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IJPDLM
33,8 EOQ models for postponed
payment of stored
686
commodities
Øyvind Halskau Sr
Molde University College, The Norwegian School of Logistics,
Molde, Norway
Keywords Inventory, Economic order quantities, Payments
Abstract In inventory theory the inventory holding cost per unit plays an important part. In most
transactions concerning selling and buying a certain postponement of payment is offered or
accepted by the seller. This should have some consequences for the order size and can be regarded
as a kind of discount. Traditionally, when average costs (AC) are used, these kinds of effects are
not explicitly incorporated in the classical formulas for economic order quantities (EOQs). On the
other hand, such effects have been treated to a certain degree in the literature when a present value
criterion (PVC) is used to estimate the inventory holding costs over a certain time interval.
However, in these models one does not differentiate between the holding costs incurred by the
capital tied up in the inventory and other costs incurred by storing an item. Approaches this
problem in an AC manner, but, opposed to the PVC, splits the inventory holding costs into two
parts. Offers an EOQ formula for the simple case of a single item stored; enhances this formula for
a situation where a family of items are ordered in a co-ordinated way, and into a situation with
stochastic demand for a single item. Finally, interprets the postponed payment in terms of an all
unit discount.

International Journal of Physical
Distribution & Logistics Management
Vol. 33 No. 8, 2003
pp. 686-700
q MCB UP Limited
0960-0035
DOI 10.1108/09600030310502876
1. Introduction
Inventory holding costs play an important part in most inventory models
described in the literature. These costs can be difficult to estimate and in most
cases the inventory holding cost is estimated as a percentage of the unit
purchasing price or unit value for a commodity placed in a warehouse. These
costs are meant to cover all kind of sub-costs incurred by keeping an item in
stock. There are basically two different ways of treating the inventory holding
costs for an item. The most common way is to make some average estimate of
the costs involved, the so-called average cost (AC) approach. This average will
in most cases be taken as a certain percentage of the value of a stock-keeping
item and should cover the two main elements, the cost of capital and other costs
involving insurance, obsolescence, heating, cleaning, payment for the workers
involved in the warehouse activities etc. In most of the literature the cost of
capital is estimated from 10 to 20 percent of the purchasing cost depending on
the general interest used at a given time in a given market. Usually this cost
element is regarded as the largest of the different cost elements that constitutes
the inventory holding cost as a whole. The second approach is to treat the
inventory holding cost as a present value problem or using present value as a
criterion (PVC) or discounted cost when finding an economic order quantity
(EOQ) for some item. Zipkin (2000) uses the PVC in Chapter 3.7 in his book. He EOQ models
claims that this approach “represents the financing component of the holding
cost in real, tangible terms. Financing charges arise from time gaps between
purchasing expenditures and sales revenues. To bridge such gaps, firms must
borrow money and pay interest” (Zipkin, 2000, Ch. 3.7). The same story
underlies of course the AC approach to the inventory holding cost problem, but
this a heuristic approach. On the other hand the two approaches do not give
687
very different results in many cases and the parameters used will always
contain a certain amount of uncertainty. It seems that the AC approach is the
most “popular” and more widely used than the PVC approach. A fairly recent
comparison between the two approaches can be found in van der Laan and
Teutner (2002).
In most cases the literature seems to assume that we pay for the received
goods immediately after reception. However, in many cases the buyer can
obtain a postponement of the payment for a substantial time period. Hence,
the financing charges that arise from time gaps between purchasing
expenditures and sales revenues can disappear or at last be substantial
decreased. For example a Norwegian firm importing tyres has to place its
orders three to four months before they receive the order. On the other hand
it can postpone the payment for three months after they have received an
order. In such cases it will be wrong to assume that the cost of capital
should be incurred for – say – half of the order size for the whole time
horizon. Some modifications should be done in the estimation of the
inventory holding cost. Silver et al. (1998) do this in a PVC way in Chapter
5.9 in their book. They arrive at a fairly simple approximation formula for
an optimal EOQ. The formula shows – as has to be expected – that the
optimal order quantity should be increased compared with a situation where
no postponement of payment is allowed. However, they discount the whole
inventory cost and do not restrict the discounting factor only to the cost of
capital involved. Similar approaches are done by Thompson (1975),
Kingsman (1983) and Arcelus and Srinivasan (1993, 1995).
Whether using the AC or the PVC approach the modifications of the
inventory holding costs can be done in at least two ways. One way is to reduce
the overall inventory holding cost by taking the postponement of the payment
into consideration and making some kind of weighted average of the two main
elements in the inventory holding cost. Alternatively, one can argue that as
long as one has not paid for the goods, no cost of capital should be incurred for
keeping an item in the inventory. In this time period only the second part of the
inventory holding cost should be considered. As soon as one has paid for the
items a substantial larger inventory holding cost should be applied. In this
paper the latter approach is taken and we use the AC approach of estimating
the inventory holding costs. To the best of my knowledge such an approach
seems to have been overlooked in the literature. The rest of this paper is
IJPDLM organised as follows: In Section 2 the necessary definitions and notations are
33,8 given as well as a new basic EOQ formula for the described postponement
situation. The new formula and its consequences are discussed. Further, we
compare the savings obtained in such a situation with an offered discount on
the unit purchasing price. In Section 3 some extensions are made. One
extension is to apply the new setting to a stochastic inventory model, another to
688 a deterministic model with several different items involved. In Section 4
examples are given for the given formulas and finally some thoughts for
further research are given in Section 5.

