A MODEL FOR DESIGNING MULTI-ECHELON

INVENTORY NETWORKS WITH FINITE CAPACITY

Ben D. Van Roo, James A. Rappold
1
Doctoral Candidate, University of Wisconsin, Madison, WI 53706, bdvanroo@wisc.edu
Abstract: We propose an approach to model and solve the joint problem of facility location, inventory
allocation, and capacity investment when demand is stochastic. The objective of the decision problem is
to minimize the total expected costs of (1) opening a number of repair facilities, (2) assigning each eld
service location to an opened facility, (3) assigning capacity levels to each of the opened repair facilities,
and (4) determining an inventory allocation among the opened repair facilities and eld service locations.
Keyword: Multi-echelon inventory optimization; Facility location; Finite capacity; Supply chain design;
Service parts logistics.
1 Introduction
When designing a multi-echelon supply chain network for reparable parts that balances cost
eciency with eectiveness, several questions must be answered and decisions made. Some of
these questions are strategic and establish the basic infrastructure of the supply chain. Such
strategic questions include: How many repair facilities are needed to support the system and
meet customer requirements? How much capacity, in terms of equipment and labor, are needed
at each repair facility? Where should these facilities be located? Which eld stocking locations
(or customer service centers) should be served by which repair facilities? While there are many
other additional strategic questions, the few that we have listed are themselves not easy decisions
to make. They are not easily changed and can establish the basic operational environment for
years. Moreover, they must be robust to contend with a constantly changing environment and
set of customer requirements.
The alternatives to these strategic decisions will have tactical operating consequences in
terms of cost and responsiveness. Some tactical consequences are: What will the transportation
costs be of a supply chain design? How much inventory and working capital will be necessary
to support customer requirements? Does sucient inventory even exist to support customer
requirements associated with a particular supply chain design? The answers to these questions
fundamentally depend on the strategic design of the supply chain.

One Capacitated
Repair Facility
Depot Stocking
Location
Field Stocking
Locations
I
t
e
m

