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European Journal of Operational Research 103 (1997) 573-583

EUROPEAN JOURNAL OF OPERATIONAL RESEARCH

Theory and Methodology

Optimal ordering and pricing policies in a single-period environment with multivariate demand and markdowns
Timothy L. Urban a,*, R.C. Baker b
a Department of Quantitative Methods and Management Information Systems, The University of Tulsa, Tulsa, OK 74104, USA h Department of lnformation Systems and Management Sciences, University of Texas at Arlington, Arlington, TX 76019, USA

Received 1 February 1996; accepted 1 October 1996

Abstract

This paper investigates a single-period inventory model in which the demand of the product is a deterministic, multivariate function of price, time, and level of inventory. Models are formulated for the basic pricing case and the case with a price markdown during the season. Solution methodologies are presented for each case when the pricing decisions are predetermined and when they are decision variables. Comments on the practical use of this model are presented, and sensitivity analysis is conducted on the decision variables and demand parameters. 1997 Elsevier Science B.V.
Keywords: Inventory theory; Optimization

1. I n t r o d u c t i o n

One area of inventory theory that has been extensively studied is the single-period model, also known as the Christmas-tree or newsboy problem. In these instances, the demand of an item occurs during a relatively short period of time. There is one opportunity for procurement at the beginning of the period and any items remaining in inventory at the end of the period are scrapped, salvaged, or sold at a loss. In many practical situations, the decision maker has the opportunity to markdown the price of the item before the end of the season, hoping to stimulate sales and avoid ending the period with excessive inventories. Historically, with single-period inventory models, demand is assumed to be stochastic with a known distribution. The objective is simply to offset the cost and probability of shortages against the cost and probability of overages. This type of model typically takes no exogenous variables into account that may affect the demand of a product. However, demand is usually a multivariate function, determined by several variables in most applications. While many inventory models have recently been developed that incorporate the impact that these variables have on the demand rate, there are few single-period models in the literature that reflect these relationships. Therefore, the purpose of this paper is to generalize existing single-period models by 1) incorporating the effect of relevant variables on the demand of the item, and 2) allowing the possibility of a price markdown

* Corresponding author. Email: urban@utulsa.edu.

0377-2217/97/$17.00 1997 Elsevier Science B.V. All rights reserved. PH S0377-22 17(96)00301-3

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during the period. In Section 2, several determinants of demand that have previously been presented in various inventory models are identified. The basic multivariate model without utilizing markdowns is developed in Section 3 in which the order quantity and the price level are the decision variables under the decision maker's control. A closed-form solution is found for the special case in which the price of the item is fixed. In Section 4, the model is extended to include a price markdown within the period. Sensitivity analysis on the decision variables and on the demand parameters is presented in Section 5. Finally, Section 6 presents managerial implications on the application of these models.

2. Determinants of demand According to classical marketing and economic theory, price is a major factor on the demand of a product. In 1955, Whitin [25] incorporated the concepts of inventory theory and economic price theory. Since then, several other authors [8,11,15,18,24] have investigated inventory models that take into consideration the interaction between the economic order quantity and pricing policies; single-period formulations have recently been developed by Lau and Lau [17] and Shah and Jha [22]. A popular formulation of the demand rate is the constant elasticity model, in the form D ( p ) - c~p -~. (1)

This type of inventory model, however, is quite simple to solve in the deterministic, single-period case. In this situation, we will purchase only as much as we would sell; there would be no reason to have any inventory at the end of the period. Thus, the only decision variable is price. Using simple calculus methods, the optimal price can easily be found (e.g., see Kotler [13]) and the exact demand for the period can then be calculated and used as the order quantity. Another variable that may be expected to have an impact on the quantity demanded of a product is time. The demand rate of various products (e.g., style goods) may vary throughout the selling season, selling better at the beginning or the end of the season. For example, holiday greeting cards may be expected to sell better at the end of the season as the holiday approaches. Extensive research [10,21,23] has been done on inventory models with time-proportional demand much of which is based on the work of Donaldson [6] which investigated the linear trend situation. Barbosa and Friedman [5] investigated a more general situation in which demand is of a polynomial functional form:
O(t) = at r-'.

