Journal of Advances in Management Research

Emerald Article: A discrete dynamic programming approach towards optimal outsourcing policy in supply chain management Navin K. Dev, Sanjeev Swami, Rahul Caprihan

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To cite this document: Navin K. Dev, Sanjeev Swami, Rahul Caprihan, (2010),"A discrete dynamic programming approach towards optimal outsourcing policy in supply chain management", Journal of Advances in Management Research, Vol. 7 Iss: 1 pp. 94 - 111 Permanent link to this document: http://dx.doi.org/10.1108/09727981011042874 Downloaded on: 04-05-2012 References: This document contains references to 16 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 679 times.

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A discrete dynamic programming approach towards optimal outsourcing policy in supply chain management
Navin K. Dev
Faculty of Engineering, Department of Mechanical Engineering, Dayalbagh Educational Institute, Agra, India

Sanjeev Swami
Faculty of Social Sciences, Department of Management, Dayalbagh Educational Institute, Agra, India, and

Rahul Caprihan
Faculty of Engineering, Department of Mechanical Engineering, Dayalbagh Educational Institute, Agra, India
Abstract
Purpose As global markets become more customer oriented, rapid response rates are now often among the most important metrics in business. To achieve the required agility, many companies are forced to take decisions of whether to vertically integrate a value chain or to outsource some of its operations. The purpose of this paper is to develop a sequential decision modeling process to enable determination of optimal outsourcing policy decisions with respect to the variables such as warehouse inventory, in-house manufacturing capacity and the ordering cost to the outsource supplier. Design/methodology/approach In this paper, a discrete dynamic programming-based modeling framework is developed for analyzing outsourcing policies for supply chain management problems. ` Specifically, the assumed situation entails a dynamic decision between in-house production vis-a-vis outsourcing, which is contingent upon several factors such as demand during the period under consideration, available inventory, available production capacity of the firm, ordering cost to the outsourced supplier and the fixed capital cost of machine capacity enhancement. Findings The framework enables the determination of a time-based outsourcing policy, which is a prescription regarding: the optimum quantities to be produced in-house vs those to be outsourced, and the level of capacity to be set in each period. Originality/value The problem investigates useful managerial decisions that are relevant to a real life dynamic situation within a manufacturing industry when effecting outsourcing decisions. Keywords Supply chain management, Outsourcing, Decision making, Production management, Productive capacity Paper type Research paper

Journal of Advances in Management Research Vol. 7 No. 1, 2010 pp. 94-111 # Emerald Group Publishing Limited 0972-7981 DOI 10.1108/09727981011042874

1. Introduction The decision to outsource or vertically integrate a value-chain activity has made outsourced manufacturing one of the fastest growing industries in a broad range of business sectors including electronics, pharmaceuticals, medical devices, automotive and food and beverage production. Increasingly, firms that traditionally manufactured their own products are outsourcing production and instead focusing on product design, development and marketing. Bendor-Samuel (1998) state explicitly that there is no alternative, as outsourcing is the only tool available that provides the ability to improve

operations while cutting costs and releasing capital and time that can be used on core areas. While this view may seem extreme, it is clear from the literature that there is a decisive move in industry toward outsourcing. Thus, outsourcing cannot be dismissed as nothing more than the latest in a series of short-lived management fashions. The outsourcing research to date has concentrated on an activity either being in or out (Harland et al., 2005). The only exception however is Dev et al. (2009), which suggested a model that explicitly considers pricing and outsourcing simultaneously by operationalizing the outsourcing decision through a variable that captures the fraction of demand (i.e. the conditions under which (partial) outsourcing is preferred). The analysis in their provides useful managerial insights by providing key strategic choices to manufacturing managers regarding whether to meet additional demand through incentives for overtime operations or through capacity enhancement by investment in new machinery. However, Dev et al. (2009) focus on static environment. In the current paper, we consider a dynamic environment in which time-based outsourcing decisions are taken using a policy framework. This approach is useful since, in realistic decision-making scenario, managerial actions are rarely taken in a static sense. Moreover, a general optimal policy would act as a guiding tool for managers to take strategic decision about outsourcing. Investment in capacity expansion remains one of the most critical decisions for a manufacturing organization. The capacity expansion decision can vary in form. For example, it can be for a policy based on an infinite or finite time horizon (Luss, 1982). The decision can specify the timing of capacity expansion, the size of capacity expansion and future market conditions (Julka et al., 2007). These multiple factors make the decision process quite complex because decisions about production are made before actual demand is observed. When a transaction volume vary, firms may find it difficult to make optimal use of available capacity or may ration production through outsourcing options when existing production scale limits activity (Green, 1986). There is scant research exploring the issues of time-based percentage of outsourcing (fraction of demand) in conjunction to the complexities discussed above. Motivated from the above, this paper provide an in-depth understanding to the manager in the situations where some general time-based policy for outsourcing under different combinations of cost of capacity building, outsourcing cost and market demand is needed. The paper is organized as follows. In section 2 we review the relevant literature. In section 3 we provide the basis of dynamic scenario of the problem under which the model of outsourcing decision making is formulated. Section 4 describes various elements of dynamic programming under which the model is analyzed. The algorithm for the optimal policy under which decisions are made is described in section 5. Details of the experiments are mentioned in section 6. The results are discussed in section 7, while section 8 summarizes the general policy recommendations and useful managerial insights. Section 9 contains the conclusions and the directions for future research in this area. 2. Literature review The outsourcing concept is rapidly growing across a spectrum of industries in the past few decades. Increasingly, firms that traditionally manufactured their own products are now outsourcing production and here begun focusing on their core activities. We already see this concept being adopted by variety of global leading brand owners like Casio, Toshiba, Network Appliances, to name a few (Colbeth, 2005). Additionally, investment in capacity expansion remains one of the most critical decisions for a manufacturing organization with global production facilities.

