Modelling and Simulation for Supply Chain Contract Based on the Inventory

Management under Uncertain Demand

Wei Guo

Guangchao Huang

College of Management, Huazhong University of Scie

Technology
Luoyu Road No. 1037
Wuhan 430074
CHINA
guoweicl@public. wh. hb. cn
Abstract -This article mainly studies the harmony problems
according to the supply chain contract about inventory
management under uncertain demand, discusses the
necessary condition to realize the harmony based on the
supply chain system about inventory management and the
concrete influence correspond to the contract. This article
also constructs two models in the same condition that base on
the supply chain contract about inventory management under
uncertain demand, one is the seller's profits model, other is
seller's profits constitutes model under the method of
negative preface of the dynamic state programming. The
conclusions indicate that the contract can help system's
Pareto optimization, and realize the best performance in the
whole supply chain and the perfect harmony of the supply
chain system under uncertain demand.

I. INTRODUCTION
At present, the harmony of the supply chain under the
uncertain demand is the emphases in the theories field and
the practical business. In reality the various activities
between the manufacturer and seller must consider the
actual need of the customer may be uncertain, we can
divide it into two stages: the first stage is a normal sale
stage, and the second stage will reduce price. In the first
stage the manufacturer's products face less competition in
the market, the manufacturer produces out products and
sells them to sellers by wholesale price, then the sellers sell
them to customers in the price that added a certain profits.
In the second stage, with the rivals increase and product's
life period comes to autumn even to winter, in order to
strengthen the product's competition ability and obtain
more profits, manufacturer decides to reduce price. But
this strategy would decrease the seller's benefits, in virtue
of the seller's customers' demand is uncertain. The
manufacturer undertakes the excess risk and must request
benefits compensate in certain form. So the manufacturer
needs to give a certain benefits compensate in response of
the products that have not yet been sold due to the
behaviour of reducing price bring loss to seller, what's
more, when the whole sell turns over, the manufacturer
also needs to certainly return to buy the surplus product.
Allowance is relatively more used in practical business,
and some literature analysed the models. Pasternack
analyse the problem of return contract under free style
order, he point out that the effective trade price and return
price can boost the harmony efficiency through Pareto
optimization. But this method has the limitation that when
the product's return price is too high, this model will lose

South China University of Technology

Wushan Road
Guangzhou, 510640
CHINA

the effect"'. Eppon studied the problem of compensation

contract between supplier and retailer, indicated that the
contract can improve both parties' benefits better2'.
Donmhue researched how to use return contract to realize
harmony between two parties in supply chain and Pareto
optimization, but he did not consider the processing cost at
reject goods"'. Liu applied the return and compensate to
make elementary research about two stages sale model
under the price drop conditionsI45,. Wang built two stages
sale model, but only applied return and price compensate
in certain stage, and the condition to realize harmony
system not only depends on system's cost construct but
also depends on need distribution"6'. Tsay studies the
available qualification of the return and strategy subsidy
under the traditional supply chain model (the seller just
order one time, the manufacturer also produce one time)7'.
Taylor also analysed the price protection model at two
stages"8', but he emphasizes the dynamic state price
protection strategy when the products on the market face
the dated risk at multi- stages. Ding studies the harmony
problem in the supply chain contract style under two
production and order, and designs the valid return contract
and unmarketable subsidy contract which can harmonize
the supply chain member's decision"9'. Many Chinese
scholars, such as Zhuang Yu"L, Yang QingdingLlli, He
Yongr'2' etc, made some simulation analysis to some supply
chain contracts. Many literature indicated the importance
of contracts, but in the respect of the harmony problems
according to the supply chain contract about inventory
management under uncertain demand, few literature have
discussed the necessary conditions to realize the harmony,
especially to the concrete influence correspond to the
contracts under uncertain demand. Although few
researchers built two stages model, but they researched
only the single contract strategy in the first or second stage,
the model was difficult to be applied in the practice. So i
use for references from Lee""3, Wang and other scholar's
ideas, build the relevant theory model in two stages, and
discuss the necessary conditions to realize the harmony of
supply chain based on inventory management and the
concrete influence correspond to the contract.

