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Optimizing Supply Chain Collaboration Based

on Joint Replenishment and Channel
Coordination

Article in Transportation Research Part E Logistics and Transportation Review · January 2008
DOI: 10.1016/j.tre.2004.06.003 · Source: RePEc

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 Transportation Research Part E 43 (2007) 338–354
www.elsevier.com/locate/tre

The profit-maximization model for a multi-item

distribution channel
a,* b
Jen-Ming Chen , Tsung-Hui Chen
a
Institute of Industrial Management, Department of Information Management, National Central University, Jhongli 32001, Taiwan
b
Department of Marketing & Logistics Management, National Pingtung Institute of Commerce,
51 Min-Sheng E. Road, Pingtung 90041, Taiwan

Received 14 April 2005; received in revised form 13 December 2005; accepted 16 December 2005

Abstract

This study focused on an area of emerging research: managing a multi-product and multi-echelon supply chain which
produces and sells deteriorating goods in the marketplace. We formulated four profit-maximization models by considering
the effects of channel coordination and a joint replenishment program on the supply-side cost control, taking into account
the effect of the pricing scheme on demand and revenue increments. In addition, a profit-sharing mechanism based on
channel rebates is proposed, which leads to Pareto improvements among the channel participants.
 2006 Elsevier Ltd. All rights reserved.

Keywords: Joint replenishment; Channel coordination; Inventory; Pricing

1. Introduction

A truly efficient supply chain does more than just reduce cost. It also creates revenue—for the retailer, the
manufacturer, and its channel partners. The evolution of the supply chain concept tends toward revenue and
demand focused strategic formation and decision making in business operations. Evidence can be found in the
increasingly prosperous revenue and yield management practices (Boyd and Bilegan, 2003) and the continuous
shift away from supply-side cost control to demand-side revenue stimulus (Lee and Whang, 2001; Frohlich
and Westbrook, 2002; Sodhi and Sodhi, 2005). This paper focuses on the profit-maximizing issue in a multiple
item distribution channel, based on cost reduction mechanisms and a revenue improvement stimulus. We for-
mulate four decision models by considering the effects of channel coordination and the joint replenishment
program (JRP) on supply-side cost control, taking into account the effect of an on demand pricing scheme
and revenue increments.
The multi-echelon channel coordination mainly deals with issues for inventory replenishments between
upstream and downstream entities in the supply chain, with the objective of minimizing the total channel-wide

*
Corresponding author. Tel.: +886 3 425 8192; fax: +886 3 425 8197.
E-mail address: jmchen@mgt.ncu.edu.tw (J.-M. Chen).

1366-5545/$ - see front matter  2006 Elsevier Ltd. All rights reserved.
doi:10.1016/j.tre.2005.12.001
 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354 339

cost. Some of the representative researches in this stream include Banerjee (1986), Banerjee and Kim (1995),
Sucky (2004), and Lee (2005) who dealt with the problem under a single-vendor and single-buyer setting, and
Banerjee and Banerjee (1992), Lu (1995), and Viswanathan and Piplani (2001) who undertook the problem
with single-vendor and multiple-buyer distribution networks. More recently, Mishra (2004) generalized the
model proposed by Viswanathan and Piplani to allow for a selective discount policy that can reduce the sup-
plier’s costs. Khouja (2003) extended past research by considering an integrated three-staged supply chain with
multiple suppliers and multiple buyers. Miranda and Garrido (2004) reconsidered the multiple-supplier and
multiple-buyer problem with stochastic demand.
The multi-item JRP deals with the coordinated replenishment of various items in the same family or same
category, so that the frequency of major setups and the total associated costs can be reduced by choosing an
appropriate common replenishment frequency and lot-sizes for the family of items. Some representative work
in this research stream includes: Abdul-Jalbar et al. (2003), Axsäter and Zhang (1999), Chan et al. (2003),
Frenk et al. (1999), Federgruen and Zheng (1992), Federgruen and Tzur (1994), Fung and Ma (2001), Hollier
et al. (2002), Jackson et al. (1985), Joneja (1990), Kaspi and Rosenblatt (1985), Kao (1979), Lee and Yao
(2003), Nielsen and Larsen (2005), Silver (1976), van Eijs (1994), Viswanathan (1997, 2002), and Wildeman
et al. (1997). The above mentioned literature proposed a wide variety of mathematical models and algorithms
for solving a multi-item problem, and in particularly focused on determining the optimal number of manufac-
turing setups, common production cycles and delivery/transportation intervals over the planning horizon.
Some of the work is devoted to algorithmic development, such as the non-iterative heuristic algorithm pro-
posed by Silver (1976) or the optimal and efficient search algorithm under the power-of-two assumption in
Jackson et al. (1985) and Lee and Yao (2003). Hollier et al. (2002) incorporated the JRP option into a con-
tinuous review, order-up-to policy, in order that a better cost performance in the inventory system could be
achieved.
Recently, Chen and Chen (2005a,b) proposed several optimization models adopting the joint replenishment
program and channel coordination practice for a three level inventory system. The main purpose behind these
models is to investigate how they influence possible supply chain improvements. Unfortunately, their work
does not take any marketing stimulus into account. For the most part they dealt with cost-minimization sup-
ply chain design. Another shortcoming in the literature is the unrealistic assumption of the goods being imper-
ishable for the period of production and selling. With this in mind, this paper extends the existing works by
considering perishable or deteriorative products in a price-endogenous supply chain, which leads to a more
practical profit-maximization decision policy in business operations.
Deterioration is a fact of life in inventory items, such as volatile liquids, agricultural products, radioactive
substances, films, drugs, blood, fashion goods, electronic components, and high-tech products. These items are
subject to depletion by phenomena other than demand; i.e., through spoilage, shrinkage, decay and obsoles-
cence. In the retail industry, for example, inventory loss due to shrinkage—a combination of employee theft,
shoplifting, administrative error and vendor fraud, amounts to 1.7% of annual sales, which is equivalent to
31.3 billion US dollars (Nation Retail Security Survey, 2003). This deterioration is quite prevalent and should
not be disregarded. Bhattacharya (2005) is one of the representative works which considers deteriorating
effects in a multi-item inventory model.
Over the past decades, enterprises have relied heavily upon the pricing scheme, one of the most important
marketing stimuli, to improve their net incomes and profits. For example, a 1% price realization improvement
can boost net income by 6.4% for Coca-Cola, 17.5% for Nestle, and 28.7% for Philips (Dolan and Simon,
1996). An industry survey of 2463 companies reveals that a 1% increase in price realization can yield, on aver-
age, 11.1% contribution improvement (Marn and Rosiello, 1992). The McKinsey Global Institute estimates
that if a carmaker dropped the unit price of a vehicle by 30%, demand would nearly double (Farrell,
2004), which would boost revenue by 40% equivalency. Due to its effectiveness in demand-side control for gen-
erating considerable run rates and profits, the pricing scheme is increasingly prevalent in retailing (Friend and
Walker, 2001), e-commerce merchandising (Boyd and Bilegan, 2003), and many others (Elmaghraby and
Keskinocak, 2003; Sodhi and Sodhi, 2005).
The remainder of this paper is organized as follows. Section 2 outlines the question and summarizes the
necessary assumptions and notations. The mathematical models for both the decentralized and the centralized
policies are developed in Sections 3 and 4, respectively. A discussion of the optimal properties of the models
340 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354

