MANACEMEm' SCIENCE

Vol. 33, Na 6, June 1987

Piinud m V.Sjt.

INVENTORY POLICIES UNDER VARIOUS OPTIMIZING

CRITERIA AND VARIABLE MARKUP RATES*
F. J. ARCELUS AND G. SRINIVASAN
Faculty of Administration, University cf New Brunswick, P.O. Box 4400,
Fredericton, New Brunswick, Canada E3B 5A3
This iMper extends the deterministic EOQ model to reflect various optimizing criteria and
alternative demand and {nice structures. Its primary purpose is to develop decision rules for the
management of finidied goods inventories, e^seciaily in retailing, where inventories are evaluated in the same way as any other investment, namely on their aUlity to generate profits, rather
than on the traditional least-cost basis. To that effect, the models developed here consider
demand to be a function of price, with price defined as a markup of unit cost. The decision
variables are the order quantity and the markup rate. Possible optimizing objectives include
profits, return on investment, or readual income, the three most widely used evaluators of
short-term inve^ment performance. Optimal solutions for each case are obtained and the
resulting inventory policies evaluated.
(ACCOUNTING; INVENTORY/PRODUCTION; DETERMINISTIC MODELS; MEASURES OF EFFECTIVENESS)

1. iBtroduction
This paper extends the deterministic EOQ model to reflect various optimizing criteria and alternative demand and price structures. Its primary purpose is to develop
decision rules for the management offinishedgoods inventories, especially in retailing,
in which inventories are evaluated in the same way as any other investment, namely on
their ability to generate profits, rather than on the traditional least cost basis. This in
turn requires the development of pricing policies designed to generate the demand level
that will optimize an objective other than cost and more in accordance with the nature
of inventory as an asset.
The standard cost-minimization model with demand and price exi^enously determined reflects the traditional emphasis on the control of raw materials and work-inprocess inventories. Extensions to the basic framework have focused on questions such
as the appropriateness of the constant unit production cost assumption. These extensions have led either to an order quantity which reflects some form of discount or
learning effect (e.g. Ladany and Stemlieb 1974; Smunt and Morton 1985) or to an
assessment of the influence on the objective function of not taking these eflects into
account (Collier 1983). In addition, variable demand models do not treat the change in
demand as behaviorally related, but usually as a function of time (e.g. Friedman 1981).
FoUowing the work of Smith (1958) and Kotier (1971), several authors have used
profit maximization as the objective or have, at least, included a lower limit on profitallity (Sankarasubramanian and Kumarasw^my 1983). An important contribution of
these works is the attempt to modify the constuit price and demand assumption.
Ladany and Stemlieb (1974) explidtiy relate demand to price and price to cost and
Sankarasubramanian and Kumaraswamy (1981) a<M the e&scl of advertiang. These
modeb assume demand to be known and changing at a constant rate. Fluctuations in
the order quantity are designed to trigger the nec^sary price changes to meet the given
demand. Brahambhatt and Jaiswal (1980) extends ti^se models by explidtiy including
variable markup rates which are considered a function of one of the decision variables,
* Accepted by Leroy B. Schwaiz; recd-^vd Sqitember 1983. This pap-has been with tte authors 14 months
for 4 revisions.
756
0025-1909/87/3)6/0756$01.25
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INVENTORY POUCIES

