European Journal of Operational Research 158 (2004) 456–469

www.elsevier.com/locate/dsw

Production, Manufacturing and Logistics

A multi-product continuous review inventory system

with stochastic demand, backorders, and a budget constraint
Babak Ghalebsaz-Jeddi a, Bruce C. Shultes a,*
, Rasoul Haji b

a
Department of Mechanical, Industrial, and Nuclear Engineering, University of Cincinnati, P.O. Box 210072,
Cincinnati, OH 45221-0072, USA
b
Department of Industrial Engineering, Sharif University of Technology, Tehran 11365, Iran
Received 2 September 2002; accepted 5 February 2003
Available online 11 August 2003

Abstract

Common characteristics of inventory systems include uncertain demand and restrictions such as budgetary or
storage space constraints. Several authors have examined budget constrained multi-item stochastic inventory systems
controlled by continuous review policies without considering marginal shortage costs. Existing models assume that
purchasing costs are paid at the time an order is placed, which is not always the case since in some systems purchasing
costs are paid when orders arrive. In the latter case the maximum investment in inventory is random since the inventory
level when an order arrives is a random variable. Hence payment of purchasing costs on delivery yields a stochastic
budget constraint for inventory. This paper models a multi-item stochastic inventory system with backordered
shortages when estimation of marginal backorder cost is available, and payment is due upon order arrival. The budget
constraint can easily be converted into a storage constraint.
Ó 2003 Elsevier B.V. All rights reserved.

Keywords: Inventory; Stochastic demand; Budget constraint; Nonlinear optimization; Penalty method

1. Introduction

Controlling several inventory items creates problems that do not arise in single item inventory models.
There are often interactions among items since they compete for finite capacity inventory system resources.
Hadley and Whitin [5] note that perhaps the most important real world constraints are budget restrictions on
the amount that can be invested in inventory. Unfortunately, there is no simple way of including budget
constraints in a model and budget restrictions in the presence of uncertainty make the problem more difficult.
Many models for continuous review inventory systems, i.e., ðQ; rÞ models, with stochastic demand and
allowable shortages have been studied. See, for example, Brown and Gerson [1], Hadley and Whitin [5],

*
Corresponding author. Tel.: +1-513-556-0378; fax: +1-513-556-3390.
E-mail address: bruce.shultes@uc.edu (B.C. Shultes).

0377-2217/$ - see front matter Ó 2003 Elsevier B.V. All rights reserved.
doi:10.1016/S0377-2217(03)00363-1
 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469 457

Parker [8], Tinarelli [11], Wagner [12], and Yano [13]. The majority of these models exclude constraints on
budget, storage, and order workload. Some of these models handle shortages by assessing a penalty per unit
short, e.g., Hadley and Whitin [5], while others include shortages as constraints, e.g., Yano [13].
There are classes of multi-item stochastic ðQ; rÞ models with shortages that include constraints on in-
ventory investment, storage, or reorder workload. Brown and Gerson [1] develop three models for multi-
item stochastic ðQ; rÞ systems with budget constraints. The most general model includes a sum of expected
annual ordering and shortage costs in the objective function, but does not consider inventory holding costs.
Brown and Gerson define the total investment in inventory as a deterministic function of order quantities
and reorder points. Schrady and Choe [9] minimize the total time-weighted shortages with budget and
reorder workload constraints. The constraints are deterministic since order charges are accrued at the time
an order is placed. Schroeder [10] presents a model constrained by total expected annual ordering and
holding costs with an objective of minimizing the expected number of units backordered per year. The costs
associated with stock outs are not considered in any of these models. In Holt et al. [6], the objective is to
minimize the expected total ordering, holding, and time weighted shortage costs while satisfying a con-
straint on expected total inventory. The solution procedure utilizes linear expansions of nonlinear functions
based on finite differences. The constraint in this model is deterministic and the solution procedure does not
directly control errors introduced by linear expansions.
Gardner [4] suggests that marginal cost parameters are difficult to measure accurately. He develops a
model for minimizing expected approximate backordered sales subject to constraints on aggregate in-
vestment and replenishment workload. The budget constraints are deterministic. Hadley and Whitin [5]
present a ðQ; rÞ inventory model for a single product with stochastic demand, allowable shortages, and no
constraints.
To our knowledge, the problem of determining optimal continuous review policies for budget con-
strained multi-item stochastic inventory systems with marginal shortage costs has not been explored pre-
viously. Existing models assume that purchasing costs are paid at the time an order is placed, which is not
always the case since in some systems purchasing costs are paid when orders arrive. In the latter case the
maximum investment in inventory is random since the inventory level when an order arrives is a random
variable. Hence payment of purchasing costs on delivery yields a stochastic budget constraint for inventory.
This paper focuses on a multi-item stochastic inventory system with backordered shortages when estima-
tion of marginal backorder cost is available, and payment is due upon order arrival. The budget constraint
can easily be converted into a storage constraint. Our objective is to minimize the expected value of ap-
proximate total annual cost. Approximate total annual cost is the summation of the approximate annual
costs for each item which are defined in Hadley and Whitin [5].
The rest of the paper is organized as follows: Section 2 presents notation, problem assumptions, and the
proposed problem formulation. Two solution approaches are described in Section 3. Section 4 presents a
numerical example and Section 5 provides concluding remarks. All proofs are given in Appendix A.