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We now review some research efforts with a specific focus on outsourcing of the manufacturing function and its related issues. Reeves et al. (1988) consider capacity expansion of an industrial firm producing multiple products in several economic regions over a multiple period horizon. They consider market demand, capital costs, labor costs and transportation cost. They solve this multi-objective problem using the interactive sequential goal programming technique. A multicriteria-capacity generation expansion planning framework was discussed by Kim and Ahn (1993). The paper discusses a case study on Koreas generation-expansion planning based upon preference-order dynamic programming. The decision to be made in each stage are the number and type of plants to be added, whereas the transition function shows the response to decision of capacity addition. Sridhar and Balachandran (1997) studied the impact of different information structures on the design of a managerial control system through their effect on the optimal task assignment decision. The paper finds conditions under which the firm will find it optimal to integrate the design of the managerial control system with performance of downstream task internally while outsourcing the upstream tasks. Hsu (2002) addresses a capacity expansion problem allowing incremental demand to remain unsatisfied by in-house capacity and usage of temporary capacity such as outsourcing until the technology gets cheaper in the near future. Such a decision is addressed as deferred capacity expansion. The model is developed with the motive to minimize total acquisition, holding and operating costs associated with capacity expansion incurred in a multi-period planning horizon. Lee et al. (2002) developed an advanced planning and scheduling model for outsourcing with due-date specification within a manufacturing supply chain. Observing that planning and scheduling are interrelated issues that should be solved simultaneously with outsourcing. Some studies have focused on the outsourcing capacity planning problem based on analytical methods. Lee and Hsu (2004) proposed a framework of outsourcing capacity planning for an IC design house, which employed a heuristic method to deal with the booking capacity planning problem. Tsai and Lai (2007) developed an activity-based costing model to incorporate outsourcing features using a mathematical programming approach. A recent research work that deals with similar issues as addressed in this paper is by Liu and Tu (2008). The authors address a dynamic capacitated production planning problem in a small- to medium-sized enterprises that are involved in outsourcing their manufacturing functions. The authors considered the outsourcing strategies that include:
.

outsourcing the demand that exceeds the installed capacity without considering backlogging; and production, inventory and outsourcing levels are all capacitated.

The outsourcing capacitated problem is formulated into an optimization problem through dynamic programming techniques within a pseudo-polynomial time. The objective of the problem is to minimize the total cost. In contrast to Liu and Tu (2008), in this paper, we consider three factors within a finite time horizon: outsourcing cost, fixed capacity enhancement cost and external demand. We consider the outsourcing option or capacity enhancement after trade-off with different combinations of increasing/decreasing values of the above-mentioned variables within each period of a finite time horizon. In this regard, we find some situations where it may be beneficial to keep some backlog in a particular period. The objective of this paper is to develop timebased general policy recommendations for outsourcing decisions.