2. An EOQ model with postponed payment

We will first consider a situation with only one commodity. We will suppose
that the demand rate is constant and all the usual assumptions for the standard
EOQ formula hold. Further, we will suppose that the payment for the
purchased goods can be postponed for a certain fraction of the total time
horizon after the ordered quantity has been received. In this time period no cost
of capital is incurred, only the other cost elements usually contained in the
inventory holding cost are used, such as insurance, handling, obsolescence etc.
When this time period has elapsed, we pay for all the received items and for the
remaining time of the order cycle a full inventory holding cost is incurred.

2.1. Definitions, notation and preliminaries

We will use a more or less standard notation for the different parameters and
decision variables necessary to describe and solve the problem. d denotes the
demand rate during the time horizon, A is the order cost per order, v the unit
purchasing price for the commodity and will correspond to the value of one unit
of the commodity when in the inventory after it has been paid for. rc is the
percentage of the value corresponding to the cost of capital and ru is the
percentage of the value corresponding to the remaining inventory holding
costs. Hence, the complete inventory holding cost in percentage per unit is
r ¼ rc þ ru . T denotes the fraction of the time horizon we can postpone the
payment. Finally, Q denotes the order size. We will assume that T is equal to or
smaller than the order cycle time.
Using the above notation in the traditional way we get the usual square root
formula (2.1) often denoted as the Wilson formula:

rffiffiffiffiffiffiffiffiffi
2dA
QW ¼ : ð2:1Þ
vr

In formula (2.1) it is tacitly understood that the inventory holding cost

comprises both cost elements, that is, we pay for the received quantity QW as
soon as we receive it. In other words, in (2.1) the time period T is equal to zero.
2.2. A model with postponed payment EOQ models
We now assume that the time period Tis positive.
The order costs for the time horizon becomes as usual: Qd A.
The inventory holding costs during the time horizon must be split into two
parts. One part will be for the time periods T where the stored items are unpaid
and a second part where they are paid for. The average inventory level during
the time period Tis QþðQ
dTÞ and the inventory holding costs per unit per time 689
2
period becomes Tvru. Hence, the total inventory holding cost for all the time
periods Tbecomes QþðQ
dTÞ2 Tvr u Qd . For the second part of the cycle time the
1
average inventory becomes  2 ðQ
dT Þ and the inventory holding cost per unit
per cycle becomes Qd
T vr. Hence, the total inventory holding cost  for all
 the
time periods for the second part of the cycles becomes 12 ðQ
dT Þ Qd
T vr Qd .
Summing up gives the total cost function TC(Q)in (2.2):
 
d Q þ ðQ
dTÞ d 1 Q d
TCðQÞ ¼ A þ Tvr u þ ðQ
dT Þ
T vr : ð2:2Þ
Q 2 Q 2 d Q
The function in (2.2) can after some manipulation be written as (2.3):
 