II. THE ASSUMPTION AND THE SIGN MEANING

UNDER UNCERTAIN DEMAND
The suppose of model are as follows:
OManufacturer produces single product, and its unit
production cost is constant;
(2)There are certain information dissymmetry between
two port of supply chain, manufacturer is the decision-

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maker and carrier of the price discount, so the

manufacturer takes larger advantage in terms of price, cost,
demand and other information than the seller;
O)The relationship between manufacturer and seller can
be divided into two stages, the first is normal sale stage,
the second is dropping price stage;
(A)The out of inventory cost of manufacturer and seller
must be considered;
(The demand of customer is uncertain, the customer's
demand has price flexibility;
(At the end of first stage, the manufacturer decides to
reduce the wholesale price, and gives seller compensate
according to the seller's surplus products at certain
quantitative rate;
MAt the end of second stage, the manufacturer returns
seller's surplus products at certain quantity rate according
to the seller's storage at beginning of the second stage;
)The relationship between manufacturer and seller is
cooperative, and both are neuter risk;
(The final sales price is equal to the manufacturer's
wholesales price add certain percentage;
(The seller adopts EOQ order strategy.
The sign meanings are as follows:
P1, P2-- the market price of product at the first and
second stage, is a constant and P2<P1;
Q --seller's order batch quantity, it is not negative,
continuous, random variable;
xI, x2-- the customer's demand of the first and
second stage;
fl (xI) , f2(x2) the probability density function
of the first and second stage;
F1 (xI) , F2 (x2 ) - - accumulation distributing
function of customer's demand, which is continuously
differential, and increases monotone strictly;

Fo(x)

f' f(X)f2 (x2 )dx2dxl

I

--in the

first and second stage, accumulation distributing function

of the order quantity, which is continuously differential,
and increases monotone strictly;
c - - the cost of unit product produced by
manufacturer
ml,m2 --unit product credit loss cost due to out of
inventory in first and second stage;
v-- the unit net remnant value of the surplus product
at the end of the second stage;
a --the adding price range in the foundation of the
manufacturer's cost, a > 0;
w-- the wholesale price of the product produced by
manufacturer, w = c X (1 + a));
cl, c2 - - the unit storage expense of the surplus
product in the first and the second stage respectively;
Qo -seller's storage quantity at the beginning of
second stage, it's not negative, continuous, random

variable;

ti

--

at the end of the first

stage, manufacturer

decides to reduce the product selling price, manufacturer

gives seller unit price compensate for the surplus products;
t2 -- at the end of the second stage, the unit return
price of seller surplus products supplied by manufacturer;
El--at the end of the first stage, when manufacturer
carries out the price compensation strategy, the proportion
that the price compensation quantity accounts for the
seller's order quantity at the beginning of the first stage;
62 - at the end of the second stage the manufacturer
carries out the return strategy, the proportion that the return
quantity accounts for the of shopkeeper's storage quantity
at the beginning of the second stage;
V1 SI(Q)/Ilm, (Q)-- under the condition of the
ordering batch quantity as Q, seller/ manufacturer obtains
the expectation profits in the first stage;
n TI (Q) --under the condition of the ordering batch
quantity as Q, manufacturer and seller obtain together the
expectation profits in the first stage;
lS2 (Q) / HM2 (Q) --under the condition of the
ordering batch quantity as Q, seller/ manufacturer obtain
the expectation profits in the second stage;
In above signs, v < c < w < p1 ; namely remnant value
of product<cost<wholesale price<market price in the first
stage; in the second stage its price is reduced, so

P2 <P1;

The product for sale is in the growth period within the

product life cycle in the first stage, the market demand is
great, and the product value is high, if the product is out of
inventory, the loss will be larger; so c2 < cl, m2 < ml;
Manufacturer and seller are both rational, in order to
assure manufacturer's strategy for price subsidy can be
accepted by seller, and seller try their best to sale product
in the first stage, the seller's reasonable choice is to accept
the price subsidy at the end of the first stage; so there is