3. Problem formulation We consider the case of a manufacturer who manufactures a single product, and has a warehouse of capacity M to store. The manufacturers production capacity, CAP, is less than the storage capacity of the warehouse. The demand faced by the manufacturer at any time t is first fulfilled by warehouse inventory. If the demand exceeds the capacity of the warehouse, it is fulfilled by the outsourced supplier, who is capable of manufacturing any quantity of products. Further it is considered that, to keep the manufacturing in-house, the manufacturer increases its manufacturing capacity by installing extra machines or equipments, but less than the capacity of the warehouse, that is, the capacity is increased to CAP , such that, 0 < CAP < M. In each planning period of the dynamic problem considered in this paper, the manufacturer determines current inventory (stock on hand) of a single product. Based upon this information, he decides whether the additional stock is to be replenished through in-house production or through outsourced supplier. In doing so, he is faced with a trade off between the costs associated with enhancing the in-house production capacity, inventory carrying cost and the ordering costs to the outsourced supplier. The decision makers objective is to maximize some measure of profit (revenue less relevant costs) over the decision-making horizon. Figure 1 illustrates the timing of events in the above problem. Let st denote the inventory on hand at the beginning of the month t, at1, the number of units ordered for in-house manufacturing and at2 be the number of units ordered through outsourcing and at3 be the level of capacity set in month t, and Dt is the deterministic demand in month t. The inventory at decision epoch t 1, st1, is related to the inventory at decision epoch t, st, through a transition function explained in a later section. 4. Dynamic programming model: a sequential decision making approach In sequential decision making problems, the decision makers goal is to choose a sequence of actions, which cause the system to perform optimally with respect to some pre-determined performance criterion (Puterman, 1994). The dynamic programming model evolved in this manner consists of five elements: decision epochs, states, actions,

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Figure 1.
Timings of events in the model

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rewards and transition function. We now describe these elements of the dynamic programming model for the above-mentioned problem. The notation used for the DP formulation is as follows: CAP existing in-house production capacity enhanced in-house production capacity maximum number of products in inventory (equal to manufacturers warehouse capacity) revenue generated at time t for the manufacturer gross margin per unit unit price at which the manufacturer sells the product holding cost per unit for the warehouse inventory setup costs for in-house manufacturing (O1) and the ordering cost for the outsourced supplier (O2), respectively capital cost for enhancement of machine capacity for the case of in-house manufacturing unit variable costs for in-house manufacturing like material cost, machining cost, etc. variable cost per unit associated with set-up of machine for each product of in-house manufacturing variable cost per unit of placing an order to the outsource supplier reward of manufacturer at time t demand that the manufacturer received at the beginning of the period t quantity of product on hand in inventory at decision epoch t positive constants CAP M Rt g p h O1 and O2 F vc1 v1 v2 rt Dt st ; 

98

4.1 Decision epochs Decisions are made at points of time referred to as decision epochs. Let T denote the set of decision epochs. Suppose there are N decisions epochs, say, the number of months, in which outsourcing decisions are to be taken: T f1; 2; 3; 4; . . . ; N g; N <1 1

These decision epochs are discrete in nature, that is, time is divided into periods or stages. We model this situation in such a way that a decision epoch corresponds to the beginning of a period, as shown in Figure 1. The set of decision epochs are finite. We thus formulate a finite horizon problem. 4.2 States At each decision epoch, the system occupies a state. In the present work, the states comprise of two variables concerned with inventory and capacity related decisions. In managing the inventory, the state variable s1 is the number of products remaining in inventory for sale. Let the maximum number of products in inventory be M (which is

equal to the warehouse capacity). Then, the system states are: s1 f. . . ; 2; 1; 0; 1; 2; . . . ; M g 2

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The negative numbers in s1 shows the backlogged inventory. In case of setting the capacity of the in-house production, the system may undergo another change at a decision epoch. This change reflects the condition that either the in-house production is being carried using existing capacity CAP or using enhanced capacity, CAP . Therefore the second state variable, s2 is specified as follows: s2 fCAP; CAP g 3

In view of above explanation, we can draw a continuum representing the placement of CAP and CAP , with the maximum capacity of warehouse as M. This is as shown in Figure 2. Therefore the complete set of states is S fs1 s2 g, where s1 s2 is the relevant cross-product. 4.3 Actions Based on system states s1 ; s2 2 S, an action triplet (a1, a2, a3) is defined as follows: a1 action regarding in-house manufacturing   if a3 L 0; . . . ; minfCAP; M s1 g 0; . . . ; minfCAP ; M s1 g if a3 H a2 action regarding outsourcing 0; . . . ; M a1 maxs1 ; 0 a3 action regarding capacity addition for in-housed manufacturing   L; H if s2 CAP H if s2 CAP

Equation (4) shows that the demand is fulfilled through existing capacity CAP or through enhanced capacity CAP of in-house manufacturing. Equation (5) fulfills the excess demand, beyond that of the sum of remaining (positive) warehouse inventory together with that manufactured in-house. Equation (6) concerns the set-up of the level of capacity as low L or high H, and shows that capacity enhancement decisions are irreversible. Therefore, the complete action set is: As fa1 ; a2 ; a3 g 8s 2 S

Figure 2.
Positioning of CAP and CAP with respect to warehouse capacity (M)

