11

Managing
Economies of Scale
in a Supply Chain:
Cycle Inventory
PowerPoint presentation to accompany
Chopra and Meindl Supply Chain Management, 5e
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11-1
1-1
 Learning Objectives
1. Balance the appropriate costs to choose the optimal
lot size and cycle inventory in a supply chain.
2. Understand the impact of quantity discounts on lot
size and cycle inventory.
3. Devise appropriate discounting schemes for a supply
chain.
4. Understand the impact of trade promotions on lot size
and cycle inventory.
5. Identify managerial levers that reduce lot size and
cycle inventory in a supply chain without increasing
cost.

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 Role of Cycle Inventory
in a Supply Chain

• Lot or batch size is the quantity that a

stage of a supply chain either produces or
purchases at a time
• 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 the customer
Q: Quantity in a lot or batch size
D: Demand per unit time

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 Inventory Profile

Figure 11-1

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 Role of Cycle Inventory
in a Supply Chain

Average flow time

resulting from
cycle inventory

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 Role of Cycle Inventory
in a Supply Chain

• Lower cycle inventory has

– Shorter average flow time
– Lower working capital requirements
– Lower inventory holding costs
• Cycle inventory is held to
– Take advantage of economies of scale
– Reduce costs in the supply chain

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 Role of Cycle Inventory
in a Supply Chain
• Average price paid per unit purchased is a key
cost in the lot-sizing decision
Material cost = C
• Fixed ordering cost includes all costs that do
not vary with the size of the order but are
incurred each time an order is placed
Fixed ordering cost = S
• Holding cost is the cost of carrying one unit in
inventory for a specified period of time
Holding cost = H = hC
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 Role of Cycle Inventory
in a Supply Chain

• 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
• 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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 Role of Cycle Inventory
in a Supply Chain

• Economies of scale exploited in three

typical situations
1. A fixed cost is incurred each time an order
is placed or produced
2. The supplier offers price discounts based
on the quantity purchased per lot
3. The supplier offers short-term price
discounts or holds trade promotions

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 Estimating Cycle Inventory Related Costs
in Practice
• Inventory Holding Cost
– Cost of capital

where
E = amount of equity
D = amount of debt
Rf = risk-free rate of return
b = the firm’s beta
MRP = market risk premium
Rb = rate at which the firm can borrow money
t = tax rate

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 Estimating Cycle Inventory Related Costs
in Practice
• Inventory Holding Cost
– Cost of capital

Adjusted for pre-tax setting

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 Estimating Cycle Inventory Related Costs
in Practice

• Inventory Holding Cost

– Obsolescence cost
– Handling cost
– Occupancy cost
– Miscellaneous costs
• Theft, security, damage, tax, insurance

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 Estimating Cycle Inventory Related Costs
in Practice

• Ordering Cost
– Buyer time
– Transportation costs
– Receiving costs
– Other costs

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 Economies of Scale
to Exploit Fixed Costs

• Lot sizing for a single product (EOQ)

D = Annual demand of the product
S = Fixed cost incurred per order
C = Cost per unit
H = Holding cost per year as a fraction of
product cost
• Basic assumptions
– Demand is steady at D units per unit time
– No shortages are allowed
– Replenishment lead time is fixed
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 Economies of Scale
to Exploit Fixed Costs

• Minimize
– Annual material cost
– Annual ordering cost
– Annual holding cost

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 Lot Sizing for a Single Product

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 Lot Sizing for a Single Product

Figure 11-2

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 Lot Sizing for a Single Product

• The economic order quantity (EOQ)

• The optimal ordering frequency

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 EOQ Example

Annual demand, D = 1,000 x 12 = 12,000 units

Order cost per lot, S = $4,000
Unit cost per computer, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2

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 EOQ Example

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 EOQ Example

• Lot size reduced to Q = 200 units

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 Lot Size and Ordering Cost
• If the lot size Q* = 200, how much
should the ordering cost be reduced?
Desired lot size, Q* = 200
Annual demand, D = 1,000 × 12 = 12,000 units
Unit cost per computer, C = $500
Holding cost per year as a fraction of inventory value, h = 0.2