R
e
c
o
v
e
r
y
Random Item Demand Random Item Demand
I
t
e
m

R
e
c
o
v
e
r
y
I
t
e
m

R
e
c
o
v
e
r
y
Two
Capacitated
Repair Facilities
Supply Chain Design #1 Supply Chain Design #2
Figure 1: An example of two alternative supply chain designs.
1
Dissertation Advisor, University of Wisconsin, Madison, WI 53706, jrappold@bus.wisc.edu
1
The strategic and tactical considerations are therefore inextricably linked. For example,
Figure 1 illustrates two alternative supply designs. Items that require repair fail at eld stocking
locations and are sent back to an assigned repair facility through an item recovery process. If a
replacement item is available at the depot stocking location, it is dispatched to the eld stocking
location. If not, the item is backordered and one is sent when one becomes available. Items
arrive at the repair facility, enter a repair queue, and are repaired by a repair team (or crew).
The repaired item is stocked at the depot until one is required at a eld stocking location.
On the one hand, an organization could consolidate (or outsource) its repair capacity into
one facility as in Supply Chain Design 1, seeking repair economies-of-scale and perhaps a high
capacity utilization; however, if the customer base is geographically dispersed, transportation
costs may overwhelm operating costs, depending on the particular economic circumstances.
Moreover, the pipeline and safety stock necessary to support long lead times (of item recovery,
queueing, repair, and transport) may lead to high working capital requirements throughout the
network.
An alternative design, Supply Chain Design 2, is to split the repair capacity into two dierent
facilities (one of which may be co-located with a eld stocking location) and assign eld stocking
locations based on transportation and inventory considerations. Due to the interdependent
nature of strategic and tactical considerations, we believe that it is imperative to include the
tactical consequences explicitly in the strategic decision-making process.
Unfortunately, in practice this seems more often an exception rather than the rule. The
reason is because these decisions are complicated by many quantitative and qualitative factors
that are dicult for groups of decision and policy makers to consider and render an informed
and rational decision. Further complicating matters, there are an enormous number of possi-
ble supply chain design alternatives to evaluate and usually limited time and data to do so.
Therefore, decision models can play a valuable role in evaluating competing alternatives.
Our objective in this research is to develop a set of integrated quantitative and computa-
tionally ecient decisions models that can be used to assist in this complicated decision process.
Our models and modeling framework must be exible enough to handle a wide variety of con-
siderations, yet computationally ecient enough to support a rapid, iterative decision process.
2 An Application
While we have observed this problem in industrial rms, the motivation for our particular
problem grew out of research performed by one of the authors in conjunction with RAND
Project Air Force and the US Air Force (USAF). The issue is how to best congure the supply
chain for the repair and deployment of aircraft engines and other complex aircraft subsystems.
The repair of aircraft engines is a notoriously dicult and complicated task that requires
teams of skilled and specialized technicians and equipment. The demand for repair is highly
uncertain and extremely dicult to forecast accurately. On the one hand, the repair of these
items may be performed locally at each air force base (eld stocking location), thereby requiring
duplication of repair facility overhead across the supply chain. This design has the advantage
that the turnaround times for failed items is fast and the pipeline inventories necessary to
support operations is small; however, it has the disadvantage that it is extremely expensive to
operate.
Studies at The RAND Corporation have shown that economies-of-scale do exist as the repair
capacity is increased at a facility. It should be noted that repair capacity is increased in discrete
blocks, consisting of a team of technicians and their equipment. An alternative supply chain
design is to centralize the repair of these items at one repair facility to serve the repair needs of
all eld stocking locations. While the labor and equipment costs would be signicantly lower,
the transportation costs, inventory requirements, and response times would be higher.
2
A unique characteristic of the repair of aircraft engines for the US Air Force is that, depend-
ing on the specic aircraft, there is likely a xed number of engines in the system at any time.
This quantity has been determined a priori, often years in advance, and is not in changeable
in the short-term. Therefore, the reparables supply chain design must include an inventory
constraint on the average number of aircraft engines in the system. It is not immediately clear
how to approach thinking about this problem, how to quantify the unique operating character-
istics and requirements of each eld stocking location and repair facility, nor how to arrive at
an informed set of decisions that can be justied in front of a Congressional committee.
3 Literature Review
Although signicant advances have been made in multi-echelon inventory theory, facility loca-
tion problems, and queueing theory, research opportunities exist at the intersection of these
areas. In particular, most multi-echelon models are concerned with optimizing inventory per-
formance in the presence of uncertainty given a network of facilities. On the other hand, facility
location models have been approached from a combinatorial optimization perspective and only
recently has uncertainty been incorporated explicitly. Though we know of no work that directly
encompasses the joint location, capacity, and inventory aspects of our problem, we believe that
integrating many of the insights gained from facility location theory with the design and opera-
tion of multi-echelon inventory systems presents opportunities for both research and application.
Beginning with the queueing aspects of our problem, we use the results from Prabhu (1965)
for M/M/k queueing systems. The multi-echelon inventory aspects of our problem are linked
to the seminal paper Sherbrooke (1968). Sherbrooke applied Palm (1938) in his formulation of
a model for Multi-Echelon Technique for Recoverable Item Control (METRIC). His technique
optimizes inventory levels in the presence of demand uncertainty by taking into consideration
the time delays caused by material shortages at upstream locations.
We leverage an important extension made by Graves (1985), which incorporated a new
method of computing both the mean and the variance of the expected number of outstanding
orders at the base level. This greatly improved the accuracy of the overall approach. To our
knowledge, Sleptchenko (2002) was the rst to extend Graves (1985) by explicitly considering
nite repair capacity. In his paper, Sleptchenko reformulates Graves (1985) by specifying a
repair shop model and selecting a multi-class M/M/k repair queue found in van Harten and
Sleptchenko (2003). He formulated the model by using the convolution of the arrival process
with the repair queueing time when formulating the mean and variance of the expected number
of outstanding orders in the system.
The facility location aspects of our problem are a special case of general facility location
problem. We determine the best choices of facilities given a set of candidate locations, and
assign demand and capacity to these best choices. Our problem is formulated as a mixed-integer
program. Similar models have been studied and, even in the case of hundreds of locations, it
is not computationally expensive to nd the mixed-integer solution. A comprehensive survey
of facility location models can be found in Drezner (1995). Location models under uncertainty
are reviewed in Snyder (2004). More specic to our problem, Eppen and Schrage (1981) and
Daskin et al. (2002) developed models with both location and inventory considerations, and
they study impacts on inventory as well as benets of risk pooling. Our work diers from
their work in that we are interested in a multi-echelon system and while selecting an optimal
location, we also seek to determine its ideal level of capacity investment.
We stress that the focus of our model is strategic and tactical in nature. It has been shown
that real-time execution decision models can outperform tactical rst-come, rst-served policies
substantially. See Pyke (1990) and Caggiano et al. (2002) for further discussion.
3
4 The Problem
We formulate our combination facility-location, multi-echelon inventory optimization prob-
lem as a mixed-integer program with non-linear partial expectation cost functions. The objective
function is to minimize the long-run expected costs of the system. Computational eciency is a
requirement of our model. We examine the problem structure and determine solution methods
that balance solution speed with accuracy.
We consider a single-item, single-indentured parts network. This is a reasonable starting
point for our situation, as specic aircraft platforms often require specialized and dedicated crew
and equipment; however, it is worthwhile to consider possible extensions to address a multi-
item, multi-indentured environment. The operating cost drivers in our case are: (1) xed repair
facility costs, (2) repair crew and equipment (repair center) capacity costs, (3) transportation
costs, (4) inventory holding costs, and (5) backorder costs at eld stocking locations (FSLs).
4.1 Assumptions and Notation
We assume that the problem is for a single-item, single-indentured parts network. The failures
at eld stocking locations follow a Poisson distribution. Repair facility times are assumed to
have an exponential repair distribution and are independent and identically distributed. Using
the exponential service distribution time is not only convenient, it also closely approximates our
empirical data. We assume constant transit times between locations, and a rst-come-rst-serve
repair, one-for-one replenishment policy with no xed cost of transportation or setup times in
repair. Assignments between eld stocking locations and repair facilities are unique, and there
are a nite number of identical, parallel repair servers at each repair facility.
As mentioned earlier, the total amount of system inventory is determined a priori and is a
hard constraint in the decision model. We assume that the total amount of inventory allocated
across all locations must be exactly equal to the total amount of inventory available. In certain
cases, this amount of system inventory may be less than desirable and the model will increase
repair capacity to reduce the need for inventory. In other cases, this amount of system inventory
may be too high and the model will have to determine the best location to hold excess inventory.
Let G be the full set of possible repair facility locations in the network, with index j G.
Let F be the set of FSLs, with index i F. The notation F
j
will refer to the set of FSLs
assigned to open repair facility j G. The failures at i F
j
, follow a Poisson process with
rate
ji
, where
j0
is the total demand rate assigned to open repair facility j. Repair times
for each repair center at j are assumed to be exponentially distributed
j
, and are independent
and identically distributed (i.i.d.) across the repair servers. Each server within repair facility
j is assumed to have identically distributed repair times. Failed units from various FSLs are
repaired and distributed in a rst-come, rst-served manner. We assume constant transit times
between locations, l
ji
. Inventories are controlled via a one-for-one replenishment policy, and the
holding costs and backorder costs associated with the inventory are independent of the number
of servers at a repair facility. We assume that there are no xed costs of transportation or setup
times in repair. Let [x]
+
= max{x, 0} for x real. We dene the following notation:
Sets and Indexes:
G = set of possible repair facility locations, with index j G;
F = set of eld stocking locations (FSLs), with index i F;
F
j
= set of eld stocking locations assigned to repair facility j G; and
Z = set of non-negative integers, with index k Z.
Decision Variables:
s
j0
= base stock level of the item at facility j;
4
s
ji
= base stock level of the item at eld stocking location i F
j
;
x
j
=