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4.4. Reward The one-period specification of reward depends on the system state and action chosen. Let rt(s, a) denotes the reward at time t in state s for the action a, where s 2 S and a 2 AS. The one-period reward function (Equation (7)) include the revenue generated (R) less the holding (h)[1] and the ordering (O)/set-up costs: rt s; As RDt hs1 a1 a2 O1 a1 ; a3 O2 a2  8s 2 S; a 2 AS  8 7

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Dt mins1 ; 0; maxs1 ; 0 RDt g min a1 a2 where g p vc1  hx  O1 a1 ; a3 x; x; x<0 x!0 

9  10

F1 v1 a1 v 1 a1

ifa3 H ; s2 CAP ifa3 L; s2 CAP

O2 a2 v2 a2

11

Equation (8) specifies the revenue function, which is the product of gross margin per unit and sales during the time period under consideration. The sales may be as high as to meet the entire demand during the current period and any backlogged demand. Alternatively, it could be a lower number taking into account current inventory, and the constraints of warehouse capacity, etc. Equation (10) specifies that a fixed cost F is incurred while the system shifts from the lower capacity level L, at time epoch t, to the higher capacity level H at time epoch t 1. 4.5 Transition function After the decision maker takes an action a in state s at epoch t, the transition function determines the system state at the next decision epoch (t 1). In the present case, the transition function at epoch t 1 is given by: s1t1 s1t a1 a2 Dt and s2t1 s2t if a3 L if a3 H 13 12

CAP

where s1t and s2t are the system states at decision epoch t.

5. Optimality criterion and policy evaluation In a sequential decision making problem, a policy defines a set of decision rules for each point in time during the planning horizon. An attractive feature of the dynamic programming model is that its solution provides the decision maker with an optimal policy or strategy, which is the prescription for choosing the optimal action in any possible future state of the system. In the current problem, the maximum cumulative reward is the criterion for comparing various policies to derive an optimal policy. In the present work, we used backward induction algorithm to find an optimal policy at each decision epoch. The implementation details for this approach are detailed below: Step (1): Set t T, and u sT rT sT ; 8 sT 2 S. T Step (2(a)): Substitute t 1 for t and compute ut*(s), 8 st 2 S where u s maxa2Ast frt st ; a u st1 jst ; ag 8 a 2 AST . t t1 Step (2(b)): Set A1 ;t arg maxa2Ast frt st ; a u st1 jst ; ag, where the transition s t1 (st1| st, a), follows from Equations (12) and (13). Step (3): If t 1, stop; else, go to Step (2(a)). 6. Experimental details The following numerical example illustrates the procedure for determining the optimal outsourcing policy with respect to the capacity level and outsourced quantity decisions. We assume the following parameters for the hypothetical example: M 700; T 10; CAP and CAP 100 and 300, respectively; v1 (Rs. per unit) 0.2; p Rs. 50 per unit; h Rs. 1 per period ( 0.2, as a penalty for backorder). In this paper, to make decisions of outsourcing vs in-house manufacturing, we focus on change in demand Dt (increasing and decreasing trend), the change in cost due to capacity enhancement (F) and the cost per unit charged by the outside manufacturer (v2). To capture the increasing and decreasing trend of F and v2 from time t to t 1, a multiplication factor  is considered. To carry the experiments under the variants, Dt, F and v2, we form a threedimensional matrix with levels; increasing (I) and decreasing (D) as shown in Figure 3. Dt is assumed to be increasing and decreasing as shown in Table I; F (Rs. per unit) is varied per period according to the experimental matrix shown in Figure 3. For each of the

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Figure 3.
Experimental design

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experiment setup as per the experiment matrix, the values considered for F and v2 are shown in Table II. Initial inventory and level of capacity 0 and L (low), respectively. 7. Results and discussions We now discuss some representative optimal general policy results obtained from simulation performed under the settings mentioned in Table II. The optimal policy results have been derived by smoothening the discrete curves of the example cases shown in the Appendix. The general policy thus derived denotes the dominant pattern of the shape of optimal decision variables for an experimental setup. The detailed computational results through tables and graphs for each experiment are mentioned in the Appendix. Case 1 (I I I): This case represent the conditions when
. . .

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capacity enhancement cost is increasing over time; outsourcing cost is increasing over time; and demand is increasing over time.

