Cycle Inventory

Managing
Economies of Scale

Role of Inventory
Improve Matching of Supply
and Demand
Improved Forecasting

Cost

Reduce Material Flow Time

Efficiency

Reduce Waiting Time

Reduce Buffer Inventory

Availability
Responsiveness

Economies of Scale

Supply / Demand
Variability

Seasonal
Variability

Cycle Inventory

Safety Inventory

Seasonal Inventory

Figure Error! No text of

Role of Cycle Inventory

Lot, or batch size = Q
Cycle inventory = Q/2
Inventory profile: plot of the inventory level
over time
Average flow time = Avg inventory / Avg flow
rate
= Q/(2D)
D = demand per unit time

Cycle Inventory
Q = 1000 units
D = 100 units/day
Cycle inventory = Q/2 = 1000/2 = 500
= Avg inventory level from cycle
inventory
Avg flow time = Q/2D = 1000/(2)(100) =
5 days

Cycle Inventory
Adds to the time a unit spends in the
supply chain
Lower cycle inventory is better
because:

Average flow time is lower

Working capital requirements are lower
Lower inventory holding costs

Role of Cycle Inventory

Held to take advantage of
economies of scale
Supply chain costs influenced by lot
size

Material cost = C ($/unit)

Fixed ordering cost = S ($/lot)
Holding cost = H = hC
h = cost of holding $1 in inventory for one year

(fraction of unit cost of product)

H = cost of holding 1 unit in inventory for one year

Role of Cycle Inventory

To purchase products in lot sizes that
minimize total material, ordering, and
holding costs
Each stage generally makes its own
cycle inventory decisions

Exploiting Economies of
Scale
3 typical situations:
Fixed cost incurred for each order
Supplier offers price discounts based
on quantity
Supplier offers short-term discounts
or holds trade promotions

Economies of Scale
to Exploit Fixed Costs
Lot sizing for a single product (EOQ)
Aggregating multiple products in a
single order
Lot sizing with multiple products or
customers
Lots are ordered and delivered
independently for each product
jointly for all products
jointly for a subset of products

Lot sizing for a single

product (EOQ)
D: Annual demand
S: Setup or Order Cost
C: Cost per unit
h: Holding cost per year as a fraction of
product cost
H: Holding cost per unit per year
Q: Lot Size
n: Ordering frequency
T: Reorder interval

Lot sizing for a single

product
Number of orders per year = D/Q
Annual material cost = CD
Annual order cost = (D/Q)S
Annual holding cost = (Q/2)H = (Q/2)hC
Total annual cost = TC
= CD + (D/Q)S + (Q/2)hC

Optimal Lot Size (EOQ)

H hC
Q*

2 DS
hC

n*

DhC
2S

EOQ Model
Demand for Deskpro computers at Bestbuy
d = 1000 computers/month
Costs for retailer:
Unit cost, C = $500
Holding cost fraction, h = 0.2
Fixed cost, S = $4,000/order
How many should the retailer order?

EOQ Model
Q* = Sqrt[(2)(12000)(4000)/(0.2)(500)] = 980
computers
Cycle inventory = Q/2 = 490
Average Flow time = Q/2D = 980/(2)(12000) = 0.041
year = 0.49 month
n* = 12.24
Reorder interval, T = 0.98 month
Annual ordering and holding cost =
= (12000/980)(4000) + (980/2)(0.2)(500) = $97,980

EOQ Model
In deciding optimal lot size, the tradeoff is
between

setup (order) cost and

holding cost.

