Production control with price, cost, and demand uncertainty

Abstract

An optimal production flow control problem of a make-to-stock manufacturing firm with price, cost, and demand uncertainty is studied. The objective of the flow rate control problem is maximizing the average profit that is the difference between the expected revenue and the expected production, inventory holding, and backlog costs. The uncertainties in the system are captured jointly in discrete environment states. In each environment state, the price, cost, and demand take different levels. The transitions between different environment states evolve according to a time-homogenous Markov chain. By using a continuous flow model, the optimal production policy is stated as a state-dependent hedging policy. The performance of the system where the production cost alternates between a high and a low cost level and the demand is either constant or also alternates between a high and a low level is analyzed under the double-hedging policy. According to this policy, the producer produces only when the cost is low and the surplus is between the two hedging levels. However when the backlog is below the lower hedging level, the producer produces with the maximum capacity regardless of the cost. The effects of production cost, production capacity, demand variability, and the dependence of the demand and the cost on the performance of the system are analyzed analytically and numerically. It is shown that controlling the production rate optimally allows producers respond to the fluctuations in price, cost, and demand in an effective way and maximize their profits.