From Table AI and Figure A1 shown in the Appendix, we draw a general decision policy for case 1 regarding in-house vs outsourced quantity and installed capacity levels, respectively, as shown in Figures 4(a) and 4(b).
Table I. Increasing and decreasing demand through ten time periods Time period Increasing demand Decreasing demand 1 100 1000 2 200 900 3 300 800 4 400 700 5 500 600 6 600 500 7 700 400 8 800 300 9 900 200 10 1000 100

Experiment I I I (Case 1)

F 2.0

v2 1.15 1.175 1.2 1.25 1.5 0.8 0.85 0.90 0.95 1.05; 1.2; 1.75

I D I (Case 2)

2.0

D I I (Case 3)

D D I (Case 4) Table II. Various experiment setting values of F and v2

0.95 0.8 0.7 0.6 0.4 0.8; 0.7; 0.6; 0.5; 0.4; 0.3; 0.2

0.8 0.7 0.6 0.5 0.4

Figure 4(a) shows that outsourcing trend should follow an increasing trend in the early periods and decreasing trend in the later periods, while in-house production should be kept constant. Figure 4(b) shows that with the increase in capacity enhancement cost per period over time, it is better to build the capacity as early as possible during the time horizon. These results make sense because in case of increasing outsourcing cost per period, it may be offset by the increasing demand up to some period of time horizon and thereby induce the manager to outsource some quantity. However, further increase in outsourcing cost may not allow outsourcing in the later periods and may encourage keeping some backlog. Similarly, in case of capacity building, as per Equation (6), once the capacity in any period shifts to high level, it does not revert back to low capacity level. Therefore, in the situation when demand is increasing in future and capacity enhancement cost is also increasing, it is better to shift to high capacity as early as possible in the time horizon. Case 2 (I D I): This case represents the conditions when:
. . .

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capacity enhancement cost is increasing over time; outsourcing cost is decreasing over time; and demand is increasing over time.

From Table AII and Figure A2 of the Appendix, we draw a general decision policy of case 2 regarding in-house vs outsourced quantity, shown in Figure 5(a) and installed capacity levels as shown in Figures 5(b) and 5(c).

Figure 4.
Time-based general policy of (a) outsourced vs in-house quantity and (b) installed capacity for case 1

Figure 5.
Time-based general policy of (a) outsourced vs in-house quantity (b) and (c) installed capacity for case 2

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Figure 5(a) shows that under the above-mentioned conditions of case 2, outsourcing quantity should follow an S-shaped curve pattern (i.e. slow growth, rapid pattern and then stable), while the in-house production should follow an inverted S-shaped curve (i.e. reverse of outsourcing pattern). Moreover, Figures 5(b) and 5(c) shows that the capacity level can be kept low in case the outsourcing cost is relatively cheap. Alternatively, capacity should be build to high level as early as possible if the outsourcing cost is relatively expensive. Case 3 (D I I): This case represents the conditions when:
. . .

capacity enhancement cost is decreasing over time; outsourcing cost is increasing over time; and demand is increasing over time.

From Table AIII and Figure A3 of the Appendix, we draw a general decision policy of case 3 regarding in-house vs outsourced quantity and installed capacity levels, respectively, as shown in Figures 6(a)(c). Figure 6(a) shows that under the above-mentioned conditions of case 3, both outsourcing and in-house manufacturing should follow an S-curve pattern. However, for high values of outsourcing cost, shown in Figure 6(b), outsourcing should follow an increasing trend in the early periods and follows a decreasing trend in later periods, whereas in-house manufacturing still follow an S-curve pattern. Further, Figure 6(c) shows that capacity should be build in earlier periods itself since outsourcing cost is expensive. Case 4 (D D I): This case represents the conditions when:
. . .

capacity enhancement cost is decreasing over time; outsourcing cost is decreasing over time; and demand is increasing over time.

From Tables AIV and Figures A4 of the Appendix, we draw a general decision policy of case 4 regarding in-house vs outsourced quantity and installed capacity levels, respectively, as shown in Figures 7(a)(c). Figure 7(a) shows that under the abovementioned conditions of case 4, outsourcing should follow an S-curve pattern, while

Figure 6. Time-based general policy of (a) and (b) outsourced vs in-house quantity (c) installed capacity for case 3

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Figure 7.
Time-based general policy of (a) outsourced vs in-house quantity, (b) and (c) installed capacity for case 4

in-house manufacturing should follow inverted S-curve pattern. Further, Figures 7(b) and 7(c) shows that the capacity should only be built if outsourcing cost is not sufficiently low in comparison to decreasing value of capacity enhancement cost. We further conducted similar experiments but with decreasing demand. These results are under similar experimental conditions for v2 and F as that of increasing demand cases. For the sake of brevity we discuss the general decision policies drawn from the experiments which have significant importance as compare to the cases with increasing demand. Case 5 (I I D): This case represents the conditions when:
. . .

capacity enhancement cost is increasing over time; outsourcing cost is increasing over time; and demand is decreasing over time.