and a solution procedure are given in Section 5. In Section 6, a self-defined simulation case is given. Based on
the case setting, several sensitivity analyses are carried out. In addition, a profit-sharing mechanism based on
channel rebates is proposed, which leads to Pareto improvements among channel participants. Conclusions
are drawn in Section 7.

2. Assumptions and notations

This paper deals with a two-echelon supply chain, consisting of one supplier (manufacturer) and one buyer
(retailer), who stocks and sells multiple (n) items for the end customers. The items have a short life-time and
are subject to exponential decay, or a constant decaying rate per unit time equivalency. The demand rate for
each item is assumed to be a time-invariant, price-dependent function over the selling period. The cash and
logistic flows of the channel are shown in Fig. 1. The retailer replenishes the stocks individually or jointly from
an exclusive source (i.e., the supplier or manufacturer) based on an EOQ policy, subject to a major setup cost
for placing an order and an item-specific minor setup cost for each additional item being ordered. We assume
that the end items are within the same category or belong to a family of products that share a common pro-
duction facility. Therefore, the exclusive manufacturer incurs a major cost for setting up the production run
and an item-specific minor processing cost for each additional item brought into production. One reasonable
assumption in the two-staged capacity-constrained production-retailing system is to allow the production rate
to be greater than or equal to the demand rate faced by the retailer. In addition, the manufacturer is assumed
to be a make-to-order producer, using a lot-for-lot policy to fill customer demand. The manufacturer pur-
chases raw materials from an outside vendor, at a quantity sufficient to last for the production run for each
end item. In a like, the purchased raw materials are also subject to exponential decay. For brevity, we assume
that there is no in-transit inventory between the upstream and downstream entities in the distribution channel.
In this particular setting, the manufacturer’s production cycle is equal to the retailer’s replenishment cycle,
and the manufacturer’s raw material procurement cycle is also equal to the downstream production/replenish-
ment cycle. Fig. 2 graphically shows the three-leveled inventory in the two-stage distribution channel, where
the X-axis denotes the planning time and the three tiered Y-axes from top to bottom denote the inventory lev-
els of the manufacturer’s raw material, the manufacturer’s finished item, and the retailer’s finished item,
respectively. The goal of the channel is to determine the individual or the common replenishment cycles
(depending on which policy is being employed) and the selling prices for the products at the retail site, with
an aim at maximizing the channel-wide profit per unit time. Before presenting the models, we define and sum-
marize the necessary notations in Table 1.

3. The decentralized policy

In the decentralized production and replenishment decision-making policy, each entity within the supply
chain aims at optimizing its own profit function, without consideration being given to its counterpart’s reac-
tion or resulting profit. The retailer makes a replenishment decision based on an EOQ policy that includes
inventory-holding cost and major and minor setup costs. The major setup cost may represent a fixed trans-
portation cost, regardless of its composition, and the minor setup cost may represent item-specific warehous-

Raw material
Wholesale price: cr,i Retail price: pj,i
cost: cmr,i

Vendors Manufacturer Retailer Customers

Raw materials Finished goods Finished goods
Cash Flow

Transportation Transportation Logistic Flow

Fig. 1. The logistic and cash flows in the manufacturer–retailer channel.

 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354 341

Imr,i (t )

Time

Im,i (t )

Time
tm,i

Ir,i (t )

Time
Tj,i

Fig. 2. The three leveled inventories in the two-echeloned supply chain.

ing, material handling, and order-processing costs, for each specific item included in the order. We first pres-
ent the individual replenishment policy (policy I), and then the joint replenishment policy (policy II) for the
problem.