(2)

Several papers have investigated the finite-horizon situation, although no single-period model with stochastic, time-proportional demand has been found in the literature. The time-proportional demand model is trivial in the deterministic, single-period case since the total demand can be easily calculated for the period and an order for the exact amount could be placed. The amount of inventory on hand has also been shown to have an impact on the demand of certain items. Wolfe [26] presented empirical evidence of the existence of this type of phenomena with style merchandise such as women's dresses or sports clothes; he noted that "within the selling season unit sales of each style are proportional to the amount of inventory displayed". Larson and DeMarais [16] discussed the concept of psychic stock which is 'carried to stimulate demand'. This phenomenon may also be experienced in products such as Christmas trees, greeting cards, etc. in which the items are generically the same but individually slightly different. In this situation, the demand could be expected to be determined in part by the number of items in inventory since the probability of making a sale will be higher with more items in inventory. This area of research has recently received considerable attention [3,19,20]. A stochastic, single-period model was developed by Gerchak and Wang [9]; however, they considered the case in which the demand rate is dependent on the initial inventory level in the period, not the instantaneous inventory level. Baker and Urban [4] investigated the

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deterministic, single-period model with an inventory-dependent demand rate in which demand is of a polynomial functional form, in the manner:
D(i) = ai'-~(3)

This model is not trivial in the deterministic, single-period case since it may be desirable not to end the period with zero inventory. It may be more profitable to order a larger amount and have increased sales due to the larger inventory level, while incurring the holding cost on some product remaining in inventory at the end of the period.

3. Basic model without markdowns A single-period inventory model is presented based on the assumptions of the classical, single-period model (a finite-length time period with only one opportunity for replenishment) except the demand of the item is a deterministic, multivariate function of price, time, and the level of inventory, in the form
D(p,t,i)=ap-~t~-lil-~,

a>0,

6>0,7>0,0</3<1.

(4)

Although theoretically, price elasticity can be less than one, it has been shown that inelastic demand schedules are not compatible with some common pricing policies such as average-cost pricing (Koutsoyiannis [14]) or markup pricing (Arcelus and Srinivasan [2]; Abad [1]). Thus, previous analyses have restricted the price elasticity to e > 1. We will consider the more general situation and include the possibility of inelastic demand. The time variable, as presented, can reflect increases (7 > 1) or decreases (7 < 1) in the demand rate over time. Moreover, this term represents trends within the selling period, not increases or decreases between periods. If jt is desired to explicitly include a variable to represent long-term trends over several selling periods, the demand function can easily be modified. The shape parameter of the inventory-level variable is constrained between zero and one to ensure diminishing returns; that is, the marginal increase in the demand rate will decrease as the inventory level increases.

Q~

Time

Fig. 1. Inventorylevelover time - basic pricingmodel.

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Since the decrease in inventory level over time is equal to the demand rate, the inventory function for the proposed model can be determined by solving the resulting differential equation (di/dt = - a p - * t r - l i l- 8) under the initial condition that i o = Q, where Q is the inventory level at the beginning of the period. This results in the mathematical representation of the inventory level over time:

i =l[Qt3-aflt~]
[ O,

t/~

when

t< [yp~Q~]l/~,

(5)

otherwise.

Since the demand of this type of product generally occurs during a fairly short interval, it is likely that there will be no inventory carried over from a previous period; thus, Q will be the order quantity. Otherwise, Q is defined as the initial inventory plus the order quantity; that is, the order-up-to level. A typical inventory-level curve is depicted in Fig. 1. The objective of this type of inventory model will be to maximize total profit for the period. It is necessary to formulate this as a profit-maximization model rather than a cost-minimization model since the decision variables directly affect the demand rate. If the objective was simply to minimize costs, it would be 'better' to decrease the demand of the item to lower costs; for example, it would be advantageous to raise the price of the items excessively high since that would reduce the demand and the subsequent costs. Therefore, the objective function would be to maximize Profit = Revenue - Purchase cost - Disposal cost, i.e. Maximize

