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Dynamic lotsizingproblemwithcontinuous-timeMarkovian
productioncost

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journal homepage: www.elsevier.com/locate/ijpe

production cost

Amir Azaron a,b,, Ou Tang b,d, Reza Tavakkoli-Moghaddam c

a

Michael Smurt Graduate School of Business, University College Dublin, Carysfort Avenue, Blackrock, Co. Dublin, Ireland

ping University, Linko

ping, Sweden

Department of Management and Engineering, Linko

Department of Industrial Engineering, College of Engineering, University of Tehran, Tehran, Iran

d

School of Economics and Management, Tongji University, Shanghai, China

b

c

a r t i c l e in fo

abstract

Article history:

Received 11 April 2007

Accepted 10 April 2009

Available online 21 April 2009

This paper develops a polynomial algorithm for obtaining dynamic economic lot sizes in

a single product multiperiod production system with the objective of minimizing total

production and inventory costs over T periods. It is assumed that production costs are

linear, inventory costs are concave, setup costs are zero and backlogging is not permitted

in all periods. Moreover, the unit production cost is a stochastic variable, which is

evolved according to a continuous-time Markov process over the planning horizon. The

model is formulated as a stochastic dynamic programming (DP) optimization with the

state variable being unit production cost. Then, it is solved using the backward dynamic

programming approach. To justify the application of the proposed model, two practical

cases are presented.

& 2009 Elsevier B.V. All rights reserved.

Keywords:

Dynamic lot sizing

Dynamic programming

Stochastic processes

1. Introduction

The classical dynamic lot sizing problem species a

discrete-time nite horizon single product inventory

management problem subject to deterministic timevarying demand that must be satised. This problem has

been the subject of extensive research since its introduction in the late 1950s until today. When the production

cost and the inventory cost of each period are linear,

several authors have presented theorems that can reduce

the computational effort required in solving the problem.

Wagner and Whitin (1958) and Zabel (1964) give results

for the no-backlogging case, while Zangwill (1969)

analyzes the backlog case. Many generalizations of the

basic model have been considered including introducing

bounds on inventory and/or production capacity, as well

Corresponding author at: Michael Smurt Graduate School of

Business, University College Dublin, Carysfort Avenue, Blackrock, Co.

Dublin, Ireland.

E-mail addresses: amir.azaron@ucd.ie, aazaron@gmail.com

(A. Azaron).

0925-5273/$ - see front matter & 2009 Elsevier B.V. All rights reserved.

doi:10.1016/j.ijpe.2009.04.007

(2006), Karimi et al. (2003) and Maes and Wassenhove

(1998) provide excellent reviews about single item lot

sizing, multiproduct capacitated lot sizing and multi item

single level capacitated dynamic lot sizing problems,

respectively.

In the last decade, three important papers, Aggarwal

and Park (1993), Federgruen and Tzur (1991) and Wagelmans et al. (1992) improved the time complexity for

obtaining an optimal solution from O(T2) to O(T log T), if T

represents the length of the planning horizon.

The existing materials in the area of stochastic lot

sizing consider mainly demand as the uncertain parameter. Silver (1978) applies a heuristic to compute the

actual lot size as the solution of a newsvendor problem.

Bookbinder and Tan (1988) convert the stochastic problem

to an equivalent deterministic problem that has the same

form as the deterministic dynamic lot sizing problem. Sox

(1997) developed an optimal algorithm for the single item

dynamic lot sizing problem with random demand and

non-stationary costs. Melo (1996) provides an excellent

review about the stochastic lot sizing in production

ARTICLE IN PRESS

608

research literature on the stochastic lot scheduling

problem, which deals with scheduling production of

multiple products with stochastic demand. Recently,

Haugen et al. (2001) used a meta-heuristic to solve

stochastic lot sizing problems.

This paper develops a polynomial algorithm for

obtaining the optimal production scheduled for each

period in single product multiperiod production systems

with stochastic production (or purchasing) costs. The

productions (purchases) must be made in markets

characterized by signicant cost (price) uctuations.

There is no assurance that the price tomorrow will be

the same as that today. Examples of such commodities are

rubber, sugar, copper, coffee and cereals. When the price is

low the purchasing ofcer would like to buy to build up

his stocks to meet at least part of the requirements for the

periods when the price is high. When the price is high he

will avoid purchasing and use his stocks to meet his

current needs.

Published paper in the eld of stochastic price

illustrating the use of operational research techniques is

rare, see Kingsman (1986). To our knowledge, only Fabian

et al. (1959) and Kingsman (1969) considered this type of

problem, but in both of their studies prices in successive

periods are independent, which is a restrictive assumption

in many practical cases.