3.1. Non-cooperative replenishment for individual items (policy I)

Under the individual replenishment, the decision problem facing the retailer is to determine the retail price
and replenishment cycle for each individual item. The change in inventory level for each item is due to the
combined effects of demand requirement and deterioration over the replenishment cycle, and can be described
by the following differential equation:
dI r;i ðtÞ
¼ I r;i ðtÞhi  Di ðpI;i Þ for 0 6 t 6 T I;i . ð1Þ
dt
It is worth noting that the constant deteriorating rate hi in Eq. (1) is due to the exponentially decaying
assumption for the on-hand level of inventory. Using the method proposed by Spiegel (1960) and the bound-
ary condition Ir,i(TI,i) = 0, we can express the inventory level of item i at time t as follows:
Di ðpI;i Þ  hi ðT I;i tÞ 
I r;i ðtÞ ¼ e 1 for 0 6 t 6 T I;i . ð2Þ
hi
In each replenishment cycle, the purchase cost and inventory holding cost of item i can be expressed by Eqs.
(3) and (4), respectively, as
cr;i Di ðpI;i Þ  hi T I;i 
cr;i I r;i ð0Þ ¼ e 1 ð3Þ
hi
and
Z  
T I;i
hr;i DðpI;i Þ 1  hi T I;i 
hr;i I r;i ðtÞ dt ¼ e  1  T I;i . ð4Þ
0 hi hi
342 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354

Table 1
Summary of notations
System
n The number of finished items
i The index of finished items, i = 1, 2, . . . , n
j The index of the decision policies, j 2 {I, II, III, IV}
pj Total profit per unit time under policy j
Manufacturer
Sm The major setup cost per lot
sm,i The minor setup cost for adding finished item i into the production schedule
smr,i The ordering cost of raw material for finished item i per lot
hm,i The inventory holding cost of finished item i
hmr,i The inventory holding cost of raw material for finished item i
cmr,i The purchase cost of raw material for finished item i per unit, i.e., the selling price charged by the outside vendor
qi The production rate of finished item i
ui The usage rate of raw material for finished item i
hm,i The deterioration rate of raw material for finished item i
tm,i The manufacturer’s starting production time for item i over each retailer’s replenishment cycle
Im,i(t) Inventory level of finished item i at time t
Imr,i(t) Inventory level of raw material for finished item i at time t
pj,m Total profit per unit time under policy j
Retailer
Sr The major setup cost per order
sr,i The minor setup cost for adding finished item i into the order
cr,i The purchase cost of finished item i per unit, i.e., the selling price charged by the manufacturer
hr,i The inventory holding cost of finished item i
Di(pj,i) The demand rate of finished item i under policy j in the marketplace, which is a function of the retail price pj,i
hi The deterioration rate of finished item i facing both the retailer and the manufacturer
Ir,i(t) Inventory level of finished item i at time t
Tj,i The individual replenishment cycle of the finished item i under policy j, j 2 {I, III}, which is a decision variable
Tj The common replenishment cycle of all finished items under policy j, j 2 {II,IV}, which is a decision variable
pj,i The retail price of finished item i under policy j, j 2 {I, II, III, IV}, which is a decision variable
pj,r Total profit per unit time under policy j

The term Ir,i(0) in Eq. (3) denotes the inventory level at the beginning of the replenishment cycle which is
equivalent to the purchase quantity. The total profit of the retailer is the difference between the generated rev-
enue and the total cost, which consists of the major setup, minor setup, purchase, and inventory holding costs
over the replenishment cycle. The exponential term ehi T I;i in the above equations can be approximated by using
h2 T 2 h3 T 3
the Taylor series expansion, i.e., ehi T I;i ¼ 1 þ hi T I;i þ i 2!I;i þ i 3!I;i þ   . One might argue that if the exponential
term (i.e., hiT1,i) is relatively large, then the Taylor approximation may generate considerable error for the
solution. Fortunately, this is not the case in our problem context. A reasonable deterioration rate for a typical
perishable product is between 0.01 and 0.1 per month. A reasonable replenishment cycle for a short lifetime
product is commonly less than one month (such as dairy and agricultural goods). And the product of these
two terms tends to be a small fraction. Therefore, the third and higher order terms of the Taylor series expan-
sion have a minor effect on the accuracy of ehi T I;i and may be ignored. Fig. 3 illustrates the relative error of the
approximation, using different values of hi and T1,i. As shown in Fig. 3, the relative error is less than 2*104
for the worst case scenario (i.e., hi = 0.1 and T1,i = 1). If a higher level of accuracy is desired, a few more terms
may be added to the approximation expression.
By neglecting the third and higher order terms of hiTI,i in the Taylor series expansion of ehi T I;i , the retailer’s
unit profit function can be expressed as
n 
X 
ðS r þ sr;i Þ ðhr;i þ cr;i hi ÞDi ðpI;i ÞT I;i
pI;r ¼ ðpI;i  cr;i ÞDi ðpI;i Þ   . ð5Þ
i¼1
T I;i 2
 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354 343

0.0002

The error of the approximation of Taylor expansion

0.0001 T=0.25
T=0.5
0.0001 T=0.75
T=1.0
0.0001

8E-5

6E-5

4E-5

2E-5

0.0000

-2E-5
0.02 0.04 0.06 0.08 0.1
Deteriorating rate θ

Fig. 3. The relative error of the Taylor approximation by neglecting the third and higher order terms.