2. Model formulation

The following notation is used throughout the paper. The input parameters are:

n number of products controlled by the inventory system

Dj yearly expected total demand of item j
Aj per order fixed ordering cost for item j
hj yearly per unit inventory holding cost for item j
pj per unit fixed penalty cost for shortages of item j
Cj unit price of item j
458 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469

Lj constant lead-time of item j

Xj demand for item j during the lead time Lj
lj mean of the lead time demand for item j
r2j variance of the lead time demand for item j
Z standard normal random variable N ð0; 1Þ
W maximum available budget for all items
c smallest acceptable probability that total investment is within budget

The decision variables are:

Qj order quantity of item j

rj reorder point of item j
kj safety factor for item j

Assume the following:

iii. For all j, Xj  N ðlj ; r2j Þ and all of the Xj are independent. Let Fj denote the cdf and fj denote the pdf for
Xj .
iii. kj is the safety factor for item j and satisfies P ðXj > rj Þ ¼ P ðZ > kj Þ, so rj ¼ lj þ kj rj and kj rj represents
the safety stock level for item j.
iii. Inventory is continuously reviewed and replenishment orders are made whenever the inventory level
hits the reorder point rj .
iv. Shortage costs do not depend on time.
iv. For all j, rj > 0.
vi. The purchasing costs for item j are paid at the time an order is received. The following constraint forces
the probability that total inventory investment is within budget to be no smaller than c.
( )
Xn
P Cj ðrj  Xj þ Qj Þ 6 W P c:
j¼1

The objective in the proposed model, as in Hadley and Whitin [5], is to minimize the expected value of the
approximate total annual cost. The cost equations are approximations because inventory levels and de-
mands are treated as continuous instead of discrete quantities. Let EACj ðrj ; Qj Þ denote the expected ap-
proximate annual cost for item j, which equals the sum of average annual ordering cost, expected annual
holding cost, and expected annual backorder cost for item j. The average annual ordering cost for item j is
ðDj =Qj ÞAj . As in Hadley and Whitin, the approximate expected annual holding cost for item j is
 
Qj
hj þ rj  l j
2
and the expected shortage for item j when an order arrives is given by
Z 1 Z 1 Z 1
bj ðrj Þ ¼ ðxj  rj Þfj ðxj Þ dxj ¼ xj fj ðxj Þ dxj  rj fj ðxj Þ dxj ð1Þ
rj rj rj

where the second term can be written as rj ð1  Fj ðrj ÞÞ ¼ rj Fj ðrj Þ. The annual expected backorder cost for
item j is ðDj =Qj Þpj bj ðrj Þ. So the expected value of the approximate total annual cost is
X n Xn   
e ¼ Dj Qj Dj
EACð~ r; QÞ EACj ðrj ; Qj Þ ¼ A j þ hj þ rj  lj þ pj bðrj Þ ;
j¼1 j¼1
Qj 2 Qj
e ¼ ðQ1 ; Q2 ; . . . ; Qn Þ. The inventory problem of interest is
r ¼ ðr1 ; r2 ; . . . ; rn Þ and Q
where ~
 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469 459

minimize EACð~ e
r; QÞ
( )
X
n
subject to P Cj ðrj  Xj þ Qj Þ 6 W P c; ð2Þ
j¼1

rj P 0; Qj P 0 for j ¼ 1; . . . ; n:

The budget constraint written as (2) is difficult to use. To solve this problem, rewrite it as
( )
X
n X
n
P Cj Xj P Cj ðrj þ Qj Þ  W P c:
j¼1 j¼1

Pn Pn Pn
Now let Y ¼ j¼1 C j Xj ; l Y ¼ j¼1 Cj lj and r2Y ¼ j¼1 Cj2 r2j , then Y  N ðlY ; r2Y Þ. The budget constraint
reduces to

