
a) ~m Vi(x) - ~n Vi(x) $ b(max(n, t) - max(m, t))= b(n - m + 6nt(t - n) +
6mt(m - t))
b} Vi(x + em) - Vi(x +en)$ b(n - m + 6nt(t - n) + 6mt(m - t)).

Proposition 5.1 states that the difference between the marginal value of one
unit of a supply arriving in period m and one unit arriving in period n is
bounded by the difference in backordering costs of using each of these supplies
in period t. This relationship implies the following important monotonicity
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70 CHAPTER 5 NEW DEMAND MANAGEMENT APPROACHES

Proposition 5.2. For all m < n and for all x with Xm, Xn ~ 1 it holds that
Pt(m, c) - ~m ½+1 (x) ~ Pt(n, c) - ~n ½+1 (x), Ve.

The terms on the left-hand-side of the inequality can be interpreted as the

net benefit of the current revenues from selling a unit of supply arriving in
period m minus the opportunity cost of not having that unit available in
the future. Proposition 5.2 states that this net benefit is decreasing in the
arrival time of the supply. Therefore, an order should always be either fulfilled
using the earliest available supply or not at all (if the left-hand-side becomes
negative). The next important property concerns the concavity of the value
function along certain axes.

Proposition 5.3. Let x be such that L; x; ~ 2. Furthermore, let m =

min{ilx; > 0} and let n = m if Xm > 1 and n = min{ili > m, X; > 0}
otherwise. Then
Pt(m, c) - ~m ½+1 (x) ~ Pt(n, c) - ~n ½+1 (x - em), Ve.

Proposition 5.3 implies in particular that the value function ½ is concave in

the quantity of the earliest available supply. This is intuitive since one would
expect available supply to have decreasing marginal benefits.
The above properties allow us to characterize the optimal fulfillment pol-
icy. The optimal policy turns out to be a generalization of the well-known
booking-limit policies in traditional revenue management (Talluri and van
Ryzin (2004)). We summarize this result in the following theorem.
Theorem 5.1. Define the following set of critical levels:
For i = 1, ... , T let fj; = x - I::t= 1 ekxk,
and let Lt(c,i,fj;) = max{k!Pt(i,c) < ~i½+1(Y; + ke;)}.
Then the following fulfillment decision is optimal in period t, given an order
quantity d from customer class c:
Start with i = 1;
0);
set u; = max ( min ( X; - Lt(c, i, y;), d - I::t-:,11 Uk) ,
if u; < x; set uk = 0 for all k > i and stop, otherwise repeat for i+ 1.

Intuitively, this policy successively consumes units of supply, in the order of

their arrival, until the immediate marginal profit drops below the opportunity
costs. This very much resembles a traditional booking-limits policy. The values
Lt(c, i, .) set nested protection levels that bar some amount of supply i from
consumption by classes c and higher. Note that we have separate protection
levels for each class and supply arrival. Also note that the protection levels of
supply i depend on the available quantities of subsequent arrivals Yi· However,
Lt(c,i,.) is independent of x; (and of all earlier arrivals xi for j < i) and
Rainer Quante - 978-3-631-75386-6
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5.1 A REVENUE MANAGEMENT APPROACH 71

120 ,-----------------.=====:;i
• • • -c2. 12=0
--cJ.12=0
100 . . . . -c2.12=50
-cJ,12=50
• .... -c2. •2=100
--c3. ,2=100

0 1 2 3 4 5 6 7 B 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 "D
Pertod

Figure 5.1: Non-Increasing Protection Levels

Lt(c, i, .) is available for consumption by customer class cat time t. It is worth

pointing out that even the most valuable customer class, i.e. c = 1, may face
non-trivial booking limits for future supplies, i.e. for i > t: While this class
can always consume supply on hand it is not necessarily optimal to backlog
demand from this class, due to the incurred backorder penalties. We illustrate
the various protection levels Lt(c, i, .) graphically in an example in the next
section.
The following proposition shows that, as in the classical case, protection
levels decrease in time. This is intuitive since a shorter remaining planning
horizon implies less selling opportunities and therefore available supply is of
less value. It is worth mentioning, however, that this result is only true for
stationary demand. Unlike in traditional revenue management models, the
holding cost term in our model may destroy the monotonicity of the protection
levels if the demand distribution changes across periods.
Proposition 5.4. The protection levels Lt(c, i, y;) defined in Theorem 5.1 are
non-increasing in t.

5.1.3 A Numerical Example

Fig. 5.1 illustrates the protection levels of supply one for different customer
classes and different levels of the second supply. For example, the line" c2, s2 =
O" shows the protection levels for class two and no remaining quantities of the
second supply. In the first period, 31 units of supply one are protected from
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72 CHAPTER 5 NEW DEMAND MANAGEMENT APPROACHES

1200

1000
------ - - - - ------- ..
800

><
-;:: 600
>
400 --s2=0
-s2=10
-s2=20
200
- - - -s2=30
- - -s2=100
0
0 10 20 30 40 50 60 70 80 90 100
Supply 1

Figure 5.2: Concave Value Function

decreases as times goes on, the protection levels decrease. At the end of the
planning horizon (period 27), no supplies have to be protected anymore. As
seen in Proposition 5.4, protection levels are non-iJ!creasing in time.
Proposition 5.3 states that the value function is concave. This behavior is
illustrated in Fig. 5.2 which shows the values of ½(x) in period 27 for different
remaining quantities of the second supply. In case of s2 = 0 and small amounts
of the first supply, each additional unit of supply one contributes much to the
expected profit which explains the huge slope of the line from s1 = 0 to
20. After the maximum is reached the slope of the line becomes negative as
holding costs are expected that reduce the expected profit. In the extreme
case of s2 = 100 each additional unit of supply never contributes in a positive
way to the profit and the line steadily decreases.

5.2 Approximations Based on Linear Programming

The idea behind the models presented in this section originates from the work
on network revenue management, as described in Talluri and van Ryzin (2004).
In network revenue management, resources are bundled together to form the
products that customers buy. As an example, airlines offer so-called origin-
destination-fares (ODF), wich often consist of several single flight legs. The
complexity of network RM results from the fact that single flight legs might be
Rainer Quante - 978-3-631-75386-6
part of more than one ODF. If two customers want
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5.2 APPROXIMATIONS BASED ON LINEAR PROGRAMMING 73

for example the first customer from Vienna to Chicago over Amsterdam and
the second customer from Vienna to Amsterdam, it has to be decided which
customer brings more profit.
Many factors contributed to the development of these approaches. First, op-
timal solutions of realistically-sized networks can not easily be computed as the
curse of dimensionality prevents fast computations. Second, as airlines usually
have an enormous amount of demand information available, approximating
the optimal solution via deterministic approaches would simply mean a waste
of resources. Third, methods of linear programming are known to be efficient
and are easily to be implemented. As an introduction to the randomized linear
programming approach of Section 5.2.2, we first introduce a deterministic lin-
ear programming model (DLP) which also serves as an approximation method
to the optimal solution but does not take into account demand variability.

5.2.1 Deterministic Linear Programming

The following deterministic linear programming model resembles the alloca-
tion planning model described in Sect. 4.3.2, only differing in the demand
constraint (5.8). Instead of restricting the allocated quantities to the demand
forecast, the deterministic linear program uses the expected demand E [dkT]
and is formulated as shown in the following.
K T+l T
max LL L>ktrZktr (5.7)
k=I t=I T=I

subject to
T+I
a'!::n ~ LZktr ~ E[dkr] Vk,r = l, ... ,T (5.8)
t=I
K T
LL Zktr + ft = ATP/ Vt = 1, ... , T. (5.9)
k=I r=I

Despite the fact that the DLP is very efficient to solve and is easily appli-
cable in practical settings, it is not the final answer for stochastic problems as
it has an important disadvantage: the DLP neglects demand variations and
simply considers the expected demand. All information included in demand
distributions are not taken into account.
To illustrate the weaknesses of the DLP approach, consider a case with ex-
treme supply shortage, two customer classes and a large difference between the
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74 CHAPTER 5 NEW DEMAND MANAGEMENT APPROACHES

possible number of units to class one-as this is the most profitable class-
which equals the expected demand of this class. The rest will be allocated to
the less profitable class two. In the case that the demand of class one exceeds
the expected demand, the DLP results in poor profits since not all class one
customers are satisfied. The profit loss in not satisfying class one customers is
substantial as class two generates only very low profits compared to class one.
This example resembles the situation in the famous newsvendor problem.
Here, one has to decide how many newspapers to order on the day before the
actual demand is realized. It is assumed that the distribution of the demand
is known when the decision about the quantity is made. An intuitive solution
to this problem is to order exactly the expected demand as the probability
of resulting in too high or too low inventory is minimized. However, this
intuitive solution does not always yield the highest profit, only in case the
costs of having too much or too less are equal. In a situation in which it is
very important to satisfy all customers because costs for loss of goodwill are
high, the optimum order quantity will be higher than the expected demand.
In the following numerical example, we show that this argumentation is also
valid for a simple allocation planning and order promising problem.
Example 5.1. Consider a two-customer class problem with an expected de-
mand per period of class one and two of E[D] = 5. Available supply is 10 units
per period. For the sake of simplicity, all units that are not consumed are lost
at the end of a period. We consider three scenarios of different profitabilities:
(1) class one yields a profit of p 1 = 5, class two of p 2 = 1, (2) p 1 = 2 and
p2 = 1 and (3) p 1 = 1 and p 2 = 1. Furthermore, we illustrate the effects of dif-
ferent allocation strategies, from the one extreme making all units available to
the first class to the other extreme case of allocating everything to the second
class. We do not consider nesting, i.e. class one is not allowed to consume from
class two. To calculate profitability of each scenario and allocation strategy,
we simulated a Poisson distributed demand stream over 10, 000 periods.

DLP
300000-r---------:-------,

100000

ATP Oaa 1 / ATP' Cl•• 2

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Figure 5.3: DLP and the Quante
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5.2 APPROXIMATIONS BASED ON LINEAR PROGRAMMING 75

Fig. 5.3 illustrates the effects of the different allocation strategies. In case
of equal profitabilities, the best allocation strategy is the one from the DLP
approach, which means allocating the expected demand quantities. However,
if class one is more profitable as class two, it is beneficial to make more units
available to class one. In these cases, the DLP strategy does not perform
well as the optimum moves away from the expected demand quantities. These
results are in compliance with the previously discussed newsvendor problem.

5.2.2 Randomized Linear Programming

We have seen that the optimal solution may not be reached by simply inserting
the expected demand in the AP step. The RLP approach combines the easy to
use LP formulation of the DLP, and the available stochastic demand informa-
tion. The idea is to repetitively solve the DLP, not with the expected, but with
a random demand drawn from the known stochastic demand distribution. Let
Dir denote a random variable following a known stochastic distribution of the
demand quantity. Then we can formulate the randomized linear programming
problem as

LL LPktrZltr
K T+l T
Ht(Dlr) = max {5.10)
k=I t=I r=I
subject to

L zitr $ Dir 'vk,

T+I
d'/,';n $ T = I, .. •, T {5.11)
t=I
K T
'°''°'
~~
k=I r=I
Zktr + ft
i = AT ptI Vt = 1, ... , T. (5.12)

Note that the resulting optimal solution H;(Dir) is a random variable. The
optimal solution of the stochastic problem can be approximated by calculating
the expected value E[Ht"(Dir)J. We estimate the allocated quantities Zktr by
using the weighted average of the resulting quantities over N simulation runs,
as shown in 5.13.