1 if facility j G is opened;
0 otherwise;
y
ji
=

1 if eld stocking location i F is assigned to be supplied from facility j G;

0 otherwise;
z
jk
=

1 if facility j G is assigned k Z or more repair machines;

0 otherwise; and
z
j
=

nZ
z
jn
, the total number of repair machines installed at facility j.
Model Parameters:

ji
= the mean failure rate of the item at a eld stock location i F
j
;

j0
=

iF
j
ji
= the mean demand rate for reparables assigned to facility j G;

j
= the mean repair rate per machine at facility j G;

j
= z
j

j
, the total repair capacity of j G based on the number of assigned machines;
l
ji
= the constant transit lead time from facility j to eld stocking location i;
c
ji
= the transportation cost per unit from facility j to eld stocking location i;
f
j
= the xed facility cost of opening facility at j G, amortized annually;
a
jk
= the annual cost of adding the k
th
repair capacity increment (to capture repair
cost economies-of-scale) at facility j G;
h
ji
= the holding cost rate for the item at eld stocking location i F
j
, where h
j0
is
the holding cost rate at facility j G, in dollars per unit per year;

ji
= the backorder cost rate for the item at i F
j
in dollars per unit per year; and
S = the steady-state total amount of inventory in the network.
Key Relationships: For a given set of FSL-to-repair assignment decisions [y
ji
], we dene:

j
(y
ji
, z
j
) =

iF
j y
ji

ji

/z
j

j
= the repair capacity utilization of facility j G;
D
j0
(
j0
, z
j
) F
j0
, the random variable (r.v.) representing the item demand at j during
the repair lead time (the queue time plus the service time) in steady-state;

j
(y
ji
, z
j
, s
j0
) = E[s
j0
D
j0
(
j0
, z
j
)]
+
= the expected number of units on-hand at facility
j associated with s
j0
, in steady-state;
E[D
j0
(
j0
, z
j
) s
j0
]
+
= the expected number of outstanding replenishment backorders at
j associated with s
j0
, in steady-state;

j
(y
ji
, z
j
, s
j0
) = E[D
j0
(
j0
, z
j
) s
j0
]
+
/
j0
= the expected replenishment delay from j to
i F
j
, steady-state;
D
ji
(
ji
[
j
+l
ji
]) F
ji
(
ji
[
j
+ l
ji
]), the r.v. representing the demand during the replen-
ishment lead time to FSL i, from repair facility j, in steady-state;

i
(y
ji
, z
j
, s
j0
, s
ji
) = E[s
ji
D
ji
(
ji
[
j
+l
ji
])]
+
= the expected number of units on-hand at
FSL i, served by facility j given s
ji
, in steady-state; and

i
(y
ji
, z
j
, s
j0
, s
ji
) = E[D
ji
(
ji
[
j
+l
ji
]) s
ji
]
+
= the expected number of backorders at
FSL i, from facility j given s
ji
, in steady-state.
5
An important aspect of our problem is the opportunity to reduce labor costs through
economies-of-scale in consolidating the repair facilities. At the strategic level, due to their
high cost, we rst consider which repair facility locations to open. The amortized annual cost
of opening facility j is f
j
. To capture the repair cost economies-of-scale from consolidation, let
z
j
be number of allocated parallel repair centers (servers), if facility j is opened. The cost of
adding the k
th
repair center increment is a
jk
. In this way, we can model the repair facility cost
as a concave cost function.
At a tactical level, our objective is to jointly optimize the repair capacity and the allocation
of available inventory across the network, given the open repair facilities. We will do this by
decomposing the supply chain into a collection of sub-networks, each comprised of one repair
facility j and its associated FSLs, F
j
. Within each sub-network, the multi-echelon inventory
decisions are concerned with the base stock levels s
j0
at each repair facility j, as well as the
base stock levels s
ji
at each FSL i F
j
. To determine these values, we will leverage the work of
Graves (1985) along with results from the queueing literature. Our model deviates from Graves
work since we cannot properly invoke Palms Theorem (Palm (1938)) based on an assumption
of innite repair capacity in Sherbrooke (1968).
Because of the parallel repair centers, each with a nite capacity, replenishment lead times
to the FSLs will not merely be variable, but will also be positively correlated especially for
the single server case. We will model the queue and distribution of repair times as an M/M/k
queueing system and use results of Prabhu (1965). Let
j
(y
ji
, z
j
) be the steady-state expected
number of items in repair facility j, either awaiting repair or in repair, as a function of the
assigned FSLs and number of repair servers. Let
2
j
(y
ji
, z
j
) be its second moment. We employ
results from Prabhu (1965) for the exact steady-state distribution of the number of units in an
M/M/k system to compute,
j
, and
2
j
.
This distribution is important for computing the expected number of backorders at the
repair facility associated with a base stock level of s
j0
units, and its associated time delay to the
FSLs. This dependence between inventories at the repair facility and inventories at the FSLs
prevents us from separating the problem by location.
An overview of the solution strategy is as follows. We will determine the rst two moments,

j
and
2
j
, for a set {z
j
} of possible repair capacities at j, and t them to a negative bino-
mial distribution. While we could employ the exact steady-state probability distribution of an
M/M/k system for the number of units in repair, we choose to use a two-moment negative
binomial approximation to this distribution for computational speed. This approximation is
extremely close for a wide variety of number of servers k and capacity utilizations. Most im-
portantly, this approximation yields virtually identical estimates of the time delay to the FSLs
for a given s
j0
.
To optimize the FSL base stock levels s
ji
, we extend the argument of Graves (1985). We
take the convolution of the FSL demand over the xed transportation lead time from the repair
facility plus any time delay associated with repair facility backorders. We assume that the
repair facility fullls FSL demand in a rst-come, rst-served manner. We estimate the rst
two moments of the number of outstanding orders at each FSL. Again, we t this to a negative
binomial distribution. This provides a method for optimizing the tactical inventory allocation
within each sub-network between its repair facility j and among the FSLs, F
j
. We use these
relationships to estimate the expected cost associated with carrying an amount of inventory
S
j
= s
j0
+

