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 Role of Cycle Inventory in a Supply Chain

 Economies of Scale to Exploit Fixed Costs
 Economies of Scale to Exploit Quantity
Discounts
 Short-Term Discounting: Trade Promotions
 Estimating Cycle Inventory-Related Costs in
Practice

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 Improve Matching of Supply
and Demand
Improved Forecasting

Reduce Material Flow Time

Reduce Waiting Time

Reduce Buffer Inventory

Supply / Demand Seasonal

Economies of Scale Variability Variability

Cycle Inventory Safety Inventory Seasonal Inventory

Figure Error! No text of

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 Lot, or batch size: quantity that a supply chain stage
either produces or orders at a given time
 Cycle inventory: Average inventory that builds up in the
supply chain because a supply chain stage either
produces or purchases in lots that are larger than those
demanded by the customer
 Q = lot or batch size of an order
 D = demand per unit time

 Inventory profile: plot of the inventory level over time

 Average flow time = Avg inventory / Avg flow rate
 Cycle inventory = Q/2 (depends directly on lot size)
 Average flow time from cycle inventory = Q/(2D) 4
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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 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 Rs.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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 How do you decide whether to go shopping at a
convenience store or at Sam’s Club?
 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
 Lots are ordered and delivered jointly for all products
 Lots are ordered and delivered jointly for a subset of
products
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Annual demand = D
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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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
T: Reorder interval
Material cost is constant and
therefore is not considered in
this model
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Demand, D = 12,000 computers per year
d = 1000 computers/month
Unit cost, C = Rs.500
Holding cost fraction, h = 0.2
Fixed cost, S = Rs.4,000/order
Q* = Sqrt[(2)(12000)(4000)/(0.2)(500)] = 980
computers
Cycle inventory = Q/2 = 490
Flow time = Q/2d = 980/(2)(1000) = 0.49 month
Reorder interval, T = 0.98 month
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Annual ordering and holding cost =
= (12000/980)(4000) + (980/2)(0.2)(500) =
Rs.97,980
Suppose lot size is reduced to Q=200, which would
reduce flow time:
Annual ordering and holding cost =
= (12000/200)(4000) + (200/2)(0.2)(500) =
Rs.250,000
To make it economically feasible to reduce lot size,
the fixed cost associated with each lot would
have to be reduced
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If desired lot size = Q* = 200 units, what would S have
to be?
D = 12000 units
C = Rs.500
h = 0.2
Use EOQ equation and solve for S:
S = [hC(Q*)2]/2D = [(0.2)(500)(200)2]/(2)(12000) =
Rs.166.67
To reduce optimal lot size by a factor of k, the fixed
order cost must be reduced by a factor of k2
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 In deciding the optimal lot size, the tradeoff is
between setup (order) cost and holding cost.

 If demand increases by a factor of 4, it is optimal to

increase batch size by a factor of 2 and produce
(order) twice as often. Cycle inventory (in days of
demand) should decrease as demand increases.

 If lot size is to be reduced, one has to reduce fixed

order cost. To reduce lot size by a factor of 2, order
cost has to be reduced by a factor of 4.
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 Transportation is a significant contributor to the fixed cost per
order
 Can possibly 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
 Can also have a single delivery coming from multiple suppliers or
a single truck delivering to multiple retailers
 Aggregating across products, retailers, or suppliers in a single
order allows for a reduction in lot size for individual products
because fixed ordering and transportation costs are now spread
across multiple products, retailers, or suppliers
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 Suppose there are 4 computer products in the previous
example: Deskpro, Litepro, Medpro, and Heavpro
 Assume 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
 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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 In practice, the fixed ordering cost is dependent at least in part on the
variety associated with an order of multiple models
 A portion of the cost is related to transportation
(independent of variety)
 A portion of the cost is related to loading and receiving
(dependent of variety)
 Three scenarios:
 Lots are ordered and delivered independently for each
product
 Lots are ordered and delivered jointly for all three models
 Lots are ordered and delivered jointly for a selected subset
of models

