Chapter 11 Cal

Department of Business Administration
JUC-Male Branch
BUS 348- Supply Chain Management
Chapter-11
Dr.Ishaq Kalanther, PhD
Assistant Professor of Business Administration
Copyright © 2016 Pearson Education, Inc. 11 – 1

Managing Economies of Scale
11 in a Supply Chain
Cycle Inventory
PowerPoint presentation
to accompany
Chopra and Meindl
Supply Chain Management, 6e
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.

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

Inventory Profile
FIGURE 11-1

in a Supply Chain
lot size Q
1000/100 Cycle inventory = =
= 10 days 2 2
200/100 = average inventory

2 days Average flow time =
average flow rate
Average flow time cycle inventory Q

resulting from cycle = =
demand 2D
inventory

in a Supply Chain Average flow time
resulting from
cycle inventory
lot size Q
Cycle inventory = =
2 2
For lot sizes of 1,000 and daily demand of 100
average inventory
Average flow time =
average flow rate
Average flow time cycle inventory Q

resulting from cycle = demand
=
2D
inventory
Q 1,000
= = = 5 days
2D 2 ´ 100
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

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
in a Supply Chain
• Following costs considered in lot sizing
decisions
Average price per unit purchased, $C/unit
Fixed ordering cost incurred per lot, $S/lot
Holding cost incurred per unit per year,

$H/unit/year = hC

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
Key Point
Cycle inventory exists in a supply chain

because different stages exploit economies
of scale to lower total cost. The costs
considered include material cost, fixed
ordering cost, and holding cost.

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

Estimating Cycle Inventory Related Costs
in Practice
• Inventory Holding Cost
– Cost of capital (Weighted Average Cost of Capital)
E D
WACC = (R f + b ´ MRP) + Rb (1– t)
D+E D+E
where
E = amount of equity E = Total investm
D = amount of debt Beta = A compan
Rf = risk-free rate of return measure of the v
systematic risk, o
b = the firm’s beta compares to the
MRP = market risk premium
Rb = rate at which the firm can borrow money
t = tax rate

in Practice
• Inventory Holding Cost (hC)

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

in Practice
• Ordering Cost (S = Fixed Cost)

– Buyer time 500/100 = 5 times; every time
place order for 100; but suppose she places
the order for 150; for extra quantity the
ordering must not change; it is fixed.
– Transportation costs
– Receiving costs
– Other costs

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 (Fixed ordering
cost)
C = Cost per unit (Material Cost)
h = Holding cost per year as a fraction of
product cost – Percentage = h*C = H
• Basic assumptions
– Demand is steady at D units per unit time
– No shortages are allowed
– Replenishment lead time is fixed
Economies of Scale
to Exploit Fixed Costs
• Minimize
– Annual material cost
– Annual ordering cost
– Annual holding cost

Lot Sizing for a Single Product
Annual material cost =CD 2*500 = 1000
D
Number of orders per year = 500/100 =5 times
Q
æD ö
Annual ordering cost =ç ÷S
èQ ø
æQ ö æQ ö
Annual holding cost =ç ÷H =ç ÷hC
è2 ø è2 ø
 D Q
Total annual cost, TC  CD    S   hC
Q  2 

FIGURE 11-2

• The economic order quantity (EOQ)

2DS
Optimal lot size, Q* =
hC
• The optimal ordering frequency

D DhC
n* = =
Q* 2S

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
• The economic order quantity (EOQ)

2DS
Optimal lot size, Q* =
hC
2 ´ 12,000 ´ 4,000
Optimal order size =Q* = =980
0.2 ´ 500
96,000,000
Optimal order size  Q*   980
100
EOQ Example
Q * 980
Cycle inventory = = =490
2 2
D
Number of orders per year = =12.24 (12,000/980
Q* =12.24)
D æQ * ö
Annual ordering and holding cost = S + ç ÷hC =$97,980
Q* è2 ø
Q* 490
Average flow time = = =0.041=0.49 month
2D 12,000

Key Point
Total ordering and holding costs are

relatively stable around the economic
order quantity. A firm is often better
served by ordering a convenient lot size
close to the EOQ rather than the precise
EOQ.

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

Key Point
Aggregating replenishment 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.

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
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

Key Point
A key to reducing cycle inventory is the reduction
of lot size. A key to reducing lot size without
increasing costs is reducing the fixed cost
associated with each lot. This may be achieved
by reducing the fixed cost itself or by aggregating
lots across multiple products, customers, or
suppliers. When aggregating across multiple
products, customers, or suppliers, simple
aggregation is effective when product-specific
order costs are small, and tailored aggregation is
best if product-specific order costs are large.

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

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?

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 q but
i
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

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
Vi =C0 (q1 – q0 ) + C1(q2 – q1) +...+Ci–1(qi – qi–1)

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

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

Key Point
For commodity products for which price is set by

the market, manufacturers with large fixed costs
per lot can use lot-size-based quantity discounts
to maximize total supply chain profits. Lot-size-
based discounts, however, increase cycle
inventory in the supply chain.

