European Journal of Operational Research 153 (2004) 769781 www.elsevier.

com/locate/dsw

Stochastics and Statistics

Customer lead time management when both demand and price are lead time sensitive
Saibal Ray a, E.M. Jewkes
a

b,*

Faculty of Management, McGill University, 1001 Sherbrooke Street West, Montreal, Que., Canada H3A 1G5 b Department of Management Sciences, University of Waterloo, Waterloo, Ont., Canada N2L 3G1 Received 25 October 2000; accepted 23 August 2002

Abstract In this paper, we model an operating system consisting of a rm and its customers, where the mean demand rate is a function of the guaranteed delivery time oered to the customers and of market price, where price itself is determined by the length of the delivery time. Economies of scale are present. The rms objective is to maximize prots by selecting an optimal guaranteed delivery time taking into account that (i) reducing delivery time will require investment, and (ii) the rm must be able to satisfy a pre-specied service level. We show that it is imperative for managers to know whether customers are price or lead time sensitive based on the simultaneous dependence of price and demand on delivery time before selecting a time-based competitive strategy. We investigate the optimal policy and provide managerial insights based on our analysis. Examples where our insights are consistent with actual practical situations are also provided. We show that our model is dierent from those in the literature that assume price and delivery time to be independent decision variables and present conditions under which ignoring the relation between price and delivery time can lead managers to substantially sub-optimal decisionswith or without the presence of economies of scale. 2002 Elsevier B.V. All rights reserved.
Keywords: Delivery time strategy; Investment and capacity analysis; Economics of queues

1. Introduction In the past decade, practitioners have focused on speed as the basis of competitive advantage (Stalk and Hout, 1990; Blackburn et al., 1992). Companies use three main strategies to utilise speed to attract customers: (i) to serve customers as fast as possible, (ii) to encourage potential

Corresponding author. Fax: +519-746-7252. E-mail address: emjewkes@engmail.uwaterloo.ca (E.M. Jewkes).

customers to get a delivery time quote prior to ordering, and (iii) to guarantee a uniform delivery lead time for all potential customers (So and Song, 1998). Many companies, specically in the service and make-to-order manufacturing sectors, are adopting the third strategy of advertising a uniform delivery time for all customers within which they guarantee to satisfy most orders (refer to examples in So, 2000; So and Song, 1998; Rao et al., 2000). While this strategy may attract many customers, there is a risk that demand may exceed the rms capacity to respond. This can lead to a penalty cost for the manufacturer or it

0377-2217/$ - see front matter 2002 Elsevier B.V. All rights reserved. doi:10.1016/S0377-2217(02)00655-0

770

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

might lead to a decrease in repeat business. With this strategy, it is important to have some internal mechanism in place to ensure that the promised delivery times are feasible and reliably met. Since the late 1980s, a large volume of operations management literature has recognized that customer demand increases with lower delivery times as well as with lower prices (Blackburn et al., 1992; So and Song, 1998; So, 2000). Karmarkar (1993) pointed out that lead times are most probably inversely related to market shares or price premiums or both. So and Song (1998) noted that shorter delivery times can allow a price premium, e.g., shipping costs from Amazon.com are more than double when the guaranteed delivery time is around two days than when it is around one week. As well, recent industry practice suggests that customers may be willing to pay a price premium for shorter delivery times (Blackburn et al., 1992; Weng, 1996; Magretta, 1998; Gupta and Weerawat, 2000). The potential for increased demand and/or a price premium creates an incentive for rms to reduce the length of the delivery time. One of the ways that rms can reliably satisfy a short delivery time is by investing in increasing capacity (So and Song, 1998; Palaka et al., 1998). Firms then must trade-o the potential for increased demand and price against the costs of investment. It is well known that economies of scale can bring down unit operating costs in manufacturing facilities and even in service facilities (Scherer, 1980). Hence, operations management models have sometimes assumed unit operating costs to be a decreasing function of demand. In this paper, we model an operating system of a rm and its customers where demand is a function of market price and a uniform guaranteed delivery time and the market price is determined by the length of the delivery time. We then expand our initial model to incorporate economies of scale. More specically, this paper presents an analytical approach for a rm to maximize its prot by optimal selection of a guaranteed delivery time. Mean demand rate is modeled as a decreasing function of price and delivery time while price itself is a decreasing function of the guaranteed delivery time. The model takes into account that

reducing delivery time by increasing capacity will require investment, the rm must be able to satisfy the guaranteed delivery time according to a prespecied reliability level, and higher demand can reduce unit operating costs, i.e., economies of scale exist. In Section 2, we summarise some of the relevant literature while Section 3 presents our initial analytical model assuming operating costs per unit to be constant. In Section 4 we show how our model diers from the existing models in the literature which assume price to be independent of delivery time. Section 5 extends the basic model to include economies of scale. Our conclusions and future research opportunities are provided in Section 6.

