Deterministic Models: Price Break Problems

Possible Situations

• As an incentive for your company to order more units of a certain item, the supplier allows you to
enjoy a discount once you reach an order quota. For example, the unit cost for each item is $ 2.50
when you order less than 100 units, but it becomes $ 2.20 when you order at least 100 units.
• Caution: Some suppliers will grant the discount only on the units beyond the order quota (i.e. you
still need to pay $ 2.50 for the first 99 units and only the units 100 up are priced at $ 2.20).
• Because you want to take advantage of overhead costs and economies of scale, you decide to increase
your production so that the more units you produce, the unit cost for each unit will decrease.

Modeling Considerations: First Situation

Let us first consider the first situation above where price discounts affect all units ordered for as long as
order quotas are reached. The most relevant graph that we will use to model this situation is an Order
Quantity (𝑄) vs Total Cost (TC) graph. The Total Cost function per unit time (for the simple EOQ model) will
now take the form
𝑎𝐾 ℎ𝑄
𝑇𝐶(𝑄) = + 𝑎𝑐𝑖 + , 𝑖 = 1,2, …
𝑄 2
Notice that this is a piecewise-defined function, so our graphs will have breaks or jumps in between.
Example Graph

Note the following from the graph:

• The graphs are essentially vertical translations of one another (they differ by 𝑎𝑐𝑗 which is a constant).
• This guarantees that the value of 𝑄 ⋆ is the same across all curves.
It suffices to consider the following procedure to determine the optimal order quantity:
1. Compute 𝑄 ⋆ . Note that the same 𝑄 ⋆ figure applies to all the curves of the graph.
2. Determine the “zone” in which 𝑄 ⋆ lies and compute 𝑇𝐶(𝑄 ⋆ ).
3. For all zones or graph portions to the left of the 𝑄 ⋆ zone, evaluate TC at the right-most endpoint.
4. For all zones or graph portions to the right of the 𝑄 ⋆ zone, evaluate TC at the left-most endpoint.
5. Compare all the computed TC values including 𝑇𝐶(𝑄 ⋆ ). The optimal order quantity is that which gives
the minimum total cost.
Additional situation (exercise): how do we deal with situations that involve model 2, 3, or 4? What parts of
total cost will change, and which will stay the same?
Modeling Considerations: Modified Price Breaks
We analyze the situation where price discounts apply only to the units ordered beyond the quota. Consider
the situation wherein the unit cost for each item is 𝑐1 for the first 𝑏1 units, 𝑐2 for the next units until 𝑏2 , 𝑐3 for
the next units until 𝑏3 , etc…
We start by deriving the total cost per cycle for each situation as follows (let’s limit first to until two price
break quotas):

ℎ𝑄 2
𝐾+ + 𝑐1 𝑄, 𝑄 ≤ 𝑏1
2𝑎
ℎ𝑄 2
𝑇(𝑄) = 𝐾+ + 𝑐1 𝑏1 + 𝑐2 (𝑄 − 𝑏1 ), 𝑏1 < 𝑄 ≤ 𝑏2
2𝑎
ℎ𝑄 2
{𝐾 + + 𝑐1 𝑏1 + 𝑐2 (𝑏2 − 𝑏1 ) + 𝑐3 (𝑄 − 𝑏2 ), 𝑏2 < 𝑄
2𝑎
Let 𝐾1 = 𝐾, 𝐾2 = 𝐾 + 𝑐1 𝑏1 − 𝑐2 𝑏1, and 𝐾3 = 𝐾 + 𝑐1 𝑏1 − 𝑐2 𝑏1 + 𝑐2 𝑏2 − 𝑐3 𝑏2 . We can then write the total cost
per cycle as
ℎ𝑄 2
𝐾1 + + 𝑐1 𝑄, 𝑄 ≤ 𝑏1
2𝑎
ℎ𝑄 2
𝑇(𝑄) = 𝐾2 + + 𝑐2 𝑄, 𝑏1 < 𝑄 ≤ 𝑏2
2𝑎
ℎ𝑄 2
𝐾
{ 3 + + 𝑐3 𝑄, 𝑏2 < 𝑄
2𝑎
Hence, the total cost per unit time is obtained as follows:
𝑎𝐾1 ℎ𝑄
+ + 𝑎𝑐1 , 𝑄 ≤ 𝑏1
𝑄 2
𝑎𝐾2 ℎ𝑄
𝑇𝐶(𝑄) = + + 𝑎𝑐2 , 𝑏1 < 𝑄 ≤ 𝑏2
𝑄 2
𝑎𝐾3 ℎ𝑄
+ + 𝑎𝑐3 , 𝑏2 < 𝑄
{ 𝑄 2
Exercise: Verify that 𝑇𝐶(𝑄) is continuous.

Graph of situation:

Note that for each case, we can compute

 2𝑎𝐾𝑖
𝑄𝑖⋆ = √
ℎ

The 𝑄𝑖⋆ that will be acquired are all different since the 𝐾𝑖 are different.

So how do we find the optimal order quantity? Recall from Calculus that minimum values can potentially
𝑑𝑇 𝑑𝑇 𝑑𝑇 𝑑𝑇
occur at wherever 𝑑𝑄 = 0 or 𝑑𝑄 is undefined. In our situation, 𝑑𝑄 = 0 at the 𝑄𝑖⋆ ’s, and 𝑑𝑄 is undefined at the
𝑏𝑖 ’s (price break quotas). Hence, we obtain our optimal order quantity using the following procedure:
1. Formulate the function 𝑇𝐶(𝑄)
2. Compute 𝑄𝑖⋆ for each situation 𝑖
3. Compute the best TC for each zone
a. If 𝑄𝑖⋆ can be found in the order quantity range of zone 𝑖, then evaluate the TC function at 𝑄𝑖⋆
b. If 𝑄𝑖⋆ cannot be found in the order quantity range of zone 𝑖, then evaluate the TC function at
the break point the is closer to the 𝑄𝑖⋆ of the zone
4. The smallest among all the computed costs will give the optimal order quantity