P1 +c1 >P2 +tl, w>tl +cl, w<tl +P2;

In order to assure manufacturer's strategy for return can

be accepted by seller, and seller will try his best to sell
product in the second stage, the seller's reasonable choice
is to perform the return at the end of second stage; so there
is t >t2 +c2 , p2+C2+m2>v , P2C2>t2
t2-C2 >V

III. PROFITS MODEL OF THE SUPPLY CHAIN

CONTRACT UNDER UNCERTAIN DEMAND
The action of the price subsidy and return is happened
between manufacturer and seller, and does not affect the
whole profits of supply chain, so the key factors that will
affect the whole profits are (P1I P2, w) .
Suppose seller has inventory products as QO at the
beginning of the second stage, for describing the problem
conveniently, adopting the method of negative preface of
the dynamic state programming to research whole profits
model of supply chain contract under uncertain demand.

2006 IEEE International Conference on Industrial Informatics

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At the second stage, the expectation demand of the

customer follows the following regulations:
X2 =d

=(P2 -v + C2 + M2)

X2 < QO
x2 > Qo

x2

(M2 -ml +P2 -P1 -cI)XFl(Q*)+(PI +M1 -c)

UQO

So the whole expectation profits of the second stage are:

f12(QO) = f P2 Xx2 +vx(QO -x2)

- C2 x (Qo - X2)]f2 (x2 )dx2
(1)
+ [p2 X Qo - m2 X (x2 - Qo)]f2 (x2 )dx2

xjC

Xi

m1 X[f Xfl(xl)dxl + Q*fi (xl)dxl]

I

are:

So

(2)

[PIp XQ+H2(O)
ml x (XI

Q)]fi (Xl )dx

Hll(Q)=(p1 +ml -C)XQ

Qf (X1

)dxl]

-m2x[t-xlx2t
~x22(x2)dx2+(Xt(2d2]
+{
x[f X'xf2(X2)d2
-in2
2f2 (3)dX2
-(ci +PI -P2 +Ml -M2)
x (Q- xI)f (xI )dX1 - (P2 + M2 + C2 -v)
1Q Xl(Q-xi -X2)2(x2)f1

(X1 dX2dxl

Take derivation to formula (3) and we can know that it

is less than zero. Therefore, the whole expectation profits
can get maximum, and there is Q satisfied:

772

(5)

+iml -im2)
x f (Q* -xl)fl (xl)dx
x

-C(2 +im2 +c2 -V)

(Q* -xi - X2)f2(X2)fl (XI)dX2dXl
IV. SELLER'S PROFITS MODEL UNDER THE
UNCERTAIN DEMAND

The price subsidy and return are both happened between

the manufacturer and seller, so the key factors which affect
the seller's profits under the uncertain demand will be
more, they include mainly (p1 , P2 , w, tl t2, E 2 ), and
the factors of influence are difference in the different stage.
As same the whole profits model, we suppose seller has
inventory products as Qo at the beginning of second
stage, and adopt the method of negative preface of the
dynamic state programming to research whole profit model
of the supply chain contract under the uncertain demand.
At the end of the second stage, manufacturer will return
seller's surplus products at the rate &2 this action will
affect seller's profits.
At the second stage, the expectation demand of the
customer follows the following regulations:

QO (1-62)
QoG(1-e2) < X2 < Qo
X2 > (o

SX2

-im x[f xIf (xl )dxl +

,x2f2 (X2 )dX2]

-(c1 +P1 -P2

As xi < Q, at the first stage the whole profits are

constituted by three parts: (0) sale income; () the
expectation profits in the second stage, for the inventory
quantity is (Q - XI) at the beginning of the second stage,
then it is equal to H,2
(Qo- xl); ( the inventory
expenses;
As xi . Q, at the first stage the whole profits are
constituted by three parts: (O)sale income; ()the loss of the
out of inventory; (O)the expectation profits of the second
stage, for the inventory quantity of seller is 0, then it is
equal to H 2 (0), remarkably, H2 (0) 0;
Besides, in the first stage the whole profits include the
cost for produce, which is equal to the cost of unit product
multiplies the customer demand of the first stage.
Therefore, the whole expectation profits of first stage

x2f2(x2)dX2

-m2x[

xi < Q
xi >Q

H1(Q) = -cxQ+ fj[P1 XI + H12(Q-xI)