2. Literature review Since the paper by Stalk and Hout (1990) on time-based competition, there has been extensive research on the eects of customer responsiveness as a strategic competitive weapon (Hum and Sim, 1996). While much of this literature is qualitative, there are a number of quantitative contributions. Many of the quantitative models focus on the effects of lead time reduction on operational decisions such as batch size and quality (for a detailed review refer to Karmarkar, 1993) and demand is typically assumed to be an exogenous parameter. Economics and marketing oriented research recognizes that longer lead times might have a negative impact on customer demand. Research in this area typically focuses on internal pricing and capacity selection issues for service facilities by taking into account users delay costs and capacity costs (Dewan and Mendelson, 1990). There also exists a stream of literature that investigates the use of quoted customer lead times to explore the impact of due-date setting on demand and protability (refer to Weng, 1999). Hill and Khosla (1992) constructed a model where demand is a function of actual delivery time and price and the rms objective is to maximize prot by optimal selection of price and delivery time, but their model is totally deterministic. Several authors have investigated the issue of shorter delivery time in a game-theoretic frame-

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

771

work. For example, Lederer and Li (1997) studied competition between rms serving delay-sensitive customers and the resulting impact on price, production rate and scheduling policies. Ha (1998) derived pricing schemes that induce customers to choose optimal service rates in a competitive framework when services are jointly produced by the customers and the facility. For other related research based on game-theoretic models refer to literature review in So and Song (1998). While all the above lines of research are important, as So and Song (1998) point out, they are basically dierent from the recently popular strategy of committing to a uniform delivery time guarantee for all customers, the focus of this paper. In the case of a delivery time guarantee, rms advertise a uniform delivery time for all customers within which they guarantee to satisfy most customer orders. The length of the delivery time is a decision variable that directly aects overall demand and a reliability constraint is used to ensure a satisfactory service level once the delivery time is selected. In perhaps the rst research paper directly addressing the issue of uniform guaranteed delivery time, So and Song (1998) model the rm as a queuing system where the mean customer demand has a log-linear relationship with price and delivery time. The objective is to maximize the prot per unit time by suitable selection of the decision variable valueslength of the guaranteed delivery time, price and capacity. They characterize the optimal decision, perform analytical comparative statics and provide useful managerial insights on the eect of operating characteristics on the optimal strategy of a rm. In Palaka et al. (1998), the objective function, capacity costs and decision variables are similar to that of So and Song albeit in a linear demand framework. However, Palaka et al. explicitly take into consideration work-in-process and penalty costs whereas So and Song do not. So (2000) extended So and Songs work by focusing on how rms select the best price and guaranteed delivery time in the presence of multiple-rm competition and how dierent rm and market characteristics aect the optimal strategy. Rao et al. (2000) integrate a uniform delivery time strategy with production planning for a make-to-order rm with

time-dependent demand. The production schedule for the rm is synchronised with the guaranteed delivery time and the rm optimises on the delivery time to maximize the average expected prot per period. While the papers based on uniform delivery time framework assume demand per unit time to be dependent on price and/or delivery time, they do not consider the relationship between price and delivery time. As mentioned earlier, customers may be willing to pay a price premium for shorter delivery times. We extend previous research by explicitly modeling such a relationship between price and delivery times. Numerical examples from previous research also show that operating costs play an important role in the optimal decision. However, no previous work analytically models the eect of demand on operating costs. We include economies of scale by modeling the unit operating cost as a decreasing function of the mean demand rate.

3. The analytical model We consider a rm that announces a uniform guaranteed delivery time (L), a decision variable, for all its customer orders. Orders arrive according to a Poisson process with mean rate k. The processing times of the orders are exponentially distributed with mean rate l. Customers are served in a rst-come-rst-served fashion, and the arrival rate depends on the market price of the service/ product (p) and the delivery time, L. We assume that customers prefer shorter delivery times and lower prices and that price is related to the length of the guaranteed delivery time; specically that the price, p, is higher for a shorter L. The rm has established an internal target delivery time reliability level, sR (0 < sR < 1), which is the probability that a random customer will have an actual waiting time of L or less. As failure to satisfy an arriving customer within the guaranteed lead time L might have an adverse impact on repeat business, the rm has set the internal target to be close to 1. The rm can invest in increasing the processing rate, l, through for example, hiring extra workers

772

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

or acquiring improved equipment. In general, it is reasonable to assume that successive investments in increasing l by the same amount will cost equal or more, i.e., the investment function, Ml, is increasing and linear/convex in l. In our initial model, we will assume that the investment function takes a linear form, Al (So and Song, 1998; Palaka et al., 1998), to obtain analytical results. We will later discuss the extension to non-linear investment functions. The rm has a unit operating cost of m per unit, initially assumed to be constant (i.e., economies of scale do not exist). Finally, the objective of the rm is to maximize its prot per unit time subject to satisfying the delivery reliability constraint. To further characterize the analytical model, we now elaborate on the precise relationships between k, p, and L. We assume that the mean demand rate depends linearly on L and p, i.e., kp; L a b1 p b2 L; 1

where a0 a b1 d

and

b0 b2 b1 e:

where a denotes the mean demand rate when both p and L are zero (a higher value of a represents a higher overall potential for demand) and b1 and b2 represent the price and lead time sensitivities of the mean demand rate, respectively (a; b1 ; b2 > 0). The linear demand function will help us to obtain qualitative insights without much analytical complexity. It also has the desirable properties that the price and lead time elasticity of demand are higher at higher prices and guaranteed delivery times (refer to Palaka et al., 1998). We explicitly model price premiums for shorter delivery times by assuming that the price is determined by the length of the guaranteed delivery time and that a shorter delivery time can command a higher market price. For a given L, the market price, p, is given by p d eL; 2

