Supply Chain Management (3rd Edition)

Chapter 10 Managing Economies of Scale in the Supply Chain: Cycle Inventory

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Outline
The Importance of Inventory Role of Cycle Inventory in a Supply Chain Lot Sizing and Supply Chain Cost Aggregating Multiple Products in a Single Order Lot Sizing with Multiple Products or Customers

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10-2

Role of Inventory in the Supply Chain

Improve Matching of Supply and Demand Improved Forecasting Reduce Material Flow Time Reduce Waiting Time Reduce Buffer Inventory

Economies of Scale Cycle Inventory

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Supply / Demand Variability Safety Inventory

Figure Error! No text of

Seasonal Variability Seasonal Inventory

10-3

The Importance of Inventory

Firms can reduce costs by reducing inventory, but customers become dissatisfied when an item is out of stock The objective of inventory management is to strike a balance between inventory investment and customer service

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Inventory Decisions
How much to order?
Order quantity or lot size (Q)

When to order?
Order frequency (n)

Find an inventory policy that is optimal with respect to some criteria (usually cost)

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Inventory Profile
Average demand D
Inventory

Average inventory due to cycle inventory Q/2

Lot size Q

Q/2

0 Time

Cycle
Average flow time =
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Average inventory Average demand

= Q/2D

Inventory Usage Over Time

Order quantity = Q (maximum inventory level) Usage rate Average inventory on hand Q 2

Inventory level

Minimum inventory
0 Time

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The Role of Cycle Inventory in a Supply Chain

What is cycle inventory?
Cycle inventory is the average inventory in a supply chain due to either production or purchases in lot sizes that are larger than those demanded by customers

What is lot size or batch size?

Lot or batch size is the quantity that a stage of a supply chain either produces or purchases at a time

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Role of Cycle Inventory in a Supply Chain

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 5 days 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

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10-9

Role of Cycle Inventory in a Supply Chain

Cycle inventory is held primarily to take advantage of economies of scale in the supply chain Supply chain costs influenced by lot size:
Material cost = C Fixed ordering cost = S Holding cost = H = hC (h = cost of holding $1 in inventory for one year)

Primary role of cycle inventory is to allow different stages to purchase product in lot sizes that minimize the sum of material, ordering, and holding costs Ideally, cycle inventory decisions should consider costs across the entire supply chain, but in practice, each stage generally makes its own supply chain decisions increases total cycle inventory and total costs in the supply chain
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Inventory Profile
Inventory Q/2 Q

0 Inventory

Time

Q/2
0
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Time

Why Order in Large/Small Lots?

Fixed ordering cost: S (cost incurred per order/lot)
Increase the lot size to decrease the fixed ordering cost per unit

Holding cost: H (cost of carrying one unit in inventory)

Decrease the lot size to decrease holding cost

Material cost: C (cost per unit)

Lot size Q is chosen by trading off holding costs against fixed ordering costs
Convenience store Sam's Club
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Fixed cost Low High

Material cost High Low

Cost Influenced by Lot Size

Annual Cost Holding Cost Ordering Cost Material Cost

Order Quantity
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Material Cost (C)

Material cost ($/unit)
The average price paid per unit

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Supply Chain Cost Influenced by Lot Size

Annual Cost

CD

Material Cost Order Quantity

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Holding Cost (H)

Holding cost ($/unit/year)
Cost of carrying one unit in inventory for a specified period of time

Category
Warehousing/occupancy cost Handling costs Obsolescence cost Cost of capital Miscellaneous cost Total holding cost
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% of Inventory Value

6% 3% 3% 11% 3% 26%

Supply Chain Cost Influenced by Lot Size

Annual Cost

(Q/2)H
Holding Cost Material Cost Order Quantity
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Ordering Cost (S)

Ordering cost ($/lot)
Fixed cost incurred each time an order is placed (does not vary with the size of the order)
Buyer time (order placement) Transportation cost Receiving cost

1000 Orders = $400,000

Purchase Order Purchase Order Purchase Order Description Purchase OrderQty. Description Qty. Description Qty. Microwave Description Qty.1 Microwave 11 Microwave Microwave 1

1 Order = $ 400
Purchase Order Description Qty. Microwave 1000

Order quantity

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Supply Chain Cost Influenced by Lot Size

Annual Cost

(D/Q)S
Holding Cost Ordering Cost
Material Cost

Order Quantity
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Supply Chain Cost Influenced by Lot Size