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 Production Lot Sizing
• The entire lot does not arrive at the same time
• Production occurs at a specified rate P
• Inventory builds up at a rate of P – D

Annual setup cost Annual holding cost

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 Aggregating Multiple Products
in a Single Order

• Savings in transportation costs

– Reduces fixed cost for each product
– Lot size for each product can be reduced
– Cycle inventory is reduced
• Single delivery from multiple suppliers or
single truck delivering to multiple retailers
• Receiving and loading costs reduced

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 Lot Sizing with Multiple
Products or Customers

• Ordering, transportation, and receiving

costs grow with the variety of products
or pickup points
• Lot sizes and ordering policy that
minimize total cost
Di: Annual demand for product i
S: Order cost incurred each time an order is
placed, independent of the variety of products in
the order
si: Additional order cost incurred if product i is
included in the order
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 Lot Sizing with Multiple
Products or Customers

• Three approaches
1. Each product manager orders his or her
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

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 Multiple Products Ordered and Delivered
Independently

Demand
DL = 12,000/yr, DM = 1,200/yr, DH = 120/yr
Common order 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
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 Multiple Products Ordered and Delivered
Independently
Litepro Medpro Heavypro
Demand per year 12,000 1,200 120
Fixed cost/order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Cycle inventory 548 173 55
Annual holding cost $54,772 $17,321 $5,477
Order frequency 11.0/year 3.5/year 1.1/year
Annual ordering cost $54,772 $17,321 $5,477
Average flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual cost $109,544 $34,642 $10,954

Table 11-1
• Total annual cost = $155,140

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 Lots Ordered and Delivered Jointly

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 Products Ordered and Delivered Jointly

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

Annual ordering
and holding cost = $61,512 + $6,151 + $615 + $68,250
= $136,528

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 Products Ordered and Delivered Jointly

Litepro Medpro Heavypro

Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 9.75/year 9.75/year 9.75/year
Optimal order size (D/n∗) 1,230 123 12.3
Cycle inventory 615 61.5 6.15
Annual holding cost $61,512 $6,151 $615
Average flow time 2.67 weeks 2.67 weeks 2.67 weeks

Table 11-2

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 Aggregation with Capacity Constraint

• W.W. Grainger example

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, si = $100

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 Aggregation with Capacity Constraint

Annual holding
cost per supplier

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 Aggregation with Capacity Constraint

Total required capacity per truck = 4 x 671 = 2,684 units

Truck capacity = 2,500 units
Order quantity from each supplier = 2,500/4 = 625
Order frequency increased to 10,000/625 = 16
Annual order cost per supplier increases to $3,600
Annual holding cost per supplier decreases to $3,125.

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 Lots Ordered and Delivered Jointly for a
Selected Subset

Step 1: Identify the most frequently ordered

product assuming each product is
ordered independently

Step 2: For all products i ≠ i*, evaluate the

ordering frequency

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 Lots Ordered and Delivered Jointly for a
Selected Subset

Step 3: For all i ≠ i*, evaluate the frequency of

product i relative to the most frequently
ordered product i* to be mi

Step 4: Recalculate the ordering frequency of the

most frequently ordered product i* to be n

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 Lots Ordered and Delivered Jointly for a
Selected Subset

Step 5: Evaluate an order frequency of ni = n/mi

and the total cost of such an ordering
policy

Tailored aggregation – higher-demand products

ordered more frequently and lower-demand
products ordered less frequently

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 Ordered and Delivered Jointly –
Frequency Varies by Order
• Applying Step 1

Thus

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 Ordered and Delivered Jointly –
Frequency Varies by Order

• Applying Step 2

• Applying Step 3

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 Ordered and Delivered Jointly –
Frequency Varies by Order

