SUPPLY CHAIN MANAGEMENT

SESSION 11

Managing Economies of Scale in a

Supply Chain Cycle Inventory
 Why do we need Inventories
1. Time lag between placing orders and getting supplies at the point of consumption
2. Variability of lead times
3. Demand variability
4. Seasonal inventory
5. Pipeline inventory
6. Other factors – Inflationary pressures, shortage of materials in the markets, and
quantity discounts to encourage bulk purchasing
 Inventory Classification
• ABC Classification: Annual Money
Value
• Class A items: High money
value; low volume
• Class B items: Medium
money value; medium
volume
• Class C items: Low money
value; high volume
 ABC Classification
Items Annual Consumption (in units) Unit Cost Total Cost

I 120 2000 240000

II 150 1500 225000

III 200 1000 200000

IV 500 200 100000

V 1000 50 50000

VI 5000 5 25000

VII 10000 2 20000

VIII 15000 1 15000

 ABC Classification
Items Annual Consumption (in Unit Cost Total Cost % of total dollar Classification
units) usage

I 120 2000 240000 A

27.43%
II 150 1500 225000 A
53.14%
III 200 1000 200000 B
76.00%
IV 500 200 100000 B
87.43%
V 1000 50 50000 B
93.14%
VI 5000 5 25000 C
96.00%
VII 10000 2 20000 C
98.29%
VIII 15000 1 15000 C
100.00%
Policies based on ABC analysis
• Higher allocation of resources to buy ‘A’ category
items
• ‘A’ category items deserve tighter inventory control
e.g. more secure area, higher frequency of checking
inventory
• Forecasting ‘A’ items is more critical for the business
 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 (Average Inventory) is
the average inventory in a supply chain
due to either production or purchases
Average flow time
in lot sizes that are larger than those resulting from cycle
demanded by the customer inventory
Q: Quantity in a lot or batch size
D: Demand per unit time

What is the flow time for lot sizes of 1,000 and daily demand of 100?

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 Role of Cycle Inventory in a Supply
•
Chain
Lower cycle inventory has
 Primary role of cycle inventory is to allow
 Shorter average flow time
different stages to purchase product in lot
 Lower working capital
requirements sizes that minimize the sum of material,
 Lower inventory holding costs ordering, and holding costs
• Cycle inventory is held to  Ideally, cycle inventory decisions should
 Take advantage of economies of consider costs across the entire supply chain
scale  In practice, each stage generally makes its
 Reduce costs in the supply chain own supply chain decisions
 Increases total cycle inventory and total costs
in the supply chain

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.
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Costs Associated with Inventory
• 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
 Type of Costs
Inventory Holding
Ordering Cost
Cost
Obsolescence (or spoilage) cost
Buyer time

Handling cost

Occupancy cost Transportation costs

Miscellaneous costs

Receiving costs
Theft, security, damage, tax, insurance
EOQ: Economic Order Quantity
• EOQ is the ideal order quantity a company should purchase to minimize
inventory costs such as holding costs, shortage costs, and order 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
Lot Sizing for a Single Product
(EOQ)
Annual material cost  CD
D
Number of orders per year 
Q
D
Annual ordering cost    S
Q 
Q  Q 
Annual holding cost    H    hC
2 2
D Q 
Total annual cost, TC    S    hC  CD
Q  2
 Lot Sizing for a Single Product – The EOQ
MODEL
• Economic Order Quantity

• Optimal ordering
frequency
Annual demand, D = 1,000 x 12 = 12,000 units

Order cost per lot, S = $4,000 Determine (a) EOQ (b) Cycle Inventory (c)
No. of order per year (d) Total cost (e)
Unit cost per computer, C = $500 Average flow time
Holding cost per year as a fraction of unit cost, h = 0.2
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E O Q Example
Annual demand, D  1,000  12  12,000units

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

2  12,000  4,000
Optimal order size  Q*   980
0.2  500
Insights from the example

• Lot size of 1100 instead of 980

• 10% increase in lot size but only 0.67% increase in cost
• Managers can change small quantities to adjust in best
possible transportation scenario
• Thus, total ordering costs and handling costs are stable
around EOQ
• Managers desire to have lot size of 200 units, what can be
done?
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 for lot size based discounts
– All-unit quantity discounts
– Marginal unit quantity discount or multi-block tariffs
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
All-Unit Quantity Discounts