1 2 1 1
TCðQÞ ¼ dA þ ðdTÞ vðr
ru Þ þ Qvr
dTvðr
ru Þ: ð2:3Þ
2 Q 2
The first and second derivatives of (2.3) can be found in (2.4) and (2.5)
respectively:
 
0 1 2 1 1
TC ¼ ðQÞ ¼
dA þ ðdTÞ vðr
r u Þ 2 þ vr; ð2:4Þ
2 Q 2
 
00 1 2 1
TC ðQÞ ¼ 2 dA þ ðdTÞ vðr
r u Þ 3 : ð2:5Þ
2 Q
As can be seen from (2.5), TC00 (Q)will always be positive for all positive Q, since
ralways is strictly larger than ru. Hence, we will have a minimal point when
solving the equation TC0 ðQÞ ¼ 0. This gives the optimal order quantity Q*(T)
in (2.6):
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 ffi
 2dA þ ðdTÞ2 vðr
r u Þ 2 2 ru
Q ðTÞ ¼ ¼ ðQW Þ þðdT Þ 1
: ð2:6Þ
vr r
As can be seen from (2.6) the optimal order quantity will be strictly larger than
the traditional Wilson quantity if the time period T is positive and the cost of
capital is positive as well. If T ¼ 0 or the cost of capital rc ¼ 0, the last part
under the square root in (2.6) becomes zero and the new optimal order quantity
will be equal to the Wilson quantity as it should be. Using the standard
 pffiffiffiffiffiffiffiffiffiffiffi pffiffiffi pffiffiffi
IJPDLM inequality a þ b # a þ b easily leads to the right hand side of the
33,8 inequalities in (2.7):
rffiffiffiffiffiffiffiffiffiffiffiffi
 ru
QW , Q ðTÞ # QW þ dT 1
ð2:7Þ
r
690 showing that the difference between the ffitwo order quantities Q*(T) and QW
pffiffiffiffiffiffiffiffiffiffi
never can exceed the quantity dT 1
rru .
It is easily verified that the formula in (2.6) has the same properties as the
traditional one given in (2.1). If the demand d increases both terms under the
square root in (2.6) will increase. Hence the order size will increase. If the order
cost A increases, the first term under the square root will increase and the second
part will be constant. Hence, the optimal order size will increase. If the unit
purchasing price v increases, the first term under the square root will decrease and
the second term will be unchanged. Hence, the optimal order size will decrease. If
the time period Tin which we can let the items in the inventory be unpaid is
increased, the first term under the square root will be unchanged and the second
term will increase. Hence, the optimal order size will increase. These observations
seem to be consistent with what one could expect from pure economical
arguments. The last parameter to be considered is the inventory holding cost in
percentage, r ¼ ru þ rc . From (2.6) we have that the term under the square root
can be written as a function of the two components of the inventory holding cost:
 
2dA 2 ru
f ðru ; rc Þ ¼ þ ðdT Þ 1
: ð2:8Þ
vðru þ r c Þ ru þ rc
Now taking the partial derivative with respect ru gives (2.9):
 
›f ðr u ; r c Þ 2dA 2 rc
¼
þ ðdTÞ : ð2:9Þ
›r u vr c ðru þ r c Þ2
Equation (2.9) shows that if ru increases the optimal order size should be
decreased as expected. Moreover, for a given increase in ru, the effect of such an
increase will be larger for a large time period T than for a smaller one.
Now taking the partial derivative with respect rc gives (2.10):
 