Litepro Medpro Heavypro

Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 11.47/year 5.74/year 2.29/year
Optimal order size (D/n∗) 1,046 209 52
Cycle inventory 523 104.5 26
Annual holding cost $52,307 $10,461 $2,615
Average flow time 2.27 weeks 4.53 weeks 11.35 weeks

Table 11-3

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 Ordered and Delivered Jointly –
Frequency Varies by Order

• Applying Step 4

• Applying Step 5

Annual order cost Total annual cost

$130,767

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 Economies of Scale to
Exploit Quantity Discounts

• Lot size-based discount – discounts based

on quantity ordered in a single lot
• Volume based discount – discount is
based on total quantity purchased over a
given period
• Two common schemes
– All-unit quantity discounts
– Marginal unit quantity discount or multi-block
tariffs
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 Quantity Discounts

• Two basic questions

1. What is the optimal purchasing decision for a
buyer seeking to maximize profits? How does
this decision affect the supply chain in terms of
lot sizes, cycle inventories, and flow times?
2. Under what conditions should a supplier offer
quantity discounts? What are appropriate pricing
schedules that a supplier seeking to maximize
profits should offer?

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 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
• Unit cost generally decreases as the quantity
increases, i.e., C0 > C1 > … > Cr
• Objective is to decide on a lot size that will
minimize the sum of material, order, and
holding costs
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 All-Unit Quantity Discounts

Figure 11-3

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 All-Unit Quantity Discounts

Step 1: Evaluate the optimal lot size for each

price Ci,0 ≤ i ≤ r as follows

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 All-Unit Quantity Discounts
Step 2: We next select the order quantity Q*i for
each price Ci
1.
2.
3.

• Case 3 can be ignored as it is considered for Qi+1

• For Case 1 if , then set Q*i = Qi
• If , then a discount is not possible
• Set Q*i = qi to qualify for the discounted price of Ci

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 All-Unit Quantity Discounts

Step 3: Calculate the total annual cost of

ordering Q*i units

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 All-Unit Quantity Discounts

Step 4: Select Q*i with the lowest total cost TCi

• Cutoff price

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 All-Unit Quantity Discount Example

Order Quantity Unit Price

0–4,999 $3.00
5,000–9,999 $2.96
10,000 or more $2.92

q0 = 0, q1 = 5,000, q2 = 10,000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120,000/year, S = $100/lot, h = 0.2

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 All-Unit Quantity Discount Example

Step 1

Step 2
Ignore i = 0 because Q0 = 6,324 > q1 = 5,000
For i = 1, 2

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 All-Unit Quantity Discount Example

Step 3

Lowest total cost is for i = 2

Order bottles per lot at $2.92 per bottle

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 Marginal Unit Quantity Discounts

• Multi-block tariffs – the marginal cost of

a unit that decreases at a breakpoint

For each value of i, 0 ≤ i ≤ r, let Vi be the cost of

ordering qi units

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 Marginal Unit Quantity Discounts

Figure 11-4

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 Marginal Unit Quantity Discounts
Material cost of each order Q is Vi + (Q – qi)Ci

Total annual cost

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 Marginal Unit Quantity Discounts

Step 1: Evaluate the optimal lot size for each

price Ci

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 Marginal Unit Quantity Discounts

Step 2: Select the order quantity Qi* for each

price Ci
1.
2.
3.

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 Marginal Unit Quantity Discounts

Step 3: Calculate the total annual cost of

ordering Qi*

Step 4: Select the order size Qi* with the

lowest total cost TCi

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 Marginal Unit Quantity Discount Example

• Original data now a marginal discount

Order Quantity Unit Price
0–4,999 $3.00
5,000–9,999 $2.96
10,000 or more $2.92

q0 = 0, q1 = 5,000, q2 = 10,000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120,000/year, S = $100/lot, h = 0.2
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 Marginal Unit Quantity Discount Example

Step 1

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 Marginal Unit Quantity Discount Example

Step 2

Step 3

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 Why Quantity Discounts?