While the link between k, p and L has been used before in the literature, the explicit dependence of p on L is an additional relationship that we introduce (Gupta and Weerawat, 2000, also relates price and lead time in a similar fashion but in a dierent context). Though the new link reduces the number of decision variables, it captures for managers a relationship that exists in practice, and, as we will show later in the paper, could lead to a decision error if ignored. First, we will assume a0 > 0, since otherwise when b0 is positive, k will be negative for all L. If b0 > 0, k decreases with L, which is the case to which most operations management literature refers. This represents the situation when customers are more lead time sensitive than price sensitive. We will henceforth refer to these customers as lead-time-sensitive (LTS) customers. Some thought shows that b0 6 0 (i.e., b1 e P b2 ) also makes sense when customers are ready to wait longer to pay a lower price, in which case k increases (or remains constant) with L. In this case the customers are more price sensitive than lead time sensitive. We will refer to these customers as price-sensitive (PS) customers. Note that the customer preferences are based not only on b1 and b2 but also on e. This type of price and lead time sensitivity of customers has been referred to in the literature before. Blackburn et al. (1992) and Smith et al. (1999) pointed out that there are both price sensitive and time-sensitive customers in the market. The former segment prefers a lower price even with longer delivery times while the latter segment is ready to pay a price premium for shorter delivery lead times. Since the rm wishes to maximize prot per unit time, its goal can be written as
P1 Maximize pl; L pL mkL Al; Subject to s P W < L 1 elkL P sR delivery reliability constraint; l > k system stability constraint; p > m > 0; L; k > 0 non-negativity constraints;

where d price when L 0, i.e., the maximum price the market is willing to pay, and e delivery time sensitivity of price (d; e > 0). Combining (1) and (2) we can express k in terms of L and system parameters as kL a b1 d b2 b1 eL a b L;
0 0

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

773

where W is the steady state actual waiting time for a random order, kL is given by (3), and pL by (2). For Poisson arrivals and exponential service times assumptions, the form of the delivery reliability constraint is exact. However, note that for high service levels, the tail of the waiting time distribution is well approximated by the exponential distribution even for a G=G=s queue (refer to So and Song, 1998). Hence, our model is approximately valid for more general demand and service time characteristics. It is not dicult to show that P1 is decreasing concave in l, and that at optimality, the delivery reliability constraint must be binding (So and Song, 1998; Palaka et al., 1998). The optimal l, lR L, is then lR L ln1 sR kL: L 5

Example 1 (b2 20). We have b0 b2 b1 e 55, and k 100 55L. In this example, customers are price sensitive. Example 2 (b2 100). We have b0 b2 b1 e 25 and k 100 25L. In this example, customers are lead time sensitive. Recall that for b0 6 0, customers are price sensitivethey are willing to wait longer if they can pay a lower price. Comparison of Examples 1 and 2 shows the eect of the change in sign of b0 on the optimal decision variable values capacity, demand and prot. For PS customers, it is intuitive that L is larger and p is smaller than for LTS customers. Note that the above examples are only illustrativedepending on the parameter values, the dierences in L and p can be higher or lower. Obviously as L increases, p will decrease. From (5) we can also show that lR L is monotone decreasing in L for LTS customers (b0 > 0), but may not be monotone for PS customers (b0 6 0). For PS customers, as L initially increases from a very low value, the capacity costs decrease. However, as L becomes large, the price becomes very low. This brings about high demand from PS customers and then capacity cost again increases. It is for this reason that l for PS customers is greater than l for LTS customers in the examples. 3.1. Comparative statics and managerial insights Now that we have seen how to determine the optimal delivery time, it is useful from a managerial viewpoint to understand how the behavior of the optimal solution will be aected by changes in system parameters. Table 2 illustrates the eects of some rm and market characteristics on the optimal delivery time, L (see Appendix B for mathematical proofs). While such analysis can be done

Since the reliability constraint is binding, explicitly modeling a penalty cost (per unit) in the objective function is also straightforward (So, 2000). Substituting lR L given by (5) for l, the prot function in P1 can be expressed in terms of a single variable L. Appendix A gives the details of determining the prot-maximizing delivery time, L , for the rm. From the appendix it is clear that a mild restriction on the parameter values can guarantee a unique L . If pL is positive for some feasible region of L, the rm can announce L and set its processing rate based on (5) to satisfy the service level. The optimal market price, p , will be determined by (2). These p and L values will then induce the mean demand rate given by (3). To illustrate, rst let us provide two numerical examples with the following parameters: a 250, b1 5, d 30, e 15, m 2, A 12 and sR 0:99. The optimal solutions are provided in Table 1.