757

capital intensity. EflFoits to incorporate other objectives have led to the use of return on
inve^ment (ROI) (Schroeder and Krishnan 1976) or residual income (RI) (Morse and
Schneider, 1979), as optimizing criteria in the design of inventory policy. However,
these models still consider demand and price to be exogeneoudy determined.
The modified EOQ models prraented here are \xtsed on the proposition that an
inventory mana^ment system d ^ ^ e d to satisfy a known demand level at a given
price is not compatible with the treatment of inventories as an investment. In the case
of some finished goods, especially in retailing, or even for some raw materials or
work-in-process inventories with flexible transfer pricing systems, pricing polici^ are
usually directed toward changing the demand level along a given demand curve, so as to
optimize an objective that measures the profit-generating potential of the investment.
To that effect, this paper relax^ the assumptions of constant demand and price and
treats demand as a function of price, price as a markup on unit cost and unit cost as
either constant or subject to learning or discount effects. The decision variables are the
order quantity and the markup rate, with maximization of profits (PR), of ROI, and of
RI as pos^ble objectives.
The oiganization of the paper is as follows. The next section discusses the advantages
and disadvantages of using PR, ROI and RI as indices of performance. 3 includes the
assumptions and the mathematical formulation of the models. 4 compares the optimal
solutions for the different optimizing criteria. Some sensitivity analysis is reported in
5, followed by concluding remarks in 6.
2. Optimizii^ Criteria
Our rationale for the selection of optimizing criteria lies in our treatment of inventories as investments. A recent survey (Reece and Cool 1978) shows that PR, ROI and RI
are, in that order, the most common measures of short-term performance for the
evaluation of profit and investment centers. PR, the best known and most widely used
index, requires little discussion. Its major drawback as a performance measure is that it
is not related to the size of the investment needed to generate the said profit. Such
independence may be acceptable in profit centers, where managers do not have the
authority to set investment levels for their units. In contrast, investment centers do have
responsibility over the type and level of investment. For them, an index that relates the
magnitude of the profits earned to the corresponding capital requirements is a more
appropriate measure of performance. ROI, the ratio of profits to investment, is one
such index.
The advant^^ and disadvantages of ROI as a performance evaluator are well known
(e.g. Kaplan 1982). On the positive side, ROI encourage goal congruence, since it can
be compared with widely available ROI's of other units smd with overall ROI's. ROI
can also be compared with the cost of capital indices constructed for external reporting
purp(es, irrespective of the aze or type of business. Furthermore, the use of ROI
encoura^s a more efficient use of assets, since mana^rs are then moti^^ted to invest
only if a fair return can be earned ratiier than as long as a marginal profit increase can
be realirad. This last conaderation is inobaUy the best argument in favor of ROI,
eqiedally when c a p i ^ budget ceilii^ exist as they frequently do in small busine^es,
such asretaUersand investment centers. If such ceilings fall below the caiHtd requirements needed to maximize PR, then the oi^mrtunity exist of the funds tied up in
inventory is no longerfixed,as inventory tlMory suggrats. Rather, the (xtst is measured
by the return on the last investment rej^^ted. Since sach an inv^tment can only be
identified once the decision is made, a new optinaizing oiterion is needed. Under these
conditions, the most mMy used index in captal budgeting (e.g. Van Home 1980) is
tte Profitalnlity Indoi, as measured by the inesent value of the benefite earned per

758

F. J. ARCELUS AND G. SUNIVASAN

doUar invest^. Since, for a single-period model and a given discount rate, maximization of ROI is equivalent to maximization of the Profitability Index, ROI deserves
consideration as a short-term performance objective.
However, ROI suffers from serious shortcomings. For example, it may encour^e
managers to raise the ROI level by decreasing or at best not increasing the capital base.
This can be done by lowering the value of the denominator, rather than by increasing
the numerator. ROI may also encourage managers to reject investments whose return
exceeds the firm's c ( ^ of capital, but decreases the unit's overall ROI. To avoid these
problems, some authors (e.g. Kaplan 1982) advocate the use of residual income as an
optimizing criterion. RI is computed by subtracting from PR a capital charge equal to
the unit's cost of capital multifriied by the investment base. As an absolute measure, RI
avoids ROI's scaling prcdjlems. More importantly, it allows for the inclusion of risk
premiums in the calculations through the assignment of different opportunity costs
and, subseqi^ntiy, of different capital charges to different investments. However, RI is
plagued by the same size problems as PR. Large investment units tend to eam a higher
RI than small ones do, even if the latter are more efficient in managing resources.
One of the main conclusions to be drawn from the above discussion is that no
short-term performance measure clearly dominates the others. All three have some
theoretical advantages and disadvantages and there exists no consensus in the literature
as to which measure is more appropriate. Thus, all three will be evaluated in the
remainder of this paper.
3. The Models
Let q be the order quantity or lot size; h, the holding cost per unit of time; h*, the
opportunity cost per unit of money tied up in inventory per unit oftime;j , the ordering
costs per order or set up cost per run; c, the production cost per unit of ^, m, the markup
on unit cost; G, the price elastidty of demand; p, the price per unit of q; and z, the
demand per unit of time.
We assume the common pridng policy (e.g. Ladany and Stemlieb 1974; Brahmbhatt
and Jaiswal 1980) of p being set at a markup of the unit cost, i.e.
p = me,