In this study, we assume that the unit production cost

(price) is a stochastic variable, which is evolved according

to a continuous-time Markov process over the time

horizon. So, the actual price in each period will be

dependent on the price in the previous period. This

assumption is different compared with the ones in Fabian

et al. (1959), Kingsman (1969). Such an assumption also

reects better the price movement in practice and it is the

main contribution of this paper. To justify the application

of the proposed model, two practical cases are presented

below. In both, the price is varying over the time horizon

and in each period its change depends on the price in the

previous period.

First, consider the problem of purchasing oil by

governments, according to the variations of oil price over

the planning horizon. In this regard, oil price can be

considered as low, medium and high levels or even more

accurately in several levels. The length of planning

horizon is dependent on the political situation of each

country (normally 4 years). Clearly, the duration of time

that the oil price remains at its present level, before

proceeding to the next level, is not constant, rather it

would be a random variable and can be considered to

follow an exponential distribution. The government

purchases oil in discrete points during the planning

horizon. Moreover, if it seems that the price of oil, in

any period, is relatively inexpensive, it might be a good

decision to purchase oil in a high volume and store it for

the next periods needs.

To model this problem and to obtain the economic oil

ordering size (number of million gallons) per period

(possibly year), oil price can be supposed to evolve

according to a proper continuous-time Markov process.

In order to properly estimate the transition probabilities

transitions of the oil price inside each level and only

consider the transitions of the oil price from each level to

other levels in this particular problem. In this regard, it is

reasonable to assume that after remaining the oil price at

any level for some time, which is stochastic, it will

eventually transit to one of the other levels. In this

problem, a transition matrix with zero diagonal elements

can properly reect the dynamic nature of oil price during

the planning horizon. As long as we decrease the range of

levels, the accuracy of the proposed model will be

increased.

Another important application arises in Iran where the

unit production costs are inuenced by the government

which frequently xes costs of basic raw materials. The

cabinet, one or two times per year, decides about xing

the unit costs for a number of strategic raw materials like

steel, wood, petroleum, etc., according to ination in the

country which is always upward. In this regard, the

cabinet submits the corresponding bill to the parliament

and the parliaments decision on xing the unit costs or

increasing them to one of the proposed unit costs, based

on the cabinets bill and the ination rate, is nal.

Increasing the raw materials costs clearly increases the

unit production costs, because for producing each product, the producer needs to purchase some related raw

materials from the government and then makes the nal

product. Moreover, the duration of time that the raw

materials costs remain at their present positions, before

changing to some new positions, is not constant, rather it

depends on the time interval for deciding about changing

the raw materials costs by the government (the cabinet

and the parliament).

To model this problem in order to obtain the economic

lot size in single product multiperiod production systems,

the unit production cost can be supposed to evolve

according to a proper continuous-time Markov process.

When the state variables (values of the unit production

cost) are sorted from the smallest to the largest one, an

upper triangular transition matrix with a single absorbing

state can properly reect the dynamic nature of the unit

production cost and its dependency on the governments

decision in this particular problem in Iran.

What makes a continuous-time Markov chain different

from a Markov chain is that the amount of time it spends

in each state, before proceeding to the next state, is

exponentially distributed, instead of a constant deterministic value. In both practical cases, the amount of time to

spend in each state is clearly a random variable. The cost

(price) in each period is also dependent on the cost in the

previous period. If the process of evolving the cost

coefcient over the time horizon is memoryless, then it

is possible to model the cost changes occurring at any

time over the planning horizon including the beginning of

each period, when the decisions about the economic lot

sizes are actually made, and to derive the proper

stochastic dynamic programming recursive functions.

The only distribution which poses the memoryless

property is exponential. Therefore, the above mentioned

problems and many similar ones in production and

business can be best modeled by continuous-time Markov

ARTICLE IN PRESS

A. Azaron et al. / Int. J. Production Economics 120 (2009) 607612

reasonable. All price information in early periods is

included in the last period, from which the current price

will departure.

Finally, the model is formulated as a stochastic DP

optimization with the state variable being unit production

cost, and the corresponding DP functional equation is

derived. Then, it is solved in the backward DP way. We

also discuss about the complexity of the proposed

algorithm to solve the problem.

609

judgments of experts in this area, especially in unstable

processes. A combination of both approaches, depending

on how much the process is unstable, can also be used to

estimate the parameters. In the combination approach, as

much as the instability of the process is increased, more

weight is assigned to the experts points of views for

estimating the parameters.