II= p( Q - it) - cQ - hi r,

(6)

where i r is the inventory level at the end of the period (t = T), c is the variable cost per unit, and h is the holding cost per unit remaining at the end of the period. If there is a salvage value for the item, h would take on a negative value. We assume p > c > - h. Substituting Eq. (5) into 6 provides

II=(p-c)Q-(p+h)[Q

t3

a[3T'] '/~
TP ~ . (7)

While the gradient vector and the Hessian matrix of the profit function can be easily calculated for this model, the complexity of these are such that it is not straightforward to find a closed-form solution when both the order quantity and the price level are decision variables. While we have not been able to prove quasiconcavity for this model, all examples examined with elastic demand schedules have demonstrated this characteristic. Thus, simple bivariate search techniques are sufficient to solve Eq. (7). For e < 1, it can be shown that the profit function no longer satisfies the quasiconcavity conditions for all values of the parameters; yet, the typical search techniques have still been effective in finding the optimal solution to this model. If the optimality conditions cannot be verified, then other solution methodologies, such as nonlinear programming, must be used. (Urban [24] presents an illustration of using separable programming for a similar formulation.)

3.1. Special case-fixed pricing


Consider a model in which the price of the item is fixed, perhaps a predetermined markup over the unit cost of the item. The only decision variable is the order quantity, as the ending inventory can be determined directly from Eq. (5) where t = T. In this case, the optimal value of the order quantity, Q *, can easily be determined by the usual calculus methods. It is shown to be

Q,=[

p'(1

arT.~

'

(8)

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where F -- ( p - c ) / ( p + h) is the solution to the classical, stochastic single-period model. Examination of the second derivative indicates the profit function is a strictly concave function, and Q* is the global optimal solution. Note that if the demand is not price dependent ( e ~ 0), time-proportional (3; = 1), or dependent on the inventory level (/3 ~ 1), then the solution approaches a T , the demand realized in the period.

Example. To illustrate the impact of this type of model, consider the following example in which the demand is of the functional form described by Eq. (4) with the values of the parameters as follows: Price: p = $7 per unit. Cost: c = $4 per unit. Holding cost: h = - $2 per unit remaining at the end of the period. Length of time period: T = 10 days. Demand parameters: a = 37, e = 1.5, 3' = 1.3, and /3 -- 0.6. As illustrated in Fig. 1, the actual demand rate under this scenario will vary from day to day. Suppose, for example, the initial inventory level is 150 units. In this case, the daily demand rate (from Eq. (5)) will range from 8 to 18 units over the ten-day period, with a mean demand of 14.7 units per day and standard deviation of 3.4 units per day. If the decision maker does not recognize that the demand rate is dependent on price, time, or the level of inventory, this may lead one to believe that demand is stochastic in nature and to use the classical, single-period inventory model. Using the traditional model under the assumption that demand is normally distributed with the given parameters, the calculated order quantity would, in fact, be 150 units. At the end of the period, 3 units would remain and the total profit would be $435. Let us next consider the fixed-price policy (the special case presented above) in which the order quantity is the only decision variable. Using the appropriate model (Eq. (8)), we will instead order 363.4 units, the ending inventory will be 101.3 units, and the total profit will be $583.48. Although we have over 100 additional units remaining at the end of the period, the total sales rate increased by 78% due to the higher inventory level, resulting in an increase in profit of over 33.8%. Of course, receiving salvage value for the items remaining at the end of the period, as in this example, will increase the likelihood of realizing significant ending inventories. If we were to extend this further and allow the price level to become a decision variable as welt, we would increase the price to $9.53 per unit and use an order quantity of 309.9 units. In this case, the increase in price reduces the demand rate and the ending inventory would be 143.3 units. However, it also results in a considerable increase in the total profit; it would now be $635.38, an increase of 9.0% over the constant pricing model and of 46.1% over the solution to the classical, single-period model.