- c X(Q-x )]f (xl )dxl

(xIV)f2 (x2)dx2dxl

So the whole expectation profits have the best value:

fJ(Q)=(pI +iml -c)xQ* -

And at the first stage, the expectation demand of the

customer follows the following regulations:

fxl

fj'

(4)

X2

X2 = X2

UQ

So the seller expectation profits of second stage are:

HS2(

)=

(1-2)

XX2 +

2 2

+vx[Qo(1-e2)-X2]-C2 X(Qo-X2)}f2(x2)dx2
(6)
+ (1 )[P2 xx2 +t2 X(QO -X2)
-C2 X(QO -X2)f2 (x2 )dx2
+

f[P2 XQO -iM2 x(X2 0)f2 (x2)dx2

-

At the first stage, the expectation demand of the

2006 IEEE International Conference on Industrial Informatics

customer follows the following regulations:

xi

xi

profits can get maximum, let

(1-81l)
Qx(l-81)<X1 <Q

xi < Qx

Fxl

(ml - m2 + P1 - P2 + cl - tl)xFl(Q)

As x < Q X (1 - ), at the first stage the whole

profits are constituted by three parts: (Osale income; the
expectation profits in the second stage, for the inventory
quantity is (Q - XI) at the beginning of the second stage,
then it is equal to
(Qo - x ) ; 3 the inventory
expenses; 4Ithe income from price subsidy.

nHS2

As

Qx(I-E1) <x, < Q

at the first stage the

seller's profits are constituted by three parts: (0) sale

income; ) the income from price subsidy carried by
manufacturer; (Q)the inventory expenses;
As xi > Q, at the first stage the seller's profits are
constituted by three parts: (O)sale income; the loss of the
out of inventory; ()the expectation profits of second stage,
for the inventory quantity of seller is 0 in first stage, then it
is equal to S2 (0) , remarkably, HIS2 (0) . 0;
Besides, in the first stage the seller's profits include
inventory cost, which is equal to the purchase cost of unit
product multiplies the customer demand of the first stage.
So the seller's expectation profits of the first stage are:

nV1 (Q)=-wxQ+ f
+

PI

xx_+t(xet

(7)
)[PI xl + t, x (Q xI )
+ HS2 (Q - XI) - Cl X (Q -x )]fi (xI )dxI
[P1 X Q +1S2 (0) - mI X (xI -Q)]f, (xl)dxl