›f ðr u ; r c Þ 2dA 2 ru
¼

ðdTÞ : ð2:10Þ
›rc vr u ðru þ r c Þ2
qffiffiffiffiffiffi
Equation (2.10) shows that if dT # 2dA vru the partial derivative will be negative
or zero. It will be shown below that this is always the case. Hence, an increase in
rc will lead to a decrease in the optimal order size. Moreover, for a given
increase in rc, the effect of such an increase will be smaller for a large time
period T than for a smaller one. Hence, we can conclude that the formula for the
optimal order size in (2.6) behaves in the same way as the traditional simple one
in (2.1) as far as the involved parameters are concerned. It will be shown in EOQ models
Section 4 that the inventory holding costs and the order costs are different
when using the optimal order size.
A special case. We have assumed that the time period T shall not exceed the
cycle time. A natural question to ask is what the optimal order size should be if
the cycle time and the time period Tare equal. This means that all the items
placed in the inventory have been taken out of the inventory just before they 691
are paid for. Hence, during the cycle time or during their stay in the inventory,
only the inventory holding cost ru is incurred. From a pure economical
argument, the optimal order size in this case should be:
sffiffiffiffiffiffiffiffiffi
2dA
Q ¼ : ð2:11Þ
vr u

The formula in (2.11) can be confirmed by a mathematical argument as follows.

Given the assumption in this special case, we must have that T ¼ Q d , that is
dT ¼ Q. Substituting this into (2.6) gives the equation (2.12):
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 ffi
 2 2 r u
Q ¼ ðQW Þ þðQ  Þ 1
: ð2:12Þ
r
Solving (2.12) with respect to Q*, gives:
rffiffiffiffiffi sffiffiffiffiffiffiffiffiffi
ru 2dA
Q ¼ QW ¼ ð2:13Þ
r vru

which is identical to (2.11).

Total logistic costs. In the traditional setting using the optimal order quantity
given by (2.1), the total order costs will equal the total order costs and the total
logistic costs are given by (2.15):
pffiffiffiffiffiffiffiffiffiffiffiffiffi
TCW ¼ 2dAvr: ð2:15Þ
Now, substituting the expression for the optimal order size given by (2.6) into
the cost function in (2.3) we obtain an expression for the total logistic costs in
the new situation. These costs are given in (2.16):
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi

TCðQ ðTÞÞ ¼ 2dAvr þ ðdTvÞ2 ðr
ru Þr
dTvðr
ru Þ
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
¼ ðTCW Þ2 þðdTvÞ2 ðr
ru Þr
dTvðr
ru Þ: ð2:16Þ
By derivation of (2.16) with respect to T it is easily seen that the total costs will
decrease if T is increased. Since TCðQ; TÞ ¼ TCW when T¼0, the total costs
IJPDLM given by (2.16) are always smaller than the traditional logistic costs given by
33,8 (2.15). The conclusion is that one should always try to obtain a postponement of
payment.

2.3. A comparison with a discount on the purchasing price

Suppose now that the buyer can choose between an all unit discount, paying v0
692 per unit instead of v and paying for the items at arrival and as an alternative,
postpone the payment for the payment for a time period T,but paying the old
and higher price v. In the first case the total logistics and purchasing costs will
become:
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2dAv0 r þ dv0 : ð2:17Þ
In the second case the total logistics and purchasing costs will become:
TCðQ  ðT; vÞÞ þ dv ð2:18Þ
where TC(Q*(T, v)) is the total logistics costs given by (2.16) when the
purchasing price is v. We get a break even when the two previous expressions
become equal.
pffiffiffiffi After some manipulation we get the following second order
equation in v0 :
pffiffiffiffi 2 pffiffiffiffiffiffiffiffiffiffiffipffiffiffiffi
d v‘ þ 2Adr v‘
TCðQ  ðT; vÞÞ
dv ¼ 0: ð2:19Þ

Solving equation (2.19) gives:

rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi rffiffiffiffiffiffi
pffiffiffiffi TCðQ  ðT; vÞÞ Ar Ar
0
v ¼ vþ þ

d 2d 2d
from which v0 can easily be found.

3. Some extensions of the previous results

In the previous section we derived a formula for an optimal order size in the
context of postponed payment. The situation described was for one single
commodity and constant demand rate. In this section we will extend the results
from Section 2 in two different ways. The first is a situation with several
commodities ordered from the same supplier at the same time and with a
common lead-time. The demand rate will still be regarded as constant. The
second extension will be for one commodity, but with a stochastic demand.