(5.13)

In the subsequent numerical analysis of the RLP approach, we choose N =

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30 which showed robust results infrom
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76 CHAPTER 5 NEW DEMAND MANAGEMENT APPROACHES

the chosen parameters of Talluri and van Ryzin (1999, p. 213), although he
mentions that this behavior might also be problem dependent.
Numerical studies of RLP applications in the airline industry does not show
promising results. It is often the case that the DLP approach dominates the
RLP solution. De Boer et al. (2002) analyzed this result in more detail and
found an answer to this problem. The authors state that" . . . the observed dom-
ination of the deterministic model over probabilistic techniques is a fortunate
by-product of ignoring the uncertainty related to demand. This phenomenon
is based on nesting".
As the RLP approach is an alternative version for the allocation planning
step, we still have to decide about how to consume the resulting aATP quanti-
ties. In Section 4.3.3 we discussed different consumption rules and mentioned
that SOPA_D might be fragile to stochastic demand streams. In contrast,
SOPA_A aggregates the aATP quantities in order to compensate forecast er-
rors. Thus, we choose SOPA_D as the consumption rule after running the
RLP because RLP already considers stochastic demand.

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Chapter 6

Simulation Environment
In order to prepare the numerical studies of Chapter 7, we start by introducing
the developed simulation environment. We divide this chapter into two parts.
First, we discuss the technical settings and issues regarding the implementa-
tion, and second, we introduce the parameter set required to run simulations.

6.1 Technical Settings and Implementation Issues

6.1.1 Test Environment
All models and algorithms are part of a single simulation environment imple-
mented in C++ and compiled under Microsoft Visual Studio 2005. The LP
models (AP and GOP) are solved using the open source GNU Linear Pro-
gramming Kit (GLPK) version 4.28. The GLPK library is accessed over a
C++ interface in order to run a large number of simulations consecutively. All
simulations are executed on a standard PC with a 2.4GHz Intel Core 2 CPU
and 512MB memory.
Uniform random numbers are generated using the "Mersenne Twister'' algo-
rithm provided by the open source GNU Scientific Library (GSL) version 1.9.
In extensive simulations, it was realized that the standard C++ random num-
ber generator does not yield satisfying results, so we turned to the Mersenne
Twister algorithm described by Matsumoto and Nishimura (1998). To gener-
ate random numbers, we use the inverse transformation method: when X is a
random variable with a cumulative distribution function F, and U is a Uniform
distributed random number between O and 1, then X can be computed with
X = p- 1 (U).

6.1.2 Implementation Issues

As the implementation usually bears some complications, we illustrate the
RM approach of Section 5.1 in pseudo code. In particular, we show how to
compute the value function of Equation 5.5 which is required to compute the
critical levels Lt(c, i, fj;). The value function Vi(x) has to be computed for all
realizations of x in all periods t. As Vi(x) can only be computed when ½+1(x)
is known, the algorithm iterates from the last period T to the first period.
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78 CHAPTER 6 SIMULATION ENVIRONMENT

This step is illustrated in Algorithm 1. The algorithm recursion as shown in

Line 2 contains the iterations through x and is explained below.

Algorithm 1: Stochastic Dynamic Program

input : The ATP(t) quantities
input : The number of periods T
input : A zero-initialized capacity vector x
input : A zero-initialized vector Vt(x) for the value function
output: The vector vt(x) filled with the expected profit-to-go for each
realization of x
1 for t +- T to 1 do
2 recursion(O,t,x,vt(x));
send

Algorithm 2 shows a recursive iteration through all realizations of x. A recur-

sive algorithm is necessary because the number of periods T-and accordingly,
possible supply arrivals-might change from one run of the algorithm to an-
other one, and for each period a loop through the supply quantities arriving
in this and all other periods is required.
For each specific realization of x, the expected value Ed,c has to be computed.
This is done by iterating through all possible demand realizations d and c. As
the theoretical limit of d goes to infinity, we have to find an upper limit for d,
denoted by D. If the limit Dis chosen too high, the computation time is above
practical limits. If the limit is chosen too low, the results are not satisfying. In
all simulations in this work we chose a limit D such that 99.9% of all possible
values d are in the range between O and D. D can be computed easily with
the inverse transformation method: D = F- 1 (0.999).
In the following, we go through the steps of the algorithm and explain the
data variables. In Line 1, the algorithm iterates through the supply quantities
arriving in the period atp _arrival_ time. In Line 2, the current supply quan-
tity of ATP arriving in atp _arrival_ time is stored in the vector x. In the next
step, the stopping criteria is checked: when the last period is reached, there are
no further supplies to be considered. Prior to the last period, a new recursion
is started (Line 4) with the next arriving supply. At the time the stopping
criteria is met and the "else" sector is reached (Line 5), the vector x contains
the supply information of all arriving supplies. In the next steps, the expected
value is calculated by iterating through all possible demand quantities (Line
6) and customer classes (Line 7).
In Line 8, the policy of Theorem 5.1 is evaluated in the Function acceptance
Rule. An order is accepted stepwise as Rainer long as the profit is larger than the
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opportunity costs. Note that in this step, any other policy can
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6.2 SIMULATION ISSUES 79

Algorithm 2: recursion(atp_arrival_time, period, x, vt(x))

input : The atp _arrival_ time of the current considered ATP
quantity
input : The current considered period t
input : The vector of the current considered capacities x
input : A zero-initialized vector Vt(i) for the value function
output: The vector Vt(x) filled with the expected profit-to-go for each
realization of x in the current period t
1 for cap - 0 to AT Patp- arrival - time do
2 Xatp_arrival_time = cap;
s if atp _arrival_ time < T then
4 recursion(atp_ arrival_ time+ 1, t, x, Vt(x));
5 else
6 for d - 0 to D do
1 for c - 1 to C do
8 profit -acceptanceRule (x, d, c);
9 expprofit - expprofit+Prob(d, c) xprofit;
10 end
11 end
12 Vt(x) - expprofit;
ts end
14 end

e.g. FCFS or the SOPA approach. Therefore, we do not describe this step
in more detail. The function acceptanceRule returns the profit associated
with the fulfillment decisions of the current order represented by the demand
quantity d and class c. For each demand realization (possible values of d
and c), the probability Prob(d, c) is multiplied to the profit resulting from
the acceptance decision (Line 9). After the iterations through all demand
realizations, the profit-to-go for the current considered realization of vector x
is stored in Vt(x) (Line 12).

6.2 Simulation Issues

6.2.1 Data Generation
Kimms and Miiller-Bungart (2007) present a review on papers dealing with
demand data generation with a focus on different assumptions on demand. The
Rainer Quante - 978-3-631-75386-6
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80 CHAPTER 6 SIMULATION ENVIRONMENT

Poisson process is more or less standard nowadays". However, the Poisson

assumption requires that demand and variance are equal, which might not be
true in many applications. For instance, Lawless (1987) states that count data
often display extra variation beyond the scope of Poisson distributions. In such
cases, the negative Binomial distribution (NB) exhibits certain advantages, as
NBs have a long tradition in the marketing and operations literature. It is often
mentioned that NBs fit best to observed customer demand (e.g. Ehrenberg,
1959, Agrawal and Smith, 1998).
We distinguish two settings of demand data streams. First, we present a
general setting representing demand fulfillment decisions of one year executed
on a rolling horizon. Second, we consider a setting which is consistent with
the assumptions of the RM approach of Section 5.1. For instance, in the RM
setting, only one order is allowed to arrive per period. Table 6.1 displays
the options considered in the two settings and shows the used symbols and
underlying assumptions.
Table 6.1: Data Stream Options

Description Distribution Symbol

~~-~-~--~~-~---
Gener al setting RM setting
Demand data stream
#Orders per period Poisson(µ) Deterministic nt
Order quantity Deterministic 1 + NB(µ- l,11 2 ) d;
Revenues per order uc(a,b) UdE(r1,••·,rK) r;
Requested due date Deterministic Deterministic Ti
No-arrival probability Deterministic Po
Supply data stream
Inter-arrival time Deterministic Deterministic <P
Supply quantity Deterministic Deterministic St

In the general setting, the number of orders nt arriving in period t is modeled

as a Poisson process. The demand quantity per order d; is set to a fixed value.
The revenues r; of order i are uniformly distributed in the range a to b. As we
focus on make-to-stock environments, we assume in the simulation runs that
an immediate order confirmation is required (i.e., Ti = 0).
Supply data is generated in both settings without any stochastic influences.
This is due to our assumption that on the short-term, supply can be considered
as given. The supply quantities s arrive in specific intervals, defined by the
inter-arrival time ¢. We model the supply arrival process St with St = s if
t mod ¢ = 0 and St = 0 otherwise.
The RM setting is different to the general setting in order to account for
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6.2 SIMULATION ISSUES 81

deterministic and set to 1 (cf. Assumption 5.1). However, in order to be

able to capture the effects of no-arrival probabilities, we introduce Po denoting
the probability that no customer order arrives in a period. Then, the arrival
process can be modeled as such that one customer class arrives per period
with an arrival probability of ( #~~;~es) for each class (all classes have the same
arrival probability). As the customer demand is expected to be discrete and
positive, we chose an NB to model the demand quantity. Additionally, it
allows us to analyze the effects of large variations in demand. The demand
quantity is modeled to be strictly positive with d; ~ 1 +NB(µ - 1, o- 2 ). Note
that in contrast to the general setting, the demand quantity is always positive
(i.e. > 0).
In contrast to the general setting, the revenues of all orders within the same
class are equal. The assignment of orders to classes is stochastic and uniformly
distributed. Due to Assumption 5.3, orders require an immediate fulfillment,
but are willing to accept later deliveries with a price discount. Therefore,
1 ; = 0 holds in all simulations.
To study the impact of supply shortage on the performance, we define short-
age as a ratio of the total supply throughout the simulation horizon and the
total expected demand, more formally stated as

ST = 1- L,r=l St (6.1)
(1 - Po) x E[nt] x E[d;] x r·

6.2.2 Simulation Options

The simulation runs of Chapter 7 can be distinguished according to the data
stream options of the previous section and simulation options as shown in
Table 6.2. We describe the simulation options in the following.

Table 6.2: Simulation Options

Description Symbol
Number of customer classes K
Simulation horizon T
Planning window w
Replanning frequency F
Backlogging costs b
Holding costs h
Forecast error e

The number of customer classes K is considered as a given input and can be

Rainer Quante - 978-3-631-75386-6
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82 CHAPTER 6 SIMULATION ENVIRONMENT

off between finer customer differentiation and increasing forecast accuracy.

In this regard, the assignment of customers to classes is done based on a
simple procedure which results in a well-balanced amount of customers in
each class. Refer to the work of Meyr (2008) for a more detailed analysis of
different clustering methods. The procedure works as follows: first, determine
the average number of customers per class by dividing the number of customers
by the number of classes. Second, sort all customers according to their profits.
Then, assign the most valuable customer to the first class. If the first class
contains the average number of customers, move to the next class. Repeat this
process until all customers are assigned.
The next three options are used to define a rolling horizon. The simulation
horizon T covers all periods of a simulation run, e.g. one year. The planning
window W covers the periods in which the short-term demand management
decisions are simulated. In practical settings, the planning window covers a few
weeks to month. The replanning frequency F determines the amount of time
that lies between two consecutive planning windows. Usually, the replanning
frequency is shorter than the planning window in order to have overlapping
time periods. Figure 6.1 illustrates the three options.