Assumption 3. Let fim t represent the conditional probability that the unit production cost changes to cm at time

t, given that it was ci at time zero.

Notations:

T

Xt

Dt

It

Ht(It)

ct

production scheduled for period t (t 1,2,y,T)

expected demand in period t

net inventory at the end of period t (I0 IT 0)

inventory cost in period t (concave function)

unit production cost at the beginning of period t

production cost be equal to N (these states are in this

order: c1,c2,y,cN), and pim represents the probability of

changing this cost from ci to cm. These probabilities form

an N N transition matrix P.

Assumption 2. Let tim represent the duration of time that

the unit production cost is ci, before changing to cm. tim is a

random variable with the exponential density function

fim(t) and the parameter lim, because the unit production

cost is evolved according to a continuous-time Markov

process. Clearly wi(t) or the density function of staying

time in state ci is given by

wi t

N

X

pim f im t

(1)

m1

can be estimated from available historical data, based on

the structure of the problem. For example, in the problem

of purchasing oil, the historical data related to the staying

times in different price levels and the number of

transitions from each level to other levels during the

previous L periods can be easily collected. Since changing

the oil price over the time horizon is not a stable process,

very old data should not be used to estimate the

parameters. Then, the average staying times in each level

i 1=li and also the probabilities of changing the price

from each level i into any new level m (pim) are all

estimated by using collected historical data. Finally, the

values of lim are estimated as follows:

lim pim li

(2)

out about using the method of maximum of likelihood for

estimating the parameters of a continuous-time Markov

process.

zero be in state cm at time t? One situation in which this is

possible is when ci and cm represent the same state and

the process does not leave state ci throughout the period

(0, t). This requires that the process makes its rst

transition after time t. Every other way to get from state

ci to state cm in the interval (0, t) requires that the process

makes at least one transition during that interval. For

example, the process could have made its rst transition

from state ci to some state cl at a time t, 0otot, and then

by some succession of transitions have made its way to

state cm at time t. These considerations lead us to Eq. (3)

for computing fim t

fim t dim

(

dim

wi t dt

N

X

l1

if i m

otherwise

pil

t

0

f il tflm t t dt

(3)

since the second integral of Eq. (3) is a convolution of two

functions, fim t can be computed by using the Laplace

e

transform. Let f il s represent the Laplace transform of fil(t)

e

and fim s represent the Laplace transform of fim t,

which is given by

feim s dim

1

0

1

t

est wi t dt dt

N

X

pil f il sflm s

(4)

l1

e

of fim s in Eq. (4), see Howard (1971) for more details.

When the unit production cost in each period is

deterministic and dynamic over the planning horizon,

the appropriate model for obtaining the optimal values of

Xt is

Min

T

X

ct X t

t1

s:t:

T 1

X

Ht It

t1

X 1 D1 I1

It1 X t Dt It

t 2; 3; . . . ; T 1

IT1 X T DT 0

It X0;

X t X0

(5)

the property that production in any period t must be one

Pk

of these values: 0 or

jt Dj, for k t, t+1,y,T, because

It1Xt 0, see Johnson and Montgomery (1974) for more

details.

ARTICLE IN PRESS

610

for periods j+1, j+2,y,k by production at the beginning of

period j+1, then in an optimal program we will have

3. Numerical examples

X j1 Dj1 Dj2 Dk

Consider the following four-period production planning problem involving raw material purchasing in Iran.

There is no initial inventory and the nal inventory level is

to be zero. The inventory cost is linear. Assuming ht as the

unit holding cost in period t, the inventory cost has the

form as Eq. (9). Estimates of ht and Dt are given in Table 1:

It X j1

t

X

k

X

Dr

Dr

t j 1; j 2; . . . ; k 1

rt1

rj1

Ij Ik 0

(6)

j+1 to k will be as Eq. (7), and the DP functional equations

can be easily written in this case to obtain the optimal

production scheduled in all periods:

k

X

cj1

Dr

rj1

k1

X

Ht

tj1

k

X

!

(7)

Dr

rt1

between the classical dynamic programming model and

ours is that in our model, the production cost in period t is

based on the value of the cost coefcient at the beginning

of the period. In this case, subject to the Markovian

assumption, ct plays the role of the state variable of a

stochastic sequential decision process.

Let Vj(ci) represent the minimum total costs from

period j+1 to T pertaining to zero inventory level at the

end of period j, if the unit production cost at the beginning

of period j+1 (decision point) is ci or cj1 ci.

