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# European Journal of Operational Research 182 (2007) 730737

www.elsevier.com/locate/ejor

## On a stochastic inventory model with a generalized

holding costs
Lakdere Benkherouf *

Department of Statistics and Operations Research, College of Science, Kuwait University, P.O. Box 5969, Safat 13060, Kuwait

## Received 3 August 2005; accepted 4 August 2006

Available online 27 November 2006

Abstract

This paper is concerned with nding the optimal replenishment policy for an inventory model that minimizes the total
expected discounted costs over an innite planning horizon. The demand is assumed to be driven by a Brownian motion
with drift and the holding costs (inventory and shortages) are assumed to take some general form. This generalizes the
earlier work where holding costs were assumed linear. It turns out that problem of nding the optimal replenishment sche-
dule reduces to the problem of solving a Quasi-Variational Inequality Problem (QVI). This QVI is then shown to lead to an
(s, S) policy, where s and S are determined uniquely as a solution of some algebraic equations.

## 1. Introduction (A1) strictly positive except at 0, where f(0) = 0,

(A2) continuous and dierentiable except possibly
This paper is concerned with nding the optimal at zero with f 0 (x) > 0, if x > 0, and f 0 (x) < 0,
replenishment schedule for an innite horizon sto- if x < 0, R1
chastic inventory model. It is assumed that only a (A3) f(x) ! +1, as x ! +1, and 0 eax f 0 x
single product is held in stock. dx < 1, for all a > 0.
ax
Let x(t) refers to the level of stock at time t and (A4) fex ! 1, as x ! +1, and eaxf(x) < 1, as
assume that we are allowed to intervene at any time x ! 1, for all a > 0.
to increase stock to any level that we wish with set
up cost k > 0, unit cost c > 0, and holding costs Functions satisfying assumptions (A1)(A4)
given by some function f(x(t)). The function f is include power functions f(x) = O(jxjn). Further,
assumed to be: assume that costs are exponentially discounted at
a rate a > 0. Unmet demand is backlogged.
A replenishment policy consists of a sequence
(ti, Qi), i = 1, . . ., where ti represents the ith time of
*
Tel.: +965 4985387. ordering and Qi represents the quantity ordered at
E-mail address: Lakdereb@kuc01.kuniv.edu.kw time ti, where t1 < t2 <   .

doi:10.1016/j.ejor.2006.08.042
L. Benkherouf / European Journal of Operational Research 182 (2007) 730737 731

## Let (p  ac) > 0. This optimal impulse control policy is

of an (s, S) form and the pair (s, S) is determined
V n fti ; Qi gi1;...;n ; 1:1 as a unique solution of a system of a certain alge-
braic equation. This paper is an attempt to take
and set
the work of Sulem a step further generalizing the
V 1 lim V n V : function f(), while hoping to keep the nice structure
n!1
of the (s, S) policy.
Policies described by (1.1) are called impulse con- A variant of the model treated by Sulem was
trol policies. examined by Bather  where he showed that an
We shall assume that the dynamics of our inven- (s, S) policy is optimal for the case of minimizing
tory model is described by the following stochastic the total cost per unit time. His treatment was based
dierential equation: on a dynamic programming.
X In the next section, we formulate problem (1.4) as
dxt g dt r dwt Qi dt  ti ; 1:2 a Quasi-Variational Inequality problem (QVI). Sec-
iP0 tion 3 is concerned with the solution of the (QVI)
problem.
where d is the Dirac function. The quantities g, and
r are strictly positive real-valued parameters, and wt
is a standard Brownian motion. 2. The quasi-variational problem and optimal (S, s)
Let policy
Ft rfxs; s 6 tg; 1:3
In this section we shall be concerned with formu-
be the r-algebra generated by the history of the lating the problem given by (1.4) as a Quasi-Varia-
inventory level x(t) up to time t. tional inequality problem: see Benssousan and
Now, assume that for each n 2 N, Vn is Fn Lions . The formulation is presented for the sake
measurable, then the problem of nding the replen- of completeness. It is based on the dynamic pro-
ishment schedule which minimizes to the total graming principle of optimality. For that we x t
discounted costs over the innite planning horizon and observe the inventory in a short interval of
reduces to the problem of nding a sequence V* that length s. Thus we have:
solves (i) If an order is made in the interval (t, t + s),
"Z then (1.4) means that
1
yx inf V Ex f xteat dt Z ts
0 yx 6 E f xseast ds
# !
X  t
 