iF
j s
ji
in sub-network j, assuming an optimal allocation of inventory within sub-
network j. Finally, linking the inventories across the sub-networks, we impose a tight allocation
constraint on the total amount of system inventory, S =

j
S
j
.
Written as a non-linear program, the objective function is the minimization of the sum of
(1) xed repair facility costs, (2) transportation costs, (3) holding costs at the repair facilities,
(4) backorder costs at bases, and (5) holding costs at bases. The Master Problem (MP) is:
6
(MP) min
y
ji
,z
jk
,s
ji
,s
j0

jG
x
j
f
j
+

jG

iF

ji
y
ji
c
ji
+

jG

kZ
z
jk
a
jk
+

jG

iF

h
j0

j
(y
ji
, z
j
, s
j0
) +h
ji

i
(y
ji
, z
j
, s
ji
, s
j0
) +
ji

i
(y
ji
, z
j
, s
ji
, s
j0
)

s.t.

jF
y
ji
= 1 i F (4.1)
y
ji
x
j
i F, j G (4.2)

iF
y
ji

ji

j

kZ
z
jk
j G (4.3)

jG

s
j0
+

iF
s
ji

= S (4.4)
z
j(k+1)
z
jk
j G, k Z (4.5)
z
j
=

nZ
z
jn
j G (4.6)
s
ji
, s
j0
0 i F, j G (4.7)
Constraint (4.1) creates an exclusive assignment between eld stocking location and repair
facilities, while (4.2) assigns FSLs to open repair facilities. Constraints (4.3) is used to set
capacity at a repair facility that corresponds with the total demand assigned to that repair
facility. Constraint (4.4) is the tight bound on the total network inventory. Constraints (4.5)
and (4.6) insure incremental increases in capacity levels and capture the total number of repair
servers in repair facility j, respectively. Constraints (4.7) insure non-negative stock levels.
5 Two Step Solution Approach
The full formulation (MP) is dicult to solve for large-scale systems with dozens of locations
and hundreds of items; however, for practical purposes, computational eciency is essential and
the problem structure lends itself well to decomposition into subproblems.
Our problem carries a few dominant features. The empirical data from the USAF indicate:
(1) xed-facility costs, transportation costs, and costs of capacity dominate other costs, (2) cost
economies-of-scale exist through consolidating demand and labor, and (3) the system inventory
is nite. Given these observations, we have developed a two-step solution approach as follows:
1. solve the facility location problem that minimizes the cost of opening facilities, trans-
portation costs, and the minimum cost of capacity at each facility; and
2. using solutions from Step 1 (locations, assignments, and minimum capacity), balance
incremental capacity with the cost associated with an optimal allocation of the network
inventory.
5.1 Step 1: Location, Assignment, and Capacity
The rst step focuses on the primary cost drivers of the system. To limit capacity utilization
at the repair facility, we introduce an upper bound,
j
, to guarantee system stability of Step 2
in the approach. We may set
j
arbitrarily close to, but strictly less than one; however, there
may be other considerations for setting
j
. For example, USAF doctrine stipulates a
j
of 77%.
This is done for responsiveness and robustness in case the forecasts of the mean demand rates
shift suddenly and dramatically.
7
In addition, we will include a constraint on the number of units dedicated to the trans-
portation pipelines of the network. We use V , to represent the total number of units that can
be dedicated to the transit pipelines. The Step 1 linear formulation for the facility location
subproblem is:
(Step 1) min
x
j
,y
ji
,z
jk

jG
x
j
f
j
+

jG

iF

ji
y
ji
c
ji
+

jG

kH
z
jk
a
jk
s.t.

jF
y
ji
= 1 i F
y
ji
x
j
i F, j G

iF
y
ji

ji

j

kZ
z
jk
j G (5.8)

iF

jG
(l
ji

ji
y
ji
) V (5.9)
0 z
jk
z
j(k+1)
j G, k Z
Constraint (5.8) now reects the upper bound on capacity utilization at the repair facility.
Constraint (5.9) is included to limit the number of units assigned to the transportation pipelines.
The upper bound of V = S, which would permit all of the system inventory to be tied up in
transportation pipelines. The tactical costs of such a solution will be revealed in Step 2.
After solving Step 1, we have decomposed the supply chain into M independent sub-
networks, where M is the number of opened repair facilities. The repair facilities, a minimum
number of servers at each repair facility, and the assignments for the eld stocking locations to
repair facilities are chosen. They are denoted as x

j
, z
j
=

nZ
z

jn
, and y

ji
, respectively. Let
the set of opened facilities be denoted j G

.
5.2 Step 2: Incremental Capacity Gains and Inventory Allocation
The basic topology of the supply chain is determined in Step 1. In Step 2, we balance the costs
of incremental repair capacity with the costs of total inventory within each sub-network. We
use the network design (x

j
, y

ji
, z
j
) to decide how much additional capacity to assign to the
repair facilities, and how to allocate the inventory among the sub-networks (and their locations)
optimally. To accomplish this, we must characterize the expect cost for each sub-network j G

as a function of its total amount of inventory and repair servers.