Simulation Horizon

Replanning Planning Window

Frequency
Figure 6.1: Simulation Horizon, Window and Frequency

Backlogging and holding costs (b and h, respectively) are not dependent

on a specific order and, therefore, are part of the simulation options. We
did not implement class- or order-dependent backlogging and holding cost
because neither the RM approach (cf. Sect. 5.1) nor the network version of
GOP (cf. Sect. 4.3.1) support it.
The last option determines how demand forecasts are generated during a
simulation run. We distinguish between forecasts based on the mean demand,
and forecasts that are generated according to a predefined forecast error e. In
the first case, we assume that the mean demand is known (e.g. by exponential
smoothing) and is used as a forecast forRainer
the demand in SOPA and the RM
Quante - 978-3-631-75386-6
approach. In case of RM, we additionally assume that the demand
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6.2 SIMULATION ISSUES 83

known as well. If the mean demand is chosen for generating demand forecasts,
we denote this by M. The resulting forecast errors in this case are hence equal
to the standard deviation of the demand stream. For example, if the demand
is Poisson distributed with >. = 10, then the standard deviation is 3.33 which
is also the mean deviation from the forecasts.
In the second case, we generate forecasts according to the predefined error
and the true realization of the demand, denoted by diet• Let ~ax denote the
demand forecast for class k in period t and fkt the forecast error, then the
forecast error is distributed as

fkt ~ N orm(0, v'K ,

Cle )
(6.2)

and the demand forecast can be calculated with ~ax= max{0, di,t+fkt}- Note
that negative demand is changed to 0. ere is chosen as a percentage of the mean
demand during the planning window. Let m denote the mean demand in the
planning window over all classes, then ere can be calculated with ere = e x m.
6.2 shows that the variability of the forecast error within a specific class
decreases with an increasing number of classes. However, the variability of the
forecast error over all classesLf= 1 Ekt increases with an increasing number of
classes. This behavior resembles common forecasting methods used in practical
settings.
For illustration of this rather counterintuitive behavior, consider a mean
demand of 1,000 units per period with a standard deviation of 500. If the
demand is equally segmented into 1,000 individual classes, a mean of one unit
per period per class can be expected. According to Formula 6.2, the standard
deviation of the demand per class changes to ~ = 15.81. This small
example shows that the standard deviation of the demand of one class has to
be smaller than the standard deviation of the total demand.

6.2.3 Output and Key Performance Indicators

Since the discussed approaches of Chapter 5 focus on profit maximization, we

choose the expected profit as the key performance indicator (KPI) in order
to compare the different approaches. Expected profits of the RM approach
described in Section 5.1 can be directly calculated by solving the value function
5.5. An implementation of the value function is discussed in Algorithm 2. If
the assumptions of the RM approach hold,Rainer
expected profits ofSOPA and FCFS
Quante - 978-3-631-75386-6
can be calculated by means of the value function, as well, just
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84 CHAPTER 6 SIMULATION ENVIRONMENT

RM acceptance rule (Line 8 in Algorithm 2) with the SOPA or FCFS rules.

Equation 6.3 shows the value function adapted to FCFS or SOPA.

V,(x) dc, [:~~~.i~~:: {t,< u,P,(i, c) - hx,6.,) + V,H (x - u)}] .

(6.3)

However, in the simulation runs of Chapter 7 we do not calculate expected

profits by means of the value function, but rather run a "reasonable" large
number of simulations with different random variates (drawn from the dis-
cussed distributions). Subsequently, we calculate the average profit over all
simulation runs as an approximation of the real expected profit. The reasons
for this are: (1) in some of the scenarios, the demand assumptions of the RM
approach do not hold. (2) The GOP solution cannot be calculated by means
of the value function, because the Bellman principle of optimality does not
hold in this case. The principle states that the optimal decision ii in period t
only depends on the current state x and the expected profits in period t + 1.
However, in case of GOP, an optimal decision in period t depends on the actual
demand realizations of all periods. (3) In large scenarios, computing the value
function is practically not possible due to the curse of dimensionality. In these
cases, the approximate expected profit is sufficient to identify trends in the
numerical results.
A problem remains how to choose a reasonable number of simulation runs,
denoted by n in the following. If n is chosen too large, the simulation time
increases too much. If chosen too low, the approximation of the expected
profits is insufficient and the results might be due to random influences. In
scenarios with a large variance in the demand, n must be chosen high in order
to prevent random outcomes. In the simulation runs of Chapter 7, we have
manually chosen n in the way that a larger n would not contribute very much
to the trends seen in the different figures.
In order to capture how much of the performance can be attributed to the
different approaches directly and not to differences in the simulation settings,
we predominantly show profit deviations to GOP in the numerical results,
instead of showing absolute profits. These profit deviations, or relative profits
respectively, are calculated according to the formula L~=l G~~·;s·, when s;
represents the optimal profit of a certain approach S in simulati~n run i and
GOP;* the optimal profit of GOP in simulation run i.
We complement the analysis of expected profits with an analysis of service
rates. We distinguish between four different service rates: (1) order quantities
fulfilled in time, order quantities fulfilledRainer
too Quante - 978-3-631-75386-6
early, order quantities fulfilled
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6.2 SIMULATION ISSUES 85

too late (backlogging), and rejected order quantities ( lost sales). We choose
quantity-oriented service measures (Tempelmeier, 2006) adapted to our set-
ting with simultaneous lost sales and backlogging. Furthermore, since order
quantities can be split, we did not focus on orders as a whole but calculated
the service measures according to single units. For instance, the amount of
backlogging covers all units (not orders) with a delivery date in the planning
window that are backlogged.

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 Rainer Quante - 978-3-631-75386-6
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Chapter 7

Numerical Analysis
We have seen in Chapter 2 that demand fulfillment with customer segmenta-
tion is able to substantially increase profitability. However, in the literature
these approaches have been analyzed only in deterministic settings neglecting
stochastic demand. Further approaches have been developed in Chapter 5 to
explicitly account for stochastic demand. Our aim in this chapter is to as-
sess both types of demand management approaches under realistic conditions,
i.e. to analyze the performance of the described approaches under stochastic
influences. Due to technical reasons, we split the analysis in two parts: first,
we analyze the different SOPA approaches in a large scenario imitating the
demand management process of a company over one year. Second, we show
a smaller scenario following the demand assumptions of the RM approach in
Section 5.1 to show the relative performance of the approaches. The numerical
results underlying the respective figures displayed in the following chapter are
shown in Appendix B. Note that the exact shapes of the figures depend on
the chosen input data. However, the movements of the curves under param-
eter changes provide interesting insights independent of the actual scenario
settings.

7.1 SOPA in Stochastic Environments

We start with a detailed analysis of SOPA under stochastic demand compared
with the optimal solution GOP and a simple FCFS rule. In a preliminary
study, it turned out that FCFS made use of the possibility to backlog, without
considering the resulting costs. Thus, for reasons of fairness, we assume that
future arriving supplies are not taken into account by FCFS. Hence, orders
are only fulfilled if inventory is on-hand and therefore extensive backlogging is
prevented. For our analysis, we define a base case in the first step and vary the
parameters in the subsequent sections. The notation and parameters follow
the description of the simulation environment in Chapter 6.
Example 7.1. Consider a problem with uniform distributed revenues ri ~
U(90, 110). The customer arrival process follows a Poisson distribution with
nt ~ P(lO) and a fixed order quantity of di = 12 units per order. Immediate
order fulfillment is assumed (i.e. 1 ; = 0). The supply inter-arrival time is
</> = 14 periods starting in period 1, each supply with a quantity of s = 1,000
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88 CHAPTER 7 NUMERICAL ANALYSIS

units. The simulation horizon is T = 365 periods, the planning window W =

28 periods and the replanning frequency is F = 7 periods. Per unit and period
backlogging costs are b = 10 and holding costs h = l. If not otherwise stated,
we consider three customer classes (K = 3) and assume that the mean demand
per class is known (e = M).
In Example 7.1, we show a demand management process executed over one
year based on a rolling horizon. The parameters are chosen to mimic a realis-
tic demand management process for a single product. In case of backlogging
costs, it is not easy to find realistic assumptions. Anderson et al. (2006) show
a method for determining stockout costs, which they apply in an empirical
study in a retail environment. Depending on whether short- or long-term ef-
fects are included, they report stockout costs of 8. 76$ and 22.69$, respectively,
for a product selling for 51.06$. This corresponds to costs of 17.15% and
44.43% of the product's price. According to these findings, we decide to give
roughly 10% discount (b = 10 and E[r;] = 100) in each period a product is
not immediately available (backlogging). The shortage ratio in this example
is sr = 1 - 1~:~;i~~ 5 = 0.3836 (cf. Equation 6.1), i.e., it can be expected that
38.36% of all orders are not satisfied.

7.1.1 Base Case Analysis

We start by applying FCFS, GOP, and the two versions of SOPA to the base
case. The base case simulated average profit of SOPA_D equals 2,543,725,
and the average profit of SOPA_A equals 1,774,840. Table 7.1 compares this
value to the average profits of the two benchmark approaches GOP and FCFS.
We observe that SOPA_D outperforms both FCFS and SOPA_A. However,
the difference to FCFS is marginal. The profits of SOPA_A indicate that
the aggregation of ATP quantities leads to poor results. We will analyze the
reasons for the poor results of SOPA_A below. The second row in the table
shows the relative performance of the approaches in relation to the optimal
solution GOP. Note that the relative profits can not be obtained from the
absolute values shown in the table, because relative profits are calculated as
an average over all single simulation runs.

Table 7.1: Base Case Average Profits for Different Approaches

GOP FCFS SOPA D SOPA A

Absolute 2,617,006 2,515,394 2,543,725 1,774,840
Relative 3.88% Rainer 2.80% 32.18%
Quante - 978-3-631-75386-6
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7.1 SOPA IN STOCHASTIC ENVIRONMENTS 89

Figure 7.1 helps to explain the observed performance differences. The figure
specifies the service levels achieved by each approach. Specifically, it shows
for each policy the average fraction of orders lost and backordered of each
customer class. Due to the large size of the scenario, the solution of GOP was
calculated with the network flow LP (cf. 4.7 described in Section 4.3.1) which

-~·~
is not able to calculate class-specific service rates .

---
.....
• Cltss1 --
..... . a..,1
• 0,02

-
c a..sl
""' ~
'""
r ..,,.
f:""',...
_;
"'w
-
,.,.
j

'""
""
'""""
FC>S SOF,._O St:RAJ, FCfS SOl>I_D SOl>\J.