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 Demand per year
 DL = 12,000; DM = 1,200; DH = 120
 Common transportation cost, S = Rs.4,000
 Product specific order cost
 sL = Rs.1,000; sM = Rs.1,000; sH = Rs.1,000
 Holding cost, h = 0.2
 Unit cost
 CL = Rs.500; CM = Rs.500; CH = Rs.500
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 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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 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 =
Rs.155,140 19
S* = S + sL + sM + sH = 4000+1000+1000+1000 =
Rs.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
Average flow time = (Q/2)/(weekly demand)
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 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 × Rs.7,000 =
Rs.68,250
Annual total cost = Rs.136,528 21
 Aggregation allows firm to lower lot size without
increasing cost
 Complete aggregation is effective if product
specific fixed cost is a small fraction of joint
fixed cost
 Tailored aggregation is effective if product
specific fixed cost is a large fraction of joint fixed
cost

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QUANTITY DISCOUNT:-Total quantity
purchased over a given period regardless lot size

 All-unit quantity discounts

 Marginal unit quantity discounts
 Why quantity discounts?
 Coordination in the supply chain
 Price discrimination to maximize supplier profits

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 Lot size based
 All units
 Marginal unit
 Volume based

 How should buyer react?

 What are appropriate discounting schemes?

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 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
 The unit cost generally decreases as the quantity
increases, i.e., C0>C1>…>Cr
 The objective for the company (a retailer in our
example) is to decide on a lot size that will minimize
the sum of material, order, and holding costs
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Order quantity Unit Price
0-5000 Rs.3.00
5001-10000 Rs.2.96
Over 10000 Rs.2.92

q0 = 0, q1 = 5000, q2 = 10000
C0 = Rs.3.00, C1 = Rs.2.96, C2 = Rs.2.92
D = 120000 units/year, S = Rs.100/lot, h = 0.2
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Step 1: Calculate Q2* = Sqrt[(2DS)/hC2]
= Sqrt[(2)(120000)(100)/(0.2)(2.92)] = 6410
Not feasible (6410 < 10001)
Calculate TC2 using C2 = Rs.2.92 and q2 = 10001
TC2 = (120000/10001)(100)+(10001/2)(0.2)
(2.92)+(120000)(2.92)
= Rs.354,520

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Step 2: Calculate Q1* = Sqrt[(2DS)/hC1]
=Sqrt[(2)(120000)(100)/(0.2)(2.96)] = 6367
Feasible (5000<6367<10000)  Stop
TC1 = (120000/6367)(100)+(6367/2)(0.2)
(2.96)+(120000)(2.96)
= Rs.358,969
TC2 < TC1  The optimal order quantity Q* is q2 =
10001

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 Suppose fixed order cost were reduced to Rs.4
 Without discount, Q* would be reduced to 1265 units
 With discount, optimal lot size would still be 10001
units
 What is the effect of such a discount schedule?
 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

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 Lot size based discounts increase lot size and
cycle inventory in the supply chain
 Lot size based discounts are justified to achieve
coordination for commodity products
 Volume based discounts with some fixed cost
passed on to retailer are more effective in general

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 Trade promotions are price discounts for a limited period of
time (also may require specific actions from retailers, such as
displays, advertising, etc.)
 Key goals for promotions from a manufacturer’s 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

conti..

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 What is the impact on the behavior of the retailer and
the performance of the supply chain?
 Retailer has two primary 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

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

(purchased in a promotional
period & sold in future
period)
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Normal order size, Q* = 6,324 bottles
Normal cost, C = Rs.3 per bottle
Discount per tube, d = Rs.0.15
Annual demand, D = 120,000
Holding cost, h = 0.2

Qd =
Forward buy =
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 When a manufacturer offers a promotion, the
goal for the manufacturer is to take actions
(countermeasures) to discourage forward buying
in the supply chain
 Counter measures
 EDLP (Every Day Low Pricing)
 Scan based promotions
 Customer coupons

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 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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 Cycle Inventory Reduction
 Reduce transfer and production lot sizes
 Aggregate fixed costs across multiple products, supply points, or
delivery points

 Are quantity discounts consistent with manufacturing and

logistics operations?
 Volume discounts on rolling horizon

 Are trade promotions essential?

 EDLP
 Based on sell-thru rather than sell-in
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 How are the appropriate costs balanced to choose the
optimal amount of cycle inventory in the supply
chain?
 What are the effects of quantity discounts on lot size
and cycle inventory?
 What are appropriate discounting schemes for the
supply chain, taking into account cycle inventory?
 What are the effects of trade promotions on lot size
and cycle inventory?
 What are managerial levers that can reduce lot size
and cycle inventory without increasing costs?
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