X
n
Cj ðrj þ Qj Þ 6 W þ lY þ z1c rY ; ð3Þ
j¼1

where z1c ¼ U1 ð1  cÞ and U is the standard normal cumulative distribution function. Eq. (3) is the form
of the budget constraint used in the proposed solution procedure. Note that if the purchasing costs for item
j are paid at ordering time, then the budget constraint can be modified by removing Cj Xj from Y . In this
case, the budget constraint is independent of the lead time demand for item j. The proposed model and
solution procedures still apply when any set of items modify the budget constraint in this way.
Constraining the available budget for inventory can be viewed as a storage constraint. Replace unit cost
by unit storage requirement, and total available budget by total available storage space. The form of the
constraint does not change to handle this case.
The objective, as in Hadley and Whitin, is convex and the constraint is a linear inequality, so any feasible
solution to the problem that satisfies the Kuhn–Tucker conditions is an optimal solution. A Lagrange
multiplier method is proposed because equating the partial derivatives of the Lagrange function to zero and
solving the simultaneous equations for the optimum solves the problem. This allows the procedure pro-
posed by Hadley and Whitin for the unconstrained problem to be adapted to the problem at hand.

3. The solution

The first step is to solve the problem ignoring the budget constraint. Apply the heuristic iterative pro-
cedure proposed by Hadley and Whitin [5] to obtain a solution to the unconstrained problem. If the un-
constrained solution satisfies the constraint, then no other computations are needed. Otherwise, the
constraint is active and a penalty function approach is needed.
Assume the constraint is active. Let k P 0 and formulate the Lagrange function
!
Xn
J ð~ e
r; Q; kÞ ¼ EACð~ e
r; QÞ þ k Cj ðrj þ Qj Þ  W  ly  z1c ry
j¼1
!
X
n X
n
¼ EACj ðrj ; Qj Þ þ k Cj ðrj þ Qj Þ  W  ly  z1c ry :
j¼1 j¼1
460 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469

The partial derivatives of J ð~ e kÞ are

r; Q;

oJ Dj Aj hj pj Dj
¼ þ  2 bj ðrj Þ þ kCj for j ¼ 1; . . . ; n;
oQj Q2j 2 Qj

oJ pj Dj
¼ hj  F j ðrj Þ þ kCj for j ¼ 1; . . . ; n;
orj Qj

oJ X n
¼ Cj ðrj þ Qj Þ  W  ly  z1c ry :
ok j¼1

Equating the partial derivatives to zero and rearranging the terms in the first two equations yields the
simultaneous equations
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2Dj ðAj þ pj bj ðrj ÞÞ
Qj ¼ for j ¼ 1; . . . ; n; ð4Þ
hj þ 2kCj

hj þ kCj
F j ðrj Þ ¼ Qj for j ¼ 1; . . . ; n; ð5Þ
pj Dj

X
n
Cj ðrj þ Qj Þ  W  ly  z1c ry ¼ 0: ð6Þ
j¼1

3.1. Procedures for solving sub-problems

The proposed solution approach solves a sequence of sub-problems. Each sub-problem involves solving
(4) and (5) for all items with a fixed k value. Without loss of generality, the index j is dropped for the
remainder of this section. Two procedures for solving these subproblems are described. One procedure is
from Hadley and Whitin [5] while the other is a new approach that directly approximates the sub-problem
solution.

3.1.1. The Hadley–Whitin procedure

This procedure for solving sub-problems is the numerical procedure introduced by Hadley and Whitin
[5] for the unconstrained version of this problem. Find Q and r for a given k by applying the following
procedure that converges in a finite number of iterations if a solution exists.

Step 1. Assume  bðrÞ ¼ 0. Compute Q using (4). Use (5) to compute r.

Step 2. Let r1 ¼ r and Q1 ¼ Q.
Step 3. Use (4) to compute Q.
Step 4. Use (5) to compute r.
Step 5. If jr  r1 j P er and jQ  Q1 j P eQ then the procedure has not converged so repeat Steps 2–5. er and
eQ are chosen error tolerances for the reorder point and the order quantity respectively. If reorder
point error is not of interest then let er ¼ r from Step 1. Similarly, if order quantity error is not of
interest then let eQ ¼ Q from Step 1.
 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469 461

3.1.2. A direct approximation

The key idea is to derive a closed form expression that solves (4) and (5). Substituting (4) into (5) yields
pffiffiffi qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
2ðh þ kCÞ
F ðrÞ ¼ pffiffiffiffipffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi A þ p bðrÞ for all k P 0:
p D h þ 2kC
Recall that demands are Normal random variables. Assumption (ii) indicates k ¼ ðr  lÞ=r and
F ðrÞ ¼ 1  UðkÞ ¼ UðkÞ. Similarly
Z 1
 1 2
bðrÞ ¼ r ðz  kÞ pffiffiffiffiffiffi ez =2 dz ¼ rUNLLIðkÞ; ð7Þ
k 2p
where UNLLIðkÞ is the Unit Normal Linear Loss Integral evaluated at k (see [3] where LðkÞ ¼ UNLLIðkÞÞ.
Hence
pffiffiffi
2ðh þ kCÞ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
UðkÞ ¼ pffiffiffiffipffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi A þ prUNLLIðkÞ ð8Þ
p D h þ 2kC
or equivalently
pffiffiffi !2
2 2ðh þ kCÞ
½UðkÞ  pffiffiffiffipffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ðA þ prUNLLIðkÞÞ ¼ 0: ð9Þ
p D h þ 2kC
This implies that k is the unique solution to (9) for a fixed k. Uniqueness readily follows from Hadley and
Whitin [5].
It is easy to solve the sub-problem if (9) is a quadratic equation in k. This may not be true in general, but
(9) can be approximated by a quadratic equation. Closed form expressions for U and UNLLI are needed.
From (1), notice that