For sub-network j, let the total amount of inventory designated to that sub-network be
S
j
= s
j0
+

iF
j s
ji
. For a capacity level z
j
z
j
, we dene C
j
(z
j
, S
j
) as the minimum
expected cost of repair capacity and inventory holding and backorder costs for sub-network j
associated with z
j
repair servers and inventory S
j
. We will refer to C
j
() as the capacity-
dependent inventory cost function for sub-network j. That is,
C
j
(z
j
, S
j
) = min
s
ji
,s
j0
z
j

n=0
a
jn
+

iF
j
h
j0

j
(y

ji
, z
j
, s
j0
)
+

iF
j
h
ji

i
(y

ji
, z
j
, s
ji
, s
j0
) +

iF
j

ji

i
(y

ji
, z
j
, s
ji
, s
j0
)
s.t. S
j
= s
j0
+

iF
j
s
ji
(5.10)
s
j0
, s
ji
0 i F
j
. (5.11)
8
Constraint (5.10) insures that amount of sub-network inventory S
j
is allocated to all loca-
tions within the sub-network. Constraints (5.11) insure non-negative base stock levels. Note
that C
j
() is dened only for z
j
z
j
, corresponding to a sub-network repair capacity utilization
that is strictly less than 1. Note also that C
j
() is not convex in S
j
for a given z
j
, although it is
near convex. This issue of non-convexity is well-known and is discussed in Sherbrooke (1968).
Starting with z
j
= z
j
, sub-network j has the highest possible utilization (but still less
than 1) based on an integer number of repair teams. Note that for an M/M/k system, the
average number of items in the system is monotonically decreasing in the capacity utilization.
Consequently, this is the condition in which the expected repair lead time will be longest. As
the number of repair teams z
j
increases, the repair cost will increase (concavely) and the repair
lead time will decrease, asymptotically approaching the mean repair time
j
. There is therefore
a limit to the inventory benet associated with adding repair capacity.
Alternatively, observe that as the amount of inventory S
j
increases, the cost advantage of a
reduced average repair lead time arising from additional repair capacity decreases. This is be-
cause additional repair capacity decreases the expected backorder costs for a given S
j
; however,
as S
j
increases, the expected backorder costs also decrease, and the inventory cost savings of
adding capacity become smaller than the incremental cost of adding capacity. Therefore, for
a given sub-network, the capacity-dependent cost curves can be combined to form an optimal
cost hull, which we will call SP
j
(S
j
). Dene the minimum expected repair and inventory costs
for sub-network j for a given S
j
as,
SP
j
(S
j
) = min
z
j
z
j
C
j
(z
j
, S
j
).
An illustration of the relationships between C
j
() and SP
j
() is shown in Figure 2 for in-
creasing repair servers (z
j
, z
j
+ 1, z
j
+ 2). From the convexity of the repair waiting time in z
j
and from the near-convexity of the expected inventory holding and backorder costs in S
j
, we
have the following important observation: associated with every level of sub-network inventory
S
j
, there is a corresponding cost-minimizing number of repair servers z

j
(S
j
). We dene,
z

j
(S
j
) = arg min
z
j
z
j
C
j
(z
j
, S
j
).
For each sub-network j, we have a means to analytically compute SP
j
(S
j
) to provide an
estimate of the long-run expected costs of repair capacity and inventory costs associated with
carrying S
j
of inventory. Because the cost functions SP
j
() are separable by sub-network, the
problem lends itself well to a parallel computing environment. Using the SP
j
(), we can state
the global optimization problem (GP) of allocating the S units of total system inventory among
the sub-networks as:
(GP) min

jG

SP
j
(S
j
)
s.t.

jG

S
j
= S.
It is important to again emphasize that the goal of our framework is to integrate strategic
and tactical aspects of the problem in a computationally ecient manner. Ideally, we would like
to solve (GP) for the optimal balance of capacity and inventory via a fast marginal allocation
algorithm or Lagrangian relaxation approach. Unfortunately, SP
j
() is not convex in S
j
, thus
hindering such fast approaches.
To deal with the non-convexity of SP
j
(), we propose constructing a fast, convex, and
accurate approximation to SP
j
(), which we denote SP
j
(). There are several attributes of
the problem that allow us to achieve increased computational performance. Our approach for
constructing fast and accurate approximation to SP
j
() for sub-network j is described in the
following steps:
9
Sub-network
Cost vs. Inventory
Inventory

E
x
p
e
c
t
e
d

C
o
s
t
) , (
j j j
S z C
) (
j j
S SP
) , 1 (
j j j
S z C
) , 2 (
j j j
S z C
0
0
j
S
Figure 2: Sub-network cost curves and the cost hull.
1. Identify an upper bound on the repair servers, z
j
. Consider the sub-network
inventory to be S
j
= 0. The expected inventory costs are the average backorder cost
rate multiplied by the average demand rate multiplied by the average time through the
network. This is where additional repair capacity provides the largest cost advantage in
the form of reduced backorder costs.
Begin by setting the number of repair servers z
j
= z
j
. If C
j
(z
j
, 0) > C
j
(z
j
+ 1, 0),
increment z
j
= z
j
+ 1. Continue until the condition is false, thus determining the z
j
at
which there is no longer an economic incentive to add another increment of capacity. Let
B
j
= {z
j
, ..., z
j
}, be the set of possible values of z
j
. Note that SP
j
(0) = C
j
(z
j
, 0) is the
initial point on the optimal hull.
2. Compute the rst two moments of the number of items in repair. The number of
repair servers aects the steady-state distribution of the number of items in repair. Using
a recursive method based on Prabhu (1965), we compute the rst two moments of the
number of units in repair in an M/M/k system,
j
(z
j
) and
2
j
(z
j
), for each z
j
B
j
. We
approximate the exact distribution by tting these two moments to a negative binomial
distribution with very little loss of accuracy.
3. Compute the sub-network cost incrementally. Interestingly, in computing SP
j
(),
we do not need to calculate C
j
(z
j
, S
j
) for all z
j
B
j
. There are two important attributes
associated with the capacity-dependent cost functions along the optimal hull: (1) only
successive increments of capacity intersect each other in order of increasing S
j
, and (2)
two capacity-dependent cost curves intersect at most at one point. Therefore, for each
increasing value of S
j
, we only need to compare the current z
j
and z
j
1. Set z
j
= z
j
, and
set SP
j
(S
j
) = min{C
j
(z
j
, S
j
), C
j
(z
j
1, S
j
)}. If C
j
(z
j
1, S
j
) C
j
(z
j
, S
j
), set z
j
= z
j
1.
Repeat until S
j
= S, where S is the total amount of inventory in the system.
4. Construct a convex approximation, SP
j
(). While computing SP
j
(), we track in-
formation that used to create the approximation curve. For each z
j
B
j
such that
C
j
(z
j
, S
j
) = SP
j
(S
j
) for some S
j
, let S