The probability that after kj periods, the unit

production cost at the beginning of period k+1 changes

to cm, given that at the beginning of period j+1 this cost

was ci, is equal to fim k j, because the continuous-time

Markov process corresponding to the transitions of the

cost coefcient over the time horizon is memoryless.

Then, by conditioning on the state of the unit production

cost after kj periods, the stochastic DP functional

equation is written as follows:

i

V j c min

8

<

jokpT :

N

X

ci

k

X

rj1

Dr

k1

X

tj1

fim k jV k cm

Ht

k

X

!

Dr

rt1

i 1; 2; . . . ; N

Ht It ht It

The unit production cost is inuenced by the governments decision on xing or increasing the required raw

materials costs over the planning horizon. The cost

coefcient is assumed to evolve according to a continuous-time Markov process with the following ve states:

c1 100, c2 120, c3 150, c4 180 and c5 200. The

upper triangular transition matrix is estimated as

3

2

0 0:6 0:4 0

0

6 0 0 0:5 0:5 0 7

7

6

7

6

7

P6

6 0 0 0:2 0:5 0:3 7

7

6

0 0:8 0:2 5

40 0

0 0

0

0

1

It should be noted that the transition matrix in this

particular case should be in upper triangular form, as

explained in Section 1. But, it can technically have any

general form such as the transition matrix related to the

oil purchasing problem, which will be solved later.

It is also assumed that the time interval for deciding

about changing the raw materials costs by the government is distributed according to an exponential distribution with the average of one period. Accordingly, fim(t) for

all i and m would be

f im t et ;

t40

(10)

e

taking the inverse Laplace of fim s in Eq. (4), as follows

(clearly, fim t 0 for i 1, 2, 3, 4, 5 and moi):

f55 t 1;

(8)

(9)

f44 t e0:2t ;

0:8t

f33 t e

f45 t 1 e0:2t ,

m1

associated with the classicaldeterministicWagner/

Whitin model, except that here future Vk(cm) values are

weighted by the conditional probabilities fim Dt.

Finally, the DP functional equation (8) is solved in a

backward manner for j T, T1,y,0. Clearly, VT(ci) 0 for

i 1; 2; . . . ; N. In order to solve (8), we need to compute

fim Dt by the inverse Laplace transformation in Eq. (4).

This is obtained by simultaneous linear equations, for

given s, in which computation time is not constant,

usually O(N3). Computing Vj(ci) in the recursive functions

(8) is carried out on O(T2N), because for each

j 0,1,y,T1, there are Tj combinations for all values

PT1

of Vj(ci), for i 1,2,y,N, and

j0 T j TT 1=2.

Therefore, the time complexity of the proposed algorithm

would be O(N3+T2N).

f22 t et ;

f25 t 1 0:56et 1:146e0:2t 0:414e0:8t ,

f11 t et f12 t 0:6tet

Table 1

Data for the numerical example 1.

t

Dt

ht

1

2

3

4

20

30

40

30

20

20

30

30

ARTICLE IN PRESS

A. Azaron et al. / Int. J. Production Economics 120 (2009) 607612

f14 t 6:641e

t

t

0:562te

0:2t

1:276e

0:8t

7:917e

611

Table 3

Data for the numerical example 2.

t

Dt

ht

1

2

3

4

10

8

15

20

20

20

30

40

backward manner to obtain the optimal production

scheduled in each period. The results are summarized in

Table 2, where each cell of the table displays the

corresponding V t1 c and Xt values.

The information in Table 2 then provides optimal

decisions. For example, if the unit production cost at the

beginning of the planning horizon is equal to 100, then the

optimal production scheduled for period 1 would be 120,

or we should supply the requirements for all periods by

production at the beginning of period 1. The reason is that

the unit production cost at the beginning of the planning

horizon has the minimum value in this case. The total

costs in this case is equal to 16 300.

For another example, if the unit production cost at

the beginning of the planning horizon is equal to 150,

then the optimal production scheduled for period 1 is

equal to 50, which covers the demands for both the

rst and the second periods. Then, we jump to the third

period. According to the columns 3 and 4 of Table 2, the

optimal production scheduled for period 3 is equal to 40

either the unit production cost at the beginning of period

3 does not change or changes to 180 or 200, and then for

period 4 is equal to 30. This is due to the higher level of

the variable cost at the beginning of the planning horizon,

comparing with the previous case, which avoids producing a lot.

level, before proceeding to the next level, for an exponential time with the average of one period. F matrix with the

elements fim t for i 1, 2, 3 and m 1, 2, 3 is computed

as below:

6

F6

4

inventory has the same form as the numerical example 1.

Estimates of ht and Dt (in millions) are given in Table 3.