(a) Lost Sales (b) Backlogged Quantities

Figure 7.1: Base Case Service Rates I

Figure 7.1 shows that FCFS rejects customers independent of their class
and results in equal amounts oflost sales (Figure 7.1 (a)). The_ two versions of
SOPA mainly differ in terms of how they treat the most profitable class. The
aggregated SOPA rejects nearly no quantities of this customer class, but this
behavior does not explain the large differences in profits.
Figure 7.1 (b) displays the amount of backlogged quantities. As said before,
in FCFS backlogged quantities are zero by definition because backlogging is
not allowed. Similarly, SOPA_D very rarely makes use of backlogging, basi-
cally in the highest and most profitable class. In contrast, SOPA_A allows
consumption of quantities reserved for all periods and therefore results in ex-
tensive backlogging. Due to the high backlogging costs, SOPA_A performs
poor in terms of profitability.
In Figure 7.2, the service rates for too early and timely deliveries are dis-
played. As expected, SOPA_D has high rates for the on-time delivery in all
customer classes. Regarding early deliveries, due to the holding costs service
rates differ considerably between the highest and the lowest customer class.
SOPA_A, however, produces high service rates regarding on-time deliveries
in the highest class, but-due to nesting-low rates for the other two classes.
Considering early deliveries, SOPA_A has low rates, especially for the two
lowest classes. This effect goes in hand with the high amount of backlogging,
which leaves no space for early deliveries. The results of FCFS are intuitive,
Rainer Quante - 978-3-631-75386-6
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90 CHAPTER 7 NUMERICAL ANALYSIS

,...
·: 1••t.••; ......
--
acrx.an, 2
70% a O.Ss3
"'6"
! .... I .,,
-..........
5%

" ......
,
so,,._c
..."' FCFS so,,._c so,,._,..
(a) Early Delivery (b) On-Time Delivery

Figure 7.2: Base Case Service Rates II

probability to occur if supply quantities are available. In the following, we

change parameters of the base case and analyze the resulting effects. For the
sake of comparability, we include the results of the base case in the following
figures. The base case is always denoted by *.

7.1.2 Impact of Customer Classes

In this section, we analyze the behavior of the profits when the number of
customer classes· increases. It is expected that with an increasing number of
classes, the SOPA results improve due to a finer allocation, but on the other
hand are negatively affected by decreasing forecast accuracy. Figure 7.3 shows
the results of FCFS, GOP, SOPA_A, and SOPA_D. Note that* indicates the
base case.
2800000

2600000

2400000

2200000

2000000

~
A,
1800000

1600000
- • - - GOP
1400000 - FCFS
--o-- SOPA_D
1200000
_ SOPA_A
1000000
2 3* 4 5 6 7 8 9 10

Number cf Classes

Figure 7.3: Average Profits with Rainer Quante

Varying - 978-3-631-75386-6
Number of Classes
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7.1 SOPA IN STOCHASTIC ENVIRONMENTS 91

First, note that FCFS and GOP do not consider customer segmentation and,
hence, are not influenced by the increasing number of classes. The figure shows
that the aggregated version of SOPA is far away from the profits of FCFS,
GOP and SOPA_D, which are located close together. Nevertheless, SOPA_A
benefits from an increasing number of classes, especially regarding the step
from one to two classes. The expected trade-off between a finer segmentation
and an increasing forecast error can be seen in the case of SOPA_D where
the profits first slightly increase up to two or three customer classes and then
decrease again. This effect is not visible from the graph, but can better be
seen in the data Table B.3 in the Appendix. Despite the small dimensions of
the phenomenon, it has proven robust to parameter changes.

00%r-------------====:::::-i
-FCFS
50%
IL
0
~ 40%
C
.9
J 30%
,!
a:
£ 20%
ii
10%

2 3* 4 5 6 7 8 9 10
i..mber of ClaHH

Figure 7.4: Average Relative Profits with Varying Number of Classes

Figure 7.4 displays the relative performance of the approaches compared

to the optimal solution (GOP) with the same scenario as used in Figure 7.3.
We see that SOPA_D and FCFS are roughly 3-4% worse than the optimal
solution, whereas SOPA_A produces poor results. These are due to the high
amount of backlogging which is not prevented by SOPA_A. Since FCFS seems
to be highly competitive in this scenario, we will analyze further settings in
the subsequent chapters.

7.1.3 Impact of Customer Heterogeneity

We have seen in the base case that FCFS is competitive to the SOPA ap-
proaches. In the following, we analyze the effect of an increased customer
heterogeneity regarding profitability. WeRainer
expect that higher variation in cus-
Quante - 978-3-631-75386-6
tomer profitability positively influences the performance of 05:39:20AM
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92 CHAPTER 7 NUMERICAL ANALYSIS

customer segmentation. We vary the heterogeneity by changing the revenues

ri. In the base case, we had a 10% deviation from the mean, upwards and
downwards (ri ~ U(90, 110)). Additionally, we now consider cases with 30%,
50%, and 70% deviation.

-~--------=== 10%,---------------,==
:...,._FCFS

1: \_ ... :-~-
!
;~SOM_D i
i_ _ SOP,._A I
---=-1

1-
•
""
1 2 3* 4 5 I 7 1!1 9 10
"'~--------~
I

1 2 3 4 5 I 7 11
lrlllnber •f ClaHII

(a) Heterogeneity 10%* (b) Heterogeneity 30%

-== -~,- - - - - - - - - =

~-'. ~;;JI
80% ~ - ~ · - · - - · · - - - - - - - - - - -
1.:.........FCFs ,j
i~!IOPl'-_D,I
~~-2-J

1::
'"'· 0-0-0::::1111==~8=8--.. i
.I
20"4

'"''i
1
'
o-4.....,.....,.,_.,.,_.,___.___......,.......,.

,--=------·-··-··-··-=-__j 1 2 3 ,. 11 e 1 a

(c) Heterogeneity 50% (d) Heterogeneity 70%

Figure 7.5: Variation of Customer Heterogeneity

Figure 7.5 displays the three scenarios with varied customer heterogeneity
in addition to the base case with 10% deviation (denoted by *). Again, the
figure shows the deviation from the optimal solution. As expected, FCFS
is not able to manage increased heterogeneity. The results get worse from
(a) (with approximately 3% profit deviation to GOP) to (d) (approximately
21% profit deviation to GOP). In contrast, both SOPA approaches benefit a
lot-especially around two to five customer classes. The jagged appearance of
SOPA_A is due to the stochastic input data and shows that it is less robust
than SOPA D.
The trade-off between forecast accuracy and a finer segmentation can better
be seen now in the curve of SOPA_D. In the case of four customer classes and
high heterogeneity, SOPA_D gets closest to GOP. Interestingly, SOPA_A
Rainer Quante - 978-3-631-75386-6
approaches the profits of SOPA_D in case of very
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7.1 SOPA IN STOCHASTIC ENVIRONMENTS 93

7.1.4 Impact of Forecast Errors

In this section, we analyze the influence of different forecast errors and their
effect on the expected profit. In the base case, (again denoted by * in Figure
7.6), we assume that the mean demand in a customer class is known and can
be used as a forecast. In addition to the base case, we analyze a setting with
no forecast errors 7.6 (a), i.e., deterministic forecasts, and settings with 50%
and 100% forecast errors. Note that we consciously do not want to simulate a
forecast procedure, but rather choose to directly calculate forecast errors. In
this respect, our analysis is independent of the chosen forecast procedure (and
its resulting forecast error), which allows us to analyze a much larger spectrum
of different forecast errors. The calculation of forecast errors is explained in
Equation 6.2.
The setting M in the upper right corner results in forecast errors which
are determined by the standard deviation of the demand data stream. In our
Example 7.1, we have a Poisson distributed arrival process of customers with
.X = 10 per period with a fixed quantity of 12 units each. Hence, on average 120
units are ordered per period with a standard deviation of 37.95 = /fO x 12.
I.e., if we use the mean demand of 120 units as forecast, we result in errors
of 37.95 units on average, approximately 32%. Therefore, in Figure 7.6 we
arrange the setting M in between the scenario with 0% forecast errors and
50% forecast errors:
Figure 7.6 shows the behavior of SOPA with different forecast errors. Since
FCFS does not require demand forecasts, its profits are not affected by increas-
ing forecast errors and are, hence, equal throughout all figures. The curve of
SOPA_D in Part 7.6 (a) approaches the GOP solution with an increasing
number of customer classes. This is intuitive since when the number of classes
equals the number of orders, the AP step optimally allocates ATP quantities
to each order. In case of only one class, low-margin customers might con-
sume quantities from the single class that are better kept for later high-margin
customers. Therefore, SOPA_D cannot yield optimal profits in case of few
customer classes.
With increasing forecast errors, SOPA_D becomes worse and is soon out-
performed by FCFS. In the cases of 50% and 100% error, SOPA_D does not
benefit from a larger number of classes since the imprecision of the forecasts of
each class increases, which overcompensates the finer customer segmentation.
The behavior of SOPA_A is rather different to SOPA_D. Due to the aggre-
gation of quantities, SOPA_A even benefits from the forecast errors and the
performance improves with an increasing number of classes. Nevertheless, the
results ofSOPA_A stay in the range between 10% and 20% deviation from the
Rainer Quante - 978-3-631-75386-6
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94 CHAPTER 7 NUMERICAL ANALYSIS

-~---------~

""'
1 2 l 4 Ii I 7 I
Nwmber of CINHI Number otcu.. ,

(a) Forecast Error 0% (b) Forecast Error M*

!--
"" ..........
-o-90F!',_D

t "" _SOM_A

; 4°"

1-
1-
I-
1-
• •
"'" ""
"' 1 2 3 4 5 II 7 e "' 1 2 3 4 11 I 7 11 I 10
l'llntNrofe&.1e•

(c) Forecast Error 50% (d) Forecast Error 100%

Figure 7.6: Variation of Forecast Errors

forecast errors, SOPA_D is in a similar range as SOPA_A. In this respect, we

conclude that in case of high errors, the allocation of ATP to customer classes
in the AP step is rather a random procedure. The consumption rules based
on the allocated ATP quantities reveal a random outcome a long way from an
optimal solution.

7.1.5 Impact of Backlogging Costs

We have seen already in the previous sections that profits are considerably
influenced by the amount of backlogged quantities. In the following, we analyze
the effects of different backlogging costs. Figure 7. 7 displays the behavior of
FCFS, SOPA_A, and SOPA_D when backlogging costs are increased, starting
from zero up to ten. Note that the last point represents the base case.
Some interesting effects are visible: First, GOP is only slightly influenced
by increasing backlogging costs confirming that the optimal allocation of ATP
to orders works fine. SOPA_D behaves similarly to GOP which indicates
that the allocation of ATP to specific due dates works well regardless of the
Rainer Quante - 978-3-631-75386-6
backlogging costs. FCFS is not influenced at allatsince
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7.2 ANALYSIS OF THE REVENUE MANAGEMENT APPROACH 95

3000000

2500000

2000000

1... 1500000

1000000
•·•·GOP

500000 -=
'--o-- SOPA_D :
,_SOPA_Ai
0
0 2345678910*
Blcklogglng Coots

Figure 7. 7: Variation of Backlogging Costs

in this case. In the case of low backlogging costs, FCFS is outperformed by

GOP and SOPA_D, but both approaches approximate the curve ofFCFS with
further increasing backlogging costs.
SOPA_A exhibits interesting behavior. In case of no backlogging costs,
the results of SOPA_A are equal to the results of GOP. This result can be
explained by the fact that the aggregation compensates all forecast errors,
whereas late fulfillment of orders does not influence the results due to the
zero backlogging costs. Early availability of ATP actually results in holding
costs, but due to the assumed scarce capacities this does not play a role in these
scenarios as ATP certainly never becomes available before the actual due date.
With increasing backlogging costs the profit of SOPA_A decreases drastically.
However, this behavior is reversed at backlogging costs of five. We explain this
behavior by the interplay of errors and backlogging costs: in the range of low
backlogging costs, wrong allocations and forecast errors do not play a pivotal
role as they are compensated by the aggregation of ATP quantities. With
medium backlogging costs, backlogged customer orders decrease the profit. In
case of high backlogging costs, the AP step allocates ATP more carefully to
the different classes which results in higher profits.