j
(z
j
) be the corresponding cost minimizer of
SP
j
(). This is the local minimum of SP
j
() associated with z
j
. As S
j
is incremented,
we store the corresponding number of servers z
j
, the local minimizer S

j
(z
j
), and the lo-
10
cal minimum cost value SP
j
(S

j
(z
j
)). We also obtain the global minimum, SP(S

j
) and
global optimizer S

j
.
Set SP
j
(0) = SP
j
(0). For S
j
= 1, ...., S, let

s
(S
j
) = |SP
j
(S
j
) SP
j
(S
j
1)|,
or the cost dierential between the convex approximation at the prior value of inventory,
S
j
1, and the true cost minimum SP
j
(S
j
). Let

g
(S
j
) =
|SP
j
(S
j
) SP
j
(S

j
)|
|S
j
S

j
|
,
or the slope between S
j
and the global minimum. Let

l
(S
j
) =
|SP
j
(S
j
) SP
j
(S

j
(z
j
1))|
|S
j
S

j
(z
j
1)|
,
or the slope between S
j
and the local minimum along the next level of capacity S

j
(z
j
1).
Lastly, we let
p
(S
j
) :=
s
(S
j
1), or the slope of the cost approximation at S
j
1. This
is used to preserve convexity between iterations of S
j
. We can then determine SP(S
j
)
conditionally upon its relative position with respect to the local and global minimums:
SP(S
j
) =

min

max{
s
(S
j
),
g
(S
j
),
l
(S
j
)},
p
(S
j
)

, if S
j
S

j
and S
j
S

j
(z
j
1);
min

max{
s
(S
j
),
g
(S
j
)},
p
(S
j
)

, if S
j
S

j
and S
j
S

j
(z
j
1);
max

min{
s
(S
j
),
g
(S
j
)},
p
(S
j
)

, if S
j
S

j
and S
j
S

j
(z
j
1);
max

min{
s
(S
j
),
g
(S
j
),
l
(S
j
)},
p
(S
j
)

, if S
j
S

j
and S
j
S

j
(z
j
1).
We then set
p
(S
j
) = SP(S
j
) and increment S
j
until S
j
= S.
We chose this approximation technique over creating the convex lower bound of the cost hull
because this approximation procedure is both accurate and very fast. The approximation pro-
cedure is O(N) versus O(N
2
) for the exact convex lower bound.
Utilizing the collection {SP
j
} of convex cost approximations (one for every sub-network),
we are able to solve a reasonably accurate approximation to (GP) and simultaneously optimize
repair capacity and the allocation of the entire network inventory S to the sub-networks via a
simple marginal allocation algorithm:
(Step 2) min

jG

SP
j
(S
j
)
s.t.