Order convenient lot size close to EOQ

If demand increases by k, optimal lot size
and n increases by k and flow time (for
cycle inventory) reduces by k

EOQ Model
Suppose lot size is reduced to Q=200 to
reduce flow time:
Annual ordering and holding cost =
= (12000/200)(4000) + (200/2)(0.2)(500) =
$250,000
Significantly higher
To make it economically feasible to reduce lot
size, the fixed cost associated with each lot
would have to be reduced

EOQ Model
If desired lot size = Q* = 200 units, what
would S have to be?
D = 12000 units
C = $500
h = 0.2
Use EOQ equation and solve for S:
S = [hC(Q*)2]/2D = [(0.2)(500)(200)2]/(2)
(12000) = $166.67
To reduce optimal lot size by a factor of k, the fixed
order cost must be reduced by a factor of k2

Products
in a Single Order
Transportation is a major fixed cost
per order
Can combine shipments of different
products from the same supplier

same overall fixed cost

shared over more than one product
effective fixed cost is reduced for each
product
lot size for each product can be reduced

Example
Suppose there are 4 computer
products :
Deskpro, Litepro, Medpro, and Heavpro
Demand for each is 1000 units per
month
If each product is ordered separately:

Q* = 980 units for each product

Total cycle inventory = 4(Q/2) = (4)(980)/2
= 1960 units

Example
Aggregate orders of all four products:

Combined Q* = 1960 units

For each product: Q* = 1960/4 = 490
Cycle inventory for each product is reduced
to 490/2 = 245
Total cycle inventory = 1960/2 = 980 units
Average flow time & inventory holding costs
will be reduced

Products
in a Single Order
Can have single delivery from multiple
suppliers or single truck delivering to
multiple retailers

Cross docking

Aggregating across products, retailers, or

suppliers in a single order

fixed ordering and transportation costs are

spread out
allows for a reduction in lot size for individual
products
Increase in product variety increases receiving/

Lot Sizing with Multiple

Products or Customers
Fixed ordering cost is dependent at least in
part on the variety associated with an order
of multiple models
With an order of multiple models the fixed
ordering cost has
A portion related to transportation
(independent of variety)
A portion related to loading and receiving
(not independent of variety)

Lot Sizing with Multiple

Products or Customers
To find lot sizes & ordering policy to
minimize total cost
Three scenarios:
Lots are ordered and delivered
independently for each product
Lots are ordered and delivered jointly for
all products in each lot
Lots are ordered and delivered jointly for
a selected subset of products

Lot Sizing with Multiple

Products
Demand per year

DL = 12,000; DM = 1,200; DH = 120

Common transportation cost, S =

$4,000
Product specific order cost

sL = $1,000; sM = $1,000; sH = $1,000

Holding cost, h = 0.2

Unit cost

CL = $500; CM = $500; CH = $500

Delivery Options
No Aggregation: Each product
ordered separately
Complete Aggregation: All products
delivered on each truck
Tailored Aggregation: Selected
subsets of products on each truck

No Aggregation
Litepro
Demand per
12,000
year
Fixed cost /
$5,000
order
Optimal
1,095
order size
Order
11.0 / year
frequency
Annual cost
$109,544

Total cost = $155,140

Medpro

Heavypro

1,200

120

$5,000

$5,000

346

110

3.5 / year

1.1 / year

$34,642

$10,954

Complete Aggregation
S* = S + sL + sM + sH
= 4000+1000+1000+1000 = $7000
n* = Sqrt[(DLhCL+ DMhCM+ DHhCH)/2S*]
= 9.75
QL = DL/n* = 12000/9.75 = 1230
QM = DM/n* = 1200/9.75 = 123
QH = DH/n* = 120/9.75 = 12.3
Cycle inventory = Q/2

Complete Aggregation
Demand per
year
Order
frequency
Optimal
order size
Annual
holding cost

Litepro

Medpro

Heavypro

12,000

1,200

120

9.75/year

9.75/year

9.75/year

1,230

123

12.3

$61,512

$6,151

$615

Annual order cost = 9.75 $7,000 = $68,250

Annual total cost = $136,528

Aggregation with capacity

constraint
Aggregating for products from 4
suppliers:
Truck capacity = 2500 units
Demand per product: Di = 10,000
Holding cost, h = 0.2
Unit cost per product Ci = $50
Common order cost S = $500
Supplier specific order cost s = $100

