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Managing Economies of Scale

in the Supply Chain


with Cycle Inventory

Planning and Managing


Inventories in a Supply Chain

The Role of Cycle Inventory in the


Supply Chain
o Cycle inventory exists because
producing or purchasing in large lots
allows a stage of the supply chain to
exploit economies of scale.
o The economies of scale are typically
associated with:
n Fixed ordering and transportation costs
n Quantity discounts in product pricing
n Short-term discounts or trade promotions.

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Managing Cycle Inventories
o Each of these factors impact upon the
lot size and cycle inventory in
particular ways.
o There are several managerial levers
that can be employed to reduce cycle
inventory in a supply chain without
raising costs.

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Cycle Inventory Defined


o Cycle inventory is the average inventory in
the supply chain due to either production or
purchases in lot sizes that are larger than
those demanded by the customer. We may
thus use the following notation
n Q = Quantity in a lot or batch
n D = Demand per unit time
o We ignore the impact of demand variability
because it has marginal impact on lot size
and cycle inventory.
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Cycle Inventory Illustrated
o Consider the sale of jeans at a
department store. Demand for jeans
is considered to be fairly stable at
D=100 jeans per day.
n If the store manager purchases in lots of
Q = 1,000 jeans, an inventory profile of
the jeans at the store can be drawn.
n This develops as a cyclical pattern
repeating over time. It can be easily
represented by a graph.

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Cycle Inventory
Interrelationships
o Lot sizes and cycle inventory also
influence the flow time of material
within the supply chain:
n Avg. flow time = Avg. inventory / Avg. flow
rate
o For any supply chain, average flow
rate equals the demand. Therefore,
n Avg. flow time = Avg. inventory / Demand
n Avg. flow time = Q/2D

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Cycle Inventory Adds to the Flow
Time
o The larger the cycle inventory, the longer
the lag time between when a product is
produced and when it is sold.
o All else being equal, a lower level of cycle
inventory is always desirable because large
time lags leave a firm vulnerable to
demand changes in the marketplace.
o A lower cycle inventory is also desirable
because it decreases the working capital
requirement for a firm.
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Understanding Costs Related


to Lot Sizes
o To understand how the supply chain
achieves economies of scale by increasing
the lot size, we must first identify supply
chain costs that are influenced by the lot
size. These are:
n Average price paid per unit purchased ‘C’
($/unit)
n Fixed ordering cost ‘S’ ($/lot)
n Holding cost ‘H’ ($/unit/year), or h*C, where h
is a %age or fraction of holding $1 in inventory
for one year.

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Lot-Size Costs Inter-relationships
Set up Cost Holding Cost Total Cost

4,500

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

0
25 50 75 100 125 150 175 200 225 250

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Extended Lot-Size Interrelationships


o A firm may be better served by ordering a
convenient lot size close to the EOQ rather
than the precise EOQ.
o If demand increases by a factor k, the EOQ
increases by a factor of k1/2. The number of
orders placed per year should also increase
by a factor k1/2. Flow time should decrease
by k1/2.
o To reduce the EOQ by a factor k, the fixed
order cost S must be reduced by k2.
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Reducing Lot Sizes Without
Increasing Costs
o A key to reducing cycle inventory is the
reduction of lot size.
o A key to reducing lot size without
increasing costs is to reduce the fixed cost
associated with each lot.
o An alternate way of reducing the lot size
and (or) fixed cost is by aggregating lots
across multiple products, customers, or
suppliers.
n When aggregating lots, tailored aggregation is
best, especially if product specific order costs
are large.

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Best Buy Computers


o Demand for the Desktop 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. Each computer costs Best Buy
$500 and carries a holding cost of 20%.
n The optimal lot size in this case will be 980
units, a cycle inventory of 480, and a total
annual inventory cost of $97,980.
n If the lot size were to be reduced to 200, then
the corresponding fixed cost will have to be
$166.7.

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Aggregating Multiple Products
in a Single Order
o To effectively reduce the lot size, the
materials manger needs to
understand the source of the fixed
cost.
o In several companies the array of
products sold is divided into families
or groups with each group managed
independently by a separate product
manager.
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Best Buy Computers Revisited


o Best Buy also purchases the Litepro,
Medpro, and Heavypro Models apart from
the Deskpro.
o Currently, a separate product manager is
responsible for the inventory and sales of
each model. As a result, the ordering and
delivery for each model is independent.
n The fixed transportation cost of $4,000 is thus
incurred separately for each model.
n This leads to each product manager ordering a
large lot size for their product.
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Optimal Lot Sizes for Independent
Demand versus Aggregated Demand

o Assume that the demand for each of


the four models is 1,000 units per
month. In this case, if each product
manager orders separately, he would
order a lot size of 980 units.
o Across the four models, the total
cycle inventory would thus be 1960
units.

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Optimal Lot Sizes for Independent


Demand versus Aggregated Demand

o If Best Buy Computers realize that all four


shipments originate from the same source,
then the managers may be asked to ensure
that all four products arrive on the same truck.
o In this case, the optimal combined lot size
across all four models turns out to be 1,960
units. This is equivalent to 480 units for each
model. This action significantly reduces the
cycle inventory (980 units) as well as cost to
Best Buy.

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An Alternate Situation
o Another way to achieve the previous
result is to have a single delivery
coming up from multiple suppliers.
n Allows fixed transportation cost to be
spread across multiple suppliers.
o Or have a single truck delivering to
multiple retailers.
n Allows fixed transportation cost to be
spread across multiple retailers.
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Receiving or Handling Costs


o When considering fixed costs, one cannot
ignore the receiving or loading costs. As more
products are included in a single order, the
product variety on a truck (shipment)
increases.
o The receiving warehouse now has to update
inventory records for more items per truck. In
addition, the task of putting inventory into
storage now becomes more expensive because
each distinct item must be stocked in a
separate location.