7.2 Analysis of the Revenue Management Approach

In the following, we numerically analyze the revenue management approach
of Section 5.1. As noted earlier, we choose a scenario following the demand
and supply assumptions of Section 5.1.1. For reasons of practicability, the
Rainer Quante - 978-3-631-75386-6
scenario is much smaller than in the previous analysis.
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96 CHAPTER 7 NUMERICAL ANALYSIS

computation time of the stochastic dynamic program. The following Example

7.2 shows the base case scenario.
Example 7.2. Consider a three-customer class problem with revenues p 1 =
100, P2 = 90, and p3 = 80. Let h = 1 and b = 10. The simulation and planning
horizon is T = 28 periods with two receipts of supply of 100 units each, the
first in the start period t = 1 and the second in period t = 15. We assume
exactly one customer arrival per period (Po = 0) with the demand quantity
following a negative Binomial distribution with mean µ = 12 and a standard
deviation of a = 8.
In the next subsection, we evaluate our RM procedure for this base case and
compare it to the FCFS, SOPA_D, and GOP benchmarks. In the subsequent
sections, we investigate the impact of several key model parameters on the rel-
ative performance of RM, thereby identifying conditions that are particularly
conductive to the use of revenue management in MTS demand management.
Specifically, we address the impact of demand variability (Section 7.2.2), cus-
tomer heterogeneity (Section 7.2.3), and supply shortage (Section 7.2.4).

7.2.1 Base Case Analysis

The base case simulated average profit of the RM policy equals 17,635.90.
Table 7.2 compares this value to the average profits of the three benchmark
policies. We observe that RM outperforms both FCFS and SOPA_D by about
2%. In terms of relative profits to GOP, FCFS looses more than 3% to GOP,
SOPA_D roughly 3%, and RM around 1%.

Table 7.2: Base Case Average Profits for Different Approaches

GOP FCFS SOPA D RM

Absolute 17,843.03 17,247.27 17,327.95 17,635.90
Relative 3.33% 2.91% 1.16%

Figure 7.8 helps to explain the observed performance differences by display-

ing the service levels graphically. Again, we measure customer service in terms
of lost sales (Figure 7.8 (a)) and backlogging of orders (Figure 7.8 (b)).
A number of differences between the policies stand out. First of all, FCFS
does not differentiate between customer classes, which is reflected in roughly
uniform service levels across classes. All other policies clearly prioritize high-
value orders. While FCFS achieves the lowest total number of lost sales, it
loses relatively many high-value orders. Comparing RM and SOPA_D, we see
Rainer Quante - 978-3-631-75386-6
that SOPA_D rejects Downloaded
even more from
orders of classes two and 05:39:20AM
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7.2 ANALYSIS OF THE REVENUE MANAGEMENT APPROACH 97

the resulting decrease in lost sales of class one-relative to RM-is insuffi-

cient to compensate the lost revenues. It appears that in the face of demand
uncertainty, the prioritization of the SOPA_D rule is slightly too aggressive.
Another difference between RM and SOPA_D concerns the backordering be-
havior. SOPA_D backorders many more orders from lower customer classes.
Under demand uncertainty, it appears preferable to reserve more future supply
for potential future orders, thereby avoiding backorder penalties.

,
-........ 3.5%

--
3.0%

""'
...,.
J so..
~
.IJ.....
,....
....
""" '·°"
...
0,5%
"'"
OC/i> FCFS SCW'l<_D FM
..... 00P FCFS ~-0 FM

(a) Lost Sales (b) Backlogged Quantities

Figure 7.8: Customer Service Levels in the Base Case

7.2.2 Impact of Demand Variability

We now investigate how the above results depend on a number of key param-
eters. We start by addressing demand variability. To this end, we vary the
standard deviation of the order size afrom 4 to 16. In addition, we consider
the case of a constant order size of µ = 12 units. This range corresponds
with a CV of the order size between O and 1.33. The scenario CV = 0.67 /
a = 8 corresponds with the base case analyzed in detail in the previous section
(again denoted by *). Note that in addition to the order size, we also have
uncertainty in the order arrivals. Therefore, even the scenario with a constant
order size is not entirely deterministic.
Figure 7.9 shows the expected profits for different CVs of GOP, RM, FCFS,
and SOPA using the setting of example 7.2. We observe the following: (1) The
negative effect of increasing variance is maximal if using the purely determin-
istic SOPA approach whereas (2) FCFS seems unaffected from the increase at
least in case of low variability. (3) In the case of deterministic demand quan-
tities (CV= 0), SOPA is competitive to RM. (4) Overall, the RM approach
performs best, but the consideration of stochastic demand does not prevent its
Rainer Quante - 978-3-631-75386-6
profit from decreasing Downloaded
with increasing demand variability.
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98 CHAPTER 7 NUMERICAL ANALYSIS

18500
18000
..
;.:
17500 ~-
e 17000
,,
a.
GI 16500
tiGI
0.
16000
__,._.FCFS
~ 15500
- - 0 - - SOPA_D
15000 -++--RM
14500
0,00 0,33 0,67* 1,00 1,33

Coefficient of Variation

Figure 7.9: Average Profits for Different Levels of Demand Variability

To summarize, we conclude that the effectiveness of customer differentiation

in demand fulfillment decreases with increasing demand variability and that
forecasting errors should be taken into account in the fulfillment decision.
Note that some of the variations in the average profits can be explained
by changes in the maximum attainable ex-post profit GOP. To eliminate this
effect, we consider again the relative deviation of FCFS, SOPA_D, and RM
with respect to GOP in the subsequent analyses.

7.2.3 Impact of Customer Heterogeneity

In Figure 7.10 we show how increasing customer heterogeneity changes the
relative performance of FCFS, RM and SOPA_D under increasing demand
variability. In the low heterogeneity case (7.10 (a)), RM and SOPA_D hardly
outperform FCFS. In particular, SOPA_D is only competitive in cases with
low variability. In the cases with medium and high customer heterogeneity
(Figures 7.10 (b) and 7.10 (c)), SOPA_D and RM in general perform better
than FCFS. The relative performance of RM and SOPA_D is only weakly
influenced by customer heterogeneity under low demand variability (less than
0.33), but we find a strong influence under high demand variability. As ex-
pected, the difference between SOPA_D and RM rises with increasing values
of heterogeneity and demand variability. Figure 7.10 (c) reveals that the de-
terministic SOPA_D is not able to benefit from increasing heterogeneity when
the variability is high. This is in line with the previous findings. Another
interesting result is that the relative performance of FCFS, though not influ-
enced by increasing variability, is stronglyRainer
affected by increasing heterogeneity.
Quante - 978-3-631-75386-6
The latter is intuitive since FCFSfrom
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7.2 ANALYSIS OF THE REVENUE MANAGEMENT APPROACH 99

care for the larger profit potential. Summarizing the results we can say that
RM outperforms FCFS and SOPA_D, especially under high variability. In
case of low variability, SOPA_D seems to be competitive to RM. FCFS as the
simplest rule is only appropriate if heterogeneity is low. The point in which
SOPA_D and FCFS approximately perform equally moves towards the upper
right corner with increasing heterogeneity (from 7.10 (a) to 7.10 (c)).

===,,..------~
--o-SOAI._O
= 20%

~
~ 18%
O 16%
_,_RM _g 14%

i 1:
j 12%

i! 6%
£ 4%

o.oo o,33 o,6r 1,00 1,33 °" 0,00 0,33 0,67 1,00 1,33
Co.tflcle nl ofV • rlatk>n Coe fflcl1n1 or V• rlatlon

(a) Heterogeneity 10% (b) Heterogeneity 20%

=.---------~
[=
ti 18%
o HI%
.!:!:
c 12%14% -6- Fa'S
i '°" -o- SOAl._0 1
!i! 8%
6'11,
- RM .J

£ 4'11,
.,_ 2%
()%~----------'
0,00 0,33 0,67 1,00 1,33
Coeffkl,nt of Variation

(c) Heterogeneity 30%

Figure 7.10: Varied Customer Heterogeneity for Different Levels of Demand

Variability

7.2.4 Impact of Supply Shortage

Figure 7.11 displays the relative performance under different no-arrival proba-
bilities (and-ceteris paribus-different shortage rates). Three different cases
have been picked to analyze shortage: We start from a setting where FCFS
and SOPA_D have an approximate equal profit (CV= 0.67). The influence
of different shortage rates in this situation is depicted in Figure 7.11 (a). Con-
trasting to this, Figure 7.11 (b) shows the setting with lower demand variability
(CV= 0.33) and 7.11 (c) shows the case with higher customer heterogeneity.
The left-hand side of each figure shows the case of supply shortage (short-
Rainer Quante - 978-3-631-75386-6
age rates > 0) whereasDownloaded
the right side depicts theatcase
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100 CHAPTER 7 NUMERICAL ANALYSIS

age rates < 0). We can see in all cases that FCFS-in contrast to RM and
SOPA_D-declines with decreasing shortages, regardless of whether we as-
sume under- or oversupply. This is intuitive since the benefit of selecting
among the most profitable orders is continuously decreasing with decreasing
shortages. Regarding RM and SOPA_D, they also approximate the GOP value
in the case of excess shortage. In the extreme case of 138% excess supply, the
benefit of rationing vanishes since all orders can be satisfied so that the dif-
ferences between the different approaches vanish. In the other extreme (large
shortages), SOPA_D and RM benefit from their rationing strategy. While
the performance of FCFS diminishes with increasing shortage, SOPA_D and
RM reach higher profits when the shortage rate shifts from 21 % to 41 %. In
Figures 7.11 (b) and 7.11 (c), both approaches outperform FCFS. Comparing
the shapes of the SOPA_D and RM curves, it can be seen that in all scenarios
SOPA_D is more dependent on the shortage rate, as it can only compete with
FCFS in cases of very high or very low shortage. For the RM approach, we
can see that it performs better than both, SOPA_D and FCFS in all cases,
even in those with oversupply.

....
~=
,..,.
......... .,,
~
... ~
... -

I:..
~
I
~

j•,.... . • I

I,... I,..._.,.
",..,.
.... .... OI.C41W.J '"-t:11.. 1 O'llilftl
'1,-4~•·"'""6111""""' ....,
llft.C•tftl 1Ml,C•I...)