m s : 1,

(1)

with a cost function satisfying the condition

c' = Sc/6q ^ 0

(2)

and the weU-known constant price-elastidty demand function (Koutsoyiannis 1979)

given by
z = zop^,
Zo^O,
G^O.
(3)
Note that (2) covers the standard constant unit cost (c' = 0) and the discount and
learning cases (c' < 0) mentioned e^lier. Explidt functional forms for c are not needed
for the theoretkl deveJ<^>ment of this s:tion. However, it should be pointed out that
the assumption of a unique lot size, q, limits the form of the leamii^ function to
atuations in which no trananisaon of teaming occurs from lot to lot or in which
inventory carrying costs per unit, h, isfixed(Smunt and Morton 1985).
Given the above assumptions and definitions, the problem is to find the order
quantity and the marie up that will maximize t l ^ desired (^jeotive, i.e.
= z(p-c)-ih-h*)cq/2-jzlq,
Max RI = PR - h*cq/2,

(4)
(5)

INVENTORY POLIQES

759

Max ROI = VKIicq/l),

(6)

"MJ

subject to conditions (l)-(3).

The differences among the objectives may now be clearly stated. In (4>-(6), cqll
represents the average inventory investment level per unit of time and h* is the predetermined cost of capital specified by the firm. Then h*cql2 measures the capital charge
or imputed interest on the funds tied up in inventory. It is this chaige that is substracted
from PR to obtain RI (Kaplan 1982). Moreover, A* may also be considered as the
predetermined minimum ROI required by the firm. It can be easily seen that as A* -
ROI, then Rl ^ 0 and PR - cqll. Thus, if A* is set at too high a value, all profits will
tend to be absorbed by the capital charges.
4. Optimality Results
To simplify the notation, the subscripts 1, 2 and 3 identify the optimal solution for
PR, RI and ROI respectively. In addition the "primes" (') denote the first derivatives
with respect to the appropriate order quantities.
Result 1. The optimal markups are given by
nii = G(l + j/Ciq,)/(G + I)

for

/=1,2,3

and

G<-1

with

m\<,m2^Tni.

(7)
(8)

Result 2. The optimal lot sizes must satisfy the following relations:
For PR and RI.
ic'iZi + h,(Ci + 9,c;) = Ijzilq],
q, = CljZilhiCd"^,
h\ = h,

/ = 1,2;

/ = 1, 2;

G< -1;

G< -1;

C = 0,

c' < 0,

(9)
(10)

h2 h A*.

For ROI.
?3C3RI'3 = (C3 + 3C'3)Rl3,
3 =-j(G + 2)/c3,
qi^q2^q3.

G < -I,

G<-2,

c' = 0,

C'< 0,
with

(11)
(12)
(13)

Thefirst-orderoptimality conditions, given by (7) and (9)-(12), can be easily derived

by setting equal to zero the first derivatives of PR, RI and ROI with respect to the
corrraponding /w, and ?,. For each objective, the end result is a set of simultaneous
nonlinear equations from which the optimal lot sizes and markups must be obtained
using iteration methodology. Further details on the solution procedure will be given in
the next section.
Note that without the m s: 1 condition of (1), an unconstrained m, would lead to
n^ative markups, when G E [-1, 0]. In fact, an examination of the second-order
conditions indicates that a h i ^ y inelastic demand schedule is not compatible with
flexible markup policies, whenever a cost-plus pricing model such as that in (1) is used,
ance a G > 1 leads to an optimal m-*- co. Problems of this type have also been found
to be common to averi^e-cost pricing models (Kouteoyiannis 1979). In acklition, tiie
more re^rictive G < - 2 condition in (12) OIK% again illustrates the difficulties of
determining c(t-plus policies, wiien demand is relatively inelastic. The value of m3, for
C = 0 and G < - 2 , is ffven by G/iG + 2). Finally, tiw relation^ps among the wi/'s and
among the 9,'s appear in (8) and (13). Given the definitions of PR and RI, it can be