Table 1 Comparison of L , lL , pL and pL for Examples 1 and 2 b0 Example 1 Example 2 )55 25 L 0.23 0.18 p lR L kL pL 26.48 132.54 27.35 121.62 112.90 1173.58 95.58 963.23

Table 2 Change in L with increase in individual parameter values Parameter A m Eect on L for b0 > 0 Increases Increases Eect on L for b0 6 0 May increase or decrease Decreases

774

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

for all the parameters (Ray, 2001), we focus on two that generate seemingly counter-intuitive results. Specically, we look at what happens to L as each of the parameter value increases. The initial observation from Table 2 is that the eect of the parameters on L depends strongly on sign of b0 . Hence, managers must first ascertain whether they are competing for primarily lead time sensitive (b0 > 0) or price sensitive (b0 6 0) customers when deciding their delivery time strategy. Impact of capacity expansion costs, A. A rm serving LTS customers and mildly PS customers, will naturally seek to increase L , and thus reduce demand and hence the investment requirement. For rms with highly PS customers, any increase in L will decrease price and so increase demand and also the capacity investment requirement. Hence, for such rms, as investment costs increase, it is optimal to decrease L (i.e., compete based on time) despite the fact that they have PS customers. This is less obvious, but understandable from the point of view that such an action will increase price, decrease demand and hence their capacity investment. Impact of unit operating costs, m. Firms with low unit operating costs (m) and PS customers should guarantee a relatively long delivery time. This will lead to a low market price, high demand and ultimately maximized prots. Alternately, rms with low unit operating costs with LTS customers should compete based on time in order to capture the maximum price premium. For high values of m, the prot-optimizing strategy for such rms is the reverse. Note that the implications provided by our results are consistent with actual industry practice. For example, some courier services companies and third-party logistics providers initially started by serving PS customers. However, as demand increased and capacity costs (Al) became an issue, these companies resorted to time-based competition by guaranteeing a smaller delivery time and charging a price premium. We can also relate the insight provided by the eect of operating costs (m) in the following setting. Compare the strategy of local small computer clone assemblers to that of a large company such as Dell both of which have low operating costs, the former because of low

infrastructure costs and the latter because of eciency. Since Dell serves LTS customers, it competes based on time and extracts a price premium their customers are willing to pay. The local assemblers know that their customers are price sensitive in nature, and so they compete based on price rather than time in order to maximize their prots. Hence, companies with the same operating costs may choose to compete on a different basis if they are aware of their customer preferences. However, as we indicated before, rms with high operating costs will have just the opposite strategy for each type of rm. In the next section we show that our model is quite dierent from models where price is assumed to be an independent decision variable (as in So and Song, 1998; Palaka et al., 1998).

4. Price as an independent decision variable In this section, our goal is to see the eect on optimal decision variable value(s) and prot if managers fail to take into account the dependence of price on the length of the delivery time (as in (2)) and assume p to be a decision variable independent of L. With p and L both as decision variables, kp; L a b1 p b2 L (b1 ; b2 > 0). The rms prot-maximization problem is similar to P1 with pl; p; L kp; Lp m AlR p; L. Note that the optimal capacity, lR , in this case depends on both p and L, lR p; L ln1 sR =L kp; L. We will refer to this model as Model 1 and its optimal price and delivery lead time guarantee as p1 and L respectively. Our original model will 1 be referred to as Model 0.
Proposition 1. The optimal price for Model 1, p1 , can be found as follows: p1 L

Am a b2 L: 2 2b1 2b1

Assuming that the price will be determined optimally for all L, a mild condition can guarantee that the firm will be able to ascertain its unique optimal delivery time, L , by solving a relatively simple 1 equation.

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

775

Proof. Refer to Appendix C.

Comparing (2) and (6), it is immediately obvious that the optimal price is decreasing in delivery time for both models, but that the rate of decrease will depend on whether customers are price sensitive or lead time sensitive. For PS customers, the rate of decrease for Model 0 is greater than Model 1; for LTS customers, the result will depend on the relative values of b1 , b2 and e. Note that when the relationship between price and delivery time is not considered, then the demand sensitivity of the customers is based only on the relative values of b1 and b2 . The sensitivity of price itself towards delivery time (e) is not taken into account and hence we do not have information about the overall customer preferences. Comparing the optimal delivery lead time values for the models, we have the following proposition: Proposition 2. L 6 L except in the special case 1 when L L A2 A1=B1 B2, where A1 1 b0 A m d a0 e, A2 b2 =2A m b2 a= 2b1 , B1 2eb0 , B2 b2 =2b1 and C Aln1sR . 2 Specifically, when A16A2, L < L . 1 Proof. Refer to Appendix D.

can be substantial. Using L in Model 0 can lead to 1 two types of mistakes(1) investing in lead time reduction to guarantee a shorter delivery lead time when customers are price sensitive, want lower prices and are willing to wait longer, or (2) not providing short enough lead times when the market is willing to pay a price premium for shorter lead times. These results are consistent with the empirical work of Sterling and Lambert (1989) who found that management frequently sets attribute levels inconsistent with customer preferences, not realising that customers have dierent needs than the seller. We have established the signicance of our model and the dierence between it and those existing in the literature. From a managerial viewpoint, it is important to understand under what conditions will it be essential to explicitly account for the interaction between price and delivery time, i.e., when using L in place of L for Model 0 will 1 result in a substantial prot loss for the rm and when such a step will be valid. We list the conditions below (refer to Appendix D): Large dierence between L and L and hence 1 substantial prot loss by using L for L in 1 Model 0 can occur for large values of e, i.e., price is very sensitive to L (L ( L ), 1 for large values of b1 , i.e., demand is very sensitive to price, and large values of d, i.e., potentially expensive product (L ) L ), 1 for large values of b1 and small values of d (L ( L ), 1 for large values of b2 , i.e., demand is very sensitive to L (L ) L ), 1 for small values of A and/or m and large values of b1 and/or e (L ) L ). 1 L1 % L and prot loss by using L for L in 1 Model 0 is small for large values of a (i.e., high potential for demand), for small values of b0 . Based on these results, we observe that it is important to take the price and delivery time relationship into account when the rm is serving either (I) very LTS customers, or (II) very PS