The optimal property of the profit function strongly depends on the value of the parameters and the form of
the demand function. Therefore we show the optimal replenishment cycle T I;i and the retail price pI;i immedi-
ately, and demonstrate the optimal property in Section 5 using a linear price-dependent demand function. For
a fixed price, the corresponding optimal replenishment cycle of each item can be obtained by differentiating
Eq. (5) with respect to TI,i, and setting the result equal to zero, which generates
!1=2
 2ðS r þ sr;i Þ
T I;i ¼ . ð6Þ
ðhr;i þ cr;i hi ÞDi ðpI;i Þ

The multivariate maximization problem can be reduced to a univariate problem by substituting T I;i into
Eq. (5):
n n
X o
1=2
pI;r ¼ ðpI;i  cr;i ÞDi ðpI;i Þ  ½2ðS r þ sr;i Þðhr;i þ cr;i hi ÞDi ðpI;i Þ . ð7Þ
i¼1

Then, the optimal retail price of each item can be obtained by setting the first derivative of Eq. (7) with
respect to p1,i equal to zero:
!1=2
 ðS r þ sr;i Þðhr;i þ cr;i hi Þ Di ðpI;i Þ
pI;i ¼ þ cr;i  . ð8Þ
2Di ðpI;i Þ dDi ðpI;i Þ=dpI;i

Since the manufacturer has adopted a produce-to-order policy, i.e., a lot-for-lot production policy, the pro-
duction is the same quantity as demanded by the downstream retailer. Again, for each production run, a
major setup cost is incurred due to such factors as changeover costs, and a minor setup cost was incurred
for each additional item being produced in the line. Furthermore, the manufacturer incurred additional hold-
ing and ordering costs for the raw materials required to produce the finished goods. During the production
cycle, the change of inventory levels of each raw material and finished item of the manufacturer are influenced
by the combined effects of production and deterioration. Their instantaneous states of inventory levels can be
described as follows:
dI mr;i ðtÞ
¼ ui qi  I mr;i ðtÞhm;i for tm;i 6 t 6 T I;i ð9Þ
dt
and
dI m;i ðtÞ
¼ qi  I m;i ðtÞhi for tm;i 6 t 6 T I;i ; ð10Þ
dt
344 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354

where tm,i and TI,i are the starting and the stopping production times, respectively. Derivation of the starting
time tm,i is detailed in Appendix A, which is

Di ðpI;i Þ 1=2
tm;i ¼ T I;i  T I;i . ð11Þ
qi
The inventory level of each raw material and each finished item at time t can be obtained by the boundary
conditions Imr,i(TI,i) = 0, Im,i(tm,i) = 0, and the method proposed by Spiegel (1960):
ui qi  hm;i ðT I;i tÞ 
I mr;i ðtÞ ¼ e  1 for tm;i 6 t 6 T I;i ð12Þ
hm;i

and
qi  
I m;i ðtÞ ¼ 1  ehi ðtm;i tÞ for tm;i 6 t 6 T I;i . ð13Þ
hi
The profit function per unit time of the manufacturer can be obtained by a procedure similar to the one
developed for the retailer, and can be expressed as follows:
Xn  
ðS m þ sm;i þ smr;i Þ T I;i
pI;m ¼ cr;i Di ðpI;i Þ   cmr;i ui qi  ½cmr;i ui qi hm;i þ ðhm;i þ hmr;i ui ÞDi ðpI;i Þ . ð14Þ
i¼1
T I;i 2
Summing up Eqs. (5) and (14) yields the profit model for the supply chain under policy I:
pI ¼ pI;r þ pI;m . ð15Þ

3.2. Non-cooperative replenishment for joint items (policy II)

Under the joint replenishment policy, the retailer determines a common replenishment cycle T II for the
simultaneous replenishment of all items, and the retail price pII;i for each item with an aim at maximizing
its profit. In this policy, the revenue and the associated costs considered by the retailer are similar to the indi-
vidual replenishment, except for the number of major replenishment setups that are reduced to one over the
cycle. The total profit per unit time of the retailer is
Xn  
sr;i ðhr;i þ cr;i hi ÞDi ðpII;i ÞT II Sr
pII;r ¼ ðpII;i  cr;i ÞDi ðpII;i Þ    . ð16Þ
i¼1
T II 2 T II

Similar to the aforementioned procedure, the optimal common replenishment cycle and the retail price of
each item can be obtained as follows:
( Pn )1=2
2ðS r þ s r;i Þ
T II ¼ Pn i¼1
ð17Þ
i¼1 ½ðhr;i þ cr;i hi ÞDi ðp II;i Þ

and
P !1=2
S r þ ni¼1 sr;i Di ðpII;i Þ
pII;i ¼ ðhr;i þ cr;i hi Þ Pn þ cr;i  . ð18Þ
2 i¼1 ðhr;i þ cr;i hi ÞDi ðpII;i Þ dDi ðpII;i Þ=dpII;i

Accordingly, the total profits per unit time for the manufacturer and for the system are
Xn  
ðsm;i þ smr;i Þ T II Sm
pII;m ¼ cr;i Di ðpII;i Þ   cmr;i ui qi  ½cmr;i ui qi hm;i þ ðhm;i þ hmr;i ui ÞDi ðpII;i Þ  ð19Þ
i¼1
T II 2 T II
and
pII ¼ pII;r þ pII;m . ð20Þ
 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354 345

4. The centralized policy

In contrast to the decentralized decision process, the centralized policy simultaneously determines the retail
price and the replenishment cycle by considering the total profit incurred by the retailer and the manufacturer,
so that the system profit is maximized. We first present the individual replenishment policy (policy III) and
then the joint replenishment policy (policy IV) for the problem.