Aggregation with capacity

constraint
S* = 500+100+100+100+100 = $900 per order
n* = Sqrt[(D1hC1+ D2hC2+ D3hC3 + D4hC4)/2S*]
= 14.91 (number of orders per year)
Q= 10,000/14.91 = 671 units per order from each
supplier
Needs truck capacity = 4 X 671 = 2684 units
Order from each can be = 2500/4 = 625 units
Ordering frequency = 10,000 /625 = 16
Annual order cost per supplier increases from $3354 to $3600
Annual holding cost per supplier decreases from $3355 to
$3125

Tailored Aggregation

Annual order cost = $65,383.5

Annual total cost = $130,767

Aggregation
Allows firm to lower lot size
without increasing cost
Use complete aggregation
If product specific fixed cost is a small
fraction of joint fixed cost

Use tailored aggregation

If product specific fixed cost is a large
fraction of joint fixed cost

Quantity Discounts
Lot size based

All units
Marginal unit

Volume based

Economies of Scale to
Exploit Quantity Discounts
Why quantity discounts?

Price discrimination to maximize

supplier profits
Coordination in the supply chain

How should buyer react?

What are appropriate discounting
schemes?

All-Unit Quantity Discounts

Pricing schedule has specified
quantity break points q0, q1, , qr,
where q0 = 0
If an order is placed that is at
least as large as qi but smaller
than qi+1, then each unit has an
average unit cost of Ci

All-Unit Quantity Discounts

The unit cost generally decreases
as the quantity increases, i.e.,
C0>C1>>Cr
The objective for the company is
to decide on a lot size that will
minimize the sum of material,
order, and holding costs

All-Unit Quantity Discount:

Example
Order quantity Unit Price
0- <5000
$3.00
5000- <10000 $2.96
10000 or more $2.92
q0 = 0, q1 = 5000, q2 = 10000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120000 units/year, S =
$100/lot,

Example
Q0 = Sqrt[2DS/h C0] = 6324 units
Since 6324 > q1 move to i = 1
Q1 = 6367 units
Since 5000<6367<10,000 set lot size = 6367
(get discounted price C1 )
TC1 = 358,969 (ordering+ holding+ material
costs)
For i=2, Q2 = 6410 units
Since 6410<10,000 set lot size = 10,000 (to get
discount price C2 )
TC2 = 354520

Effects of Quantity
Discounts
Retailers are encouraged to increase
the size of their orders
Average inventory (cycle inventory) in
the supply chain is increased
Average flow time is increased

Is quantity discount an advantage in the

supply chain?

Value of Quantity
Discounts
Improved coordination to increase
supply chain profits

Commodity products
Products for which firms have market
power

Extraction of surplus through price

discrimination

Commodity products:
Example
D =10,000 / month
For retailer:
Fixed Order cost=100; C=$3; h=.2
Q=6324
Annual Order & holding cost=$3795
For manufacturer:
Order filling cost=$250;
Production cost =$2/bottle ; h=.2
Annual Order & holding cost=$6009
Total SC cost=$9804

Commodity products:
Example
Convince retailer to increase lot size to say
10,000 units
Implications:
For retailer:
Annual Order & holding cost =$1200+$3000
=$4200
Cost increases by $(4200-3795) = $405
For manufacturer:
Annual Order & holding cost=$(3000+2000) =
$5000
Cost decreases by $(6009-5000) = $1009
Total SC cost decreases by=$(9804-9200) =$604

Commodity products:
Example
Why should retailer agree?
Give just enough discount to offset
his increased ordering & holding
costs
Cost increased by 405 for 120000
units
Discount to be given per unit
= 405 / 120000 =0.003375

Products for which firms have

market power: Example
Final Demand D=360,000 60,000p
Production cost of manufacturer: $2
per unit
How much manufacturer charges?
How much retailer charges?
What is the optimal price for SC?