• Quantity discounts can increase the

supply chain surplus for the following
two main reasons
1. Improved coordination to increase total
supply chain profits
2. Extraction of surplus through price
discrimination

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 Quantity Discounts for Commodity
Products
D = 120,000 bottles/year, SR = $100, hR = 0.2, CR = $3
SM = $250, hM = 0.2, CM = $2

Annual supply chain cost

= $6,009 + $3,795 = $9,804
(manufacturer + DO)
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 Locally Optimal Lot Sizes

Annual cost for DO

and manufacturer

Annual supply chain cost

= $5,106 + $4,059 = $9,165
(manufacturer + DO)
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 Designing a Suitable Lot Size-Based
Quantity Discount
• Design a suitable quantity discount that gets
DO to order in lots of 9,165 units when its
aims to minimize only its own total costs
• Manufacturer needs to offer an incentive of at
least $264 per year to DO in terms of
decreased material cost if DO orders in lots
of 9,165 units
• Appropriate quantity discount is $3 if DO
orders in lots smaller than 9,165 units and
$2.9978 for orders of 9,165 or more

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 Quantity Discounts When
Firm Has Market Power
Demand curve = 360,000 – 60,000p
Production cost = CM = $2 per bottle

p to maximize ProfR

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 Quantity Discounts When
Firm Has Market Power
CR = $4 per bottle, p = $5 per bottle
Total market demand = 360,000 – 60,000p = 60,000
ProfR = (5 – 4)(360,000 – 60,000 × 5) = $60,000
ProfM = (4 – 2)(360,000 – 60,000 × 5) = $120,000

ProfSC = (p – CM)(360,000 – 60,000p)

Coordinated retail price

ProfSC = ($4 – $2) x 120,000 = $240,000

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 Two-Part Tariff
• Manufacturer charges its entire profit as
an up-front franchise fee ff
• Sells to the retailer at cost
• Retail pricing decision is based on
maximizing its profits
• Effectively maximizes the coordinated
supply chain profit

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 Volume-Based Quantity Discounts

• Design a volume-based discount

scheme that gets the retailer to
purchase and sell the quantity sold
when the two stages coordinate their
actions

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 Lessons from Discounting Schemes

• Quantity discounts play a role in supply chain

coordination and improved supply chain profits
• Discount schemes that are optimal are volume based
and not lot size based unless the manufacturer has
large fixed costs associated with each lot
• Even in the presence of large fixed costs for the
manufacturer, a two-part tariff or volume-based
discount, with the manufacturer passing on some of
the fixed cost to the retailer, optimally coordinates the
supply chain and maximizes profits

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 Lessons from Discounting Schemes

• Lot size–based discounts tend to raise the cycle

inventory in the supply chain
• Volume-based discounts are compatible with small
lots that reduce cycle inventory
• Retailers will tend to increase the size of the lot
toward the end of the evaluation period, the hockey
stick phenomenon
• With multiple retailers with different demand curves
optimal discount continues to be volume based with
the average price charged to the retailers decreasing
as the rate of purchase increases

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 Price Discrimination to Maximize Supplier
Profits
• Firm charges differential prices to maximize
profits
• Setting a fixed price for all units does not
maximize profits for the manufacturer
• Manufacturer can obtain maximum profits by
pricing each unit differently based on customers’
marginal evaluation at each quantity
• Quantity discounts are one mechanism for price
discrimination because customers pay different
prices based on the quantity purchased

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 Short-Term Discounting:
Trade Promotions

• Trade promotions are price discounts

for a limited period of time
• Key goals
1. Induce retailers to use price discounts,
displays, or advertising to spur sales
2. Shift inventory from the manufacturer to
the retailer and the customer
3. Defend a brand against competition

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 Short-Term Discounting:
Trade Promotions

• Impact on the behavior of the retailer and

supply chain performance
• Retailer has two primary options
1. Pass through some or all of the promotion
to customers to spur sales
2. Pass through very little of the promotion to
customers but purchase in greater quantity
during the promotion period to exploit the
temporary reduction in price (forward buy)