4.1. Cooperative replenishment for individual items (policy III)

In this policy, the replenishment cycle and the retail price for each item are determined jointly by the mem-
bers in the supply chain. The system profit of policy III is
X n 
ðS r þ S m þ sr;i þ sm;i þ smr;i Þ
pIII ¼ pI;r þ pI;m ¼ pIII;i Di ðpIII;i Þ   cmr;i ui qi
i¼1
T III;i
 
T III;i
 cmr;i ui qi hm;i þ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui ÞDi ðpIII;i Þ . ð21Þ
2
The aim of the channel parties in policy III is to determine the optimal values of the replenishment cycle
and the retail price for each item so that the system profit is maximized. Given a specific retail price, the length
of the optimal replenishment cycle for each item can be obtained by differentiating Eq. (21) with respect to
TIII,i, and setting the result equal to zero:
( )1=2
2ðS r þ S m þ s r;i þ s m;i þ smr;i Þ
T III;i ¼ . ð22Þ
cmr;i ui qi hm;i þ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui ÞDi ðpIII;i Þ

The system profit per unit time can be re-expressed by substituting T III;i into Eq. (21):
n n
X

pIII ¼ pIII;i Di ðpIII;i Þ  cmr;i ui qi  2ðS r þ S m þ sr;i þ sm;i þ smr;i Þ

i¼1
 1=2 o
 cmr;i ui qi hm;i þ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui ÞDi ðpIII;i Þ . ð23Þ

After setting the first derivative of Eq. (23) equal to zero, we can obtain the optimal retail price for each
item:
( )1=2
 S r þ S m þ sr;i þ sm;i þ smr;i
pIII;i ¼ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui Þ 
2½cmr;i ui qi hm;i þ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui ÞDi ðpIII;i Þ
Di ðpIII;i Þ
 . ð24Þ
dDi ðpIII;i Þ=dpIII;i

4.2. Cooperative replenishment for joint items (policy IV)

If both cooperation and joint replenishment are employed, the decision facing the retailer and the manu-
facturer is to jointly determine a common replenishment cycle and retail price for each item. The system profit
per unit time is
Xn 
ðsr;i þ sm;i þ smr;i Þ
pIV ¼ pII;r þ pII;m ¼ pIV;i Di ðpIV;i Þ 
i¼1
T IV


 T IV ðS r þ S m Þ
 cmr;i ui qi  cmr;i ui qi hm;i þ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui ÞDi ðpIV;i Þ  . ð25Þ
2 T IV
Using a similar procedure developed in the previous section, the optimal common replenishment cycle and
retail price are:
346 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354

( Pn )1=2
2½S r þ S m þ i¼1 ðsr;i þ sm;i þ smr;i Þ
T IV ¼ Pn . ð26Þ
i¼1 ½cmr;i ui qi hm;i þ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui ÞDi ðpIV;i Þ
( Pn )1=2
S r þ S m þ ðs r;i þ s m;i þ s mr;i Þ
pIV;i ¼ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui Þ  P i¼1
2 ni¼1 ½cmr;i ui qi hm;i þ ðhr;i þ cr;i hi þ hm;i þ hmr;i ui ÞDi ðpIV;i Þ
Di ðpIV;i Þ
 . ð27Þ
dDi ðpIV;i Þ=dpIV;i

5. A linear demand case

It is not difficult to solve the problem under a wide variety of demand functions, but then we can no longer
characterize the optimal property of the models. Therefore, we focus on analyzing the models for the case of
linear price-dependent demand function, i.e., Di(pj,i) = ai  bipj,i, where ai > 0, bi > 0, and pj,i 6 ai/bi. We first
demonstrate that the profit models are a concave function in the replenishment cycle and in the retail price.
Then, an effective solution procedure is proposed to solve the multivariate maximization problem.

5.1. Optimal property

Since the optimal properties for the profit models are similar, we only demonstrate the property for policy I
and omit the others.
Lemma 1. The unit profit function of the retailer under policy I, pI,r, is concave in TI,i.

Proof. The concave property of the retailer’s unit profit function can easily be verified by substituting the lin-
ear price-dependent demand function into Eq. (5) and taking the second-order derivative with respect to TI,i,
which yields
o2 pI;r 2ðS r þ sr;i Þ
¼ . ð28Þ
oT 2I;i T 3I;i
Eq. (28) is strictly negative since Sr > 0, sr,i > 0, and TI,i > 0. Therefore the retailer’s unit profit function is con-
cave in TI,i. h
Further investigation reveals that the profit function is concave in TI,i regardless of the demand function.
Thus, the concavity holds in a more general sense.
Lemma 2. The unit profit function of the retailer under policy I, pI,r, is concave in pI,i.

Proof. Substitute the linear price-dependent demand function into Eq. (5) and take the second-order deriva-
tive with respect to pI,i yielding
o2 pI;r
¼ 2bi . ð29Þ
op2I;i
Since the result of Eq. (29) is strictly negative, the retailer’s unit profit function is concave in pI,i. h
For other demand functions, the concavity property may not hold. For example, if the iso-elasticity
demand function (i.e., Di ðpj;i Þ ¼ ape
j;i Þ is applied to the profit model, the concavity property holds only if
the following condition is satisfied:

p1;i < ðcr;i ðe þ 1Þ þ ðhr;i þ cr;i hi ÞT 1;i ðe þ 1Þ=2Þ=ðe  1Þ.