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9
Advanced Shipping Notices
(ASN)
o When attempting to reduce lot sizes, it is
important to focus on reducing the handling
costs. Advanced Shipping Notices (ASN) are
files sent electronically by the supplier to the
customer that contain precise records of the
contents of the truck.
o These electronic notices facilitate updating of
inventory records as well as the decision
regarding storage locations, helping to reduce
the fixed cost of receiving. The reduced fixed
cost of receiving makes it optimal to reduce
the lot size ordered, thus reducing cycle
inventory.

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Optimal Lot Sizing with Multiple


Products or Customers
o Our objective is to arrive at lot sizes
and an ordering policy that minimizes
the total cost. We assume the
following input:
n Di = Annual demand for product i
n S = Order cost incurred each time an
order is placed independently of the
variety of products included in the order
n si = Additional order cost incurred if
product i is included in the order

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Multiple Order Policy for Best Buy
o In the case of Best Buy Computers with
multiple products, the materials manager
may consider three approaches to the lot
sizing decision:
1. Each product manager orders his model
independently.
2. The product managers jointly order every
product in each lot.
3. Product managers order jointly but not every
order contains every product; that is, each lot
contains a selected subset of the products.
This is also called ‘tailored aggregation.’

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Relative Merits of Each


Approach
o The first approach does not use any
aggregation and will result in the highest cost.
o The weakness with the second approach is that
low-volume products are aggregated with high-
volume products in every order, which results
in the product-specific order cost for the low-
volume product being incurred with each order.
n In such a situation it may be better to order the
low-volume products less frequently than the
high-volume products.
n As a result, the third approach is likely to yield
the lowest cost.

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The ‘Selected Subset’ Approach
1. Identify the most frequently ordered
product, assuming each product is ordered
independently.
2. Identify the frequency with which other
products are included with the most
frequently-ordered product.
3. Having decided the ordering frequency of
each product, recalculate the ordering
frequency of the most-frequently ordered
product.
4. For each product, evaluate an order
frequency of ni = n/mi.
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Economies of Scale to Exploit


Quantity Discounts
o There are many instances where the
pricing schedule yields economies of scale,
with prices decreasing as lot size is
increased. This form of pricing is very
common in B2B transactions.
o Two commonly used lot-size based
discount schemes are:
o All unit quantity discounts
o Marginal unit quantity discount or multi-block
tariffs.

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Economies of Scale to Exploit
Quantity Discounts cont.
o In assessing the impact of quantity
discounts on the supply chain, the following
two questions should be answered.
n Given a pricing schedule with quantity discounts,
what is the optimal purchasing decision for a
buyer seeking to maximize profits? How does
this decision impact the supply chain in terms of
lot sizes, cycle inventories, and flow times.
n Under what conditions should a supplier offer
quantity discounts? What are appropriate pricing
schedules that supplier should offer?

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All Unit Quantity Discounts


o In all unit quantity discounts, the pricing
schedule contains specified 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 is obtained at a
cost of Ci.
o In general, the unit cost decreases as the
quantity ordered increases; that is, C0≥
C1≥ Cr.
n The company’s objective is to decide on lot sizes
to maximize profits or equivalently, to minimize
the sum of material, order, and holding costs.

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Optimal Lot-Sizing Approach
o The solution procedure evaluates the
optimal lot size for each price Ci and
then settles on the lot size that
minimizes the overall cost.
o There are three possible cases for Qi:
1. qi ≤ Qi.≤ qi+1
2. Qi < qi
3. Qi > qi+1

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Marginal Unit Quantity Discount


o In this case, the pricing schedule contains
specified break points q0, q1,.....,qr where
q0= 0. It is not the average cost of a unit
but the marginal cost of a unit that
decreases at a break point. If an order of
size q is placed, the first q1 - q0 units are
priced at C0, the next q2 - q1 at C1, and so
on.
o The marginal cost per unit varies with the
quantity purchased.
n The company’s objective is to decide on lot sizes
to maximize profits or equivalently, to minimize
the sum of material, order, and holding costs.

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Optimal Lot-Sizing Approach
o For each ‘i’ the optimal lot size and
the corresponding costs are
evaluated. The solution is to set the
lot size to be the one that minimizes
total annual cost across all ranges i.
n It can be shown that the overall optimal
lot size will always lie within the range
qi ≤ Qi.≤ qi+1. Hence, the case where
Qi < qi or Qi > qi+1 will not be evaluated
any further.

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Quantity Discount and Coordination


in the Supply Chain
o A supply chain is coordinated if the
decisions the retailer and supplier make
maximize total supply chain profits.
o In reality, each stage has a separate owner
and considers its own costs in an effort to
maximize its own profits. Such independent
actions can result in a lack of coordination
in the supply chain.
o With respect to the quantity discounts, two
particular situations can be considered:
1. Quantity discounts for commodity products.
2. Quantity discounts where the firm has market
power.
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A Commodity Product Example
Vitamin Product Retailer Manufacturer

Annual Demand 120,000 120,000


Fixed Order Cost $100 $250

Unit price/cost $3 $2

Holding cost (item value) 20% 20%


If the manufacturer were to price vitamins so that each
bottle cost $3 for all orders with lot sizes under 9,165 and
$2.9978 for all orders above 9,165, the retailer will have an
incentive to order in lots of 9,165.

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A Key Point
o For commodity products where price
is set by the market, manufacturers
can use lot size based quantity
discounts to achieve coordination in
the supply chain and decrease supply
chain costs.
n Lot size based discounts, however,
increase cycle inventory in the supply
chain.

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