ati  
k cQi e x0 x ; 1:4 xt seas X t x : 2:1
iP0


## where the expectation is taken over all possible real-

To make things simple, write
ization of the process x(t) under policy V.
Sulem  treated the problem described in (1.4) xt s xt Dxs :
with the function f() taking the form
 Recall that E[wt] = 0, Ew2t  t. The Taylor
px for x 6 0 shortage cost expansion of the right hand side of (2.1) with (1.2)
f x
qx for x > 0 holding cost; gives

with p > 0, and q > 0. It is clear that the class of yx 6 sf xt yxt EDxs y 0 xt
functions f satisfying assumptions (A1)(A4) above 1 2
is very large and contains Sulems model as a special EDxs  y 00 xt  asyxt
2
case.
1
In her paper Sulem showed that, under some  asEDxs y 0 xt  asEDxs 2 y 00 xt
2
conditions on the parameters on the model, a 2
unique solution to the (QVI) exists if and only if Os ;
732 L. Benkherouf / European Journal of Operational Research 182 (2007) 730737

## leading to The solution y() of (2.4) is continuously dieren-

tiable and continuity at the boundary point s gives
1
0 6 sf xt  gsy 0 xt r2 sy 00 xt  asyxt from (3.2) that
2
Os2 ; y 0 s c: 3:3
The innimum in (3.1) is attained at S. This
where y 0 () and y00 (x) stands for rst and the second
implies that
derivatives of y.
Dividing by s and letting s ! 0, gives y 0 S c: 3:4

## 1 Further, y is continuous at s which means that

 r2 y 00 x gy 0 x ayx 6 f : (3.2) gives
2
yS ys  k  cS  s: 3:5
(ii) Now, if an order of size Q is placed at time t,
then the inventory level jumps from x(t) to x(t) + Q. Also, we require some for some technical reasons
This means that see: Bensoussan and Lions  that
yx
yxt 6 k inf Q cQ yxt Q: lim < 1: 3:6
x!1 f x
Let A and M be two operators dened such that Condition (3.6) is known as the growth con-
1 dition.
Ayx  r2 y 00 x gy 0 x ayx; 2:2
2 Remark 1. Our approach in showing that the (s, S)
Myx k inf Q cQ yxt Q: 2:3 policy is optimal starts by postulating that an (s, S)
policy satisfying requirements (3.1)(3.6). This solu-
Then, the optimal expected cost for the inventory
tion is then shown to be unique. Finally, the pair
model is given as a solution of the following (QVI)
(s, S) is shown to be lead to the optimal solution of
problem:
8 the (QVI).
>
< Ay 6 f;
Let
y 6 My; 2:4
>
: Lx yx cx;
Ay  f y  My 0:
then Ay = f reduces to
1
3. Solution of the QVI problem  r2 L00 x gL0 x aLx
2
In our quest to solve the (QVI) given by (2.4) we f x acx gc: 3:7
shall initially follow Sulem  and divide the inven- It follows by (3.3) and (3.4) that L 0 (S) = L 0 (s) = 0.
tory space into two regions: the continuation region
C fx 2 R; yx < Myxg fx 2 R; x > sg; Lemma 1. The solution s satisfying (3.3)(3.6) if it
exists must be strictly negative.
where no order is made and
Ay f ; Proof. Assume that s > 0. Note that since S > s,
and f is an increasing function we have by (3.3),
where A is dened in (2.2). The complement
(3.4), and (3.7)
C fx 2 R; yx Myxg fx 2 R; x 6 sg; 1 1
 r2 L00 S aLS >  r2 L00 s aLs: 3:8
where M is given by (2.3), corresponds to the states 2 2
where an order is made. We call C the stopping We shall consider the possibilities
region.
In C, we have (i) L00 (s) P 0, L00 (S) P 0,
(ii) L00 (s) P 0, L00 (S) < 0,
yx k inf Q cQ yx Q; 3:1 (iii) L00 (s) < 0, L00 (S) P 0,
k cS  x yS: 3:2 (iv) L00 (s) < 0, L00 (S) < 0.
L. Benkherouf / European Journal of Operational Research 182 (2007) 730737 733

