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The set-up cost and yield variability are given and fixed in existing production/inventory models with random yields. However, in many practical situations, they can be reduced by investment in modern production technology. In this paper, we consider an inventory system with random yield in which both the set-up cost and yield variability can be reduced through capital investment. The objective is to determine the optimal capital investment and ordering policies that minimize the expected total annual costs for the system. In addition, an iterative solution procedure is presented to find the optimal order quantity and reorder point and then the optimal set-up cost and yield standard deviation. Numerical examples are given to illustrate the results obtained and assess the cost savings by adopting capital investments. Managerial implications are also included.

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