(a) CV = 0.67 and Low Heterogeneity (b) CV= 0.33 and Low Heterogeneity
......
. ...
.....
§ ...
,
I ::
.....,...
1-
.... ' - - - -- - - - - = -'-=~I--

(c) CV = 0.67 and Medium Hetero-

geneity

Figure 7.11: Impact of Shortage Rate on Average Profit Deviation from GOP
for Different Scenarios

Rainer Quante - 978-3-631-75386-6

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7.3 ANALYSIS OF RANDOMIZED LINEAR PROGRAMMING 101

7.3 Analysis of Randomized Linear Programming

The RLP approach presented in Section 5.2.2 aims at combining the general
applicability of SOPA with consideration of stochastic demand. Therefore, now
we focus on analyzing the effects of demand variability on the performance
of RLP. We start with the base case as described in Example 7.1 and run
the RLP approach with 30 iterations. In each iteration, the RLP approach
draws random variates from the known demand distribution and uses them as
forecasts in the allocation planning step. The second step (order promising) is
done in the same way as in the SOPA_D approach.
In order to capture the effects of high demand variability, we complement
the base case scenario (Poisson arrival process with a mean and variance of
10) with scenarios that follow a negative Binomial distributed process with the
same mean (µ = 10) but higher variances (o- 2 = 64 and 144). Furthermore,
we consider a scenario with a fixed number of customers per day. As in the
base case, we assume in all settings that the mean demand is known. In case
of the RLP approach, we additionally assume that the variance of the demand
distribution is known as well.
Given these parameters, we can calculate the resulting forecast errors. In
Section 7.1.4, we result in a forecast error of 32% in the base case scenario ifwe
assume that the mean demand is known. Accordingly, the forecast error with
variance 64 is 80% = 0%~ 12 x 100 and 120% = v'.Ifl; 12 x 100 with variance

144. In case of a fixed number of customers per day, we result in no forecast

errors since the known mean demand is equal to the real demand. All these
calculations are based on the setting of Example 7.1 in which we assume on
average 10 customers per day with a fixed order quantity of 12 units (= 120
units total demand per period).
Analog to Section 7.1.3 we consider different customer heterogeneities of
10%, 30%, 50%, and 70%. The results can be seen in Figure 7.12. From the
upper left hand side to the lower right hand side the variability of the demand
increases. Correspondingly, the forecast errors increase as well and, hence, the
AP step results in less reliable allocations. Figure 7.12 (a) shows the setting
in which we have a fixed number of customers per period and, therefore, no
variability. SOPA_D and RLP result in the same profits because RLP draws
random variates from a distribution with no variance and therefore uses always
the mean.
Like in the analysis before, FCFS is unaffected by demand variability and
its curve does not seem to move from Part 7.12 (a) to 7.12 (d). This behavior
is intuitive since FCFS fulfills incoming demand irrespective on fluctuations.
The profits of SOPA_D are affected negatively by increasing variability, but
Rainer Quante - 978-3-631-75386-6
benefit from increasingDownloaded
heterogeneity. In contrast,
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102 CHAPTER 7 NUMERICAL ANALYSIS

~-j:-
!-.-r:o:s :
....
i~SCJPII. D:
"" 1----scw.=,.: g""
i:115"
JO%
~~--;

.'"''"
115%
~ ''"'
'"'
''"' - ""
eu,1-•, HtWir•n.~
(a)nt=lO
""
'"
"' ,.,..
(b) nt
"" .,,.
~ Poisson(lO)
""

~-j: ~-j:
"'" -.-i=aas i

"" -o-90PA_O;
_9Clf'IA._A!
~

.
115%
""
"'
.I 'fi"'
'"'
'"' .,,. .,,.
"" "" ""
(c) nt ~NB(l0,64) (d) nt ~ N B(lO, 144)
Figure 7.12: RLP with Different Forecast Errors and Varied Customer Hetero-
geneity

fit from increasing variability in case of low heterogeneity and high demand
variability. The profits of SOPA_A move from nearly 33% deviation from
the optimal solution GOP with no variability to nearly 26% with 144 demand
variability, while in case of high heterogeneities (70%), there is a slight deteri-
oration from 12% to 15% deviation from GOP.
In general the RLP approach performs equally well as SOPA_D. A reason
for the strong resemblance between RLP and SOPA_D is the same way of
aATP consumption. Astonishingly, the more complex RLP approach brings
no real benefit in contrast to SOPA_D. The consideration of the variance
in the RLP approach seemingly is no suitable way to cope with stochastic
demand. RLP even results in slightly less profits in case of a 2 = 64 demand
variance. However, in the last scenario with the highest considered variability
(a 2 = 144 ), RLP performs slightly better than SOPA_D, but on a low level
which is even far away from the FCFS solution.
The results are in line with the previously mentioned findings of De Boer
et al. (2002). The authors claim that the stochastic nature of the demand
is already compensated by the "nested" Rainer
protection levels and cannot further
Quante - 978-3-631-75386-6
be improved by the RLP approach. In order to check this argument,
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7.3 ANALYSIS OF RANDOMIZED LINEAR PROGRAMMING 103

additional simulations that forbid the nested consumption of ATP quantities.

The setting of Figure 7.13 is in all terms equal to the one of Figure 7.12, but
nested consumption is not allowed in the RLP approach and the two versions
ofSOPA.

0
-
~- ,.. :-ra:•
:-o-SCJM_O
;~!CIPA._A
i_ _ ......
,
!-
-. ~
~acw._o
_..,.
~ICll'l'o_A

i= i=
. ..
1115'11,

"" .I ""..
15'JI.

"'
'"' -
(a) nt = 10
""
CU11Mt1r Hlllltote•ttr - "' ,,...

(b) nt
,..
~ Poisson(IO)
""
Cwl_lr .. ll'OfeMllr
,...

-,.. -""
~- -
~

i= i=
..
11!%
'"' ..
111511,
'"'
"'
'"'
(c) nt
,.. ...
CuatoMltHltlfot,IMtlJ'

~ NB(I0,64)
,... "' ""
(d) nt
,..
- -
c..1-,, ..........,.

~ N B(IO, 144)
Figure 7.13: RLP and SOPA with Non-Nested Order Consumption

Note that in Figure 7.13, the FCFS line is equal to the one of the previous
figure but the lines of RLP and SOPA changed. In general it can be said that
the prohibition of nesting leads to slightly lower profits than in the previous
scenarios with nesting. However, the decrease in profits lies around 2% and
is even hard to see in the figure. Refer to the data tables B.12 and B.13
for a better illustration of this issue. Interestingly, the prohibition of nesting
affects all four considered scenarios in the same way, even the constant demand
scenario 7.13 (a). In this respect, the claim of De Boer et al. (2002) that nesting
compensates for high demand variabilityRainer cannot be supported in our settings
Quante - 978-3-631-75386-6
as it brings profit improvements irrespective on the level of variability.
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104 CHAPTER 7 NUMERICAL ANALYSIS

7.4 Summary
We have seen in this chapter that the performance of demand management
approaches in stochastic environments is essentially driven by the degree of
customer heterogeneity and the quality of demand forecasts. The amount of
supply shortage and the degree of stochasticity are further important influenc-
ing factors. In general it can be said that SOPA is beneficial in comparison
with FCFS when customer heterogeneity is high and forecasts are good. How-
ever, the use of SOPA has to be carefully considered that the effort to segment
customers and to create demand forecasts pays off.
The RLP approach performs similar to the analyzed SOPA_D approach.
Therefore, a use of the more complex RLP instead of SOPA_D cannot be rec-
ommended, as the gathering of information about demand distribution requires
much more effort.
The RM approach dominates the benchmark approaches throughout the
different scenarios. However, RM requires much more effort and is dependent
on certain assumptions on the demand. The use of RM can be recommended
when the effort of gathering reliable demand data and spending computing
time stays in a reasonable proportion to the expected profit improvements.

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Chapter 8

Conclusion
In this work, we discussed the problem of how to effectively manage stochastic
demand in make-to-stock manufacturing. Specifically, we considered the situ-
ation of a manufacturer who decides on the quantities he is willing to sell to
different customer classes. The order acceptance decisions take into account
on-hand inventory as well as already planned production quantities scheduled
to arrive in the future. For each order, the manufacturer has to decide-based
on its profitability-whether to accept the order, to reject it, or to backlog it
against a price discount. The problem is motivated by the demand fulfillment
task in advanced planning systems. A key characteristic of the problem setting
is that production orders cannot be changed in the short term. This is in line
with the hierarchical planning approach of most advanced planning systems
and reflects the reality of many manufacturers.
We presented a literature classification and overview of research in demand
management. It turned out that the majority of models considering stochas-
tic demand focuses on make-to-order environments. We adopted ideas from
the classified literature, especially from traditional revenue management ap-
proaches, and transferred them to make-to-stock manufacturing. To. our knowl-
edge, this work is the first to apply revenue management in this context.
We developed two different approaches considering stochastic demand. First,
we model the make-to-stock demand fulfillment problem as a stochastic dy-
namic program. We proved that the optimal policy in this model has a simple,
intuitive structure, which can be interpreted as an extension of the well-known
booking-limit policies in classical revenue-management problems. By explicitly
capturing demand uncertainty, our model differs from the rule-based determin-
istic models commonly underlying the demand fulfillment modules of advanced
planning systems. Second, we combined conventional LP-based models with
stochastic demand information by repetitively solving the LP with different
random variates. This idea stems from the randomized linear programming of
network revenue management problems.
We tested the models numerically and compared them against a first-come-
first-served rule and against a deterministic optimization approach. Our results
show that explicitly accounting for demand uncertainty significantly improves
the performance of demand fulfillment. The results also show that customer
differentiation can yield a substantial profit increase, in particular if differences
Rainer Quante - 978-3-631-75386-6
in profitability are largeDownloaded
across orders and if supply is scarce. In conclusion, our
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106 CHAPTER 8 CONCLUSION

results highlight substantial opportunities for improving the current practice

of order fulfillment in make-to-stock manufacturing.
Our models make a first step in this direction. However, many challenges
remain. For the RM approach, the biggest limitation is that it is not easily
scalable. For large-scale applications, the full evaluation of the value function
is computationally intractable. The RLP approach, however, is applicable
even in large-scale applications, but seems to bring no further benefits to-
wards deterministic linear programming approaches. In order to gain further
insight into the relative performance of different methods, they should also be
compared based on empirical data, in addition to theoretical demand distri-
butions. In addition, further analysis of the mentioned rules in Section 2.3.2
is necessary. As they are commonly applied in APS, FCFS alone is not a fair
benchmark for RLP and the RM approach.
Another relevant extension to our model would be to include different cus-
tomer due-dates. It is not immediately clear which effect this will have on
the structure of the optimal fulfillment policy. Another direction for future
research will be to include short-term price incentives, which complement the
order acceptance decisions addressed here.

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Appendix A

Proofs of the Structural Properties of

the RM approach 1

A. l Proof of Proposition 5.1

We show part a) by induction. Fort= T+l the inequality holds since Vr+ 1 = 0
and since the right-hand side is non-negative for n > m.
Now assume that inequality a) holds for t + l. We show that it also holds
fort. We can rewrite

6.m ½(x) - 6.n ½(x) $ b(n - m + Ont(t - n) + Omt(m - t))

¢? ½(x - en) - ½(x - em)$ b(n - m + Ont(t - n) + Omt(m - t)).
We show that this inequality holds for any given values of c and d, which
implies that it also holds in expectation. To this end, let wtu(x, c, d) denote
the maximum expected profit-to-go when starting in period t with a supply
vector x, receiving demand d from customer class c and taking the fulfillment
decision u. Furthermore, let u;(x, d, c) be an optimal decision in period t under
the same conditions.
Using this notation, we have to show that

Wtu;(x-en,d,c)(-X - en,
- C, d) - wu;(x-em,d,c)(-
t X
- C, d)
- em,
$ b(n - m + Ont(t - n) + Omt(m - t)).