jG

S
j
= S.
We will examine the accuracy of this approximation under various system conditions through
a comprehensive numerical study.
6 Numerical Study
To assess the quality and accuracy of our approach, we perform two numerical studies. The
purpose of the rst numerical study is to validate the accuracy of our deviation from Palms
Theorem. The second numerical study focuses on the two step approach itself. We study its
ability to reach the optimal solution as well as the benecial aspects of the approach.
11
6.1 Numerical Study of Model Accuracy
It is unclear how the cost accuracy of the model is aected by incorporating the estimated queue
time of an M/M/k queue and invoking Graves approximation. We emphasize that while our
algorithm is a computationally ecient way to unify the strategic and tactical aspects of the
decision problem, it is not appropriate for day-to-day operational purposes.
In addition to a general understanding of when the approximation is reasonable and when
it is not, we are interested in the following questions: How well does the negative binomial
approximation represent the steady-state probability distribution of the number of items in
repair? How well would Graves conditioning argument approximate the rst two moments of
the units outstanding at the FSLs when repair capacity is nite?
6.1.1 Design of Numerical Study
For a series of scenarios, we compare our estimated costs with those observed through a simula-
tion. The test network is comprised of one repair facility and ve eld stocking locations. The
FSL holding cost rate to $1 per unit per period. The factors of the study are listed in Table 1:
Factor Low Medium High
Inventory Shortage Optimal Excess
Capacity Utilization (%) 75 85 95
Number of Parallel Servers 1 3 5
Transit Lead Time (days) 1 3 5
Depot Holding Cost ($) 0.1 0.5 0.9
Backorder Costs ($) 9 - 99
Table 1: Factors examined to validate estimation technique.
The two-step decomposition optimization algorithm is developed using GAMS and Microsoft
Excel. Step 1 is solved by GAMS in fractions of a second. The data tables are built in Microsoft
Excel. Step 2 then determines the optimal allocation of inventory using marginal analysis.
Step 2 solution times range from a few seconds to a half minute, depending on the number
of units in the network, and are dominated by the creation of the tables SP
j
() and SP
j
().
We develop a continuous-time simulator to simulate actual costs for comparison purposes. We
sample 500,000 repair events from sixteen random input streams and their antithetic stream as
a variance reduction technique.
6.1.2 Accuracy Study Results
Across all test scenarios, the total expected costs under-estimated the actual simulated costs by
3.2% on average. We believe that given the strategic and tactical nature of our approach, this
is a reasonable level of accuracy under a wide variety of test cases.
Separating the test cases by the backorder costs, with a backorder to holding cost ratio of 9:1,
the expected costs are within 0.52% of the simulated costs. Under these nominal conditions, the
approximation is quite accurate. We are therefore interested in determining the circumstances
in which the approximation performs poorly.
For the backorder to holding cost ratio of 99:1, Table 2 details the expected costs, actual
costs, and relative dierence for varying depot holding costs, FSL backorder costs, FSL holding
costs, and total costs. In this case, all backorder estimation errors are signicantly magnied
by the high backorder costs, and our approach under-estimates the total cost by 5.06%. We
believe that this case is a reasonable worst-case performance.
To further explore conditions that negatively impact our cost estimate, we found that cou-
pling the high backorder cost ratio with increases in repair server utilization leads to the greatest
12
Cap.
Util.
Num.
of
Serv.
Depot
Holding
Costs Expected
Actual
Simulated
Relative
Difference Expected
Actual
Simulated
Relative
Difference Expected
Actual
Simulated
Relative
Difference Expected
Actual
Simulated
Relative
Difference
.1 3.21 $ 3.21 $ 0.02% 19.45 $ 19.47 $ 0.08% 24.06 $ 24.37 $ 1.26% 46.73 $ 47.05 $ 0.68%
.5 13.00 $ 13.00 $ 0.02% 17.99 $ 18.00 $ 0.08% 42.29 $ 42.53 $ 0.56% 73.28 $ 73.53 $ 0.35%
.9 19.77 $ 19.77 $ 0.02% 19.87 $ 19.88 $ 0.08% 48.98 $ 49.21 $ 0.48% 88.61 $ 88.87 $ 0.29%
.1 3.37 $ 3.37 $ -0.06% 19.46 $ 19.48 $ 0.08% 23.99 $ 24.64 $ 2.70% 46.83 $ 47.49 $ 1.41%
.5 13.96 $ 13.94 $ -0.10% 18.65 $ 18.67 $ 0.12% 39.49 $ 40.19 $ 1.76% 72.09 $ 72.80 $ 0.98%
.9 21.28 $ 21.24 $ -0.16% 19.97 $ 20.01 $ 0.16% 45.56 $ 46.18 $ 1.37% 86.81 $ 87.43 $ 0.72%
.1 3.47 $ 3.47 $ -0.05% 19.43 $ 19.45 $ 0.14% 24.81 $ 25.46 $ 2.64% 47.70 $ 48.38 $ 1.43%
.5 15.08 $ 15.06 $ -0.11% 19.38 $ 19.42 $ 0.21% 34.09 $ 34.87 $ 2.28% 68.55 $ 69.35 $ 1.17%
.9 23.38 $ 23.33 $ -0.20% 20.45 $ 20.51 $ 0.29% 44.42 $ 44.94 $ 1.16% 88.25 $ 88.78 $ 0.60%
.1 4.38 $ 4.38 $ 0.00% 20.66 $ 20.68 $ 0.11% 23.29 $ 25.24 $ 8.39% 48.33 $ 50.30 $ 4.09%
.5 18.14 $ 18.14 $ 0.00% 20.09 $ 20.11 $ 0.12% 36.39 $ 38.43 $ 5.62% 74.62 $ 76.69 $ 2.77%
.9 28.16 $ 28.16 $ 0.00% 22.48 $ 22.50 $ 0.12% 42.56 $ 44.82 $ 5.31% 93.20 $ 95.48 $ 2.45%
.1 4.55 $ 4.54 $ -0.05% 20.72 $ 20.75 $ 0.15% 21.62 $ 24.21 $ 12.01% 46.89 $ 49.51 $ 5.60%
.5 19.05 $ 19.04 $ -0.07% 19.70 $ 19.73 $ 0.17% 37.10 $ 39.54 $ 6.58% 75.84 $ 78.30 $ 3.24%
.9 29.89 $ 29.86 $ -0.11% 22.18 $ 22.22 $ 0.20% 40.57 $ 43.30 $ 6.73% 92.64 $ 95.38 $ 2.96%
.1 4.67 $ 4.67 $ -0.09% 20.66 $ 20.69 $ 0.19% 22.71 $ 25.53 $ 12.43% 48.04 $ 50.90 $ 5.95%
.5 20.02 $ 20.00 $ -0.10% 19.79 $ 19.82 $ 0.17% 33.81 $ 36.74 $ 8.68% 73.62 $ 76.57 $ 4.01%
.9 31.46 $ 31.40 $ -0.17% 22.17 $ 22.23 $ 0.26% 41.37 $ 44.36 $ 7.22% 95.00 $ 97.99 $ 3.15%
.1 12.12 $ 12.14 $ 0.23% 25.62 $ 25.81 $ 0.73% 22.22 $ 28.07 $ 26.37% 59.95 $ 66.03 $ 10.13%
.5 49.45 $ 49.57 $ 0.24% 27.63 $ 27.86 $ 0.85% 40.83 $ 47.52 $ 16.39% 117.90 $ 124.95 $ 5.98%
.9 79.51 $ 79.70 $ 0.24% 31.48 $ 31.75 $ 0.84% 49.26 $ 56.52 $ 14.73% 160.26 $ 167.97 $ 4.81%
.1 12.52 $ 12.55 $ 0.25% 25.15 $ 25.33 $ 0.71% 20.05 $ 28.82 $ 43.69% 57.73 $ 66.70 $ 15.54%
.5 50.25 $ 50.39 $ 0.26% 27.68 $ 27.93 $ 0.89% 37.76 $ 48.08 $ 27.32% 115.69 $ 126.39 $ 9.24%
.9 80.81 $ 81.02 $ 0.26% 31.06 $ 31.33 $ 0.90% 47.64 $ 58.14 $ 22.04% 159.50 $ 170.49 $ 6.89%
.1 12.91 $ 12.93 $ 0.16% 24.65 $ 24.79 $ 0.54% 18.13 $ 30.81 $ 69.96% 55.69 $ 68.52 $ 23.05%