760

F. S. ARCELUS AND G. SRINIVASAN

easily shown that mi ^ m2 and qi ^92- The proo& for m2 ^ m^ and 92 ^ 93.> both by
contradiction, are straightforward and will be omitted.
5. Comparison of Results
An extensive set of proMems were used to study the effect on the optimal solutions of
different forms for the demand and cost functions. Examples of these forms include
Whitin (1955)'s demand structure, the discount functions in Ladany and Stemlieb
(1974), the teaming functions in Muth and Spreeman (1983), as well as the unit cost
case. Further analysis was carried out on the sensitivity of changes in the different
parameters of the models. To that effect, the price elastidty of demand, G, was allowed
to vary from -5.00 to -1.25 in steps of 0.25 and the other parameters were subject to
sequential changes of 10%, 20% and 50%. Full details appear in Arcelus and
Srinivasan(1986).
Only the effects of changes in G, for c' = 0 and with demand and price as defined by
(1) and (3), respectively, are discussed here. Figure 1 summarizes the necessary information. The following values for the different parameters were used: zo = 500 units,
7 = 100 per order or set-up, h - 0.45 per unit, A* = 0.15 per unit and c = 0.50 per unit.
All costs are in dollars. With (1) to (13), the computation of the optimal z,'s and /n,'s are
relatively straightforward. The ZEROIN routine of Forsythe, Malcolm and Moler
(1977) was used to solve the nonlinear equations of Results 1 and 2. This procedure
combines the bisection and the secant-iteration methods. Thus, conveigence at a very
high speed is guaranteed.
The graphs of Figure 1 include the optimal values of the order quantities, of the
markup rates and of the indices of preformance PR, RI and ROI, for selected values of
G. The results for RI and PR are entirely consistent with (8) and (13). That is to say, qi
> 92) with the difference increasii^ as G decreases and conversely, mi <m2, with the
difference decreasing along with the elastidty. As demand becomes more elastic, inventory policy will be more concemed with the determination of the order quantity, since
the profit margin will tend to zero, i.e., m-*- I. Similar behavior may be observed for
ROI. The main difference lies in the magnitudes of the values for the different variables,
specially in the case of the order quantities, with the 93's being substantially lower. This
is as it should be. If maximizii^ ROI is the objective, fewer units will be supplied at
higher mark up rates, since one would expect the investment base on inventory to be
kept as low as possible. Moreover, the results underline once more the advantages and
disadvantages of ROI as a performance evaluator. The low investment level required to
maximize ROI appears to be compatible with low budget ceilings and suggests a h^hly
efficient use of invested cajMtal. On the other hand, the opportunity forgone on at least
the most profitable investment rej:ted is likely to be above the firm's real cost of
a^ital. This is certainly a less than optimal investment strategy. Finally, further analysis, not shown here, sug^sts that optimal inventory polid^ are quite sensitive to
changes in the demand and in the unit exist and relatively independent of fluctuations
in either the order in or the holding costs. These results aLso appear to hold true for the
different forms of the cost, price and demand, previoudy outlined.
6. CtrndiBimis
Hie main t a ^ of tiiis paper has been the formulation of inventory models applicable
mostly to tte management offinMiedgootte, partkularly in r^ailing. Tte rationsde for
siK^ a stcdy Ves in tl^ treatment of tiiese inventor^ % wimt they {oe, namely inve^ments, to be eviduated in terms (^ thdr p r t ^ genoating potential. Such modeling
requires two fundan^nt^ (^IMGrtures from standaid invoitorytiie(Hy.llie first a)imsts

761

INVENTORY POUOES
ROI

350

ao

300

25

250

20

200

15
150

!0
100

05

50

5 -G

-G

LOT SIZE xlOO

25
20
15
10

RGURE 1. Sensitivity Analysis for the Constant Cost Case.

of the development of demand and price structures that explidtly relate demand to
price and price to cost. This fundamental connection between price theory and inventory control, advocated by Whitin as early as 1955, has been relatively neglected. The
second departure deals with the selection of optimizing criteria other than least cost and
more in line with investment analysis. To that effect, the three most widely used
evaluators of short-term investment performance have been used, namely profits, retum on investment and residual income. Our examination of the models brings up
clearly identifiable differences in strat^c decision making. An ROI maximizing manager will tend to follow a strategy of high maigin, low volume and low inventory,
whereas the RI and PR counterparts will be operating within a low margin, high
volume and high inventory frameworic.'
' Support by the Natural Sciences and Engineering Research Council of Canada for the completion of this
rsearch is gratefully acknoviedged.

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762

F. J. ARCELUS AND G. SRINIVASAN

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