We show that there is a feasible decision u1(x-em, d, c) for which this inequality
holds. This suffices since wtui(x-em,d,c) 2: wtu,(x-em,d,c).

1 The Rainer Quante - 978-3-631-75386-6

proofs in this chapter are part of the paper of Quante et al. (2009a)
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108 APPENDIX A

By definition, we have
T
Wtu;(x-en,d,c)(-X -
_ c, d)-'°'(*P.(")
en, - ~ U; t i, C -
hX;Uit
s:)
i=l
+ Mnt + ½+1((x - en) - ii.*)
= · · · + u;,,,Pt(m, c) - hxmDmt + · · · + u~P1(n, c)
- h(xn - I)8nt + · · · + ½+1(x - en - ii.*), (A.I)
where we have omitted the arguments of u;
for notational convenience. We
now construct an appropriate feasible decision for state x - em, We distinguish
two cases.
Case (i): u;,,, > 0
In this case, the decision W(x - en, d, c) - em+ en is feasible in state x - em
and we get
T
em, c, d)-'°'(
W1u;(x-en,d,c)-em+en(---
X - ~ U;•n(·
•t i, C
)-hx,u,t
_s:_)
i=l
+ P1(n, c) - P1(m, c)
+ Mmt + ½+1((x - em) - (u* - em+ en))
= · · · + (u;,,, - I)P1(m, c) - h(xm - I)Dmt
+ · · · + (u~ + I)P1(n,c) - hxnDnt + ...
+ ½+1(x - en - ii.*). (A.2)

Taking the difference between Equations A.I and A.2, the profits-to-go after
period t + I vanish and we are left with the difference in current profits, which
equals

P1(m, c) - Pt(n, c) + Mnt - Mmt = b(n - m + Dnt(t - n) + Dmt(m - t)),

by definition of P1•
Case (ii): u;,, = 0

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A.2 109

In this case, the decision u;(x - en, d, c) is feasible in state x - em and we

get
T
- c, d) -_ "'(
W tui(x-en,d,c)(-X - em, L..., U;*P,t ( z,· C) - , ) + h'Umt
h X;u;i
i=l
+ ½+1((x - em) - u*)
= · · · + u:nPt(m, c) - h(xm - 1)8mt + ...
+ u~.Pi(n, c) - hxn8nt + · · · + ½+1 (x - em - u*).
(A.3)

Calculating the difference in current profits between Equations A.1 and A.3
yields

- hxm8mt - h(xn -1)8nt - (-h(xm -1)8mt - hxn8nt)

= h(8nt - 8mt) $ 0,
where the inequality follows from n > m. For the difference in expected future
profits we obtain

Vt+1(x - en - u*) - Vt+1(x - em - u*)

$ b(n - m + 8nt+1(t + 1 - n) + 8mt+1(m - t - 1))
$ b(n - m + 8nt(t - n) + 8mt(m - t)), (A.4)

where the first inequality follows from the induction assumption and the second
inequality follows since A.4 is decreasing in t for m < n. This completes the
proof of Part a).
Part b) follows immediately from Part a) by replacing x with x +em+ en
and using the definition of A; ½(x). •

A.2 Proof of proposition 5.2

We have the following equivalences

Pi(m,c) - Am½+1(x) 2: Pt(n,c) -An½+1(x)

¢:}Pt(m,c) - Pt(n,c) 2: Am½+1(x) - An½+1(x)
g b(n - m + 8nt(t - n) + 8mi(m - t)) + h(8mt - 8nt) 2:
Am½+1(x) - An½+1(x). Rainer Quante - 978-3-631-75386-6
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110 APPENDIX A

From Part a) of Proposition 5.1 we know that Lim½+ 1 (x) - Lin½+1(x) ::;
b(n - m + 8nt+ 1(t + 1 - n) + 8mt+ 1(m - t - 1)). As in Case (ii) of the proof
of Proposition 5.1, this implies the desired result since for n > m we have
bnt+l (t+ l-n)+8mt+1(m-t- l) ::; 8nt(t-n)+8mt(m-t) and bmt-bnt :::: 0. D

A.3 Proof of Proposition 5.3 and Theorem 5.1

We show both properties jointly by induction. For t = T, Proposition 5.3
holds since Vr+ 1(.) = 0 and Pr(m,c) = Pr(n,c) for m,n::; T.
Now assume that Proposition 5.3 holds for Period t. We first show that
Theorem 5.1 then holds for Period t and subsequently that Proposition 5.3
holds for Period t - l.
Equation 5.6 shows that one can decompose the fulfillment decision into unit
steps and that selling a given unit is beneficial if immediate profits outweigh
the opportunity cost of losing this unit. Proposition 5.2 shows that there is
an optimal policy u* for which u; > 0 implies xi - uj = 0 for all j < i.
Any optimal policy that does not satisfy this property can be modified by
swapping one unit of supply j against one unit of supply i. Proposition 5.2
implies that this modification does not decrease the objective function value.
Therefore, one can obtain an optimal solution through a line search, starting
with the earliest available supply, i.e. the smallest i, for which x; > 0. The
induction assumption of Proposition 5.3 shows that the objective function is
concave along this search line. Therefore, one can stop the search as soon
as immediate profits drop below the opportunity costs. This proves that the
procedure defined in Theorem 5.1 yields an optimal policy.
We now show Proposition 5.3 for Period t - 1. We use the same notation as
in the proofof Proposition 5.1. Let u1 := W(x, c, d), u2 := u;(x-em, c, d), and
u3 := u;(x - em - en, c, d) denote the optimal decisions in states x, x- em, and
x - em - en, respectively, for a given customer class c and demand quantity d.
Furthermore, let

A:= Wf (x,c,d) - wt(x - em, c, d) and

Wt em, c, d) - Wt (x - em - en, c, d).
-2 -3
B := (x -

We rewrite Proposition 5.3 for Period t - 1 as Lim ½(x) - Lin ½(x - em) ::;
Pt_ 1(m,c)- Pt_ 1(n,c) and show that

A - B ::; Pt(m, c) - Pt(n, c) - h(8mt - bnt)

::; Pt-1 (m, c) - Pt-1 (n,Quante
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A.3 111

for any values of c and d, which implies that these inequalities also hold in
expectation.
The second inequality follows directly from the definition of Pt(.,.) form<
n. For the first inequality, we distinguish three cases, based on the value of u1 .
Case (i): u1 = O
Theorem 5.1 implies u2 = u3 = 0. From the definition of Wt we get

A- B = Am½+1(x) - h8mt - An ½+1(x ---~) + h8nt

$ Pt(m, c) - Pt(n, c) - h(8mt - 8nt),

where the inequality follows from the induction assumption.

Case (ii): 0 < Li=t uf < d
Theorem 5.1 implies u2 = u1 - em. There are two possibilities for u3 . If
u2 =I- 0 then u3 = u2 - en , otherwise u3 = 0. In the first case, we get

A- B = Pt(m, c) - Pt(n, c) - h(8mt - 8nt),

In the second case, B = An½+ 1 (x-em)-h8nt and Theorem 5.1 implies that
this value is smaller than Pt(n, c) - h8nt since it is optimal not to sell another
unit of supply n. Thus, A - B satisfies the desired inequality in either case.
Case (iii): Li=t uf = d
Theorem 5.1 implies that either u2 = u1 - em or u2 = u1 - em + ek for
some k ~ n. The first alternative leads to the same calculations as in Case
(ii) above. The second alternative leaves two options for u3 , namely either
u3 = u2 - en+ e1 for some l ~ k or u3 = u2 - en, In the first case, we get
A- B = Pt(m, c) - Pi(k, c) + Ak½+ 1(x - u1)
- Pi(n, c) - Pi(l, c) + A1½+1(x - ii 1 - ek) - h(8mt - 8nt)
$ Pt(m, c) - Pt(n, c) - h(8mt - 8nt),
where the inequality follows from the induction assumption. The other case
regarding u3 yields B = Pt(n, c) - h8nt and therefore

A- B = Pt(m, c) - Pt(k, c) + AkVt+1(x - iii) - Pt(n, c) - h(8mt - 8nt)

$ Pt(m, c) - Pt(n, c) - h(8mt - 8nt),
where the inequality follows from the fact that it is optimal in state x - u1 to
sell an additional unit of supply k. •
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112 APPENDIX A

A.4 Proof of Proposition 5.4

We show by induction that .6.;\/i+ 1 (x) > 0 implies .6.;\li(x) 2:: .6.;\/i+ 1 (x). Since
Pi(i,c) is increasing int this assures non-increasing protection levels for any i
and c.
For t = T the condition is empty since .6.; Vr+ 1 (x) = 0 for all i, c, and x. In
other words, all protection levels vanish at the end of the planning horizon.
Assume now that Proposition 5.4 holds for Period t + l. We show that it
also holds for Period t. To this end, assume that .6.; \/i+ 1 (x) > 0. Using the
Bellman recursion of Vi we have

.6.; Vi(x) = -Mit + Ec,d (max {Pt( i, c)Jd>O ; .6.; Vi+1 (x)}]' (A.5)

where Jd>O equals unity if d > 0 and zero otherwise. For t < i the holding-cost
term vanishes and we immediately get .6.; Vi (x) 2:: .6.; Vi+ 1 ( x). For t 2:: i we
rewrite (A.5) for t + 1

.6.; Vi+1 (x) = -Mit+l + Ec,d (max {Pt+I (i, c)Jd>O ; .6.; Vi+2(x)}] ' (A.6)

and compare the individual terms. We have -Mit = -Mit+I and Pt(i, c) =
Pt+ 1 (i, c) since t 2:: i . In addition, the induction assumption implies that
.6.;\/i+ 1 {x) 2:: .6.;\/i+ 2 (x) if the maximum in (A.6) is attained by the last term.
Therefore, .6.;\li(x) 2:: .6.;\/i+ 1 {x), which completes the proof. •

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Appendix B

Data Tables
Table B.l: Data of Fig. 7.1

(a) Lost Sales

Cl. FCFS SOPA D SOPA A
1 40.89% 11.76% 1.56%
2 40.52% 28.73% 31.83%
3 40.97% 77.30% 82.98%

(b) Backlogged Quantities

Cl. FCFS SOPA D SOPA A
1 0.00% 4.28% 47.59%
2 0.00% 2.09% 60.59%
3 0.00% 1.96% 16.37%

Table B.2: Data of Fig. 7.2

(a) Early Delivery

CJ. FCFS SOPA D SOPA A
1 58.84% 77.43% 43.99%
2 59.21% 62.95% 4.36%
3 58.82% 15.40% 0.45%

(b) On Time Delivery

Cl. FCFS SOPA D SOPA A
1 0.27% 6.53% 6.86%
2 0.27% 6.23% 3.22%
3 0.20% 5.35% 0.20%

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114 APPENDIX B

Table B.3: Data of Fig. 7.3

Cl. GOP FCFS SOPA D SOPA A

1 2,617,006 2,515,394 2,535,015 1,231,004
2 2,617,006 2,515,394 2,544,101 1,767,756
3 2,617,006 2,515,394 2,543,725 1,774,840
4 2,617,006 2,515,394 2,540,218 1,849,463
5 2,617,006 2,515,394 2,539,859 1,860,748
6 2,617,006 2,515,394 2,535,119 1,882,588
7 2,617,006 2,515,394 2,533,737 1,870,950
8 2,617,006 2,515,394 2,531,967 1,894,752
9 2,617,006 2,515,394 2,531,083 1,894,894
10 2,617,006 2,515,394 2,533,138 1,900,758

