Supply Chain Management

Managing Economies of Scale in the

Supply Chain: Cycle Inventory

.
 Delivery Options
No Aggregation: Each product ordered separately.

Complete Aggregation: All products delivered on

each truck.

Tailored Aggregation: Selected subsets of products

on each truck.

Dr. Srikanta Routroy. 2

 No Aggregation: Order Each
Product Independently
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 = $155,140

Dr. Srikanta Routroy. 3
 Aggregation: Order All
Products Jointly
Here all three models are included in each time an order is placed.

S * S s L sM s H
Annualordering cos t S * * n
D * h * C L DM * h * CM DH * h * C H
Annualhodi ng cos t L
2n 2n 2n
DL * h * C L DM * h * CM DH * h * C H
TotalCost S *n
2n 2n 2n
DL * h * C L DM * h * CM DH * h * C H
n*
2* S*
k

D * h *C
i i
n
* i 1
2* S*
Dr. Srikanta Routroy. 4
 Tailored Aggregation: Using Heuristic
Litepro Medpro Heavypro

Demand per 12,000 1,200 120

year
Order 10.47/year 5.74/year 2.29/year
frequency
Optimal 1,046 209 52
order size
Annual $52,307 $10,461 $2,615
holding cost
Annual order cost = $65,383.5
Annual total cost = $130,767
Dr. Srikanta Routroy. 5
 Comparison for all three options

Options Total Cost

No Aggregation $155,140

Complete Aggregation $136,528

Tailored Aggregation $130,767

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 Lessons from Aggregation
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 Discounts
Lot size based
All units
Marginal unit
Volume based

How should buyer react?

What are appropriate discounting schemes?

Dr. Srikanta Routroy. 8

 All-Unit Quantity Discounts: Example
Cost/Unit Total Material Cost

$3
$2.96
$2.92

5,000 10,000 5,000 10,000

Order Quantity Order Quantity

Dr. Srikanta Routroy. 9

 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.
The unit cost generally decreases as the quantity
increases, i.e., C0>C1>>Cr.
The objective for the company 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 Discount Procedure
Step 1: Calculate the EOQ for the lowest price. If it is feasible
(i.e., this order quantity is in the range for that price),
then stop. This is optimal lot size. Calculate TC for
this lot size.
Step 2: If the EOQ is not feasible, calculate the TC for this price
and the smallest quantity for that price.
Step 3: Calculate the EOQ for the next lowest price. If it is
feasible, stop and calculate the TC for that quantity and
price.
Step 4: Compare the TC for Steps 2 and 3. Choose the quantity
corresponding to the lowest TC.
Step 5: If the EOQ in Step 3 is not feasible, repeat Steps 2, 3, and 4
until a feasible EOQ is found.

Dr. Srikanta Routroy. 11

 All-Unit Quantity Discount:
Example
Order quantity Unit Price
0-5000 $3.00
5001-10000 $2.96
Over 10000 $2.92
q0 = 0, q1 = 5000, q2 = 10000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120000 units/year, S = $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 = $2.92 and q2 = 10001
TC2=(120000/10001)(100)+(10001/2)(0.2)(2.92)+
(120000)(2.92)= $354,520
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) =
$358,969
TC2 < TC1 The optimal order quantity Q* is q2 = 10001

Dr. Srikanta Routroy. 13

 Marginal Unit Quantity Discount
It is referred as multi-block tariffs.

The marginal cost per unit varies with the quantity

purchased.

If an order of size q is placed, the first q1-q0 units are

priced at C0, the next q2-q1 are priced at Ci and so on.

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 MUQD______
Vi be the cost of ordering qi units. Define V0=0 and Vi for 0 i r

Vi Co q1 qo C1 q2 q1 ............ Ci 1 qi qi 1

For each value of i, o i r 1 ,consider

MCO Vi Q qi Ci an order size Q in the range qi to qi+1 units.

D
ACO
Q
S
The material cost of each order of size Q
(qi Q qi 1 ) is given by

AHC Vi Q qi Ci
h
2

AMC
D
Vi Q qi Ci
Q
Dr. Srikanta Routroy. 15
 MUQD______

TAC ACO AHC AMC

D
S Vi Q qi Ci Vi Q qi Ci
h D

Q 2 Q

2 DS Vi qi Ci
Qi
hCi

Dr. Srikanta Routroy. 16

 MUQD______
There are three possible cases for Qi

1. qi Qi qi 1
2. Qi qi

3. Qi qi 1

Dr. Srikanta Routroy. 17

 Case 1
In this case the optimal lot size in this price range is Qi

The total annual cost for this policy is given by

D
TCi S Vi Qi qi Ci
h
Qi 2 Equation1

D
Vi Qi qi Ci
Qi
Dr. Srikanta Routroy. 18
 Case 2 and Case 3
If or Q q the lot size in this range is either
Qi qi i i 1 qi or
q depending on which has the lower total cost.
i 1

Evaluate the total annual cost:

D Vi * h D
S Vi ,
TCi Min qi 2 qi
D Vi 1 * h D
S Vi 1
qi 1 2 qi 1
Dr. Srikanta Routroy. 19
 MUQD______
Observe that for each range the optimal lot size is the
quantity defined by equation 1 if it is feasible or one
of the break points if it is not feasible.

For each i , evaluate the optimal lot size and total cost.

The solution is to set the lot size to be the one that

minimizes the total annual cost across all ranges .

Dr. Srikanta Routroy. 20

 Example
Assume that manufacturer uses the following MUQD
pricing schedule.
Order quantity Unit Price
0-5000 $3.00
5001-10000 $2.96
Over 10000 $2.92

Evaluate the number of bottles that Drugs Online should

order in each lot.