db db db  dr
¼ F ðrÞ; so ¼ ¼ F ðrÞr ¼ UðkÞr
dr dk dr dk
and from (7)
db dUNLLI
¼r ;
dk dk
so
dUNLLI
¼ UðkÞ:
dk
This relationship implies that if both U and UNLLI are approximated by polynomial equations in k, then
the degree of the polynomial for U should be one less than the degree of the polynomial for UNLLI. To
force (9) to be a quadratic equation, a piecewise linear approximation for U and a piecewise quadratic
approximation for UNLLI are used. Specifically, break the range of values for k into m sub-ranges
R1 ; . . . ; Rm ¼ ½K1 ; K2 ; ½K2 ; K3 ; . . . ; ½Km1 ; Km ; ½Km ; 1Þ that overlap at the boundaries, and then let
ai k 2
Ui ðkÞ ¼ ai k þ bi UNLLIi ðkÞ ¼  bi k þ c i for all k 2 Ri ; i ¼ 1; . . . ; m:
2
For each i, identify ni equally spaced sample values for k in range Ri ,
8  
< Ki þ j1 ðKiþ1  Ki Þ; 1 6 i < m;
ni 1
kij ¼  
: Km1 þ j1
ðKmax  Km Þ; i ¼ m;
nm1 1
462 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469

for j ¼ 1; . . . ; ni with Kmax as an artificial upper bound for k and compute UðkÞ for each value. Least squares
linear regression yields
Pni P  P 
1 ni ni
j¼1 kij Uðkij Þ  ni j¼1 kij j¼1 Uðkij Þ 1 X ni
ai ¼ Pni 2 1  Pni 2 ; and b i ¼ ðUðkij Þ  ai kij Þ
ni j¼1
k
j¼1 ij  ni
k
j¼1 ij

for all i. See Neter et al. [7] for a detailed discussion of least squares regression. Viewing the ai and bi as
known constants allows the remaining parameters to be estimated as
ni  
1 X ai
ci ¼ UNLLIðkij Þ þ kij2 þ bi kij :
ni j¼1 2

This leads to a natural piecewise quadratic approximation to (9). Hence, for a fixed i, the quadratic
equation can be solved for two roots. The one useable root falls in Ri and the other root falls outside Ri .
The approximations are not necessarily continuous functions. To identify the appropriate range to use
when solving for k, it is sufficient to evaluate the endpoints of the intervals and identify the range where the
left hand side (LHS) of (8) is greater than the right hand side (RHS) at one endpoint and the RHS > LHS
at the other endpoint. This does not require any additional function evaluations for U or UNLLI. Notice
that, for a fixed k, the LHS of (8) is independent of k and the RHS is increasing in k. This simplifies the
implementation. A detailed implementation of the proposed approximation procedure is described and
illustrated in Section 4.2.

3.2. The algorithm

The proposed solution approach exploits the observation that the sub-problem described in Section 3.1
e for any chosen k and this reduces the simultaneous equations to one
can be used to compute r~ and Q
equation with one unknown. For notational convenience, let
X
n
gð~ e ¼
r; QÞ Cj ðrj þ Qj Þ  W  ly  z1c ry : ð10Þ
j¼1

Notice that gð~ e can be rewritten as gðkÞ if (4) and (5) are solved for ~r and Q
r; QÞ e and these are plugged into
gð~ e It is sufficient to use a one dimensional search technique if the following three conditions are
r; QÞ.
satisfied:

(a) gðkÞ is a continuous function.

(b) There are two distinct values k1 ,k2 P 0 such that gðk1 Þgðk2 Þ < 0.
(c) gðkÞ is strictly monotone.

Condition (a) is immediately satisfied. A simple procedure for identifying appropriate k1 ; k2 P 0 (see Step 1
below) satisfies condition (b). The following theorem satisfies condition (c).

Theorem 1. gðkÞ is strictly decreasing in k.