It is also assumed that the oil price is changing over the

planning horizon according to a continuous-time Markov

process with three states: c1 low level (40 Dollars per

gallon), c2 medium level (80 Dollars per gallon) and

c3 high level (120 Dollars per gallon). The transition

Table 2

Results of the numerical example 1.

c

100

120

150

180

200

t

1

16 300

120

18 434.8

90

21 018.98

50

22 242.38

20

24 000

20

12 300

100

14 300

100

16 763

70

18 342.34

30

20 000

30

7900

70

9300

70

11141.7

40

12 708.6

40

14 000

40

3000

30

3600

30

4500

30

5400

30

6000

30

Table 4

Results of the numerical example 2.

c

40 (low)

80 (medium)

120 (high)

3675.5

18

4387.8

10

5000.2

10

2771.2

23

3569.8

8

4172.8

8

1937.6

15

2868.8

15

3726.4

15

800

20

1600

20

2400

20

matrix is estimated as

2

3

0

1

0

6 0:4 0 0:6 7

P4

5

0

1

0

0:2 0:2e2t

0:2 0:4et 0:2e2t

0:5 0:5e2t

0:5 0:5e2t

0:5 0:5e2t

3

0:3 0:6et 0:3e2t

7

2t

7

0:3 0:3e

5

0:3 0:4et 0:3e2t

backward to obtain the optimal oil ordering size (in

million gallons). The results are summarized in Table 4.

According to Table 4, if for example the oil price at the

beginning of the planning horizon is low, then 18 gallons

is to be purchased at the beginning, which covers the

demands for both the rst and the second periods. Then,

the optimal oil ordering size in each of the last two

periods will be as equal as its expected demand, in all

states.

We also used Matlab to solve the problems up to 14

states for the unit production cost, analytically. Fig. 1

shows the computational times. Even for the higher

dimensions, since the Laplace transform and its inverse

transform are linear and the proposed algorithm is

polynomial, we do not have much problem in computation time. In this case, we can at least calculate fim t

numerically and then easily solve the DP functional

equation using the backward approach.

4. Conclusion

In this paper, we proposed a polynomial algorithm

based on semi-Markovian decision processes to solve the

ARTICLE IN PRESS

612

problem.

The proposed model can also be extended to solving

the equipment replacement problem in dynamic setting.

Suppose that the unit procurement cost of facility is

changing over the time horizon according to a continuoustime Markov process. Then, the optimal strategy of

replacement can be easily found by extending the

proposed model in this paper. Hence the only difference

between the dynamic economic lot size model and the

standard equipment replacement model is the calculation

of the costs, that is the maintenance and procurement

costs.

350

Time (second)

300

250

200

150

100

50

0

0

5 6 7 8 9 10 11 12 13 14 15

Dimention Of Matrix

Acknowledgment

dynamic lot sizing problem, in which the production and

the inventory costs of each period are concave, and the

unit production cost evolves according to a continuoustime Markov process over the planning horizon.

As explained, we need to consider continues-time

Markov process in our analysis, because we need the

memoryless property of evolving the unit production cost

over the time horizon to derive the DP functional Eq. (8).

The main computational difculty of the proposed

algorithm is to compute fim Dt by the inverse Laplace

transformation in Eq. (4). The usual method for solving

such equations is to approximate them by a discrete-time

analog or determine the inverse Laplace transform

numerically, in moderately large problems.

Apart from the two cases mentioned in Section 1, this

model can be applied in many practical production and

business cases for instance in global supply chains. Due to

the comparative advantages of different countries, nowadays rms are developing manufacturing and sourcing

strategies in a global supply chain. Material purchasing,

manufacturing and market often locate in different

regions. One challenge is then to deal with nancial risk.

Firms have an impressing need to take into consideration

of price and exchange rate uctuation in production

systems. The proposed model can be easily used to

manage sourcing decision at the strategic and tactical

level for purchasing decisions dealing with raw materials.

The proposed model can be extended to some more

general settings. For example, some other parameters of

the model, like the unit holding cost per period, might

also evolve according to continuous-time Markov processes. In this case, ht would be equal to ict+wt, where i is

the inventory carrying cost rate and wt is the unit storage

cost at the beginning of period t. It can be assumed that

the unit storage cost evolves according to another

continuous-time Markov process, which is independent

of the continuous-time Markov process corresponding to

the evolution of the unit production cost. There are two

state variables in this new problem. The rst is the unit

production cost, the same as that of the original problem,

and the second is the unit storage cost. Finally, the DP

functional equation (8) can be extended to obtain the

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