4. Price markdown model

In many situations, it is desirable to consider a markdown in price during the selling season. This increases the demand of the product and reduces the amount in inventory at the end of the period. Frequently, markdowns are the result of over-ordering; however, they can be part of a strategic pricing policy that can result in improved profits. The inventory level over time will no longer be a smooth curve as depicted in Fig. 1; the rate of decrease in the inventory level will increase at the time of the price markdown. The inventory function before the markdown will be as specified in the previous section; after the markdown, we determine i t by solving the differential equation ( d i / d t = - a p 2 ~ t ~ - l il-t3) under the initial condition i w = [Qt3_ {afl W V / ( y p ~ ) } ] l / t3, where pj is the original price, P2 is the markdown price, and W is the time of the markdown. The inventory

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Time Fig. 2. Inventory level over time - price markdown model.

level can then be expressed in the following manner (Fig. 2 illustrates the inventory level over time for this situation):

aflt_____]l/~ r

]
it =

ifo_<,_<w
ifW<t<
otherwise.

I ],
a----~+W" l-I--~l! I '

[QaO,

yp~

The total profit function in this context can be then expressed in the following manner (by substituting Eq. (9) into Eq. (6)):

7P~ ]

_(P2+h)

Q/3

YP~

YP~

(lO)
As with the basic, no-markdown case, typical search techniques have been effective in solving this problem, even though we have not been able to formally prove quasiconcavity.

4.1. Special case-fixed pricing


Again consider the situation in which the pricing policies (the price level at the beginning of the period, the markdown price, and the time of the markdown) are given. The only decision variable in this situation will be the order quantity. Due to the complexity of this model, a closed-form solution could not be obtained. However, the solution can be determined by finding the solution to the following equation:

( P~ - c)Q ' - # - ( Pt -P2)i~ -tJ- ( P2 + h)i~ -~ = 0,

(ll)

T.L. Urban, R.C. Baker~European Journal of Operational Research 103 (1997) 573-583

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where

/io,

YP~ ]

'

it=

i~w -

yp~

'

with i w the inventory level at the time of the markdown, and i r the end-of-period inventory level. Examination of the second derivative shows the profit function to be strictly concave, so the solution will be the global maximum. Since the solution will likely be integral, the optimal solution can easily be found in a finite number of iterations using a simple univariate search technique. This model can easily be shown to reduce to the basic model where no markdowns are made by simply setting W = T. Consider the situation where we further restrict this special case by examining the model when /3 = 0.5. In this situation, we can identify a closed-form solution using Eq. (11); it is Q* =
2 y ( c + h)

p~ + h
p~

It is interesting to note that the optimal order quantity in this situation is a squared value, as opposed to a square root value obtained with the typical EOQ models.

Example. To continue with the illustrative example from the previous section, let's again consider the use of a
fixed-pricing policy in which we are to markdown the price by 30% (p2 = 4.90) at the beginning of the ninth day (W = 8) to try to reduce the inventory left at the end of the period. Under this policy, the order quantity would be 367.0 units (using Eq. (11)). A total of 135.6 units are sold at the initial price and 86.5 units at the markdown price, leaving 71.0 units in inventory at the end of the period. This will result in total profit of $534.45, a 3.2% decrease in profit from the situation in which no markdowns were made. Although sales increased by 34 units, many were at the lower price. Obviously, arbitrary markdown policies are not always in the best interest of the firm. On the other hand, if the pricing policies are also under the decision maker's control, additional profits can be realized. In this case, the initial price will be set at $10.57, the markdown price will be $7.60 and will take effect at the beginning of the eighth day (W = 7). The order quantity will be 308.8 units, resulting in sales of 94.8 units at the initial price and 80.4 units at the markdown price. This results in profits of $645.30, an increase of more than 48% over the classical, single-period model, an increase of 14% over the fixed pricing policy case, but only 1.4% higher than the optimal no-markdown case. In practice, it would need to be determined if the additional $8 in profits to utilize a markdown policy is worth the additional effort required for such a policy.