Since the problem satisfies conditions (a), (b), and (c), any one-dimensional search technique can be used
to solve gðkÞ ¼ 0 for k. Candidate techniques include the Newton-Raphson, secant, and bisection methods
as well as others. The bisection method is presented below.
 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469 463

Step 1. Find initial values for k1 ; k2 P 0 such that gðk1 Þgðk2 Þ < 0. Let k1 ¼ 0 since this corresponds to the
unconstrained model and the budget constraint is violated, i.e., gðk1 Þ > 0. Let k2 be the smallest
power of 2 such that gðk2 Þ < 0, i.e., k2 ¼ 20 , i P 0. If i > 0, then redefine k1 ¼ 2i1 .
Step 2. Let Qe 1 and r~1 be the result from the sub-problem described in Section 3.1 when k ¼ k1 and let Q e2
and r~2 be the result when k ¼ k2 . These were found in Step 1 to compute the corresponding gðkÞ
value. This step is only needed if stopping criterion involves tolerances on Q e or ~r.
Step 3. Let k ¼ ðk1 þ k2 Þ=2 and solve the sub-problem described in Section 3.1 for Q e and r~.
Step 4. Use the result from Step 3 in (10) to compute gðkÞ ¼ gð~r; QÞ. e If gðkÞ > 0 then let k1 ¼ k; Qe 1 ¼ Q,
e
and ~r1 ¼ ~ e 2 ¼ Q,
r. If gðkÞ < 0 then let k2 ¼ k; Q e and ~r2 ¼ ~r.
Step 5. If the stopping criterion (described below) is satisfied, then the final Q, e ~r, and k are the solution.
Otherwise, repeat Steps 3–5.

Stopping criterion. There are several stopping criteria to choose from. The choice depends partially on
the preferences for the decision maker. It is not practical to require gðkÞ ¼ 0. Instead, one of the following
can be used:
maxðgðk1 Þ; gðk2 ÞÞ
gðk1 Þ  gðk2 Þ < eg ; < eg or ðgðk1 Þ; gðk2 ÞÞ < eg : ð11Þ
gðk1 Þ  gðk2 Þ

The first condition is the absolute deviation between the values for the derivative of the constraint while the
second condition is a relative error. The third condition (11) can be used to identify the first solution found
that satisfies a tolerance on the constraint. Alternatively, these conditions could be placed on Q, e ~r or k
values similar to the Hadley–Whitin procedure for solving sub-problems. The stopping criterion used in
Section 4 is a practical application of (11).
The algorithm is independent of the distribution for lead time demand provided (2) can be written in the
form of (3), and evaluating (4) and (5) for a fixed k is tractable. Specifically, one needs to evaluate
the inverse cdf for Y , and for each product: the inverse cdf for X and the pdf for X to compute bðrÞ. The
Normal distribution is used for illustrative purposes. In some cases the normal distribution can be used to
approximate the distribution of Y , but in general this requires an application of the central limit theorem.
Also note, if the payment is due at the time an order is placed then constraint (2) is written as
Xn
Cj ðrj þ Qj Þ 6 W :
j¼1

3.3. Computational complexity

To establish a relationship between the computational effort required by each of the proposed algo-
rithms, the computational complexities of each algorithm is presented. Consider any product ðjÞ and let
i ¼ 1; . . . ; I index the k values evaluated. The Hadley–Whitin procedure requires a finite, but unknown
number of iterations ðMij Þ to find a solution for the associated sub-problem that satisfies the chosen error
tolerance values. The Mij increase as the acceptable error tolerances decrease. In contrast, the direct ap-
proximation procedure requires one iteration to solve each sub-problem. The error tolerance on the
computation of U applies to both methods since there is no closed-form expression for it.
A function is OðIÞ if there exists a finite c > 0 such that cI is an upper bound for the Pfunction.
Pn The
I
computational complexity of the algorithm based on the Hadley–Whitin procedure is O i¼1 j¼1 Mij
while the algorithm based on the direct approximation is OðIÞ. Since each Mij is finite, these are equivalent
in terms of computational complexity. In practice, the factors of Mij can have a significant impact on
computational effort since each Mij is at least 2.
464 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469

4. A numerical example

Consider a two-product inventory system with normally distributed lead-time demands, W ¼ 36000,
c ¼ 0:903 then z1c ¼ 1:3, and parameters as shown in Table 1. Product 2 in this example is from a single
product example presented in Hadley and Whitin [5]. The goal is to find a solution to the inventory
problem that violates the budget constraint by no more than 1%, so the stopping criterion is jgðkÞj <
0:01  36; 000 ¼ 360, which is a form of (11).

4.1. Using the Hadley–Whitin approach to subproblems

Table 2 depicts the steps in the application of the proposed solution procedure to this example. Initial k
values are k1 ¼ 0 and k2 ¼ 2. Initial rj values for j ¼ 1; 2 are the solution to the unconstrained model. Since
gðk1 Þ > 0, the budget constraint is not satisfied. For all Hadley–Whitin subproblems, let er ¼ eQ ¼ 1. The
final solution is highlighted in the table.