3.1. Postponed payment for several commodities with co-ordinated

replenishments
We will denote the different commodities by the index i ¼ 1; 2; . . .; n. The
relevant parameters and decision variables will be denoted as above, but with
an appropriate index added. However, we will assume that there is a common
order cost incurred each time the set of commodities are ordered. Further, we EOQ models
use the same inventory order cost in percentage for all the commodities, that is
r ¼ ru þ rc for all i. Optimal order quantities can be found by the formulas in
(3.1):
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2A 693
ðQCOM Þi ¼ di Pn ;i: ð3:1Þ
i¼1 d i vi r

Now, let the number of replenishments during the time horizon be m. Then a
total cost function for ordering the n different commodities in a co-ordinated
way from the same supplier and a common time period for postponing the
payment of all items can be formulated as in (3.2):
Xn
Qi þ ðQi
di TÞ di
TCðQ1 ; :::Qn Þ ¼ Am þ Tvi r u
i¼1
2 Qi

Xn  
1 Qi di
þ ðQi
d i T Þ
T vi r : ð3:2Þ
i¼1
2 di Qi

Equation (3.2) transforms after some manipulations into (3.3):

1X n
1 1X n
TCðQ1 ; :::Qn Þ ¼ Am þ ðd i TÞ2 vi ðr
r u Þ þ Qi v1 r
2 i¼1 Qi 2 i¼1

X
n

d i Tvi ðr
ru Þ: ð3:3Þ
i¼1

Now, since all the commodities are ordered at the same time, the equation (3.4)
must hold:
di d1
m¼ ¼ ;i: ð3:4Þ
Qi Q1
Combining (3.3) and (3.4) we obtain a total cost function in one variable and
after some manipulations we get (3.5):
! !
d1 1 Xn
1 1 1 Xn
TCðQ1 Þ ¼ A þ d 1 T 2 ðr
ru Þ d i vi þ d i v 1 r Q1
Q1 2 i¼1
Q1 2 d 1 i¼1

X
n

d i Tvi ðr
r u Þ: ð3:5Þ
i¼1
IJPDLM The first and second order derivatives of (3.5) can be found in (3.6) and (3.7)
33,8 respectively:
! !
d 1 1 Xn
1 1 1 Xn
TC0 ðQ1 Þ ¼
2 A
d1 T 2 ðr
ru Þ d i vi þ di v1 r ; ð3:6Þ
Q1 2 i¼1 Q21 2 d 1 i¼1
694
!
d1 X
n
1
00 2
TC ðQ1 Þ ¼ 2 A þ d1 T ðr
ru Þ d i vi : ð3:7Þ
Q31 i¼1 Q31
Since r is strictly larger than ru the second derivative in (3.7) is always large
than zero. Hence, we have minimal point when setting the first derivative equal
to zero. Solving this equation gives (3.8):
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2A  ru
Q1 ðTÞ ¼ d 1 Pn þ T2 1
: ð3:8Þ
r i¼1 di vi r

Substituting (3.8) into (3.4) gives the optimal order sizes for any of the
commodities:
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2A  ru

Qi ðTÞ ¼ d i Pn þ T2 1
;i: ð3:9Þ
r i¼1 di vi r

Equation (3.9) can be re-written as (3.10) if we use (3.1):

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2d2i A  ru
 2
Qi ðTÞ ¼ P þ ðdi T Þ 1