5. Sensitivity analysis
We now investigate the sensitivity of this model to changes in the values of the decision variables as well as to errors made in estimating the parameters of the demand function (all else equal). We will consider the most general model investigated in which all decision variables are under the decision-maker's control. This analysis is based on the example presented in the previous section that accounted for the use of markdown pricing.
5.1. Sensitivity of decision variables

Fig. 3 illustrates the sensitivity of the model to changes in the values of the decision variables. As shown in the figure, the model is fairly insensitive to increases in the price levels, as doubling the initial price, Pl, will result in a reduction in profit of 13.6%, and doubling the markdown price, P2, will realize an 8.1% loss. However, the performance of the model quickly deteriorates when the price levels are set too low; the losses rapidly increase as the prices approach the cost of the item. The model is also fairly insensitive to changes in the

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T.L. Urban, R. C. Baker~European Journal of Operational Research 103 (1997) 573-583


60

pl
5O

,--4 40-

p2 i
~' "
.=

~o

\
..\

20

/I / //" pl / i . . " .,"" i .*

'.,

to

t.--I00

i -80

~ -60

40

-20

20

40

60

80

100

Percent Change from Optimal

Fig. 3. Sensitivity analysis of decision variables.

time of markdown, W. This variable can range from T (never marking down the price) to zero (using the markdown price during the entire period) and realize no more than a 7% decrease in profit. Concerning the sensitivity to changes in the order level, Q, the results are very similar to traditional inventory models.

5.2. Sensitivity of demand parameters


Fig. 4 illustrates the sensitivity of the model to errors made in estimating the demand parameters. It appears from the figure that the model is somewhat insensitive to errors in the scale parameter, a, as an error of 50%
140

? iI

I00

I I

I I
!

~...'/

.I

\i
: -50 : -40 t

'

"
20 30 40 50

-30

-20

-10

tO

percent Error

Fig. 4. Sensitivity analysis of demand parameters.

T. L Urban, R. C. Baker / European Journal of Operational Research 103 (1997) 573-583

581

will result in a decrease in profit of no more than 27%. However, this parameter can take on a larger range of values than the other parameters (e.g., /3 is constrained to be between 0 and 1) and could realistically incur relatively large errors. The sensitivity of the model to changes in the shape parameter for price, e, is fairly significant, particularly for negative errors. Utilizing an estimate 20% less than the actual value will incur a reduction of profit of over 100%. The sensitivity of the model to changes in the shape parameter for the level of inventory, /3, follows a similar pattern as that of e, although the severity of the loss is greater; an estimate 20% lower than the actual value will realize a loss of 245%. The sensitivity of the time parameter, y, follows a similar but reverse pattern, as the model is relatively insensitive to smaller values. However, as the estimate gets larger, the loss quickly increases; using a parameter estimate 50% larger than the true value results in a decrease in profit of nearly 250%.

6. Managerial implications
Beyond the theoretical implications of incorporating the effects of price, time, and inventory levels on the demand rate of an item, as opposed to simply assuming a constant demand rate, there are several other reasons this particular model is appealing. One reason is the constant elasticity property of the demand pattern; economists have long used this type of model to estimate demand. Another reason is the ease of use of this functional form; a simple logarithmic transformation allows the use of linear regression to estimate the parameters. Perhaps the most compelling reason to use this functional form of demand is its richness. The inventory curve can take on many shapes by varying the value of the parameters. For example, a situation may arise in which price goes down during the season, which has a positive effect on demand, but as the season nears its end, demand decreases. The model can reflect this with appropriate parameter values; Fig. 5 illustrates the variety of shapes the curve can take on as the values of e, y, and /3 vary. While this functional form of demand is very rich, care should be taken when obtaining estimates of the demand parameters. Multicollinearity may be present since, as time increases throughout the period, the quantity

T
t

Fig. 5. Examples of potential inventory curves,

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in inventory decreases and the price decreases due to markdowns. There are a number of methods for dealing with multicollinearity (see, e.g., Doran [7]) such as: 1) obtaining additional data, through larger sample sizes, data with high variation in the explanatory variables, or augmenting time-series data with cross-sectional data; 2) using a priori information, in particular, estimates of price elasticity have been identified for many products [12]; and 3) applying statistical techniques, such as transforming the data (e.g., first differences) or using ridge regression or principal components regression.

7. Summary
A single-period inventory model is presented that generalizes existing models to incorporate the effects of relevant variables on the demand of an item - namely price, time, and inventory level. The model is also extended to incorporate price markdowns during the period. The consequences of failing to use this model when appropriate have been shown to be substantial; the example presented indicates that an increase in profit of nearly 50% can be realized over the classical, single-period model. Sensitivity analysis indicates that the model is fairly sensitive to errors in the parameter estimates; again, supporting the fact that misleading results may be obtained by ignoring this type of demand pattern.