4.2. Using the direct approximation

In practice, the safety factors kj are non-negative real numbers and are rarely larger than four. This
observation motivates setting Kmax ¼ 4. The interval ½0; 4 should be split into segments so that the re-

Table 1
Parameters for a two product inventory system
Product (j) Dj lj rj Aj hj pj Cj
1 120 30 10 40 20 50 100
2 1600 750 50 4000 10 2000 50

Table 2
Illustration of the Hadley–Whitin based procedure
Step k1 k2 k j Qj DQj rj Drj gðkÞ
a 0 1 18.19 43.54
b 0 22.34 )4.143 42.37 1.161
c 0 23.36 )1.027 42.11 0.263
d 0 23.62 )0.256 42.05 0.064
e 0 2 1131.37 884.67
f 0 1146.58 )15.211 884.45 0.223
g 0 1146.80 )0.221 884.45 0.003 35129.66

h 1 1 6.47 40.84
i 1 8.89 )2.416 38.74 2.102
j 1 9.86 )0.965 38.00 0.738
k 1 2 341.12 874.48
l 1 349.84 )8.716 874.03 0.449
m 1 350.08 )0.242 874.01 0.012 )7009.56
1 0 1 0.5 1 8.63 42.08
2 0.5 11.22 )2.589 40.46 1.612
3 0.5 12.05 )0.839 40.00 0.467
4 0.5 2 461.88 878.61
5 0.5 471.02 )9.138 878.27 0.339
6 0.5 471.21 )0.196 878.27 0.007 )320.42
 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469 465

Table 3
Ranges for k and piecewise approximation coefficients
i Ki Kiþ1 ai bi ci UðKi Þ UNLLIðKi Þ
1 0.00 0.58 )0.37940 0.49757 0.39897 5.0000E)01 3.9894E)01
2 0.58 0.98 )0.29380 0.44853 0.38499 2.8096E)01 1.7422E)01
3 0.98 1.30 )0.20848 0.36583 0.34494 1.6354E)01 8.6537E)02
4 1.30 1.58 )0.14180 0.27988 0.28957 9.6801E)02 4.5528E)02
5 1.58 1.84 )0.09280 0.20284 0.22902 5.7053E)02 2.4360E)02
6 1.84 2.08 )0.05872 0.14040 0.17185 3.2884E)02 1.2900E)02
7 2.08 2.32 )0.03570 0.09267 0.12235 1.8763E)02 6.8347E)03
8 2.32 2.54 )0.02097 0.05864 0.08305 1.0170E)02 3.4527E)03
9 2.54 2.74 )0.01232 0.03673 0.05533 5.5426E)03 1.7693E)03
10 2.74 2.94 )0.00713 0.02255 0.03594 3.0720E)03 9.2932E)04
11 2.94 3.14 )0.00397 0.01326 0.02233 1.6411E)03 4.7142E)04
12 3.14 3.32 )0.00218 0.00769 0.01360 8.4481E)04 2.3084E)04
13 3.32 3.50 )0.00120 0.00444 0.00821 4.5014E)04 1.1775E)04
14 3.50 3.68 )0.00064 0.00247 0.00478 2.3267E)04 5.8326E)05
15 3.68 3.86 )0.00033 0.00133 0.00269 1.1665E)04 2.8048E)05
16 3.86 4.00 )0.00018 0.00074 0.00156 5.6715E)05 1.3089E)05
– 4.00 – – – – 3.1686E)05 7.0861E)06

gression error terms are acceptable. The split used can vary based on the preferences of a decision maker.
The following procedure illustrates a general method for identifying the coefficients for the approximation.
Experience with the procedure led to the observation that solving (8) for k is equivalent to identifying the
intersection of two equations, the RHS and LHS of (8) and the RHS typically has a very small slope. This
implies that errors or distances along the independent variable axis are likely larger than errors or distances
along the dependent axis for the linear approximation to U. Hence, Step 4 in the following algorithm
examines errors along the independent axis.

Step 1. Evaluate U and UNLLI at 0.00, 0.02, 0.04; . . . ; 3:98, 4.00 for use as data points in the piecewise
fitting procedure. Note: UNLLIðkÞ ¼ /ðkÞ  kUðkÞ, where /ðkÞ is the standard normal probability
density evaluated at k.
Step 2. Let i ¼ 1, K1 ¼ 0, n1 ¼ 2.
Step 3. Solve for ai and bi .
Step 4. Find D ¼ maxj¼0;...;ni 1 jai ðKi þ jð0:2ÞÞ þ bi  UðKi þ jð0:2ÞÞj the largest horizontal deviation.
Step 5. If D < 0:01, then let ni ¼ ni þ 1 and if Ki þ 0:02ðni  1Þ 6 4:0, then go to Step 3.
Step 6. If D > 0:01 then let ni ¼ ni  1, Kiþ1 ¼ Ki þ 0:02ðni  1Þ, i ¼ i þ 1, ni ¼ 2 and go to Step 3.
Step 7. For all i, Solve for ci .