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

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

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

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

Key Point
For products for which the firm has market

power, two-part tariffs or volume-based quantity
discounts can be used to achieve coordination in
the supply chain and maximize supply chain
profits.

Key Point
For products for which a firm has market power,

lot-size-based discounts are not optimal for the
supply chain even in the presence of inventory
costs. In such a setting, either a two-part tariff or
a volume-based discount, with the supplier
passing on some of its fixed cost to the retailer, is
needed for the supply chain to be coordinated
and maximize profits.

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

Key Point
Price discrimination to maximize profits at the

manufacturer may also be a reason to offer
quantity discounts within a supply chain.

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

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)

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*

Forward Buy
• Optimal order quantity
d dD CQ *
Q = +
(C – d)h C – d
• Retailers are often aware of the timing of the

next promotion
Forward buy =Q d – Q *

Key Point
Trade promotions lead to a significant increase in

lot size and cycle inventory because of forward
buying by the retailer. This generally results in
reduced supply chain profits unless the trade
promotion reduces demand fluctuations.

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

Managing Multiechelon
Cycle Inventory
• Multiechelon 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

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

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

Key Point
Integer replenishment policies can be

synchronized in multiechelon supply chains to
keep cycle inventory and order costs low. Under
such policies, the reorder interval at any stage is
an integer multiple of a base reorder interval.
Synchronized integer replenishment policies
facilitate a high level of cross-docking across the
supply chain.

Calculation
Calculation available in Chapter-11a
Separate chapter in word form

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

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

Any Question
Thank You

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Department of Business Administration

BUS 348- Supply Chain Management

Copyright © 2016 Pearson Education, Inc. 11 – 1

Copyright © 2016 Pearson Education, Inc. 11 – 3

Copyright © 2016 Pearson Education, Inc. 11 – 4

Copyright © 2016 Pearson Education, Inc. 11 – 5

200/100 = average inventory

Average flow time cycle inventory Q

Copyright © 2016 Pearson Education, Inc. 11 – 6

Average flow time cycle inventory Q

Copyright © 2016 Pearson Education, Inc. 11 – 8

Average price per unit purchased, $C/unit

Fixed ordering cost incurred per lot, $S/lot

Holding cost incurred per unit per year,

Copyright © 2016 Pearson Education, Inc. 11 – 10

Cycle inventory exists in a supply chain

Copyright © 2016 Pearson Education, Inc. 11 – 12

Copyright © 2016 Pearson Education, Inc. 11 – 13

Copyright © 2016 Pearson Education, Inc. 11 – 14

• Inventory Holding Cost (hC)

Copyright © 2016 Pearson Education, Inc. 11 – 15

• Ordering Cost (S = Fixed Cost)

Copyright © 2016 Pearson Education, Inc. 11 – 16

Copyright © 2016 Pearson Education, Inc. 11 – 18

Copyright © 2016 Pearson Education, Inc. 11 – 19

Copyright © 2016 Pearson Education, Inc. 11 – 20

• The economic order quantity (EOQ)

• The optimal ordering frequency

Copyright © 2016 Pearson Education, Inc. 11 – 21

• The economic order quantity (EOQ)

Copyright © 2016 Pearson Education, Inc. 11 – 23

Total ordering and holding costs are

Copyright © 2016 Pearson Education, Inc. 11 – 24

Copyright © 2016 Pearson Education, Inc. 11 – 25

Aggregating replenishment across

Copyright © 2016 Pearson Education, Inc. 11 – 26

Copyright © 2016 Pearson Education, Inc. 11 – 28

Copyright © 2016 Pearson Education, Inc. 11 – 29

Copyright © 2016 Pearson Education, Inc. 11 – 30

• Two basic questions

Copyright © 2016 Pearson Education, Inc. 11 – 31

Copyright © 2016 Pearson Education, Inc. 11 – 32

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

Vi =C0 (q1 – q0 ) + C1(q2 – q1) +...+Ci–1(qi – qi–1)

Copyright © 2016 Pearson Education, Inc. 11 – 33

• Quantity discounts can increase the

Copyright © 2016 Pearson Education, Inc. 11 – 34

Copyright © 2016 Pearson Education, Inc. 11 – 35

For commodity products for which price is set by

Copyright © 2016 Pearson Education, Inc. 11 – 36

Copyright © 2016 Pearson Education, Inc. 11 – 37

• Design a volume-based discount scheme

Copyright © 2016 Pearson Education, Inc. 11 – 38

• Quantity discounts play a role in supply chain

Copyright © 2016 Pearson Education, Inc. 11 – 39

• Lot size–based discounts tend to raise the cycle inventory

Copyright © 2016 Pearson Education, Inc. 11 – 40

For products for which the firm has market

Copyright © 2016 Pearson Education, Inc. 11 – 41

For products for which a firm has market power,