Proposition 2 shows that taking into account the relationship between price and delivery time will, in general, give a dierent optimal solution than assuming p is an independent decision variable. The dierence in optimal delivery times implies that there will be a prot penalty for rms in not taking into account the dependence of price on delivery time. Example 3. Using the same parameter values as in Example 1, but assuming that p and L are inde pendent decision variables, we have p1 31:20 and L1 0:40. Note that L1 is almost 74% more than L . Using L in place of L in Model 0 will 1 lead to p 24 and an associated prot of 1081.1, a loss in prot of almost 8.6%. While Example 3 is simply illustrative, other computational work conrms that L can be either 1 larger or smaller than L , and that the loss in prot

776

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

customers, or (III) potentially very expensive products, or (IV) when price is very delivery time sensitive. On the other hand, when the potential market is very large or when the customers are not very sensitive towards either price or delivery time, ignoring the additional relationship will not be a major cause of concern. The above analysis showed the potential adverse eects of using L in place of L . We now 1 focus on the eects of making an error in calculation of L itself. As in So and Song (1998), it is possible to show that for both LTS and PS customers, it is more harmful (in the sense of prot loss) to guarantee a shorter than optimal delivery time compared to longer than optimal delivery time provided the deviations are equal (Appendix E). If managers are not sure about their parameter values, it is better to err on the side of caution and guarantee a higher than optimal delivery lead time. We can even show that for any delivery time, whether above or below the optimal (but close to it), the penalty for deviating from the optimal is more for Model 0 than for Model 1, provided the deviations are of equal amount (Appendix F). Therefore, the loss of prot from making errors in calculating the optimal delivery time is greater for Model 0 than for Model 1. From a managerial viewpoint, this implies that the managers must be more careful choosing the optimal delivery time when market price is governed by delivery time rather than when price is a decision variable.

scale economies will depend on many factors, here we analyse the case where the unit operating cost, m ukv , is decreasing convex with respect to the mean demand rate. In our model, v P 1 (i.e., sufciently decreasing and convex) represents the sensitivity of unit operating cost to the mean demand rate and u is a nite constant denoting the operating cost for unit demand rate. The relationships between k and L, p and L and form of investment function remain the same as in Section 3. The optimisation problem can now be written as
P2 Maximize pl; L p mk Al; Subject to P W < L P sR ; i:e:; 1 elkL P sR delivery reliability constraint; l > k system stability constraint; p > m > 0; L; k > 0 non-negativity constraints;

5. Incorporating economies of scale Companies may be able to achieve economies of scale by spreading xed costs over a larger production volume (Scherer, 1980). For such operations, it is reasonable to assume that the unit operating cost is a decreasing function of the demand rate, at least within a certain volume range. As Section 3 in this paper and numerical examples of So and Song (1998), Palaka et al. (1998) and So (2000) show, operating costs might have a signicant impact on the delivery time strategy of a rm. In this section, we analytically explore the implications of scale economies on the basic model introduced in Section 3. While the exact nature of the

where p d eL, k a0 b0 L and hence m v ua0 b0 L . It is clear that m is decreasing convex with respect to k. When b0 6 0 (PS customers), kL is non-negative and m is non-increasing convex in L and when b0 > 0 (LTS customers), kL is negative and m is increasing convex in L. The reasoning in Section 3 showing that the optimal l will be along lR L given by (5), is still valid as the expression for lR L is independent of m and so remains unchanged. Substituting lR L for l, the prot-maximization problem can again be expressed in terms of a single decision variable L. We will refer to this model as Model 2 and the optimal price and guaranteed delivery time of this model as p2 and L respectively. 2 Dierentiating the prot function with respect to L and analysing we can show that for b0 6 0 there can be at most one feasible solution to 1pL 0. If any feasible solution exists, it will be the optimal delivery time, L , and if there is no 2 feasible solution, then L is one of the feasible 2 limits of L (Appendix G). The prot function for

In this paper Zy represent the rst derivative and Zyy represent the second derivative of Z with respect to y and ! represents tends towards.

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

777

b0 > 0 might not be unimodal. However, as has been shown in Ray (2001), it is not dicult to determine L by a simple comparison of the prot 2 values at a nite number of possible alternatives. Once L is determined and if pL > 0, the rm 2 2 can announce L and the optimal processing rate 2 and market price will be given by (5) and (2) respectively. The resulting mean demand rate will induce the operating cost, mL , and the rms 2 prot will be maximized. In the following parts of this section, we assume that there is a unique prot maximizing L and 2 provide insights on the eects of economies of scale on the optimal policy. We begin with the particular case of v 1. Proposition 3. For v 1, L < L when b0 > 0, and 2 L P L when b0 6 0. 2 Proof. Refer to Appendix H.