Figure 8(a) shows that under the conditions of case 5, outsourcing should follow inverted S-curve pattern whereas in-house manufacturing remains constant. Capacity building should be done as early as possible during the time horizon as shown in Figure 8(b). These results make sense as the initial high demand with low outsourcing cost in initial periods induces outsourcing. However, the increasing value of outsourcing cost in the later periods and the low demand results in decreased level of outsourcing. Case 6 (I D D) do not find any significant difference in the general policy for outsourcing and capacity building while comparing this experiment with the corresponding experimental Case 2 (I D I).

Figure 8.
Time-based general policy of (a) outsourced vs in-house quantity, (b) installed capacity for case 5

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Case 7 (D I D): This case represents the conditions when:

. . .

capacity enhancement cost is decreasing over time; outsourcing cost is increasing over time; and demand is decreasing over time.

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Figure 9(a) shows that under conditions of case 7, outsourcing should follow inverted S-curve pattern while the in-house manufacturing should follow S-curve pattern. This result shows the conflicting nature of variables (v2 and F ), that is, low value of outsourcing cost in initial periods would allow outsourcing to fulfill high demand. Contrary to it, the decreasing trend of capacity enhancement cost would encourage more in-house production in the later periods. However, Figure 9(b) shows that capacity building depends upon the interplay of variables: outsourcing cost (v2), capacity enhancement cost (F ) and demand (Dt), that is, the capacity building would take place in the period where it outperforms the outsourcing cost. Case 8 (D D D) also do not find any significant results while comparing with the corresponding experimental Case 4 (D D I). 8. Summary and managerial implication The optimal results of the above simulation analysis to delineate the general policy recommendations can be summarized as follows:
.

With the decrease in outsourcing cost (v2), the outsourced quantity increases and in-house quantity decreases. This makes sense because a manufacturer would like to fulfill its demand as much as possible from the outsource supplier as long as he finds it expensive to enhance its capacity in a relative sense. Conversely, he would cut down the outsourced quantity with the increase in outsourcing cost in comparison to fixed cost of machine installation. With high demand in the later period it is not prudent to increase the installed capacity as long as the high fixed cost of capacity installation offsets the increasing rate of outsourcing cost. Similarly, high demand in early periods does not warrant switching to high capacity unless the cost of building capacity off sets the outsourcing cost. There

Figure 9. Time-based general policy of (a) outsourced vs in-house quantity, (b) and (c) installed capacity for case 7

is possibility that low increasing rate of outsourcing cost allows switching to high capacity in later periods. Thus, the investment on capacity enhancement is a critical issue often required to be made by production managers. Such decisions are typically required to be made by the manager before actual demand is realized. Moreover, once the investment is made, reverting back to lower capacities is very cumbersome and may eventually lead to losses to a firm. In such situations, managers have a viable option to outsource a fraction of the demand observed. The proposed model has the potential to effect educated outsourcing decisions given various trade-off variables including outsourcing cost and operational costs over a finite time horizon. The optimal policy results are delineated as general recommendations for the managers for effecting time-based outsourcing decisions in the presence of different combinations of cost of capacity building, outsourcing cost and market demand. 9. Conclusions In this paper, we develop a sequential decision modeling process to enable determination of optimal outsourcing policy decisions with respect to the variables such as warehouse inventory, in-house manufacturing capacity and the ordering cost to the outsource supplier. The conflicting nature of capacity enhancement cost and outsourcing cost leads to development of eight experimental setups. These experiments generated various combinational impacts on outsourcing decisions over the time horizon when the market conditions in terms of demand increases or decreases. By means of an illustrative example, we show how an optimal outsourcing policy can be derived using the developed model. The results from the numerical example demonstrate that the level of in-house capacity and the quantity of outsourced products are affected by the outsourcing cost, capacity enhancement cost and the varying trend of demand. Thus, in some managerial situations, although the outsourcing options or the capacity enhancement option may be available, close attention should be paid to the cost structure ` of the outsourced supplier vis-a-vis the cost of capacity enhancement. Future work may include outsourcing policies based upon relative quality, more varied demand effects and their uncertainty, and examination of interactions of parameters.
Note 1. The holding cost is also defined for negative values of x. When x < 0, it may be regarded as a penalty cost associated with unsatisfied demand. References Bendor-Samuel, P. (1998), The brave new world of outsourcing, available at: www.outsourcingjournal.com/issues/may1998/html/everest.html Colbeth, D. (2005), The 21st century supply chain, perspectives on innovative supply chain manoagement strategies, available at: http://blog.kinaxis.com/2005/11/focus-on-corecompetency-should-strengthen-brand Dev, N.K., Swami, S. and Caprihan, R. (2009), A modeling approach for outsourcing decisions in supply chain management, International Journal of Manufacturing Technology and Management, Vol. 16 No. 4, pp. 377-97. Green, J.R. (1986), Vertical integration and assurance of markets, in Stiglitz, J.E. and Mathewson, G.F. (Eds), New Development in the Analysis of Market Structure, MIT Press, Cambridge, MA, pp. 177-207.