.5 44.40 $ 44.48 $ 0.17% 25.31 $ 25.45 $ 0.55% 98.31 $ 105.82 $ 7.63% 168.03 $ 175.75 $ 4.59%
.9 81.60 $ 81.73 $ 0.15% 31.04 $ 31.28 $ 0.79% 46.26 $ 63.38 $ 37.01% 158.90 $ 176.39 $ 11.01%
25.94 $ 25.97 $ 0.10% 22.69 $ 22.78 $ 0.40% 37.32 $ 41.54 $ 11.33% 85.95 $ 90.30 $ 5.06%
3
Base Holding Costs
5
Overall
75
85
95
1
3
5
Base Backorder Costs Total Costs
3
1
Depot Holding Costs
1
5
Table 2: Actual versus expected costs when base backorder to cost ratio is 99:1.
under-estimates of the total cost. For example, when increasing the utilization from 75% to
95% in the 99:1 case, the gap in our estimate increases from 0.78% to 8.5% on average.
As can be expected, the absolute variance of the number in queue and in repair at a repair
facility greatly impacts the estimate of the variance of the number of outstanding orders at a
FSL. More specically, when the variance of the repair process (in queue and in repair) is high,
as in the 95% utilization case, our use of the Graves (1985) approximation under-estimates the
variance of the outstanding orders at a FSL, and subsequently, we under-estimate the number
of backorders at the FSLs. This in turn causes the under stocking of inventory at the FSL.
The root cause is due to the nite repair capacity that we model as a M/M/K queue versus
Graves M/G/ assumption. Further research is needed to develop a better approximation of
the second moment of the number of units outstanding to a FSL.
Overall, we feel that our approximation for the number of units in repair over the repair
time delay is reasonably accurate and provides the necessary foundation to link the strategic
supply chain design decision with the tactical repair capacity and inventory allocation decision.
We have explored the circumstances in which it performs well, and have assessed worst-case
scenarios.
6.2 Numerical Study of the Two Step Optimization Approach
Using data that are representative of actual operating USAF data, we construct a numerical
study with ve candidate locations (under current operating structure, repair facilities are co-
located at each operating location). We then create a table of factors that we use to analyze
the approach under a myriad of conditions. Finally, we enumerate each candidate solution in
Step 1, solve Step 2, and compare are two step solution with each possible enumerated solution.
The goal of this study is three-fold: (1) to assess the economic value of consolidating repair
capacity and locations; (2) to determine the performance of the two step approach in reaching
13
the optimal solution; and (3) to examine the cost improvements gained by including the tactical
considerations in the strategic model formulation (Step 2).
6.2.1 Design of the Numerical Study
The current supply chain locations as well as the table of factors under study are listed Figure
3. There are 864 total combinations of system inventory, demand, transit lead times, xed
facility costs, economies-of-scale (EOS), transportation costs, repair facility holding costs, and
base backorder costs.
The daily failure rates at the locations are: (1) 0.571; (2) 0.326; (3) 0.202; (4) 0.127;
and (5) 0.106. The average one-way transportation cost is $1,500, and the average one-way
transportation time between locations is four days. The cost of a unit is $3,500,000, and we
assume the annual holding cost at a base is 20% of the unit cost. The annual amortized xed
facility costs are assumed to be $1,000,000, and incremental capacity costs are $900,000. We
represent economies-of-scale with a function that is concave in the number of repair teams at a
repair facility.
Factor Low Medium High
Inventory Shortage Optimal Excess
Demand 1 - 2
Lead Time 1/3 1 3
Fixed 1 - 2
Productivity Normal - EOS
Transit Cost 1 2 5
Depot Hold .5 - .9
BO Cost 9 - 99
5
1
2
3
4
Figure 3: Enumeration factors and the supply chain candidate locations.
6.2.2 Two Step Approach Study Results
The rst exploration in this experiment is to justify the consolidation of repair facilities and
capacity. Across the 864 combinations, the average annual savings of consolidation is $7,500,000.
This represents a total annual cost reduction of 24%. This is a signicant annual savings given
the scale of this ve location experiment.
The two step approach performs well in its ability to choose the optimal solution. Since
Master Problem is a non-linear integer program, it is very dicult to solve by itself directly.
We addressed this problem in each scenario by enumerating over all possibilities in Step 1, and
then solving Step 2. Of the 864 scenarios, there are 84 scenarios in which the two step algorithm
did not achieve the minimum solution. Of those 84 cases, the relative dierence between the
minimum value and the two step solution is 1.65%, with a maximum gap of 7.35%. We believe
this is an acceptable cost gap given the strategic nature of the model.
The justication for incorporating tactical considerations is shown in Figure 3. Across all
scenarios, 107 scenarios add additional repair capacity in Step 2 of our approach. For this
subset, we compare the two step approach to an approach that solves Step 1, and determines
the inventory allocation as a function of z
j
. We do so to quantify the value of incorporating Step
2. As a result of solving Step 2, average of 1.94 increments of capacity are added, decreasing
the average FSL backorders. The average cost savings associated with Step 2 is approximately
$900,000, which represents an average of 3% of the total cost, with a maximum of 12%. As a
result of this study, we assessed the ability of the two step approach to nd the optimal solution.
The relative value will depend on the specic economic costs associated with a particular aircraft
14
Economies
Fixed
Facility ($)
Depot
Holding
Costs ($)
Savings of
Approach ($)
Savings
Relative to
Costs (%)
Ave. Number of
Servers Added
EOS x1 0.5 1,170,546.75 $ 4.24% 1.92
EOS x1 0.9 1,088,145.76 $ 4.12% 2.29
EOS x2 0.5 1,105,016.31 $ 3.70% 1.85
EOS x2 0.9 1,123,947.80 $ 3.88% 2.29
Norm x1 0.5 591,241.61 $ 1.85% 1.73
Norm x1 0.9 665,808.34 $ 2.19% 2.00
Norm x2 0.5 730,494.99 $ 1.93% 1.55
Norm x2 0.9 689,030.68 $ 1.94% 1.92
Average 895,529.03 $ 2.98% 1.94
Table 3: Economic value of two step approach.
subsystem. Our expectation is that when this method is applied to a wide variety of product
families, the annual cost savings will be signicant.
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15