r ni¼1 d i vi r
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 ffi
2 2 ru
¼ ðQcom Þi þ ðdi T Þ 1
;i: ð3:10Þ
r
We see that (3.10) has the same structure as the formula (2.6) for a single
commodity. Hence, we get the same kind of inequality for each of the
commodities that we obtained in (2.7), namely (3.11):
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 ru
ðQCOM Þi , Qi ðTÞ # ðQCOM Þi þdi T 1
;i ð3:11Þ
r
showing that the difference between the two ffiorder quantities (QCOM)i and
pffiffiffiffiffiffiffiffiffiffi
Qi*(T) never can exceed the quantity di T 1
rru for any i. Moreover, since the
structure of the two mentioned formulas are the same, the discussion of the
impact of the different parameters on the order size done in Section 2, carries
over to this new and more general situation, with one exception. The exception
is for the demand rate. Now, if the demand rate di for commodity iincreases, the EOQ models
optimal order quantity for commodity iwill increase, as in Section 2. Note that
the demand is squared in the numerator and not in the denominator in the first
part of (3.10). Hence, the numerator will dominate the denominator in this case.
So, in this respect the parameter di has the same type of impact in the
multi-commodity case as in the single commodity case in Section 2. However,
increasing di not only has an impact on commodity i but also on all the other 695
optimal quantities. As can be seen from the first part of (3.10) an increase in di
will lead to a decrease in all the order quantities Qj ; j – i.
A special case. We have assumed that the time period Tshall not exceed the
cycle time. Again we can ask what the optimal order sizes should be if the cycle
time and the time period T are equal. This means that all the items for all the
commodities placed in the inventory have been taken out of the inventory just
before they are paid for. Hence, during the cycle time or during their stay in the
inventory, only the inventory holding cost ru is incurred.
Q
Given the assumption in this special case, we must have that T ¼ dii , that is
d i T ¼ Qi . Substituting this in to (3.10) gives the equation in (3.12):
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 ffi
2 2 ru
di T ¼ ðQcom Þi þ ðd i T Þ 1
;i: ð3:12Þ
r
Solving (3.12) with respect to diT, gives:
rffiffiffiffiffi sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
r 2A
Qi ¼ ðQCOM Þi ¼ d i Pn ;i: ð3:13Þ
ru r u i¼1 d i vi

Equation (3.13) reflects the same properties that (2.13) does.

3.2. Postponed payment for a single commodity with stochastic demand

In this sub-section we will discuss a single commodity with stochastic demand
in the same setting as in Section 2. The demand is supposed to be normally
distributed with a standard deviation sL during the lead-time L. We will
introduce a safety stock with safety factor k and suppose that we have a service
policy of type 1, that is a stock-out cost B1 is incurred each time a stock-out
situation is experienced. We let pu $ ðkÞ denote the probability for such a
stock-out situation.
Following for example Silver et al. (1998), using the total cost function (3.14):
d 1 d
TCðQ; kÞ ¼ A þ Qvr þ ksL vr þ B1 pu$ ðkÞ ð3:14Þ
Q 2 Q
the optimal values for the order size and the safety factor can be found with the
help of the two formulas given in (3.15) and (3.16), starting with QðB1 Þ ¼ QW in
(3.16):
IJPDLM rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
33,8 B1
QðB1 Þ ¼ QW 1 þ pu$ ðkÞ; ð3:15Þ
A

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
 ffi
696 dB1
k ¼ 2ln pffiffiffiffiffiffi : ð3:16Þ
2pQðB1 ÞsL vr

Now, introducing the postponement of payment for a given time period T, the
total cost function becomes:
 
1 1 1
TCðQ; kÞ ¼ dA þ ðdTÞ2 vðr
ru Þ þ Qvr þ ksL vr
2 Q 2
d
þ B1 pu$ ðkÞ
dTvðr
ru Þ: ð3:17Þ
Q

Note that we have assumed that we have paid for the items in the safety stock.
Taking the derivatives of TC(Q, k) with respect to Q and k we get the two first
order conditions in (3.18) and (3.19), respectively:

d 1 1 1 1


ðdT Þ2 vðr
r u Þ 2
dB1 pu$ ðkÞ 2 þ vr ¼ 0; ð3:18Þ
Q 2A 2 Q Q 2

d 1 1 2
sL vr
B1 pffiffiffiffiffiffi e
2k ¼ 0: ð3:19Þ
Q 2p

Solving (3.18) we get (3.20):

sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
  ffi
B1  ru
2 2
QðB1 ; TÞ ¼ QW 1 þ pu$ ðkÞ þ ðdT Þ 1