Proposition 1. Eq. (5) has optimal solutions T I;i and pI;i which maximize the retailer’s profit per unit time when
the concave properties and Hessian matrix condition ðo2 pI;r =oT 2I;i Þðo2 pI;r =op2I;i Þ  ðo2 pI;r =oT I;i pI;i Þ2 > 0 are
satisfied.
 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354 347

Proof. See Appendix A. h

5.2. Solution procedure

To solve the multivariate problem, a search procedure is developed in this section. Under the linear price-
dependent demand function, the polynomial equation of the retail price under policy I can be obtained by
substituting Di(pj,i) = ai  bipj,i into Eq. (8) and by simplifying the terms:
   2
2ai ai pI;i ðS r þ sr;i Þðhr;i þ cr;i hi Þ ai ai
p3I;i  þ cr;i p2I;i þ ð5ai þ bi cr;i Þ þ cr;i þ  þ cr;i ¼ 0. ð30Þ
bi bi 4bi 8bi 4bi bi
Let p1;i be the optimal solution of Eq. (30). Substitute p1;i into Eq. (6) to obtain the optimal replenishment
interval T 1;i . Finally, the profit per unit time is obtained by substituting each retail price p1;i and its correspond-
ing replenishment cycle T 1;i into model (15). The solution procedure for the other policies follows a similar
path.

6. Numerical study

The profit models we have developed can be applied in solving multi-product problems with an arbitrary
number of items. To illustrate the effect of the models, we have assumed that there are three items involved in
the supply chain. Again, to ensure the optimality of the solution, we only use a linear demand function in this
study. The four policies incorporated with the proposed solution procedure were implemented on a personal
computer with a Pentium CPU at 2.0 GHz under a Windows XP operating system using Mathematica 5.2.
Several numerical studies were conducted to uncover the potential improvements via pricing in conjunction
with various replenishment policies. In the following, we report on the numerical result of a base case. A Par-
eto improvement scheme is then proposed through a channel rebate mechanism. Finally, sensitivity analyses
with respect to major parameters and decision variables are carried out.

6.1. The base case

In the underlying base case, the parameters for the retailer’s monthly price-dependent demand rates
Di(pj,i) = ai  bipj,i are assumed to be (ai, bi) = (350, 2.0), (500, 2.5), and (450, 3.0). The corresponding rates
of the manufacturer’s production are 250, 350, and 300, and the raw material usages per unit for each finished
item are 0.3, 0.2, and 0.25. The deterioration rates facing both entities are assumed to be hi = 0.08, 0.07, and
0.075, and hm,i = 0.04, 0.02, and 0.03. Table 2 summarizes the parameter settings for the three items, which
include the cost components facing both the manufacturer and the retailer.
Table 3 reports the optimal replenishment cycles, pricing solutions and the generated profits for the retailer,
the manufacturer, and the channel-wide system. To investigate the effects of the demand-side pricing, the sup-
ply-side joint replenishment and the channel coordination on the profit increments, the result generated from
policy I is used as the base line. Against this the effectiveness of policies II, III, and IV are estimated by com-
puting the profit increment percentages. From the aspect of the system’s profit, policy III which generates an
8.02% increment through channel coordination, outperforms policy II which generates a 4.62% increment
through joint replenishment, and policy IV outperforms the others by generating a 12.73% profit increment.
Further investigation reveals that policies III and IV are unacceptable to the retailer because they will decrease
its profit by coordinating with the upstream manufacturer. One of the persuadable actions to achieve channel-
wide coordination and Pareto improvements is a properly designed rebate. It is a payment from a manufac-
turer to a retailer based on retailer sales to the end customers.

6.2. Pareto improvements

A so-called Pareto improvement exists when in a two-echelon supply chain one party is better off and the
other one is no worse off. In this section, we present a target rebate mechanism (Taylor, 2002) to achieve
348 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354

Table 2
Parameter settings for the base case
Item (i) 1 2 3
Retailer
Demand parameters (ai, bi) (350, 2.0) (500, 2.5) (450, 3.0)
Deterioration rate of finished item (hi) 0.08 0.07 0.075
Major setup cost (Sr) 250 250 250
Minor setup cost (sr,i) 45 60 40
Holding cost of finished item (hr,i) 5.2 5.1 4.8
Purchase cost of finished item (cr,i) 47 45 40
Manufacturer
Production rate (qi) 250 350 300
Deterioration rate of raw material (hm,i) 0.04 0.02 0.03
Usage rate of the raw material (ui) 0.3 0.2 0.25
Major setup cost (Sm) 450 450 450
Minor setup cost (sm,i) 65 80 55
Ordering cost of raw material (smr,i) 35 50 30
Holding cost of finished item (hm,i) 3.8 3.5 2.6
Holding cost of raw material (hmr,i) 1.8 1.7 1.2
Purchase cost of raw material (cmr,i) 20 18 16