0.124
L*

0.122

0.12

L2*

0.118 1
(a)

1.5

2 v

2.5

0.26
L2*

0.25

0.24
L*

0.23 1
(b)

For v > 1, analytical results are much more dicult to obtain. However, based on numerical experiments, we have been able to ascertain the eects of increasing v. We observed that in general (i.e., even for v > 1), L < L when 2 b0 > 0 (LTS customers), and L P L when 2 b0 6 0 (PS customers); as v increases, L changes in a convexconcave 2 manner for b0 > 0 (Fig. 1(a)) and in a concaveconvex manner for b0 6 0 (Fig. 1(b)). The above observations are quite intuitive, but have managerial importance. For LTS customers, there is an incentive to guarantee a shorter delivery time in order to attract more demand and thereby decrease m. Thus, for low values of v, as v increases, L decreases. Because of higher demand, 2 the rm must invest in increasing the processing rate to satisfy the reliability constraint. Once v increases to a point where the capacity investment costs are osetting the scale economies, L starts to 2 increase with v. A similar, but reverse explanation holds for PS customers. The important managerial insight to note here is again the significant role that customer characteristics play in setting the optimal delivery time.

1.5

2 v

2.5

Fig. 1. Optimal delivery time versus v for Models 0 and 2: (a) b0 > 0 and (b) b0 6 0.

Example 4. In this example, we assume the same parameters as in Examples 1 and 2 with u 115 and v 1:5 (to ensure that the operating cost with economies of scale is comparable to m). We have L 0:25 for Example 1 (compared to L 0:23) 2 and L 0:17 for Example 2 (compared to L 2 0:18). While the optimal decision variable values are dierent, the prot penalty of using L for L in 2 Model 0 is not severe. For a broad range of numerical experiments, we observed results consistent with Example 4: that incorporating economies of scale leads to a different optimal delivery lead time than not modeling economies of scale, but the loss of prot is not severe as long as the price delivery time relationship captured, even for a comparatively large value of v. This means that managers should determine the relation between market price and delivery time before investigating the impact of economies of scale.

778

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

6. Conclusions and future research opportunities In this paper, we model an operating system consisting of a rm and its customers where the mean demand rate is a function of market price and guaranteed delivery time and the market price is determined by the length of the delivery time. The rm can invest in increasing capacity to guarantee a shorter delivery time but must be able to satisfy the guarantee according to a pre-specied reliability level. Our model accounts for whether customers are price sensitive or lead time sensitive by capturing the dependence of both price and demand on delivery time. We show how the rm can determine the optimal length of the guaranteed delivery time, analyse the optimal policy and study the change in the behavior of the policy as various system parameters change. We provide examples where our insights are consistent with actual practical situations. Our analysis clearly shows that the time-based competitive strategy for rms whose customers are more sensitive towards price than delivery time will be different from rms whose customers want shorter delivery time and is ready to pay a price premium. Hence, the primary concern for managers would be to understand customer characteristicsbased on the simultaneous dependence of price and demand on delivery timebefore deciding on a delivery time strategy. We also show how our model is quite dierent from those in the literature that assume price and delivery time to be independent decision variables. We specically address under what conditions ignoring the relation between price and the delivery time can lead to substantial profit penalty for the firm. One of our more interesting results is that when market price is dependent on delivery time, managers need to take greater care in choosing the optimal delivery time as compared to when price is a decision variable. We then extended our model by incorporating economies of scale where the unit operating cost is a decreasing function of the mean demand rate. We show that for practicing managers it is important not only to know the lead time sensitivity of price, but also to take into account the eect of economies of scale, when they are present. However, our results indicated that the effect of delivery

time on price seems to be more important than that of economies of scale. The analytical results for this paper are based on the assumption of a linear investment function. We also investigated the impact of non-linear investment functions. Analytical work and numerical experiments with the investment function Ali (i > 1) show that most of the qualitative insights from sensitivity results of Model 0 still hold. The eect of increasing i will be similar to that of increasing A, since for either case (i.e., an increase in A or i) it will require more investment to attain a particular processing rate. For LTS customers and mildly PS customers, as i increases, L will increase in order to reduce the investment cost. If the customers are extremely price sensitive, L could decrease with increase in i. When L increases, it does so in a concave manner for PS customers while for LTS customers the increase in L follows a S-curve pattern. In our experiments we also noted that for higher values of i, it becomes more important to include the additional price and delivery time relationship while deciding on the optimal delivery time (i.e. the prot penalty of using L for L in 1 Model 0 is more). There are a number of further research opportunities for our model: ii(i) Extending this work in a competitive framework (e.g., So, 2000), i.e., what managerial insights can be provided in the presence of multiple-rm competition and how dierent rm and market characteristics would aect the optimal delivery time strategies. i(ii) Rather than assuming service level to be a constraint, make it a decision variable (it will perhaps model the small, repetitive customers well). (iii) Model the dependence of demand on price and delivery time and price on delivery time in a non-linear fashion (e.g., So and Song, 1998).

Acknowledgements Helpful comments from an anonymous referee and Prof. Yigal Gerchak are gratefully acknowledged.