A r
rffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi


2 ru
¼ QðB1 Þ þðdT Þ2 1
: ð3:20Þ
r

Solving (3.19) leads to (3.16) as before. Hence, the combination of (3.16) and
(3.20) will, through an iterative process, yield the optimal values for the safety
factor and q theffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
order size. The iteration process should be started using
2  
QðB1 ; TÞ ¼ QW þ ðdTÞ2 1
rru .
 Note that the following inequalities hold: EOQ models
rffiffiffiffiffiffiffiffiffiffiffiffi
ru
QW , QðB1 Þ # QðB1 ; TÞ # QðB1 Þ þ dT 1
ð3:21Þ
r
again showing that the difference between p theffiffiffiffiffiffiffiffiffiffi
twoffi order quantities Q(B1, T)
and Q(B) never can exceed the quantity dT 1
rru . 697
A special case. As in the previous two cases we have assumed that the time
period T does not exceed the cycle time. Again we can ask what the optimal
order sizes should be if the cycle time and the time period Tare equal. Hence,
during the cycle time or during their stay in the inventory, only the inventory
holding cost ru is incurred. Given this assumption we must have that
dT ¼ QðB; TÞ. Substituting this in to (3.20) gives the equation in (3.22):
rffiffiffiffiffirffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi sffiffiffiffiffiffiffiffiffirffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
r B1 2dA B1
QðB1 ; TÞ ¼ QW 1 þ pu$ ðkÞ ¼ 1 þ pu$ ðkÞ ð3:22Þ
ru A ru A

which is similar to (3.15), but we shall now start the iterative process with Q(B1,
T) equal to a quantity larger than the classical economical order size, that is
starting the process with an EOQ using and interest rate where the cost of
capital is not included.

4. Examples
In order to illustrate the effects of the above approaches, we offer some simple
examples corresponding to the three cases treated above.

4.1 Example 1. Single commodity – deterministic demand

Let the annual demand be d ¼ 1; 200units, the order cost per order be A ¼ 500, the
value v ¼ 100perunit, the interest rate when the cost of capital is included r ¼ 0:20,
the ru ¼ 0:05 and the time period T ¼ 0:1. Now, using (2.1) gives QW ¼ 245units.
The order costs will equal the inventory holding costs and each becomes 2,450 and
so the total costs will be 4,900. The number of replenishments becomes 4.9 per year.
On the other hand using (2.6) gives Q  ðT ¼ 0:1Þ ¼ 266units. Hence, the
number of replenishments becomes 4.5 and the order costs 2255. The demand
during the time period T is 1,200 units £ 0.1 ¼ 120 units. The inventory
holding costs for the average inventory in time period T becomes:
1
½266 þ ð266
120Þ1000:050:14:5 ¼ 464
2
The inventory holding cost for the rest of cycle times becomes:
 
1 266
½266
1201000:2
0:1 4:5 ¼ 800
2 1200
IJPDLM Hence, the total inventory holding costs becomes NOK1,264 showing that the order
33,8 costs and the inventory holding costs are not equal in this situation. The total cost
becomes NOK3,519, which is substantially less than in the classical case. Now, if
we compare the consequences of being allowed to postpone the payment for the
time period T ¼ 0:1 with having an all unit discount, we get by (3.22) that the unit
purchasing cost should be v0 ¼ 98.96, that is a discount of 1 percent.
698
4.2 Example 2. Several commodities with co-ordinated replenishments –
deterministic demand
We will give an example with two commodities. The first will be the same
commodity as in example 1 and the second having an annual demand of 2,000
units and a unit purchasing value of 50. The rest of the parameters will be as in
example 1.
Using a co-ordinated replenishment policy without postponement of
payment gives by (3.1) ðQCOM Þ1 ¼ 181units and ðQCOM Þ2 ¼ 300 units,
corresponding to 6.6 replenishments per year. Hence, the order costs become
3,300 and the inventory holding costs for commodity 1 and 2 become 1,810 and
1,500, respectively. The total cost becomes NOK6,610.
Now, if we assume that we can postpone the payment for the
commodities for T¼0.1 year and using (3.11) we get Q1 ðT ¼ 0:1Þ ¼ 209 units
and Q2 ðT ¼ 0:1Þ ¼ 346 units. This corresponds to 5.8 replenishments per year
and gives an annual order cost of 2,900. The inventory holding costs will
become as follows:
For commodity 1. The inventory holding costs for the average inventory in
time period T becomes:
1
½209 þ ð209
120Þ1000:050:15:8 ¼ 216:
2
The inventory holding cost for the rest of cycle times becomes:
 