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Harland, C., Knight, L., Lamming, R. and Walker, H. (2005), Outsourcing: assessing the risks and benefits for organizations, sectors and nations, International Journal of Operations and Production Management, Vol. 25 No. 9, pp. 831-50. Hsu, V.N. (2002), Dynamic capacity expansion problem with deferred expansion and age-dependent shortage cost, Manufacturing & Service Operations Management, Vol. 4 No. 1, pp. 44-54. Julka, N., Baines, T., Tjahjono, B., Lendermann, P. and Vitanov, V. (2007), A review of multi-factor capacity expansion models for manufacturing plants: searching for a holistic decision aid, International Journal of Production Economics, Vol. 106, pp. 607-21. Kim, Y.C. and Ahn, B.H. (1993), Multicriteria generation-expansion planning with global environmental consideration, IEEE Transactions on Engineering Management, Vol. 40 No. 2, pp. 154-61. Lee, C.E. and Hsu, S.C. (2004), Outsourcing capacity planning for an IC design house, International Journal of Advance Manufacturing Technology, Vol. 24, pp. 306-20. Lee, Y.H., Jeong, C.S. and Moon, C. (2002), Advanced planning and scheduling with outsourcing in manufacturing supply chain, Computers and Industrial Engineering, Vol. 43, pp. 351-74. Liu, X. and Tu, Y.L. (2008), Capacitated production planning with outsourcing in an OKP company, International Journal of Production Economics, Vol. 46 No. 20, pp. 5781-95. Luss, H. (1982), Operations research and capacity problems: a survey, Operations Research, Vol. 30 No. 5, pp. 907-47. Puterman, M.L. (1994), Markov Decision Processes: Discrete Stochastic Dynamic Programming, John Wiley & Sons, New York, NY. Reeves, G.R., Lawrence, K.D., Lawrence, S.M. and Gonzalez, J.J. (1988), A multiple criteria approach to aggregate industrial capacity expansion, Computers and Operation Research, Vol. 15 No. 4, pp. 333-9. Sridhar, S.S. and Balachandran, B.V. (1997), Incomplete information, task assignment, and managerial control systems, Management Science, Vol. 43 No. 6, pp. 764-78. Tsai, W.H. and Lai, C.W. (2007), Outsourcing or capacity expansions: application of activitybased costing model on joint products decisions, Computers & Operations Research, Vol. 43 No. 12, pp. 3666-81. Appendix Detailed simulation results Cases with increasing demand: Case 1 (I I I)
(a) T 1 2 3 4 5 6 7 8 9 10 Dt 100 200 300 400 500 600 700 800 900 1000 s1 0 300 400 400 300 200 100 0 100 300 s2 L H H H H H H H H H A 1 300 300 300 300 300 300 300 300 300 300 A 2 100 0 0 0 100 200 300 400 400 400 A 3 H H H H H H H H H H T 1 2 3 4 5 6 7 8 9 10 Dt 100 200 300 400 500 600 700 800 900 1000 s1 0 300 400 400 300 200 100 0 500 1100 (b) s2 L H H H H H H H H H

A 1 300 300 300 300 300 300 300 300 300 300

A 2 100 0 0 0 100 200 300 0 0 0

A 3 H H H H H H H H H H

Table AI. In-house vs outsourcing with (a) v2 1.15 and (b) v2 1.2; F 2.0

Discrete dynamic programming approach 109

Figure A1.
In-house vs outsourcing for experimental case1

Case 2 (I D I)