Annual Cost

CD + (D/Q)S + (Q/2)H

Total Cost Curve

Holding Cost Ordering Cost
Material Cost

Optimal Order Quantity (Q*) 2007 Pearson Education

Order Quantity

Economic Order Quantity (EOQ)

Optimal order quantity

2 D S EOQ Q* hC H
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Example: Economic Order Quantity

Example 10-1
Demand for the Deskpro computer at Best Buy is 1,000 units per month. Best Buy incurs a fixed order placement, transportation, and receiving cost of $4,000 each time an order is placed. Each computer costs Best Buy $500 and the retailer has an annual holding cost of 20 percent.

D S C h
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= 1,000 x 12 = 12,000 = $4,000 = $500 = 0.2

Example: Economic Order Quantity

Example 10-1

D = 12,000 S = 4,000 C = 500 h = 0.2

2 D S EOQ Q* hC H

Q* = sqrt((2DS)/(hC)) = sqrt((2 x 12,000 x 4,000)/(0.2 x 500)) = 980

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Example: Economic Order Quantity

Example 10-1

D = 12,000 S = 4,000 C = 500 h = 0.2 Q* = 980

Order frequency = D/Q = 12,000 / 980 = 12.24 Cycle inventory = 980 / 2 = 490 = Q/2

Average flow time = Q/(2D) = 980 / (2 x 12,000) = 0.041

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Example: Economic Order Quantity

Example 10-1

D = 12,000 S = 4,000 C = 500 h = 0.2 Q* = 980

Annual ordering and holding cost

= (D/Q*)S + (Q*/2)hC = $48,990 + $48,990 = $97,980

What if Q = 1,000 What if Q = 900 What if Q = 200 cost = $98,000 cost = $98,333 cost = $250,000

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Summary
Description Formula Optimal order quantity Q* sqrt((2DS)/H)

Order frequency
Cycle inventory Average flow time

D/Q
Q/2 (Avg inventory)/(Avg demand)

Order cost
Holding cost Material cost
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(D/Q)S
(Q/2)H CD

Key Points from EOQ Model

1. Total ordering and holding costs are relatively stable around the economic order quantity 2. If demand increases by a factor k, the optimal lot size increases by a factor k 3. To reduce the optimal lot size by a factor of k, the fixed order cost S must be reduced by a factor k2

2 D S EOQ Q* hC H
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Example: Economic Order Quantity

Example 10-2
The store manager at Best Buy would like to reduce the optimal lot size from 980 to 200. For this lot size reduction to be optimal, the store manager wants to evaluate how much the order cost per lot should be reduced (currently $4,000)

Q* = sqrt((2DS)/(hC)) 200 = sqrt((2 x 12,000 x S)/(0.2 x 500)) S = (hC(Q*)2)/2D = (0.2 x 500 x 2002)/(2 x 12,000) = $166.7
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Example: Economic Order Quantity

How can the store manager reduce the fixed ordering cost?
Aggregate multiple products in a single order
Can possibly combine shipments of different products from the same supplier Can also have a single delivery coming from multiple suppliers

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Aggregating Multiple Products in a Single Order

Example 10-1 (continued)
Assume Best Buy sells 4 different models of Deskpro each with demand of 1,000 units per month (all costs are same) 4 single orders
Q* for each model equals 980 Annual order and holding cost equal 97,980 x 4 = $391,920

1 aggregate order
D = 12,000 x 4 = 48,000 Q* = sqrt((2 x 48,000 x 4,000)/(0.2 x 500)) = 1,960 (= 490 for each model) Annual order and holding cost = (D/Q)S + (Q/2)hC = ((48,000/1,960) x 4,000) + (1,960/2) x 0.2 x 500 = $244,918
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Lot Sizing with Multiple Products or Customers

Ordering cost has two components
Common (to all products) Individual (to each product)

Example
It is cheaper for Wal-Mart to receive a truck containing a single product than a truck containing many different products
Inventory and restocking effort is much less for a single product

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Lot Sizing with Multiple Products or Customers

Multiple products
Independent orders
No aggregation: Each product ordered separately

Joint order of all products

Complete aggregation: All products delivered on each truck

1 2 3

1 2 3

1 2 3

Joint order of a subset of products

Tailored aggregation: Selected subsets of products on each truck

1 2

1 2 3

Which option will likely have the lowest cost?

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