1 209
½209
1201000:2
0:1 5:8 ¼ 382:
2 1200
For commodity 2. The inventory holding costs for the average inventory in
time period T becomes:
1
½346 þ ð346
200Þ500:050:15:8 ¼ 357:
2
The inventory holding cost for the rest of cycle times becomes:
 
1 346
½346
200500:2
0:1 5:8 ¼ 313:
2 2000
Hence, the inventory holding costs taken together become 1,268 and the total
costs 4,158, which is substantial less than in the case without postponement of
payment. The number of replenishments has increased leading to higher order EOQ models
cost, but the inventory holding costs are much lower.

4.3. Example 3. Single commodity – stochastic demand with P1 policy

We will use the parameter from example 1 together with a stock-out cost of
2,000 and a standard deviation during the lead-time of 50 units. Now using
(3.15) and (3.16) starting with QW ¼ 245units, gives after three iterations an 699
optimal order quantity of QðB1 Þ ¼ 271units, safety factor k ¼ 1:59 and the
probability of stock-out pu $ ðkÞ ¼ 0:05592. This gives a safety stock of 80
units. The order costs become – with 4.4 replenishments per year – 2,200, the
inventory costs for the cycle stock become 2,710, the inventory holding costs
for the safety stock become 1,600 and the stock-out cost will be 495. Taken
together, we get 7,005 as the total costs for this situation.
If we have a postponement of payment forqthe time period T ¼ 0:1 and using
ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2  
(3.19) and (3.15), starting with QðB1 ; TÞ ¼ QW þ ðdTÞ2 1
rru ¼ 266 units,
we get after four iterations an optimal order quantity of QðB1 ; TÞ  293units,
safety factor k ¼ 1:54 and the probability of stock-out pu $ ðkÞ ¼ 0:06178. This
gives a safety stock of 77 units. The order costs become – with 4.1
replenishments per year – 2,050, the inventory holding costs for the safety stock
will be 1,540 and the stock out costs 506. The inventory holding costs for the
cycle stock are as follows:
(1) The inventory holding costs for the average inventory in time period T
becomes:
1
½293 þ ð293
120Þ1000:050:14:1 ¼ 477:
2
(2) The inventory holding cost for the rest of cycle times becomes:
 
1 293
½293
1201000:2
0:1 4:1 ¼ 1; 020:
2 1; 200

Hence, the total inventory holding costs becomes 1,597. Taken together we get
a total cost of 5,593, which is less than in the case without postponement of
payment. Compared to the latter case, we can see that the cost of safety stock
and the stock out costs are approximately the same in the two cases. However,
the order costs have decreased in the postponement case as have the cycle
costs.

5. Conclusions and further research

Above we have discussed some economical consequences of postponed
payment. First a deterministic situation with only one commodity, secondly a
similar situation with several commodities were discussed and finally a
IJPDLM situation with stochastic demand and a single commodity and a so-called P1
33,8 service concept were treated. The literature describes very many deterministic
inventory models that can be regarded as variation of the one given in (2.1) and
(3.1). Some of these variations may be extended to the topic treated in this
paper. Examples of such extensions can for instance be a situation with
intended back-orders or restriction on capital tied up in the inventory. In this
700 paper we have tacitly supposed that the commodity treated is either used in
some kind of production or sold to a customer without further processing and
we have supposed that the time period T never exceeds the cycle time. If the
item treated can be sold with some profit before the time period T has elapsed
or the time period T exceeds the cycle time, some extra income in the form of
extra interest should be incorporated in the cost functions used. In the
stochastic case there are other inventory policies that should be looked into. If
we instead of using a P1 service policy, one could try with so-called
“ready-rate” or “fill-rate” and see if one can derive similar formulas for these
policies as we have done above for the P1 policy.

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