Table B.4: Data of Fig. 7.4

Cl. FCFS SOPA D SOPA A

1 3.88% 3.13% 52.96%
2 3.88% 2.79% 32.45%
3 3.88% 2.80% 32.18%
4 3.88% 2.93% 29.33%
5 3.88% 2.95% 28.90%
6 3.88% 3.13% 28.06%
7 3.88% 3.18% 28.51%
8 3.88% 3.25% 27.60%
9 3.88% 3.28% 27.59%
10 3.88% 3.21% 27.37%

Table B.5: Data of Fig. 7.5

(a) Heterogeneity 10%

Cl. FCFS SOPA D SOPA A
1 3.88% 3.13% 52.96%
2 3.88% 2. 79% 32.45%
3 3.88% 2.80% 32.18%
4 3.88% 2.93% 29.33%
5 3.88% 2.95% 28.90%
6 3.88% 3.13% 28.06%
7 3.88% 3.18% 28.51%
8 3.88% 3.25% 27.60%
9 3.88% 3.28% Rainer27.59%
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APPENDIX B 115

(b) Heterogeneity 30%

Cl. FCFS SOPA D SOPA A
1 10.24% 9.67% 54.44%
2 10.24% 5.42% 12.52%
3 10.24% 5.38% 14.69%
4 10.24% 4.91% 13.61%
5 10.24% 5.01% 8.50%
6 10.24% 5.27% 10.09%
7 10.24% 5.28% 10.11%
8 10.24% 5.32% 9.52%
9 10.24% 5.36% 9.70%
10 10.24% 5.27% 9.55%

(c) Heterogeneity 50%

Cl. FCFS SOPA D SOPA A
1 16.29% 15.63% 54.40%
2 16.29% 8.28% 10.51%
3 16.29% 7.23% 13.49%
4 16.29% 6.33% 12.16%
5 16.29% 6.50% 7.80%
6 16.29% 6.94% 8,78%
7 16.29% 6.76% 8.07%
8 16.29% 6.94% 8.05%
9 16.29% 7.02% 7.37%
10 16.29% 6.90% 7.36%

(d) Heterogeneity 70%

Cl. FCFS SOPA D SOPA A
1 21.61% 21.08% 52.63%
2 21.61% 10.41% 9.04%
3 21.61% 8.63% 12.76%
4 21.61% 7.47% 10.53%
5 21.61% 7.81% 6.60%
6 21.61% 8.40% 7.66%
7 21.61% 8.02% 7.14%
8 21.61% 8.05% 6.07%
9 21.61% 8.31% 6.37%
10 21.61% 8.20% 5.94%

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116 APPENDIX B

Table B.6: Data of Fig. 7.6

(a) Forecast Error 0%

Cl. FCFS SOPA D SOPA A
1 3.88% 1.94% 52.96%
2 3.88% 0.36% 33.43%
3 3.88% 0.15% 31.04%
4 3.88% 0.10% 30.00%
5 3.88% 0.06% 29.13%
6 3.88% 0.04% 28.66%
7 3.88% 0.03% 28.33%
8 3.88% 0.02% 27.67%
9 3.88% 0.02% 27.19%
10 3.88% 0.02% 26.83%

(b) Forecast Error M

Cl. FCFS SOPA D SOPA A
1 3.88% 3.13% 52.96%
2 3.88% 2.79% 32.45%
3 3.88% 2.80% 32.18%
4 3.88% 2.93% 29.33%
5 3.88% 2.95% 28.90%
6 3.88% 3.13% 28.06%
7 3.88% 3.18% 28.51%
8 3.88% 3.25% 27.60%
9 3.88% 3.28% 27.59%
10 3.88% 3.21% 27.37%

(c) Forecast Error 50%

Cl. FCFS SOPA D SOPA A
1 3.88% 4.54% 52.96%
2 3.88% 5.42% 31.21%
3 3.88% 5.41% 23.94%
4 3.88% 5.61% 21.51%
5 3.88% 5.40% 19.60%
6 3.88% 5.24% 16.87%
7 3.88% 5.63% 15.84%
8 3.88% 5.54% 13.90%
9 3.88% 6.01% 13.69%
10 3.88% 5.54% 13.13%

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APPENDIX B 117

(d) Forecast Error 100%

CL FCFS SOPA D SOPA A
1 3.88% 8.88% 52.96%
2 3.88% 11.79% 17.47%
3 3.88% 11.07% 16.21%
4 3.88% 11.63% 14.84%
5 3.88% 11.74% 11.49%
6 3.88% 12.10% 11.02%
7 3.88% 12.39% 11.14%
8 3.88% 12.58% 10.19%
9 3.88% 13.59% 11.16%
10 3.88% 12.49% 9.55%

Table B.7: Data of Fig. 7.7

Backlogging Costs GOP FCFS SOPA D SOPA A

0 2,799,229 2,515,394 2,701,440 2,788,465
1 2,713,034 2,515,394 2,638,449 2,606,074
2 2,683,542 2,515,394 2,608,421 2,231,926
3 2,666,971 2,515,394 2,590,617 1,760,303
4 2,655,540 2,515,394 2,579,133 1,253,369
5 2,646,701 2,515,394 2,569,319 1,112,489
6 2,639,198 2,515,394 2,563,497 1,556,233
7 2,632,968 2,515,394 2,558,761 1,682,605
8 2,627,311 2,515,394 2,554,074 1,702,957
9 2,621,976 2,515,394 2,548,068 1,745,037
10 2,617,006 2,515,394 2,543,725 1,774,840

Table B.8: Data of Fig. 7.8

(a) Lost Sales

Cl. GOP FCFS SOPA D RM
1 1.82% 38.65% 7.82% 14.62%
2 32.73% 40.40% 29.45% 26.91%
3 86.41% 38.53% 83.62% 76.89%
(b) Backlogged Quantities
Cl. GOP FCFS SOPA D RM
1 2.62% 0.00% 2.84% 3.10%
2 1.51 % 0.00% 2.62% 1.45%
3 0.03% 0.00% Rainer
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Table B.9: Data of Fig. 7.9

CV GOP FCFS SOPA D RM

0.00 17,890.36 17,265.44 17,682.46 17,768.62
0.33 17,851.67 17,229.71 17,553.97 17,694.21
0.67 17,843.03 17,247.27 17,327.95 17,635.90
1.00 17,748.89 17,164.66 16,767.71 17,449.12
1.33 17,440.88 16,803.89 15,880.23 17,031.49

Table B.10: Data of Fig. 7.10

(a) Heterogeneity 10%

CV FCFS SOPA D RM
0.00 3.49% 1.17% 0.68%
0.33 3.48% 1.68% 0.88%
0.67 3.33% 2.91% 1.16%
1.00 3.28% 5.58% 1.69%
1.33 3.65% 9.10% 2.37%

(b) Heterogeneity 20%

CV FCFS SOPA_D RM
0.00 10.04% 1.72% 1.25%
0.33 9.77% 2.44% 1.63%
0.67 9.42% 4.50% 2.45%
1.00 8.84% 7.95% 3.47%
1.33 8.89% 12.21% 4.63%

(c) Heterogeneity 30%

CV FCFS SOPA D RM
0.00 17.07% 2.50% 1.73%
0.33 17.28% 3.32% 2.26%
0.67 16.95% 5.71% 3.29%
1.00 15.10% 9.58% 4.86%
1.33 14.82% 14.57% 6.31%

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APPENDIX B 119

Table B.11: Data of Fig. 7.11

(a) CV = 0.67 and Low Heterogeneity

Shortage Rate FCFS SOPA D RM
0% (41%) 3.38% 3.28% 1.24%
25% (21%) 2.70% 5.73% 1.64%
41% (0%) 2.47% 3.23% 1.02%
50% (-19%) 2.03% 2.56% 0.49%
75% (-138%) 0.31% 0.10% 0.00%
(b) CV= 0.33 and Low Heterogeneity
Shortage Rate FCFS SOPA D RM
0% (41%) 3.52% 1.66% 0.89%
25% (21%) 2.29% 3.53% 1.28%
41% (0%) 2.03% 2.39% 0.76%
50% (-19%) 1.38% 1.44% 0.28%
75% (-138%) 0.01% 0.00% 0.00%
(c) CV= 0.67 and Medium Heterogeneity
Shortage Rate FCFS SOPA D RM
0% (41%) 9.18% 4.41% 2.36%
25% (21%) 5.64% 6.93% 3.25%
75% (-138%) 3.50% 3.75% 1.71%
41% (0%) 1.83% 2.63% 0.66%
50% (-19%) 0.23% 0.07% 0.00%

Table B.12: Data of Fig. 7.12

(a) nt = 10
Heterogeneity FCFS SOPA D SOPA A RLP
10% 3.81% 1.65% 32.60% 1.65%
30% 10.28% 3.34% 14.81% 3.34%
50% 16.47% 4.37% 13.79% 4.37%
70% 21.78% 5.11% 12.45% 5.11%
(b) nt ~ Poisson(IO)
Heterogeneity FCFS SOPA D SOPA A RLP
10% 3.83% 2.98% 31.24% 3.19%
30% 9.65% 5.50% 15.86% 5.64%
50% 15.90% 7.05% 15.07% 7.20%
70% 20.97% 8.62% 12.92% 8.81%
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120 APPENDIX B

(c) nt ~ N B(IO, 64)

Heterogeneity FCFS SOPA D SOPA A RLP
10% 3.40% 7.45% 29.98% 7.87%
30% 9.77% 12.42% 14.15% 13.49%
50% 16.46% 16.26% 12.63% 17.04%
70% 20.37% 18.98% 13.45% 19.65%

(d) nt ~ NB(IO, 144)

Heterogeneity FCFS SOPA D SOPA A RLP
10% 3.83% 18.59% 25.56% 17.75%
30% 10.33% 21.65% 15.41% 21.23%
50% 16.36% 26.08% 16.87% 25.56%
70% 21.63% 30.00% 14.78% 29.50%

Table B.13: Data of Fig. 7.13

(a) nt = 10
Heterogeneity FCFS SOPA D SOPA A RLP
10% 3.81% 3.17% 33.69% 3.17%
30% 10.28% 6.45% 14.92% 6.45%
50% 16.47% 8.94% 14.15% 8.94%
70% 21.78% 10.10% 12.34% 10.10%

(b) nt ~ Poisson(IO)
Heterogeneity FCFS SOPA D SOPA A RLP
10% 3.83% 3.93% 32.23% 4.12%
30% 9.65% 7.02% 14.97% 6.99%
50% 15.90% 9.75% 14.01% 9.70%
70% 20.97% 12.66% 12.32% 12.59%

(c) nt ~ NB(I0,64)
Heterogeneity FCFS SOPA D SOPA A RLP
10% 3.40% 8.18% 30.56% 8.65%
30% 9.77% 14.96% 14.05% 16.01%
50% 16.46% 20.26% 12.81% 20.81%
70% 20.37% 23.29% 13.01% 23.65%

(d) nt ~ NB(IO, 144)

Heterogeneity FCFS SOPA D SOPA A RLP
10% 3.83% 21.37% 27.81% 20.57%
30% 10.33% 25.92% 17.04% 25.21%
50% 16.36% 30.28% 17.90% 29.45%
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