Expression (3.5) shows that L(S) < L(s). Clearly yx c1 sek1 x c2 sek2 x y p x; 3:12
possibility (iii) cannot hold since (3.8) will not be
valid. If (i) holds, this in turn implies that there exits where
some x* 2 (s, S) such that L 0 (x*) = 0, L00 (x*) 6 0 and Z x
2
y p x fek1 xt  ek2 xt gf t dt;
1 1 r2 k1  k2
 r2 L00 S aLS >  r2 L00 x aLx ; 0
2 2
and c1(s) and c2(s) are parameters depending on s.
which also cannot be true. Now for (ii) to hold,
there must exists x1 2 s; S, and x2 2 s; S with 2
x1 < x2 , such that L0 x1 L0 x2 0, L00 x1 6 0, y p x
r2 k
1  k2
L00 x2 P 0, and Lx1 > Lx2 . Again we have Z x Z x
k1 xt k2 xt
1 1  e f t dt  e f t dt :
 r2 L00 x2 aLx2 >  r2 L00 x1 aLx1 ; 0 0
2 2
which cannot be true. The possibility (iv) is treated Integrating by the parts the rst integral and using
in a similar fashion. Consequently a value of s > 0 lHopital rule for the second integral as x ! 1
cannot be accepted as a solution satisfying (3.3) yields
(3.6). h 2
y p x 
Rewrite Ay = f in the form r2 k1  k2
 Z x
2 2a 2 k2  k1 1
y 00  2 gy 0  2 y  2 f : 3:9  f x ek1 x ek1 t f 0 t dt :
r r r k1 k2 k1 0
A general solution of (3.9), for x < 0, is given by R x k t 0
But 0 e f t dt is bounded by assumption
1

## yx a1 sek1 xs a2 sek2 xs y p x; 3:10 (A3). Therefore

where 1
y p x  f x gek1 x ;
1 p a
k1 2 g g2 2ar2 ;
r
1 p for some strictly positive g. Hence, for (3.12) to be
k2 2 g  g2 2ar2 valid as a solution of Ay = f with the growth con-
r
dition (3.6) and Assumption (A4) the coefcient
and yp is a particular solution. The values a1(s), and
c2(s) must vanish, in which case the value function
a2(s) are parameters (depending on s) which are ob-
in the continuation region is
tained by using the boundary condition y 0 (s) = c
and the value of y(s). yx a2 sek2 xs ~y p x;
The variation of the parameters method shows
that yp can be written as where ~y p x  f x. This leads to the required
Z x result. h
2
y p x  2 fek2 xt  ek1 xt gf t dt:
r k2  k1 s Now consider the dierential equation
3:11 Ay f ;

Lemma 2. Let y denotes the solution of the differen- where A is given by (2.2). Write
tial equation Ay = f in the interval (0, 1), where A is 
y x; if x > 0;
given by (2.2). Then in order for hypothesis (3.6) to yx :
y  x; if x 6 0:
hold
If x 6 0, then y coincides with the solution y
yx  c2 sek2 x ~y p x;
given in (3.10) and yp given by (3.11). The coe-
as x ! 1 where ~y p x Of x, and c2(s) is some cients a1 and a2 can be found from solving the sys-
parameter depending on s. tem of equations:
y  s ys;
Proof. In view of (3.10) and (3.11), the solution y
for x P 0 of Ay = f may be represented by y 0 s c;
734 L. Benkherouf / European Journal of Operational Research 182 (2007) 730737

## which gives Lemma 3. As s ! 0, in (3.16) and (3.17) and S is a

a1 s a2 s ys; solution of (3.18) we have
k1 a1 s k2 a2 s c: Ls < k LS:
Thus
Proof. Note that as s ! 0, (3.16) and (3.17)
1
a1 s fk2 ys cg; 3:13 become,
k2  k1
1 a1 s a2 s  c2 s
a2 s fk1 ys cg: 3:14
k1  k2
k1 a1 s k2 a2 s  k2 c2 s;
If x > 0, then the argument used in the proof of
Lemma 1 shows that from which we deduce that a1(s) ! 0 as s ! 0, and
y x c2 se k2 x
y p x; 3:15 a2(s)  c2(s). It follows from (3.13) that

