Managing Inventory

in supply chains
Role of Inventory
Improve Matching of Supply
and Demand
Improved Forecasting

Cost Availability
Reduce Material Flow Time

Reduce Waiting Time

Efficiency Responsiveness
Reduce Buffer Inventory

Supply / Demand Seasonal

Economies of Scale Variability Variability

Cycle Inventory Safety Inventory Seasonal Inventory

Figure Error! No text of

2
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
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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
4
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
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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
6
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

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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

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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

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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 10
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
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Optimal Lot Size (EOQ)

H hC
2 DS
Q*
hC
DhC
n*
2S

12
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?

13
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

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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
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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

16
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
17 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
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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
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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

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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
21 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)

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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

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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 =24 $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

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 No Aggregation
Litepro Medpro Heavypro

Demand per 12,000 1,200 120

year
Fixed cost / $5,000 $5,000 $5,000
order
Optimal 1,095 346 110
order size
Order 11.0 / year 3.5 / year 1.1 / year
frequency
Annual cost $109,544 $34,642 $10,954

Total cost = $155,140 26

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

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Complete Aggregation
Litepro Medpro Heavypro

Demand per 12,000 1,200 120

year
Order 9.75/year 9.75/year 9.75/year
frequency
Optimal 1,230 123 12.3
order size
Annual $61,512 $6,151 $615
holding cost
Annual order cost = 9.75 $7,000 = $68,250
Annual total cost = $136,528
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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

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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 30
Tailored Aggregation

Annual order cost = $65,383.5

Annual total cost = $130,767
31
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
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Quantity Discounts

Lot size based

All units
Marginal unit

Volume based

33
Economies of Scale to
Exploit Quantity Discounts

When should supplier offer

discounts?
What are appropriate discounting
schemes?
How should the buyer react?

34
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

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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

36
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,
37
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
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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?

39
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

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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
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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

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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 =0.00337543
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

44
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
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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)
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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

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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 48
Short-Term Discounting
Forward buy
Increase demand variability
Increase inventory
Increase flow time
Decrease SC profits

Retailers optimal response?

49
Weekly Consumption of
Chicken Noodle Soup

50
Weekly Shipments of
Chicken Noodle Soup

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Short Term Discounting
Q*: Normal order
quantity
C: Normal unit cost *

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

Qd: Short term order

quantity 52
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*
53
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 months54
Trade Promotions
Major contributor to bullwhip effect
Retailers total cost decreases
Manufacturer justified when
Excess inventory
Smooth demand from peak to low demand
periods

55
Trade Promotions

Manufacturer revenue reduces if most

product sold at discount

Supply chain
Increase inventory
Decrease revenue
Total profit decreases

56
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%
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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

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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
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Inventory-Related Costs in
Practice
Inventory holding cost
Cost of capital
Obsolescence cost
Handling cost
Occupancy cost
Miscellaneous costs
Order cost
Buyer time
Transportation costs
Receiving costs
Other costs
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