Figure 11-3 Average Unit Cost with All Unit Quantity Discounts
 All-Unit Quantity Discounts

Step 1: Evaluate the optimal lot size for each price as follows:

2DS
Qi 
hCi
All-Unit Quantity Discounts
Step 2: We next select the order quantity Q*i for each price Ci

1. qi  Qi  qi 1
2. Qi  qi
3. Qi  qi 1
• Case 3 can be ignored as it is considered for Qi +1
• For Case 1 if qi  Qi  qi 1, then set Q * i  Qi
• If Qi  qi , then a discount is not possible

• Set Q i  qi to qualify for the discounted price of Ci

All-Unit Quantity Discounts

Step 3: Calculate the total annual cost of ordering Q i units

D  Qi* 
Total annual cost, TCi   *  S    hCi  DCi
 Qi   2 
 All-Unit Quantity Discounts
Step 4: Select Qi* with the lowest total cost TCi

• Cutoff price

1 DS h 
C*   DCr   q C
r r  2hDSCr 
D qr 2 
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

All-Unit Quantity Discount Example
Step 1

2DS 2DS 2DS

Q0   6,325; Q1   6,367; Q2   6,411
hC0 hC1 hC2

Step 2

Ignore i = 0 because Q0 = 6,325 > q1 = 5,000

For i = 1, 2

Q1*  Q1  6,367; Q2*  q2  10,000

All-Unit Quantity Discount Example

Step 3

D   Q1* 
TC1   * S    hC1  DC1  $358,969; TC2  $354,520
 Q1   2 

Lowest total cost is for i = 2

Order Q *2 = 10,000 bottles per lot at $2.92 per bottle

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 )

Marginal Unit Quantity Discounts

Figure 11-4 Marginal Unit Cost with Marginal Unit Quantity Discount
Marginal Unit Quantity Discounts
Material cost of each order Q is Vi  Q  qi Ci

D
Annual order cost    S
Q 
Annual holding cost  Vi  (Q  qi )C i  h / 2
D
Annual materials cost  Vi  (Q  qi )Ci 
Q
D
Total annual cost    S  Vi  (Q  qi )C i  h / 2
Q 
D
 Vi  (Q  qi )Ci 
Q
Marginal Unit Quantity Discounts
Step 1: Evaluate the optimal lot size for each price Ci

2D(S  Vi  qi Ci )
Optimal lot size for Ci is Qi 
hCi
Marginal Unit Quantity Discounts

Step 2: Select the order quantity Qi* for each price Ci

1. If qi  Qi  qi 1 then set Qi*  Qi

2. If Qi  qi then set Qi*  qi
3. If Qi  qi 1 then set Qi*  qi 1
Marginal Unit Quantity Discounts
Step 3: Calculate the total annual cost of ordering Qi*

D  D
TCi   *  S  Vi  (Qi*  qi )C i  h / 2  * Vi  (Qi*  qi )Ci 
 Qi  Qi

Step 4: Select the order size Qi* with the lowest total
cost TCi
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
 V0  0; V1  3(5,000 – 0)  $15,000
V2  3(5,000 – 0)  2.96(10,000 – 5,000)  $29,800

Step 1
2D(S  V0  q0C0 )
Q0   6,325
hC0

2D(S  V1  q1C1 )
Q1   11,028
hC1

2D(S  V2  q2C2 )
Q2   16,961
hC2
Step 2
Q0*  q1  5,000 because Q0  6,324  5,000
Q1*  q2  10,000; Q2  Q2  16,961
Step 3

D  D
TC0   *  S  V0  (Q0*  q0 )C 0  h / 2  * V0  (Q0*  q0 )C0   $363,900
 Q0  Q0
D  D
TC1   *  S  V1  (Q1*  q1 )C 1  h / 2  * V1  (Q1*  q1 )C1   $361,780
 Q1  Q1
D  D
TC2   *  S  V2  (Q2  q2 )C 2  h / 2  * V2  (Q2  q2 )C2   $360,365
* *

 Q2  Q2