References
[1] Abad, P.L., "Determining optimal selling price and lot size when the supplier offers all-unit quantity discounts", Decision Sciences 19 (1988) 622-634. [2] Arcelus, F.J., and Srinivasan, G., "Inventory policies under various optimizing criteria and variable markup rates", Management Science 33 (1987) 756-762. [3] Baker, R.C., and Urban, T,L., "A deterministic inventory system with an inventory-level-dependent demand rate", Journal of the Operational Research Society 39 (1988) 823-831. [4] Baker, R.C., and Urban, T.L., "Single-period inventory dependent demand models", Omega 16 (1988) 605-607. [5] Barbosa, L.C., and Friedman, M., "Deterministic inventory lot size models - A general root law", Management Science 24 (1978) 819-826. [6] Donaldson, W.A., "Inventory replenishment policy for a linear trend in demand - An analytical solution", Operational Research Quarterly 28 (1977) 633-670. [7] Doran, H.E., Applied Regression Analysis in Econometrics, Marcel Dekker, New York, 1989. [8] Gallego, G., and van Ryzin, G., "Optimal dynamic pricing of inventories with stochastic demand over finite horizons", Management Science 40 (1994) 999-1020. [9] Gerchak, Y., and Wang, Y., "Periodic-review inventory models with inventory-level-dependent demand", Naval Research Logistics 41 (1994) 99-116. [10] Goyal, S.K., "On improving replenishment policies for linear trend in demand", Engineering Costs and Production Economics 20 (1979) 47-53. [1 I] Hanssmann, F., Operations Research in Production and Inventory Control, Wiley, New York, 1962. [12] Houthakker, H.S., and Taylor, L.D., Consumer Demand in the United States: Analysis and Projections, Harvard University Press, Cambridge, MA, 1970. [13] Kotler, P., Marketing Decision Making: A Model Building Approach, Holt, Reinhart & Winston, New York, 1971. [14] Koutsoyiannis, A., Modern Microeconomics, Wiley, New York, 1975. [15] Ladany, S.P., and Stemlieb, A., "The interaction of economic order quantities and marketing policies", AllE Transactions 6 (1974) 35 -40. [16] Larson, P.D., and DeMarais, R.A., "Psychic stock: An independent variable category of inventory", International Journal of Physical Distribution and Logistics Management 20 (1990) 28-34. [17] Lan, A.H., and Lau, H.-S., "The newsboy problem with price-dependent demand distribution", liE Transactions 20 (1988) 168-175. [18] Lee, H.L., and Rosenblatt, M.J., "The effects of varying marketing policies and conditions on the economic order quantity", International Journal of Production Research 24 (1986) 593 -598. [19] Mandal, B.N., and Phanjdar, S., "An inventory model for deterioruting items and stock-dependent consumption rate", Journal of the Operational Research Society 40 (1989) 483-488.

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[20] Padmanabhan, G., and Vrat, P., "An EOQ model for items with stock dependent consumption rate and exponential decay", Engineering Costs and Production Economics 18 (1990) 241-246. [21] Resh, M., Friedman, M., and Barbosa, L.C., "On a general solution of the deterministic lot size problem with time-proportional demand", Operations Research 24 (1976) 718-725. [22] Shah, Y.K., and Jha, P.J., " A single-period stochastic inventory model under the influence of marketing policies", Journal of the Operational Research Society 42 (1991) 173-176. [23] Silver, E.A., " A simple inventory replenishment decision rule for a linear trend in demand", Journal of the Operational Research Society 30 (1981) 71-75. [24] Urban, T.L., "Deterministic inventory models incorporating marketing decisions", Computers and Industrial Engineering 22 (1992) 85-93. [25] Whitin, T.M., "Inventory control and price theory", Management Science 2 (1955) 61-68, [26] Wolfe, H.B., "A model for control of style merchandise", Industrial Management Review 9 (1968) 69-82.