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 Forward Buying Inventory Profile

Figure 11-5

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 Forward Buy

• Costs to be considered – material cost,

holding cost, and order cost
• Three assumptions
1. The discount is offered once, with no
future discounts
2. The retailer takes no action to influence
customer demand
3. Analyze a period over which the demand
is an integer multiple of Q*

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 Forward Buy
• Optimal order quantity

• Retailers are often aware of the timing of

the next promotion

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 Impact of Trade Promotions
on Lot Sizes

Q* = 6,324 bottles, C = $3 per bottle

d = $0.15, D = 120,000, h = 0.2

Cycle inventory at DO = Q*/2 = 6,324/2 = 3,162 bottles

Average flow time = Q*/2D = 6,324/(2D) = 0.3162 months

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 Impact of Trade Promotions
on Lot Sizes

• With trade promotions

Cycle inventory at DO = Qd/2 = 38,236/2 = 19,118 bottles
Average flow time = Qd/2D = 38,236/(20,000)
= 1.9118 months

Forward buy = Qd – Q* = 38,236 – 6,324 = 31,912 bottles

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 How Much of a Discount Should the
Retailer Pass Through?
• Profits for the retailer
ProfR = (300,000 – 60,000p)p – (300,000 – 60,000p)CR
• Optimal price
p = (300,000 + 60,000CR)/120,000
• Demand with no promotion
DR = 30,000 – 60,000p = 60,000
• Optimal price with discount
p = (300,000 + 60,000 x 2.85)/120,000 = $3.925
• Demand with promotion
DR = 300,000 - 60,000p = 64,500
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 Trade Promotions
• Trade promotions generally increase
cycle inventory in a supply chain and
hurt performance
• Counter measures
– EDLP (every day low pricing)
– Discount applies to items sold to
customers (sell-through) not the quantity
purchased by the retailer (sell-in)
– Scan based promotions

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 Managing Multiechelon
Cycle Inventory

• Multi-echelon supply chains have multiple

stages with possibly many players at each
stage
• Lack of coordination in lot sizing decisions
across the supply chain results in high costs
and more cycle inventory than required
• The goal is to decrease total costs by
coordinating orders across the supply chain

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 Managing Multiechelon
Cycle Inventory

Figure 11-6

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 Integer Replenishment Policy
• Divide all parties within a stage into groups such that all
parties within a group order from the same supplier and
have the same reorder interval
• Set reorder intervals across stages such that the receipt
of a replenishment order at any stage is synchronized
with the shipment of a replenishment order to at least
one of its customers
• For customers with a longer reorder interval than the
supplier, make the customer’s reorder interval an integer
multiple of the supplier’s interval and synchronize
replenishment at the two stages to facilitate cross-
docking

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 Integer Replenishment Policy
• For customers with a shorter reorder interval than the
supplier, make the supplier’s reorder interval an integer
multiple of the customer’s interval and synchronize
replenishment at the two stages to facilitate cross-
docking
• The relative frequency of reordering depends on the
setup cost, holding cost, and demand at different parties

• These polices make the most sense for supply chains in

which cycle inventories are large and demand is
relatively predictable

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 Integer Replenishment Policy
Figure 11-7

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 Integer Replenishment Policy

Figure 11-8

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 Summary of Learning Objectives

1. Balance the appropriate costs to choose the

optimal lot size and cycle inventory in a
supply chain
2. Understand the impact of quantity discounts
on lot size and cycle inventory
3. Devise appropriate discounting schemes for
a supply chain
4. Understand the impact of trade promotions
on lot size and cycle inventory

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 Summary of Learning Objectives

5. Identify managerial levers that reduce lot

size and cycle inventory in a supply chain
without increasing cost
– Reduce fixed ordering and transportation costs
incurred per order
– Implement volume-based discounting schemes
rather than individual lot size–based discounting
schemes
– Eliminate or reduce trade promotions and
encourage EDLP – base trade promotions on sell-
through rather than sell-in to the retailer

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