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POM Lecture (31)

# POM Lecture (31)

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08/13/2009

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Unit 2Management of Conversion SystemChapter 10: Inventory ManagementLesson 30 - Quantity discount models
Learning ObjectivesAfter reading this lesson you would be able to understand
Role of quantity discount in inventory decisions
Quantity discount model
Continuous review systems
Periodic review systemsGood Morning students, today we are going to introduce the concept of what is knownas quantity discount model and the various types of inventory review systems.
Well friends, we started off with the concept of inventory management during the previous lectureand were able to cover quite a bit of ground. Today we shall start our discussions with Quantitydiscount models.
To increase sales, many companies offer quantity discounts to their customers. Aquantity discount is simply a reduced price (P) for the item when it is purchased inlarger quantities. It is common to have a discount schedule with several discounts for large orders.As always, management must decide when and how much to order. But withquantity discounts, how does the operations manager make these decisions?As with other inventory model, the overall objective will be to minimize thetotal cost. Placing an order for the quantity with the greatest discount price might notminimize the total inventory cost. As the discount quantity goes up, the product costgoes down, but the holding cost increases because the orders are large. Thus, themajor trade-off when considering quantity discounts is between the reduced product

cost and the increased holding cost. When we include the cost of the product, theequation for the total annual inventory cost becomes:Total cost = Setup cost + Holding cost + Product costOr T
c
= (D / Q)S + (QH / 2) + PDWhereQ = Quantity orderedD = Annual demand in unitsS = Ordering or setup cost per order or per setupP = Price per unitH = Holding cost per unit per year  Now, we have to determine the quantity that will minimize the total annual inventorycost. Because there are several discounts, this process involves four steps:Figure 30.1 Total cost curve for the quantity discount model

Step 1. For each discount, calculate a value for Q*, using the following equation:Q* =
(2DS / IP)You should note that the holding cost is IP instead of H. Because the price of the item is a factor in annual holding cost, we cannot assume that the holding cost is aconstant when the price per unit changes for each quantity discount. Thus, it iscommon to express the holding cost (I) as a percentage of unit price (P) instead of as aconstant cost per unit per year, H.Step 2. For any discount, if the order quantity is too low to qualify for the discount,adjust the order quantity upward to the lowest quantity that will qualify for thediscount.This reasoning may not be obvious. If the order quantity is below the quantityrange that will qualify for a discount, a quantity within this range may still result inthe lowest total cost.Step 3. Using the total cost equation above, compute a total cost for every Q*determined in steps 1 and 2. If you had to adjust Q* upward because it was below theallowable quantity range, make sure to use the adjusted value for Q*.Step 4. Select that Q* that has the lowest total cost as computed in step 3. It will bethe quantity that will minimize the total inventory cost.
It’s now the right time to consider the practical applicability of the aforesaidconcept.
Let us see how this procedure can be applied with an example.