So

11s, (Q) = (Pi + ml - w) X Q

+t X
)[XI - Qx(12)(I - )If, (xl )dxl
+
fQ-XIXfQ
(t - v) x
xl
XI)
2

~~~~[2-(x)

X (1 - 2 )]Af (xI )f2 (x2 )dx2dx1

+ (C2 +P2 +m2 -2)
X ft

(8)

x)fX1(XI)f2(x2)dx2dx

'(X2 -Q+

+(P1 -P2 +ml -iM2 +cI -t/)

- Q)fi (x1

-11 ))+2 -t2 +c2 +m2)xFO(Q*)

+tlxF(Q*X(l
= (P1 +ml w)+(v-t2)xFo(Q* X(1-2))
(9)
So the seller's expectation profits have the best value:

nls(Q)=(pI +ml-w)Qx

[x -Q X(1 -e1 )Ih (xl)dxl

+(t,2VX Q*-XI)X('-'2) [2 VQ -X)
x (1 -e )]f1 (xl )f2 (x2 )dx2dx1
+t1x

+(C2 +P2 +m2 t2)

x1(X2 Q*+Xl)fi(XI)f2(x2)dx2dx
+(p1 -P2 + m1 - m2 +cI -ti)

X f f2

(xl Q*)fl(xl)dxl
(10)

Because

xQ

HS2 (Q - XI) - Cl X (Q - XI)]f (xI )dxI

+ ;-1

"I = 0 . And

there is Q satisfied:

xi >Q

IQ

n SI

(Q

< 0, the Q that maximizes

Els, (Q) is unique, the order quantity for seller's max

profits must be equal to the order quantity that makes the
whole profits of supply chain maximize. Only in this
condition, the seller can make profit maximize, at the same
time, it will also reach the whole perfect performance
under uncertain demand.
It can be seen that the contract can help system's Pareto
optimization, and realize the best performance in the whole
supply chain and the perfect harmony of the supply chain
system under the uncertain demand.
If the order quantity for seller's maximal profits is
differ from the order quantity that makes the whole profits
of supply chain maximize, the seller may damage the
whole profits in order to pursuit the maximal profits for
themselves. At the same time, the manufacturer should
adjust two parameter's value, one is the compensate price
ti for reduce price of unit product, other is the unit return
price t2 of surplus product, to make sure change the best
ordering quantity for reduce price, and induct the order
quantity for seller's maximal profits to be close to the
order quantity that makes the whole profits of supply chain
maximize.

)dxl

V. NUMERICAL SIMULATION

Take derivation to formula (8), according to the above

assumption and the relations of signs, we know that the
result is less than zero. Therefore, the seller's expectation

I will simulate the number of related parameters in the

table 1 and use them to verify the related conclusion based
on the supply chain contract of inventory manage under the

(X1

2006 IEEE International Conference on Industrial Informatics

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uncertain demand.

symbol

TABLE 1
VALUE OF EACH PARAMETER
parameter
symbol

parameter

40

ml
m?

1500

20

U(x)

300

P2

50

A(X )
A(X2)

1000

Cl

p1
c

100

U(x )

150

500

U(X2)

200

C2

Assume the distribute function F(x) of the whole

product demand in the market is a normal distribution
function, its mean is equal to 1500 and deviation is 3002.
So the normal distribution of x is the homogeneous
distribution at the range of [1500-300, 1500 + 300].
Among them, the distribute function F(xl) of product
demand at the first stage in the market is the normal
distribution function, its mean is equal to 1000 and
deviation is 1502, so the normal distribution of xi is the
homogeneous distribution at the range of [1000 -150,
1000+ 150]. When the depreciation of product caused by
the reinforcement of market competition in the second
stage, the distribute function F(x2) of the product
demand is the normal distribution function, its mean is
equal to 500 and deviation is 2002 So the normal
distribution of x2 is the homogeneous distribution at the
range of [500 -200, 500+200].
We can solve the most economical order quantity of
seller by the formula (4) based on the model of supply
chain contract of inventory management under uncertain
demand:

Q* = 1104.6 1105

Taking the above result into the formula (5), we can get
the best whole expectation profits based the supply chain
contract of inventory management:
flJ(Q*) = 64430.17
In the model based on the supply chain contract of
inventory management under uncertain demand, because
the market demand is uncertain, so it will lead the
probability that the order quantity which makes the seller's
profits maximize is inconsistent with the order quantity
which makes the whole profits of the supply chain
maximize, and the profits of seller and the profits of whole
supply chain will also change immediately. So, we will
research the profits change of the seller and whole supply
chain under the condition of uncertain market demand.
Firstly, we will analyse the profits change of the seller
and whole supply chain under the condition of uncertain
market demand in the first stage. In this stage the distribute
function F(xj ) of product demand in the market is the
normal distribution function, its mean is equal to 1000 and

774

deviation is 1502, so the normal distribution of xi is the

homogeneous distribution at the range of [1000- 150,
1000+150]. We can imitate the seller's profits and the
whole profits respectively, when the deviation of the
product demand reduces or extends respectively, then
compare them with the profits under the original deviation.
Then, in the first stage the profits which are corresponding
to different deviation under the uncertain market demand
can be showed in table 2.
TABLE 2

PROFITS COMPARISON WITH DIFFERENT (7

a,1

100
150
200

200
200
200

1071
1105
1150

Seller's
profit
58459.4
58545.38
59051.05