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

779

Appendix A For b0 > 0, the feasible region for L is 0; 0 min a0 ; dm and for b0 6 0, the feasible region for b edm L is 0; e . As L tends towards the feasible limits, the prots are negativeinnite at lower limit and nite at the upper feasible limit (say, LU ). Expressing the prot function in terms of a single variable L, dierentiating with respect to L and simplifying we have pL L b0 A m d a0 e 2eb0 L A ln1 sR ; L2 A:1 A:2

pLL 2b0 e

2A ln1 sR 6 0: L3

Total dierentiation of (A.1) with respect to A gives b0 ln1s 2 oL L : oA 2b0 e 2A ln1sR 3 L If b0 > 0, oL =oA > 0. If b0 6 0, (oL =oA) is unrestricted in sign. However, if sR is high and b0 is not very negative, oL =oA will be positive; if sR is low and b0 ( 0, oL =oA can be negative. Total dierentiation of (A.1) wrt m gives oL b0 : om 2b0 e 2A ln1sR 3 L when b0 > 0, oL =om > 0. If b0 6 0, oL = om 6 0.
R

2A ln1 sR pLL L 2eb0 : L3

As L ! 0, the prot function is increasing concave in L. (a) If b0 6 0, pLL is non-positive which implies pL is concave in L. If the solution to pL 0 is feasible then it will be L , and if it is not, then L LU (since p will be increasing). (b) If b0 > 0, pLL is non-positive till L h i1=3 2A ln1sR and then positive. This implies  h 2b0 e i1=3  R that pL is concave for 0; 2A ln1s 2b0 e and then convex. Therefore there can be at most two solutions to pL 0. If both solutions are feasible, then the smaller one will be L (since p is initially increasing); if only one solution is feasible, it will be L ; if none are feasible, then L LU (since p will be increasing). From (a) and (b) we can conclude that for any b0 , pL L < 0 for L LU is sucient to guarantee an interior prot-maximizing solution. Note that a necessary condition for pL L < 0 at L LU to hold is that a0 must be suciently positive.

Appendix C. Proof of Proposition 1 For this model, the prot function will be given by pp; L a b1 p b2 Lp m ' & ln1 sR A a b1 p b2 L : L C:1
Since ppp is negative, solving pp 0 we have p1 L of (6). Substituting p1 L for p in (C.1) and differentiating with respect to L, we have pL p1 L; L b2 =2A m b2 a=2b1

b2 =2b1 L 2 and
pLL p1 L; L b2 =2b1 2

A ln1 sR L2

C:2

2A ln1 sR : L3

C:3

Appendix B. Proof of comparative statics results Assuming that pL 0 has a unique solution implies that L will be determined by that solution and

Following the same logic as in Appendix A (since e 0, so b0 > 0), we can then convince ourselves that as long as a is suciently high, L will be 1 given by the unique solution to (C.2) 0.

780

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

Appendix D. Proof of Proposition 2 With A1 b0 A m d a0 e, A2 b2 =2 A m b2 a=2b1 , B1 2eb0 , B2 b2 =2b1 and 2 C A ln1 sR , we have pL L A1 B1 L C;
pL p1 L; L A2 B2 L C:

a0 e b0 A m d 2b0 eL P L : pL L d P L 2b0 ed P L d and pL L d P L 2b0 ed P L d. Since, P L is positive, decreasing convex in L, so 0 < P L d < P L d and 0 < P L P L d < P L dP L , implying that pL L dP jpL L dj.

Note that A2 must be negative to have an interior solution ) A2 < 0, B2 > 0 and C > 0. pL
pL p1 L; L

Appendix F From (D.1), we already know that pLL L pLL p1 L; L < 0. Since both pLL L and pLL p1 L; L are negative until the point they are concave (which surely includes L and L ), we can conclude 1 that pL is more concave than pp1 L; L in the vicinity of the optimal values. This implies that the penalty for deviating from the optimal is more for Model 0 than for Model 1, provided the deviations are of equal amount. Appendix G Dierentiating the prot function in terms of the single decision variable L for Model 2 we have pL b0 p m ek b0 uvkv A olR oL G:1

A1 A2 B1 B2L;

pLL pLL p1 L; L B1 B2:

B1 B2

2b1 e b2 < 0: 2b1

D:1

Since we are only comparing the optimal values, the portion of interest is the increasing, concave portion of the curve. Both pL and pL p1 L; L will ! 1 as L ! 0 and will surely be decreasing up to their optimal values. Since B1 B2 is negative, it implies that pL will decrease faster than pL p1 L; L. If A1 6 A2 (remember A2 is negative), pL will start below pL p1 L; L and also decrease faster implying that L < L . If A1 > A2, then until 1 L A2 A1=B1 B2, pL > pL p1 L; L and after that pL < pL p1 L; L. So, the only way L L is if both of them are equal to 1 A2 A1=B1 B2. Note that if A1 > A2, L can still be smaller than L if B1 B2 is highly neg1 ative. If A1 is highly positive and B1 B2 is not negative enough, then L > L . 1 Comparing the values of A1, A2, B1 and B2 it is possible to deduce the conditions when L and L 1 will dier signicantly, or not. For example, if e is large, both A1 and B1 B2 will be very negative. This implies that pL will start much below pL p1 L; L and also decrease much faster implying that L ( L 1 Appendix E Let P L A ln1 sR =L2 implying that P L is positive, decreasing convex in L. L will be determined by the solution to pL 0 which on simplication yields

and pLL 2kL pL 2kL mL kmLL A o2 lR : oL2 G:2

On rearranging the terms of pL 0 we have kL p m kpL kmL A olR : oL G:3

Dierentiating both sides of (G.3) with respect to L we have o 2 LHS 2kL pL uvkL kv1 1 v; oL G:4 o2 3 LHS uv1 v1 vkv2 kL ; oL2 G:5