Table 3
Numerical results generated by the base case
Channel coordination Joint replenishment
No
No Policy I
P I;1 ¼ 112:6, T I;1 ¼ 0:73
P I;2 ¼ 123:8, T I;2 ¼ 0:63
P I;3 ¼ 96:3, T I;3 ¼ 0:68
Retailer’s profit = 29,615
Manufacturer’s profit = 13,824
System’s profit = 43,439
Yes Policy III
P III;1 ¼ 89:5, T III;1 ¼ 0:85
P III;2 ¼ 101:6, T III;2 ¼ 0:77
P III;3 ¼ 76:6, T III;3 ¼ 0:83
Retailer’s profit = 26,004 (12.19%)
Manufacturer’s profit = 20,918 (+51.32%)
System’s profit = 46,922 (+8.02%)
Yes
Policy II
P II;1 ¼ 112:0, T II;1 ¼ 0:45
P II;2 ¼ 123:4
P II;3 ¼ 95:9
Retailer’s profit = 30,504 (+3.00%)
Manufacturer’s profit = 14,940 (+8.07%)
System’s profit = 45,444 (+4.62%)
Policy IV
P IV;1 ¼ 88:8, T IV ¼ 0:55
P IV;2 ¼ 101:2
P IV;3 ¼ 76:0
Retailer’s profit = 26,897 (9.18%)
Manufacturer’s profit = 22,073 (+59.67%)
System’s profit = 48,970 (+12.73%)

Pareto improvements in the channel. A target rebate is a payment from the manufacturer to the retailer for
each unit sold beyond a specified target level. The ultimate unit price paid by the retailer to the manufacturer
is its original purchase cost (i.e., the wholesale price) less the rebate. Based on Taylor’s scheme, the target
rebates for the three items are summarized in Table 4. For example, if the total number of units sold for item
1 is greater than 52 (i.e., the target level), then the retailer will receive $28.5 cash back from the manufacturer
for each unit sold beyond 52. Table 5 summarizes the profit improvements of policy IV versus policy I before
and after applying the rebates. It shows that the proposed rebates will improve the retailer’s profit from
$26,897 (9.18%) to $31,474 (+6.28%) under policy IV. The 6.28% profit increment is also higher than the
3% increment generated by policy II (see Table 3). In other words, channel coordination is acceptable by
the retailer only if the manufacturer provides some profit-sharing mechanisms such as the channel rebates.
Under this new cooperative arrangement, the percentages of profit improvements for the retailer, the manu-
facturer, and the channel-wide system are 6.28%, 26.56%, and 12.73%, respectively.
 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354 349

Table 4
A target rebate scheme based on Taylor (2002)
Item Wholesale price (cr,i) Rebate Target level
1 47 28.5 52
2 45 29.8 73
3 40 27.3 68

Table 5
Pareto improvements of policy IV via channel rebates
Policy I Policy IV
Before channel rebate After channel rebate
Retailer’s profit 29,615 26,897 (9.18%) 31,474 (+6.28%)
Manufacturer’s profit 13,824 22,073 (+59.67%) 17,496 (+26.56%)
System’s profit 43,439 48,970 (+12.73%) 48,970 (+12.73%)

6.3. Sensitivity analysis with respect to major parameters

The sensitivity of profit improvements (policies II, III, and IV versus policy I) was analyzed with respect to
major parameters, including the deteriorating rate, the demand rate, the retailer’s unit cost (i.e., the wholesale
price), the major and minor setup costs, and the inventory holding cost. The values of these parameters have
been changed by up to ±50% from the basic settings. Results are graphically illustrated in Figs. 4–9, and from
them the following meaningful implications can be observed.

• The channel coordination mechanism can generate higher profit improvement than the joint replenishment
scheme under a wide range of parameter settings. The only exception is when the retailer’s unit cost is low,
in which case the joint effect of the two mechanisms in profit improvement is even higher.
• The profit improvements increase with the deterioration rates, the retailer’s unit costs, the major setup
costs, and the inventory holding costs, while decreasing with the minor setup cost and the demand rates.

6.4. Sensitivity analysis with respect to decision variables

This section analyzes the sensitivity of profit improvements with respect to the decision variables, i.e., pric-
ing and replenishment cycles under policy IV. Again, we changed the values up to ±50% from the optimal

16

14
Percentage of profit improvement

12 II vs I
III vs I
10 IV vs I

2
-50 -40 -30 -20 -10 0 10 20 30 40 50
Percentage changes of deteriorating rates from basic settings

Fig. 4. Profit improvements for different values of deteriorating rates: policies II, III, and IV versus policy I.
350 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354

20

18

Percentage of profit improvement

II vs I
16 III vs I
IV vs I
14

12

10

0
-50 -40 -30 -20 -10 0 10 20 30 40 50
Percentage changes of demand rates from basic settings

Fig. 5. Profit improvements for different values of demand rates: policies II, III, and IV versus policy I.

28

24
Percentage of profit improvement

II vs I
20 III vs I
IV vs I

16

12

0
-50 -40 -30 -20 -10 0 10 20 30 40 50
Percentage changes of retailer's unit costs from basic settings

Fig. 6. Profit improvements for different values of retailer’s unit costs (i.e., wholesale prices): policies II, III, and IV versus policy I.

16

14
Percentage of profit improvement

12 II vs I
III vs I
IV vs I
10

2
0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5
Percentage changes of major setup costs from basic settings

Fig. 7. Profit improvements for different values of major setup costs: policies II, III, and IV versus policy I.

solutions generated from policy IV. The results are shown in Fig. 10, which indicates that the pricing decision
is more sensitive and therefore more critical than the replenishment decision for profit improvement. In other
 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354 351

14

Percentage of profit improvement

12

II vs I
III vs I
10 IV vs I

4
-50 -40 -30 -20 -10 0 10 20 30 40 50
Percentage changes of minor setup costs from basic settings

Fig. 8. Profit improvements for different values of minor setup costs: policies II, III, and IV versus policy I.