The result from applying this algorithm is shown in Table 3.

Applying the direct approximation procedure is straightforward. At each step, start by solving both
sides (LHS and RHS) of (8) at the end points of each interval for k. Notice that only the RHS varies
with k. For each product, identify the interval i where LHS > RHS at one end point and LHS < RHS at
the other. For each i, solve the quadratic equation (9) for k. Use assumption (ii) to solve for r and use (4)
and (7) to solve for Q. This procedure is illustrated in Table 4 and the final solution is highlighted in the
table.
The results from the two procedures are approximately the same. The number of steps required
using the direct approximation procedure is much smaller than the Hadley–Whitin approach even
though the number of k values evaluated is identical. The approximations of U and UNLLI are fairly
accurate.
466 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469

Table 4
Illustration of direct approximation solution procedure
Step k1 k2 k j i Quadratic coefficients Quadratic roots k Q r gðkÞ
k 2
k Constant + )
a 0 1 4 1.54E)02 )6.07E)02 5.37E)02 2.610 1.338 1.338 27.06 43.38
b 0 2 9 1.50E)04 )8.93E)04 1.32E)03 3.273 2.691 2.691 1146.67 884.54 35604.99
c 1 1 2 5.43E)02 )1.66E)01 9.97E)02 2.229 0.825 0.825 10.31 38.25
d 1 2 8 4.29E)04 )2.40E)03 3.31E)03 3.109 2.483 2.483 350.00 874.14 )6936.87
1 0 1 0.5 1 3 2.93E)02 )1.03E)01 7.60E)02 2.450 1.059 1.059 12.42 40.59
2 0.5 2 9 1.48E)04 )8.81E)04 1.29E)03 3.400 2.563 2.563 471.29 878.17 )224.86

5. Conclusions

The proposed model adds a budget or storage constraint to the unconstrained stochastic approximation
model described in Hadley and Whitin [5] for a multi-product inventory system with backorders. The new
model assumes that purchasing costs are paid when products arrive and constrains the probability that
total inventory investment exceeds a specified value. A Lagrange multiplier technique solves the problem.
The optimization steps for two different solution procedures are explicitly described and a sample problem
illustrates the effectiveness of these approaches.
The main differences between the two solution procedures are: (1) the Hadley–Whitin procedure
utilizes error tolerances for the decision variables while the direct approximation procedure utilizes
an error tolerance on the approximation for computing U, and (2) the direct approximation pro-
cedure solves sub-problems in one step while the Hadley–Whitin procedure requires several itera-
tions. The proposed approximation procedure can be used in place of the Hadley–Whitin procedure
in general. In practice, there is no closed-form expression for U, so it must be approximated to
apply the Haldey–Whitin procedure. Since the error tolerance on U can be controlled, there is no
penalty for choosing the proposed direct approximation. In the example provided, there are no ill-
effects from using the proposed direct approximation procedure instead of the Hadley–Whitin ap-
proach. The worst-case complexities of the two procedures are the same. The second difference
between the solution procedures implies that the direct approximation procedure is computationally
more efficient.
Certain model extensions are readily solved by the proposed methods. The Normal distribution for
lead-time demand can be replaced by other distributions as long as the distribution for Y used in (3)
is invertible and (4) and (5) can be modified accordingly. Many related constrained inventory
problems can be solved using similar approaches. One modification would handle unfilled demand in
a different way, i.e., through mixtures of limited backorders and lost sales. Multiple constraints, such
as simultaneous constraints on inventory investment and reorder workload, could be handled. These
modifications and the extension of the direct approximation approach to other contexts are areas of
future work.
It is not clear whether the proposed approach is directly adaptable to other problems of interest. Annual
costs could be replaced by a risk sensitive cost function, e.g. an exponential cost function, that can encode
decision makers preferences. This approach has been successfully applied by Bouakiz and Sobel [2] in the
study of a periodic review inventory model. Constrained inventory systems that can not be viewed as
continuous review models are also of interest. Exploring these and related problems are additional research
directions.
 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469 467