T 1 2 3 4 5 6 7 8 9 10

Dt 100 200 300 400 500 600 700 800 900 1000

s1 0 200 300 300 200 0 0 0 100 300

(a) s2 L H H H H H H H H H

A 1 300 300 300 300 300 300 300 300 300 300

A 2 0 0 0 0 0 300 400 400 400 400

A 3 H H H H H H H H H H

T 1 2 3 4 5 6 7 8 9 10

Dt 100 200 300 400 500 600 700 800 900 1000

s1 0 100 200 400 300 100 0 0 100 300

(b) s2 L L L L L L L L L L

A 1 0 100 100 100 0 0 0 0 0 0

A 2 0 0 0 400 700 700 700 700 700 700

A 3 L L L L L L L L L L

Table AII.
In-house vs outsourcing with (a) v2 0.95 and (b) v2 0.8; F 2.0

Figure A2.
In-house vs outsourcing for experimental case 2

JAMR 7,1
T

Case 3 (D I I),

Dt 100 200 300 400 500 600 700 800 900 1000

s1 0 600 500 400 300 200 100 0 100 300

(a) s2 L L L L L L L H H H

A 1 100 100 100 100 100 100 300 300 300 300

A 2 600 0 100 200 300 400 300 400 400 400

A 3 L L L L L L H H H H

T 1 2 3 4 5 6 7 8 9 10

Dt 100 200 300 400 500 600 700 800 900 1000

s1 0 500 400 400 300 200 100 0 100 300

(b) s2 0 0 0 1 1 1 1 1 1 1

A 1 100 100 300 300 300 300 300 300 300 300

A 2 500 0 0 0 100 200 300 400 400 400

A 3 L L H H H H H H H H

110

1 2 3 4 5 6 7 Table AIII. 8 In-house vs outsourcing with (a) F 0.8 and (b) 9 10 F 0.4; v2 1.05

Figure A3. In-house vs outsourcing for experimental case 3 with v2 1.05

Case 4 (D D I).
(a) s2 L L L L H H H H H H (b) s2 L L L L L L L L L L

T 1 2 3 4 5 6 7 8 9 10

Dt 100 200 300 400 500 600 700 800 900 1000

s1 0 0 100 300 300 100 0 0 100 300

A 1 100 100 100 300 300 300 300 300 300 300

A 2 0 0 0 100 400 400 400 400 400 400

A 3 L L L H H H H H H H

T 1 2 3 4 5 6 7 8 9 10

Dt 100 200 300 400 500 600 700 800 900 1000

s1 0 0 100 300 300 100 0 0 100 300

A 1 100 100 100 100 100 100 0 0 0 0

A 2 0 0 0 300 600 600 700 700 700 700

A 3 L L L L L L L L L L

Table AIV. In-house vs outsourcing with (a) v2 0.8 and (b) v2 0.6; F 0.8

Discrete dynamic programming approach 111

Figure A4.
In-house vs outsourcing for experimental case 4 with F 0.8

About the authors Navin K. Dev is a doctoral student in the Department of Mechanical Engineering, Dayalbagh Educational Institute, Dayalbagh, Agra, India. He earned his Masters degree in Systems Engineering from Dayalbagh Educational Institute, Dayalbagh, Agra, India. His areas of research interest include analytical modeling in supply chain management and dynamic analysis of supply chain structures through discrete event simulation. Sanjeev Swami is a Professor and Head, Department of Management, DEI, Agra. Prior to this, he was with Department of Industrial and Management Engineering, IIT Kanpur. His PhD is in Commerce and Business Administration from the University of British Columbia, Canada, MTech in Industrial and Management Engineering from IIT Kanpur, and BE in Production and Industrial Engineering from MNREC, Allahabad. He has been a Lecturer at UBC, Canada, and a Visiting Professor at Rotterdam School of Management, Holland and IIM, Bangalore. He has consulted international organizations like Pathe (Holland), EWW (USA), TERI and BHEL (India). He has published nearly 100 research papers, including several papers in reputed journals like Marketing Science, Interfaces, Manufacturing and Service Operations Management, Marketing Letters, IJPE, Vikalpa, DEIJSER, Annals of Operations Research, JORS, and Journal of Cleaner Production. He has won Doctoral Consortium Fellowship by American Marketing Association, and University Graduate Fellowship, UBC. His research contributions have recently been recognized in the form of AIMS International Top Young Researcher Award. Sanjeev Swami is the corresponding author and can be contacted at: sswami1853@gmail.com Rahul Caprihan is a Reader in the Department of Mechanical Engineering at the Dayalbagh Educational Institute, Dayalbagh, Agra, India. He holds a Bachelors and a Doctoral degree in Mechanical Engineering from the DEI, and a Masters degree in Production and Industrial Engineering from the University of Roorkee (now Indian Institute of Technology, Roorkee), India. He has been a BOYSCAST Visiting Scholar to the University of Michigans Ross Business School, Ann Arbor, USA from 1998 through 1999, and has been a Visiting Professor at the Faculty of Economics and Business, University of Groningen, The Netherlands from January, 2009 through June, 2009. Over the years, his research has been supported by several agencies including the DST and AICTE. His publications have appeared in the International Journal of Flexible Manufacturing Systems, International Journal of Production Research, International Journal of Advanced Manufacturing Technology, Computers and Industrial Engineering, International Journal of Manufacturing Technology and Management and Journal of Advanced Manufacturing Systems, and he has also served on the editorial boards of the International Journal of Flexible Manufacturing Systems and the International Journal of Systemics, Cybernetics and Informatics, USA. To purchase reprints of this article please e-mail: reprints@emeraldinsight.com Or visit our web site for further details: www.emeraldinsight.com/reprints