Double Marginalization

Products for which firms have

market power: Example
Pricing schemes for manufacturer:
2-part tariff

Charge an upfront fee

Plus material cost

Volume-based quantity discount

Price such that retailer buys total

volume sold when two stages
coordinate pricing

Quantity Discounts
Lot size based

Commodity products
Manufacturers have large fixed costs
Maximize SC profits
Increase cycle inventory

Volume based

Firm has market power

Manufacturer passes some fixed cost to
retailer
Better even when we consider inventory
(ordering & holding costs)

Short-Term Discounting:
Trade Promotions
Price discounts for a limited period of time

may require specific actions from retailers, such

as displays, advertising, etc.

Key goals from a manufacturers perspective:

Induce retailers to use price discounts, displays,

advertising to increase sales
Shift inventory from the manufacturer to the
retailer and customer
Defend a brand against competition
Goals are not always achieved by a trade promotion

Short-Term Discounting:
Trade Promotions
What is the impact on the behavior of the
retailer and on the performance of supply
chain?
Retailer options in response to a promotion

Pass through some or all of the promotion to

customers to spur sales

Purchase in greater quantity during promotion

period to take advantage of temporary price
reduction, but pass through very little of savings
to customers
Forward buy

Short-Term Discounting
Forward buy

Increase demand variability

Increase inventory
Increase flow time
Decrease SC profits

Retailers optimal response?

Weekly Consumption of
Chicken Noodle Soup

Weekly Shipments of
Chicken Noodle Soup

Short Term Discounting

Q*: Normal order
quantity
C: Normal unit cost
*
CQ
d
dD
d: Short term
=
+
Q
(C - d )h C - d
discount
D: Annual demand
h: Cost of holding
d
Forward
buy
=
Q
- Q*
$1 per year
Qd: Short term order
quantity

Short-Term Discounting
Costs retailer considers

Material
Holding
Order

Assumptions

Discount offered only once

Retailer takes no action to influence
customer demand
Analyze a period over which demand is
an integer multiple of Q*

Short Term Discounts:

Forward Buying
Annual demand D = 120,000
Normal cost C = $3 per bottle
Discount per tube d = $0.15 ; Holding cost h =
0.2
Normal order size Q* = 6,324 bottles
Cycle inventory =3162 bottles
Average Flow Time = 0.3162 months
Qd = 38,236
Forward buy = 38,236 - 6,324 = 31,912 bottles
Cycle inventory =19118 bottles
Average Flow Time = 1.9118 months

Trade Promotions
Major contributor to bullwhip effect
Retailers total cost decreases
Manufacturer justified when

Excess inventory
Smooth demand from peak to low demand
periods

Trade Promotions
Manufacturer revenue reduces if most
product sold at discount
Supply chain

Increase inventory
Decrease revenue
Total profit decreases

Promotion Pass Through

to Consumers
Demand curve at retailer: 300,000 - 60,000p
Normal price to retailer, CR = $3.00
Optimal retail price = $4.00
Customer demand = 60,000
Promotion discount = $0.15
Optimal retail price = $3.925
Customer demand = 64,500
Retailer only passes through half the
promotion discount (0.075) and demand
increases by 7.5%

Trade Promotions
Manufacturer takes actions to
discourage forward buying

EDLP
Promotions for products with high
deal elasticity
Scanner-based promotions
For sell-through, not sell-in items
Not possible for weak brands

Managing Multi-Echelon
Cycle Inventory
Multi-Echelon SC

Multiple stages, with many players at each

stage and one stage supplying another

Synchronize lot sizes at different stages

Unnecessary cycle inventory eliminated

Cross-dock orders

from customers who order less frequently

some of the orders from customers that order
more frequently
Use integer replenishment policy

Inventory-Related Costs in
Practice
Inventory holding cost

Cost of capital
Obsolescence cost
Handling cost
Occupancy cost
Miscellaneous costs

Inventory-Related Costs in
Practice
Order cost

Buyer time
Transportation costs
Receiving costs
Other costs