16

14
Percentage of profit improvement

12
II vs I
III vs I
10 IV vs I

2
-50 -40 -30 -20 -10 0 10 20 30 40 50
Percentage changes of holding costs from basic settings

Fig. 9. Profit improvements for different values of holding costs: policies II, III, and IV versus policy I.

50000

48000

46000

44000
System's profit

42000

40000

38000

36000 Retailer price

Replenishment cycle
34000

32000
-50 -40 -30 -20 -10 0 10 20 30 40 50
Percentage changes of the optimal retail price and
replenishment cycle

Fig. 10. Sensitivity analysis with respect to the retail price and the replenishment cycle under policy IV.
352 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354

words, a 1% price realization improvement will generate a higher profit increment than a 1% improvement in
the replenishment decision, that is the demand-side pricing scheme is a more effective mechanism than the sup-
ply-side replenishment scheme for creating profit improvement.

7. Conclusion

This paper deals with the emerging research of managing a multi-product and multi-echelon supply chain
which produces and sells deteriorative goods in the marketplace. Conventional wisdom suggests that channel
coordination and workflow collaboration, between upstream and downstream entities, are promising mecha-
nisms for achieving a cost-effective supply chain. In a multi-product situation, additional savings can be real-
ized by coordinating the replenishment of various items in conjunction with vertical coordination, in a
distribution channel. This is due, in large part, to the fact that various cost components, such as setup and
transportation costs, are often jointly incurred between several distinct items. A joint cost structure often
reflects economies of scale, and simplifies the business process by combining different items in the same pro-
duction batch and delivery schedule.
However, the existing literature deals mainly with the cost-minimization supply chain design, while uncon-
sciously ignoring the more effective marketing stimulus. Another shortcoming in the literature is the unrealistic
assumption of the imperishable property of the goods for the duration of the production and selling period. In
these regards, this paper makes a contribution by considering perishable or deteriorative products in a price-
endogenous supply chain, which leads to a more practical profit-maximization decision-making. We have for-
mulated four decision models by considering the effects of channel coordination and joint replenishment pro-
gram on the supply-side cost control, and taking into account the effect of the pricing scheme on demand and
revenue increments. In addition, a profit-sharing mechanism via target rebates has been proposed, leading to
Pareto improvements among channel participants.
As with most management science applications, the models developed were purely theoretical. In our study,
the retailer’s ultimate demand was treated as a certainty and was assumed to be price-dependent. In addition,
the retailer’s ordering behavior was assumed to be captured by a simple EOQ model, while the production
behavior of the manufacturer was assumed to employ a lot-for-lot policy. These assumptions are abstract,
which may restrict the models applicability in the real world. We believe, however, that our models provide
a good starting point in this research stream. Future direction may be aimed at considering more general dete-
rioration rates and/or demand rates. The use of other replenishment policies such as the order-up-to model
and the use of other demand-side revenue boosting variables such as promotional efforts are potential areas
for future research.

Acknowledgments

We would like to thank the editor and three anonymous reviewers for their valuable and constructive com-
ments which have led to a significant improvement in the manuscript. This research was partially supported by
the National Science Council (Taiwan) under Grant NSC95-2416-H-008.

Appendix A. Derivation of the starting production time tm,i

For the lot-for-lot production policy, the production quantity of the manufacturer is equal to the quantity
demanded by the retailer:
Z T j;i Z T j;i
I m;i ðxÞ dx ¼ I r;i ðxÞ dx. ðA:1Þ
tm;i 0

Manipulating some mathematical operations yields

   
qi 1  hi ðtm;i T j;i Þ  Di ðpi Þ 1  hi T j;i 
T j;i  tm;i þ e 1 ¼ e  1  T j;i . ðA:2Þ
hi hi hi hi
 J.-M. Chen, T.-H. Chen / Transportation Research Part E 43 (2007) 338–354 353

In Eq. (A.2), the technique of the Taylor series expansion for terms ehi ðtm;i T j;i Þ and ehi T j;i is applied, and the
third and higher order terms are neglected, yielding
 
Di ðpj;i Þ 1=2 Di ðpj;i Þ 1=2
tm;i ¼ T j;i þ T j;i or tm;i ¼ T j;i  T j;i . ðA:3Þ
qi qi
Since tm,i is smaller than Tj,i and the solution becomes
 1=2
Di ðpj;i Þ
tm;i ¼ T j;i  T j;i . ðA:4Þ
qi

Proposition 1. Eq. (5) has optimal solutions T I;i and pI;i which can maximize the retailer’s profit per unit time
when the concave properties and Hessian matrix condition ðo2 pI;r =oT 2I;i Þðo2 pI;r =op2I;i Þ  ðo2 pI;r =oT I;i pI;i Þ2 > 0 are
satisfied.

Proof. The concave properties of Eq. (5) have been given in Lemmas 1 and 2. After some mathematical oper-
ations, the Hessian matrix condition can be reduced as
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
3 16ðS r þ sr;i Þ
T I;i < 2
. ðA:5Þ
bi ðhr;i þ cr;i hi Þ

Based on the above argument the profit model (5) has the optimal solutions T I;i and pI;i provided the condition
holds. h

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