Appendix A

Proof of Theorem 1. The derivative of g with respect to k is

 
dg X n
drj dQj
¼ Cj þ :
dk j¼1
dk dk

It is sufficient to show that the quantity inside the parentheses, for each j, is less than zero. For simplicity,
drop the subscript j. Taking the derivative of both sides of (4) with respect to k yields
" # " #
dQ 1 1 d 2DðA þ p bðrÞÞ D p dbðrÞ A þ pbðrÞ
¼ ¼  2
2C
dk 2 Q dk h þ 2kC Q h þ 2kC dk ðh þ 2kCÞ
"   #    
D p dr 
A þ pbðrÞ 1 dr 2
¼  F ðrÞ  2
2C ¼ pD  F ðrÞ Q C ðA:1Þ
Q h þ 2kC dk ðh þ 2kCÞ Qðh þ 2kCÞ dk

and performing the same operation on (5) yields

d dr h þ kC dQ C
ðF ðrÞÞ ¼ f ðrÞ ¼ þQ :
dk dk pD dk pD
Solving the last equation for dr=dk yields
 
dr 1 h þ kC dQ C
¼ þQ : ðA:2Þ
dk f ðrÞ pD dk pD
Plugging (A.2) into (A.1) yields
   
dQ 1 F ðrÞ dQ 2
¼ ðh þ kCÞ þ QC  Q C :
dk Qðh þ 2kCÞ f ðrÞ dk
Then
   
F ðrÞ dQ F ðrÞ 2 F ðrÞ
Qðh þ 2kCÞ  ðh þ kCÞ ¼ QC  Q C ¼ QC Q
f ðrÞ dk f ðrÞ f ðrÞ
and finally
dQ ½Qf ðrÞ  F ðrÞ
¼ QC : ðA:3Þ
dk Qðh þ 2kCÞf ðrÞ  F ðrÞðh þ kCÞ
Using (A.3) with (A.2)
" #
dr QC ½Qf ðrÞ  F ðrÞ
¼ 1  ðhþ2kCÞ : ðA:4Þ
dk f ðrÞpD Q f ðrÞ  F ðrÞ
ðhþkCÞ

Clearly
ðh þ 2kCÞ
Q f ðrÞ  F ðrÞ > Qf ðrÞ  F ðrÞ
ðh þ kCÞ
since k P 0. If both sides of this inequality are positive or both negative, then dr=dk < 0. The only other
case is that the LHS is positive and the RHS is negative. This case also yields dr=dk < 0.
468 B. Ghalebsaz-Jeddi et al. / European Journal of Operational Research 158 (2004) 456–469

Now, using (A.1) and (A.2)

      
dr 1 h þ kC 1 dr C
¼ pD  F ðrÞ  Q2 C þQ
dk f ðrÞ pD Qðh þ 2kCÞ dk pD
     
1 1 h þ kC dr
¼ pD  F ðrÞ  Q2 C þ Q2 C :
Qf ðrÞ pD h þ 2kC dk
Collecting terms and simplifying yields
    
h þ kC dr Q2 C h þ kC
F ðrÞ  Qf ðrÞ ¼ 1 :
h þ 2kC dk pD h þ 2kC
The RHS is clearly positive. Hence
 
h þ kC
F ðrÞ  Qf ðrÞ < 0: ðA:5Þ
h þ 2kC
Adding (A.3) and (A.4) yields
dQ dr QC½Qf ðrÞ  F ðrÞ
þ ¼
dk dk Qðh þ 2kCÞf ðrÞ  F ðrÞðh þ kCÞ
Qc
 f ðrÞpD ½Qðh þ 2kCÞf ðrÞ  ðh þ kCÞF ðrÞ  ðh þ kCÞ½Qf ðrÞ  F ðrÞ
þ
Qðh þ 2kCÞf ðrÞ  F ðrÞðh þ kCÞ
h i
QC Qf ðrÞ  F ðrÞ þ Qðhþ2kCÞ
pD
 F ðrÞðhþkCÞ
f ðrÞpD
 QðhþkCÞ
pD
þ F ðrÞðhþkCÞ
f ðrÞpD
¼
Qðh þ 2kCÞf ðrÞ  F ðrÞðh þ kCÞ
h  i
F ðrÞ
QC½Qf ðrÞ  F ðrÞ þ QkC  QC Qf ðrÞ  F ðrÞ þ kC hþkC
pD
¼ ¼ :
Qðh þ 2kCÞf ðrÞ  F ðrÞðh þ kCÞ Qðh þ 2kCÞf ðrÞ  F ðrÞðh þ kCÞ
Eq. (A.5) indicates that the denominator is positive. The term inside the brackets is
h
Qf ðrÞ  F ðrÞ
h þ kC
but
h þ kC h
> ; since h2 þ 2hkC þ k2 C 2 > h2 þ 2hkC:
h þ 2kC h þ kC
So
h h þ kC
Qf ðrÞ  F ðrÞ > Qf ðrÞ  F ðrÞ > 0
h þ kC h þ 2kC
and the sum of the derivatives is negative. This completes the proof. 

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