## for some c2(s) and c

ys   ; 3:20
Z x k2
2
y p x  2 ek2 xt f t dt:
r k2 0 and hence a2(s) = c/k2 by (3.14). Recalling (3.15)
Now, the matching conditions at the point means 0 we have
means that y(0) = y+(0), and y 0 0 y 0 0, which  Z S
0 k2 S 2 k2 St
give since f(0) = 0 y S ce  2 f S k2 e f t dt
r k2 0
2
a1 sek1 s a2 sek2 s  2 c: 3:21
r k2  k1
Z 0 Clearly S = 0, is a solution to the above equation.
 ek2 t  ek1 t f t dt c2 s; 3:16 Also, (3.21) with (3.15) imply that
s
2 2
a1 sk1 ek1 s a2 sk2 ek2 s   f S c  k2 yS:
r2 k 2  k1
r 2 k2
Z 0
The left hand side of the above relation is strictly
 k2 ek2 t  k1 ek1 t f t dt k2 c2 s: 3:17 positive by Assumption (A1). This in turn implies
s
that yS >  kc2 ys (by (3.20)). This leads to
It is clear, using (3.13) and (3.14), that y(s) and c2(s)
the required result. h
can be uniquely determined as a function of s from
the above system of equations. We shall not give
Lemma 4. As s ! 1, ys ! 1a f s.
the details of the algebra as it is straightforward.
Now, the problem of nding (s, S) satisfying (3.3)
and (3.4) may be restated as that of nding (s, S) Proof. Using (3.16) and (3.17) one can show that
such that R0
2 s ek1 t f t dt
L0 S 0; 3:18 a1 s 2 :
r k1  k2 ek1 s
and
Let s ! 1, and use lHopital rule to get that
Ls k LS: 3:19 a1 s  r2 k1 k21 k2 f s.
We shall call the system of nonlinear equations This in turn leads using (3.13) after some simple
generated by Eqs. (3.18) and (3.19) system (E), algebra to the required result. h
and show that system (E) has a unique solution if
the function r dened by Lemma 5. Assume that r(x) ! +1, then as
rx : f x acx; s ! 1, the solution S to y 0 (S) = c exists and is
finite.
is decreasing for x < 0. The proof is long and is done
in stages. Proof. Let s ! 1, and use (3.16) and (3.17) to
We remark before we proceed to the proof that show that
r(0) = 0, and the requirement that r be decreasing
for x < 0 implies that r(x) > 0, for all x 2 R. c2 s  a2 sek2 s :
L. Benkherouf / European Journal of Operational Research 182 (2007) 730737 735

Lemma 4 and (3.14) yield x ! +1, implies that there must exist an e S > S,
 S 0, L00 e
with L e S P 0 and Lx > LS > L e
S .
1 k1
c2 s  f s c ek2 s : For this Se
k1  k2 a
1 1
Clearly c2(s) must be bounded and positive by  r2 L00 x aLx <  r2 L00 e
S aL e
S;
Assumption (A4). Therefore, the term c2 sek2 x ! 2 2
0, as x ! +1 uniformly in s. It follows after some which leads to a contradiction. This completes the
computations similar to that of Lemma 2 that proof. h
y(x) ! +1, as x ! +1, uniformly in s. h
An argument similar to the one used in the proof
of Lemma 6 leads to the following result.
Corollary 1. Under the hypothesis of Lemma 5, we
have as s ! 1 Lemma 7. Assume that r is decreasing for x < 0 and
Ls > k LS: increasing for x > 0 and that (s, S) is the solution of
system (E), then
Proof. Under the hypothesis of Lemma 5, and using L0 x 6 0; s6x6S
Lemma 4 we have L(s) ! +1, as s ! 1. Also, 0
L x P 0; x P S:
we have L(x) ! +1, as x ! +1, uniformly in s.
Therefore there exists a nite S 2 R such that
Theorem 1. If r is decreasing for x < 0, and that (s, S)
L 0 (S) = 0. For this particular S, we have as s ! 1
is the solution of system (E), then this solution is also
Ls > k LS; optimal for the (QVI) problem (2.4).
which leads to the required result. h
Proof. We need to show that y < My, for x P s
The next step is to show that if the function r is and Ay 6 f, for x 6 s. To show Ay 6 f for x 6 s.
decreasing for x < 0, then the (s, S) policy prescribed Let x 6 s, then (3.2) gives
is indeed the optimal and unique solution of the
(QVI) (2.4). This will be done in a number of steps. yx k cS  x yS ys cs  x:

## Lemma 6. Assume that f(x) + cx is decreasing for Also, we have Ay 6 f is equivalent to

x < 0 and that (s, S) is the solution of system (E), then gc ays acs 6 f x acx rx
L00 (s) 6 0.
But r is decreasing for x < 0, and x 6 s < 0, then it is
00 enough to show that
Proof. Assume that L (s) > 0. The fact that
L(S) < L(s), implies there exists some x* 2 (s,S) such gc ays acs 6 f s acs;
that L 0 (x*) = 0, L00 (x*) 6 0, and L(x*) > L(S).
Assume rst that x* < 0, then straight application which is equivalent to
of (3.7) with the hypothesis that r is decreasing for gc ays 6 f s:
x < 0, yields to
1 1
 r2 L00 x aLx <  r2 L00 s aLs; 1
2 2  r2 y 00 s  gc ays f s;
If x* > 0, then we get by (3.7) that and y00 (s) < 0, by Lemma 6, hence Ay 6 f. To show
that y < My for x P s, note that
1 1
 r2 L00 x aLx <  r2 L00 S aLS: Myx k cS  x yS; for s 6 x 6 S;
2 2
We get a number of possible scenarios as in the Myx k yx; for x P S:
proof of Lemma 1 On the interval (s, S) the function y  My whose
values
(i) L00 (x*) < 0, L00 (S) P 0,
yx  Mx yx cx  cS  yS  k;
(ii) L00 (x*) < 0, L00 (S) < 0.
is decreasing by Lemma 7, from 0 to k and is equal
Clearly scenario (i) cannot happen. If scenario to k for x > S, which leads to the required
(ii) happens, then the fact that L(x) ! +1, as result. h
736 L. Benkherouf / European Journal of Operational Research 182 (2007) 730737

## It is worth noting at this stage that if r is decreas- ek1 x

A0 4 ! 1; as x ! 1; and
ing for x < 0, then the solution (s, S) is the solution f x
of system (E) is unique. The argument for showing ek2 x f x < 1; as x ! 1:
this follows along the same lines of the proofs
of Lemma 6 where if another solution of (E) is
Remark 3. Note that if you let the discount factor a
assumed then this solution leads to some con-
goes to zero and consider replenishment schedule
that minimizes the average expected costs per unit
Theorem 2. If the function r is increasing for x time, then a similar (QVI) approach to the problem
< 0, then there is no solution to the (QVI) problem of minimizing the total expected costs can be
(2.4). adopted. As before one may consider impulse con-
trol policies of the form V = {(ti, Qi)}i=1,. . ., where
Proof. Assume that there is a solution (s, S) to the tis represents the ordering times and Qis the quan-
(QVI) problem. Then tity ordered. Write

Ay 6 f ; for all x 6 s; y V x
hR P i
which is equivalent to T
f X tdt
Ex 0 ti 6T K cQi jX 0 x
1 gc lim ;
Ls 6 f x acx : 3:22 T !1 T
a a
where the dynamics of the process are given by (1.2)
(i) If f(x) + acx is strictly increasing, then clearly and the expectation is taken with respect to all real-
inequality (3.22) is violated when x ! 1. ization of the process. Then, we say that V* is aver-
Hence (s, S) cannot be a solution. age cost optimal if
(ii) If f(x) + acx = 0, then (3.22) gives y V  x inf V y V x: 3:23
gc Let l y V  x. Then, it is known: see Lions and
Ls 6 ;
a Perthame ,
that the optimal cost y in ((1.4)) be-
which in turn leads by (3.19) to haves like la y 0 where y0 satises the following
(QVI) problem:
gc 8
LS 6  k: e
a >
< Ay 0 6 f
Now, using the fact that AL(S) = f(S) + acS + gc, y0 6 Mu;
>
: e
and L 0 (S) = 0, we get Ay 0  f y 0  My 0 0
1
 r2 L00 S f S acS gc  aLS: with
2
e 1
Therefore Ayx  r2 y 00 x gy 0 x l; 3:24
 2
1 gc ak; if S < 0
 r2 L00 S P and M is dened in (2.3). The optimal (s, S) policy
2 f S acS gc ak; if S > 0: obtained from (2.4) converges to the optimal policy
minimizing the expected average future costs.
Note that the right-hand side of the above inequal-
ity is strictly positive while the left hand-side is neg- This paper was concerned with the problem of
ative since S is the minimum of the function L, nding the optimal replenishment policy for an
which leads to a contradiction. h inventory model that minimizes the total expected
discounted costs over an innite planning horizon.
Remark 2. Note that, by going through the proofs The demand is assumed to be driven by a Brownian
of the results of the paper, assumptions (A3) and motion with drift and the holding costs (inventory
(A4) can be weakened and replaced by and shortages) are assumed to take some general
form. This generalizes the earlier work where hold-
A0 3 f x ! 1; as x ! 1; and
Z 1 ing costs were assumed linear. It turns out that
ek1 x f 0 x dx < 1; problem of nding the optimal replenishment sche-
0 dule reduces to the problem of solving a Quasi-Var-
L. Benkherouf / European Journal of Operational Research 182 (2007) 730737 737

## iational Inequality Problem (QVI). This QVI was References

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The author would like to thank Brian Gilding  A. Sulem, A solvable-one dimensional model of a diusion
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