whole profit
in supply chain
65586.25
64430.17
62900.77

We can know from the table 2 that with the uncertainty

of market demand increasing gradually, the whole profits
of supply chain will decrease tardily, the cause is that the
manufacturer will pay more depreciate compensation to
seller to stimulate seller produce more order quantity in
order to sell more product, its advantage is less than
disadvantage to the whole supply chain. But the profits of
seller will increase tardily along with the uncertainty of
market demand increases, there are two reasons: on one
hand, in the first stage the number of competitor is small,
marginal profit of the out product is high comparatively,
the more order quantity will take more profit; on the other
hand, the depreciate compensation will increase along with
the number of products that are not yet sold increases.
Therefore, in the first stage the uncertainty of market
demand is advantageous to the seller, the depreciate
compensation contract can advance the Pareto optimization
of seller's decision, but the uncertainty of market demand
will bring some risk to the whole supply chain.
Secondly, we will analyse the profits change of the
seller and whole supply chain under the condition of
uncertain market demand in the second stage. In this stage
the product price reduced because the effect of the
competition is strengthened, so, the distribute function
F(x2) of products demand in the second stage is the
normal distribution function, its mean is equal to 500 and
deviation is 2002, so the normal distribution of xi is the
homogeneous distribution at the range of [500-200, 500
+200]. We can imitate the seller's profits and the whole
profits of supply chain respectively, when the deviations of
the product demand reduces or extends respectively, then
compare them with the profits under the original deviation.
Then, in the second stage the profits which is
corresponding to different demand deviations under the
uncertain market demand can be showed in table 3.
TABLE 3

PROFITS COMPARISON WITH DIFFERENT 072

whole chain
profit
isuly
Seller's profit
a1
in supply chain
150
150
1063
58901.69
65162.86
150
200
1105
58545.38
64430.17
150
250
1172
56416.92
59002.25

U2

Q*

2006 IEEE International Conference on Industrial Informatics

We can know from the table 3 that with the uncertainty

of market demand increasing gradually, the seller's profits
will decrease tardily, the cause is that the increased
competitors induce the product marginal profit decreased,
with the risk leaded by the behaviour of order and sell
increasing, the seller's profits will drop gradually; though
the incomes from the manufacturer's return contact
counteract partly the dropping profits, the return contact
can take some effect. The marginal income produced by
returning the inventory product is less than the marginal
profit produced by selling the product, in the result, the
seller profits will decrease tardily with the uncertainty of
market demand increasing. In addition, with the
uncertainty of market demand increasing gradually, the
inventory will increase tardily in the second stage. On one
hand, it conduces the seller's profits drop, on other hand
manufacturer will afford some expense to the inventory
products in the end of the second stage, so the profits of
whole supply chain present the dropping trend. Therefore,
in the second stage, the uncertainty of market demand
produces risk for the seller and whole supply chain, but the
return contract can promote the Pareto optimization of the
seller's decision in some extent, and its effect is limited.
In the all, under the environment of uncertain market
demand, the supply chain contract can insure the perfect
harmony system and induce the realization of the whole
supply chain optimization. But the uncertainty products the
different effect between the participator and the whole
supply chain.

VI. CONCLUSION
This article mainly studies the harmony according to the
supply chain contract about inventory management under
the uncertain demand, discusses the necessary condition to
realize the harmony based on the supply chain system
about inventory management and the concrete influence
correspond to the contract under uncertain market demand.
This paper constructs a seller's profits model based on the
supply chain contract of inventory management under
uncertain demand, and analyses the key factors that affect
seller, and builds seller's profits constitutes model with the
method of negative preface of dynamic state programming.
The research results indicate that the contract model in this
article can make system's Pareto optimisation better. This
article provides an approach how the manufacturer designs
a stimulant contract strategy to influence the behaviour of
seller, realize the best performance in the whole supply
chain and the perfect harmony of the supply chain system
under the uncertain market demand. Compared with the
models that apply only one simple contract in two stages,
the model of contracts in this article is more applied.

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VII. ACKNOWLEDGMENT
This work was supported in part by the Science and
Technology Bureau of Wuhan in China (project ID:
20065004116-11).

Vm. REFERENCES

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