Dr. Srikanta Routroy. 21

 Solution

q0 0; q1 5,000; q2 10,000
C0 $3.00; C1 $2.96; C2 $2.92
q0 0; q1 5,000; q2 10,000
C0 $3.00; C1 $2.96; C2 $2.92

Vo 0;V1 35000 0 15,000

Vo 0;V1 35000 0 15,000

V2 3 5000 0 2.96(10,000 5,000)
$29,800

V2 35000 0 2.96(10,000 5,000)

D 120,000; S $100 / lot ; h 0.2

$29,800
D 120,000; S $100 / lot ; h 0.2

Dr. Srikanta Routroy. 22

 Solution
For i=0, evaluate Q0=6,324 (it is not feasible).
Optimum order size is 5,000 and corresponding total
cost is $363,900 in this price range.
For i=1, evaluate Q1=11,028 (it is not feasible)
Optimum order size is 10,000 and corresponding total
cost is $361,780 in this price range.
For i=1, evaluate Q2=16,961 (it is feasible).
Optimum order size is 16,961 and corresponding total
cost is $360,365 in this price range.
Optimum order size is 16,961.

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 Why Quantity Discounts?
Coordination in the supply chain
Commodity products
Products with demand curve
2-part tariffs
Volume discounts

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 Coordination for
Commodity Products
D = 120,000 bottles/year
SR = $100, hR = 0.2, CR = $3
SS = $250, hS = 0.2, CS = $2

Retailers optimal lot size = 6,324 bottles

Retailer cost = $3,795; Supplier cost = $6,009
Supply chain cost = $9,804

Dr. Srikanta Routroy. 25

 Coordination for
Commodity Products
What can the supplier do to decrease supply chain
costs?
Coordinated lot size: 9,165; Retailer cost = $4,059;
Supplier cost = $5,106; Supply chain cost = $9,165
Effective pricing schemes
All-unit quantity discount
$3 for lots below 9,165
$2.9978 for lots of 9,165 or more
Pass some fixed cost to retailer (enough that he raises
order size from 6,324 to 9,165)

Dr. Srikanta Routroy. 26

 Quantity Discounts When
Firm Has Market Power
Demand curve : 360,000 - 60,000p (where p is the price at
which DO sells vitaherb).
The manufacturer incurs a production cost of Cs=$2.
The manufacturer charges DO a price of CR.
When the two make their decisions independently, it is optimal
value of p=$5; CR=4.
The profit at DO as result of this policy is given by:
ProfR= p(360,000 - 60,000p)- (360,000 - 60,000p ) CR=$60,000
The profit at manufacturer as result of this policy is given
by:60,000*2=$120,000
Total profit in the supply chain= $180,000
Dr. Srikanta Routroy. 27
 Quantity Discounts When
Firm Has Market Power
The two stages coordinate the pricing decision
Price = $4, Profit = $240,000, Demand = 120,000
No inventory related costs
As a result of each stage setting its price independently,
the supply chain loses $60,000 in profit.
This phenomenon is referred to as double
marginalization.
It leads to loss in supply chain profit because supply
chain margin is divided between two stages but each
stages makes its decision considering only its local
margin.
Dr. Srikanta Routroy. 28
 Lessons from Discounting Schemes
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.
Volume based discounts are better over rolling horizon

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 Short-Term Discounting:
Trade Promotions
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 manufacturers 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

What is the impact on the behavior of the retailer and on 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.
Dr. Srikanta Routroy. 30
Dr. Srikanta Routroy. 31
 Short Term Discounting
Q*: Normal order quantity
C: Normal unit cost
d: Short term discount
D: Annual demand
h: Cost of holding $1 per year
Qd: Short term order quantity
Assumptions:
1. Discount will only be offered once.
2. The order quantity Qd is multiple
of Q*
3. Retailer take no action to influence
the customer demand. The customer
demand remains unchanged

*
d dD CQ
Forward buy = Qd - Q* Q = +
(C - d )h C - d
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 Short Term Discounts:
Forward Buying
Normal order size, Q* = 6,324 bottles
Normal cost, C = $3 per bottle
Discount per tube, d = $0.15
Annual demand, D = 120,000
Holding cost, h = 0.2
d 0.15 *120,000 0.15*6324
Q =
(3 0.15)0.2
+
(3 0.15)
Qd = 38,236
Forward buy = 38,236-6324=31,912
Dr. Srikanta Routroy. 33
 Promotion Pass Through
to Consumers
Demand curve at retailer: 300,000 - 60,000p
Normal supplier price, CR = $3.00
Optimal retail price = $4.00
Customer demand = 60,000
Promotion discount = $0.15
Optimal retail price = $3.925
Customer demand = 64,500
Retailer only passes through half the promotion
discount and demand increases by only 7.5%

Dr. Srikanta Routroy. 34

 Trade Promotions
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
Scan based promotions
Customer coupons

Dr. Srikanta Routroy. 35

 Managing Multi-Echelon
Cycle Inventory
Multi-echelon supply chains have multiple
stages, with possibly many players at each
stage and one stage supplying another stage.

The goal is to synchronize lot sizes at different

stages in a way that no unnecessary cycle
inventory is carried at any stage.

Dr. Srikanta Routroy. 36

 Estimating Cycle Inventory-
Related Costs in Practice
Inventory holding cost
Cost of capital
Obsolescence cost
Handling cost
Occupancy cost
Miscellaneous costs
Order cost
Buyer time
Transportation costs
Receiving costs
Other costs
Dr. Srikanta Routroy. 37
 Levers to Reduce Lot Sizes
Without Hurting Costs
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
Two-part tariff
Are trade promotions essential?
EDLP
Based on sell-thru rather than sell-in

Dr. Srikanta Routroy. 38

 Summary of Learning Objectives
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?
Dr. Srikanta Routroy. 39