S. Ray, E.M. Jewkes / European Journal of Operational Research 153 (2004) 769781

781

 2 R  o o l L RHS A : oL oL2

G:6

We can show that the RHS of (G.3) is q increasing c and concave in L, negative until L b0 and then positive (as L ! 0, the RHS ! 1). We can also show that the LHS will be unrestricted in sign, nite as L ! 0 and decreasing convex in L. Hence, we can convince ourselves that there can be zero or one feasible solution to pL 0. If the solution is feasible, it must be L (since as L ! 0, pL is in2 creasing concave). If there is no feasible solution, one of the limits of L will be L depending on 2 whether the prot function is increasing or decreasing.

Appendix H. Proof of Proposition 3 For v 1, pLL for Model 2 will be the same as for Model 0. For pL , B1 and C will remain the same. However, A1Model 2 A1Model 0 b0 m, implying that if b0 > 0, A1Model 2 < A1Model 0 and if b0 6 0, A1Model 2 P A1Model 0. Hence for b0 > 0, pL for Model 2 will intersect the L-axis earlier than for Model 1 and for b0 6 0, pL for Model 2 will intersect the L-axis later than for Model 1 which proves the proposition.

References
Blackburn, J.D., Elrod, T., Lindsley, W.B., Zahorik, A.J., 1992. The Strategic Value of Response Time and Product Variety. In: Voss, C.A. (Ed.), Manufacturing StrategyProcess and Content. Chapman and Hall, London (Chapter 13). Dewan, S., Mendelson, H., 1990. User delay costs and internal pricing for a service facility. Management Science 36 (12), 15021507. Gupta, D., Weerawat, W., 2000. Incentive mechanisms and supply chain design for quick response. Working Paper, Division of Industrial Engineering, Department of Mechanical Engineering, University of Minnesota, MN, December. Ha, A., 1998. Incentive-compatible pricing for a service facility with joint production and congestion externalities. Management Science 44 (12, Part 1 of 2), 16231636.

Hill, A.V., Khosla, I.S., 1992. Models for optimal lead time reduction. Production and Operations Management 1 (2), 185197. Hum, S.-H., Sim, H.-H., 1996. Time-based competition: Literature review and implications for modelling. International Journal of Operations and Production Management 16 (1), 7590. Karmarkar, U.S., 1993. Manufacturing lead times. In: Graves, S.C., RinnoyKan, A.H.G., Zipkin, P.H. (Eds.), Logistics of Production and Inventory. In: Handbooks in Operations Research and Management Science, vol. 4. North-Holland (Elsevier Science Publishers B.V.), Amsterdam, The Netherlanhds. Lederer, P.J., Li, L., 1997. Pricing, production, scheduling and delivery-time competition. Operations Research 45 (3), 407 420. Magretta, J., 1998. Fast, global and entrepreneurial: Supply chain management, Hong Kong stylean interview with Victor Fung. Harvard Business Review 76 (5), 102114. Palaka, K., Erlebacher, S., Kropp, D.H., 1998. Lead time setting, capacity utilisation, and pricing decisions under lead time dependent demand. IIE Transactions 30, 151163. Rao, U.S., Swaminathan, J.M., Zhang, J., 2000. Integrated demand and production management in a periodic, maketo-order setting with uniform guaranteed lead time and outsourcing. Working Paper, GSIA, Carnegie Mellon University, Pittsburgh, September. Ray, S., 2001. Lead time management in supply chains. Unpublished Ph.D. Thesis, Department of Management Sciences, University of Waterloo, Waterloo, Ontario, Canada. Scherer, F.M., 1980. Industrial Market Structure and Economic Performance. Houghton Miin Company, USA. Smith, M.D., Bailey, J., Brynjolfsson, E., 1999. Understanding digital markets: Review and Assessment. In: Brynjolfsson, E., Kahin, B. (Eds.), Understanding the Digital Economy. MIT Press. So, K.C., 2000. Price and time competition for service delivery. Manufacturing and Service Operations Management 2 (4), 392409. So, K.C., Song, J.-S., 1998. Price, delivery time guarantees and capacity selection. European Journal of Operational Research 111, 2849. Stalk, G., Hout, T.M., 1990. Competing Against Time: How Time-Based Competition is Reshaping Global Markets. The Free Press, NY. Sterling, J.U., Lambert, D.M., 1989. Customer service research: Past, present and future. International Journal of Physical Distribution and Materials Management 19 (2), 17. Weng, Z.K., 1996. Manufacturing lead times, system utilisation rates and lead-time-related demands. European Journal of Operational Research 89, 259268. Weng, Z.K., 1999. Strategies for integrating lead time and customer-order decisions. IIE Transactions 31, 161171.