Chapter11 - Managing Cycle Inventory PDF

Managing Economies of Scale in a
Supply Chain: Cycle Inventory

Copyright: Pearson Education
Hasin Md. Muhtasim Taqi

Lecturer, Dept. of MPE
Email: swopniltaqi@gmail.com
Copyright ©2013 Pearson Education. 11-1

Can you recall the EOQ model studied in the previous
semester?
A company makes bicycles. It produces 450 bicycles a month. It

buys the tires for bicycles from a supplier at a cost of $20 per tire.
The company’s inventory carrying cost is estimated to be 15% of
cost and the ordering is $50 per order. Find EOQ, Cycle inventory,
average flow time, number of orders per year, total cost related to
cycle inventory.
PowerPoint presentation to accompany

Chopra and Meindl Supply Chain Management, 5e
Global Edition
Copyright ©2013 Pearson Education.
11-2
1-2
Can you recall Little’s Law?
Little’s Law states that I = R * T

Where, I is Inventory, R is Flow Rate and
T is Flow Time.
Average flow time cycle inventory Q

resulting from = =
demand 2D
cycle inventory

Can you recall the Quantity Discount
Models?
• Unit price depends upon the quantity ordered
How can you apply the EOQ model?

An example application
• Annual Demand = 5000 units
• Ordering cost = $49
• Annual carrying charge = 20%
• Unit price schedule:
Quantity Unit Price
0 to 999 $5.00
1000 to 1999 $4.80
2000 and over $4.75
5,000 1000
TCQ =1000 =  49 +  0.2  4.80 + 4.80  5000 = $24,725
1000 2
11
Managing
Economies of Scale
in a Supply Chain:
Cycle Inventory
PowerPoint presentation to accompany
Chopra and Meindl Supply Chain Management, 5e
Global Edition
Copyright ©2013 Pearson Education.
11-6
1-6
Learning Objectives
1. Balance the appropriate costs to choose the
optimal lot size and cycle inventory in a
supply chain.
2. Lot sizing with multiple products or
customers
3. Understand the impact of quantity discounts
on lot size and cycle inventory.
4. Understand the impact of trade promotions
on lot size and cycle inventory.

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

resulting from = =
demand 2D
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

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

Estimating Cycle Inventory Related
Costs in Practice
• Ordering Cost
– Buyer time
– 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
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
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
D
Number of orders per year =
Q
æ Dö
Annual ordering cost = ç ÷ S
èQø
æQ ö æQö
Annual holding cost = ç ÷ H = ç ÷ hC
è2ø è2ø
æ Dö æQ ö
Total annual cost, TC = CD + ç ÷ S + ç ÷ hC
èQø è2ø

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
Example 11-1
Best Buy Retail chain selling Deskpro computers
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
2 ´12,000 ´ 4,000
Optimal order size = Q* = = 980
0.2 ´ 500

EOQ Example
Q * 980
Cycle inventory = = = 490
2 2
D
Number of orders per year = = 12.24
Q*
D æQ *ö
Annual ordering and holding cost = S +ç ÷ hC = 97,980
Q* è 2 ø
Q* 490
Average flow time = = = 0.041= 0.49 month
2D 12,000

EOQ Example
If Q=1100 is used instead of 980 (10% increase) annual

cost increase to $98,930, a 0.67% increase;
- We don’t have to use EOQ exactly, a convenient value
near the EOQ is ok.
If the demand in a month increases to 4000 unites

(an increase by a factor 4 (k=4) )
- EOQ figure doubles (increases by k )

- Number of orders per year doubles
- Average flow time decreases by a factor of 2 (decreases
by k )
EOQ Example
• Lot size reduced to Q = 200 units
D æQ *ö
Annual inventory-related costs = S +ç ÷ hC = 250,000
Q* è 2 ø

Lot Size and Ordering Cost
• In order to have 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
hC(Q*)2 0.2 ´ 500 ´ 2002

S= = = 166.7
2D 2 ´12,000

Aggregating Multiple Products
in a Single Order
• Single delivery from multiple suppliers or

single truck delivering to multiple retailers
• Savings in transportation costs
– Reduces fixed cost for each product
– Lot size for each product can be reduced
– Cycle inventory is reduced
• Receiving and loading costs can be
reduced using ASP(advanced shipping
notice), RFID, badcode
Lot Sizing with Multiple
Products or Customers
• Ordering, and receiving costs grow with the
variety of products
• Ttransportation cost is independent of the variety
of products, but it increases in 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

Multiple Products Ordered and
Delivered Independently
-Case example
-Best buy selling three models of
computers
- A fixed cost of transportation is incurred
each time an order is delivered
- For each model delivered an additional
fixed ordering cost of $1000 is also
incurred

Example 11-3
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

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

Lots Ordered and Delivered Jointly
(Example 11-4)
S* = S + sL + sM + sH Annual order cost = S * n
DL hC L DM hCM DH hC H
Annual holding cost = + +
2n 2n 2n
DL hC L DM hCM DH hC H
Total annual cost = + + +S*n
2n 2n 2n
å
k
DL hC L + DM hCM + DH hC H Di hCi
n* = n* = i=1
2S * 2S *

Products Ordered and Delivered
Jointly
S* = S + sA + sB + sC = $7,000 per order
12,000 ´100 +1,200 ´100 +120 ´100

n* = = 9.75
2 ´ 7,000
Annual order cost = 9.75 x 7,000 = $68,250
Annual ordering
and holding cost = $61,512 + $6,151 + $615 + $68,250
= $136,528

Products Ordered and Delivered
Jointly

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
Table 11-2

Lots Ordered and Delivered
Jointly for a Selected Subset
• It is not necessarily optimal to include every item in every
order.
• We have found n=9.75 in joint ordering case.
• If we order Heavy-pro in every fourth order instead of
every order
– We save 9,750x1000x(3/4)=7312 $/year in ordering
cost
– We increase the inventory holding cost by
(120/(9,75/4) -120/9,75)x500x0,2/2 = 1846,15 $/year
- The net saving is 7312-1846,15=5465,85 $/year
• What should be the order frequency for each item ?

for a Selected Subset
Step 1: Identify the most frequently ordered
product assuming each product is
ordered independently
hCi Di
ni =
2(S + si )
Step 2: For all products i ≠ i*, evaluate the
ordering frequency
hCi Di
ni =
2si
Step 3: For all i ≠ i*, evaluate the frequency of
product i relative to the most frequently
ordered product i* to be mi (round up)
é ù
mi = ên / ni ú
Step 4: Recalculate the ordering frequency of the

most frequently ordered product i* to be n
å
l
hCi mi D
n= i=1
(
2 S + å si / mi
l
i=1 )
Step 5: Evaluate an order frequency of ni = n/mi
and the total cost of such an ordering
policy
l l
 Di 
TC = nS +  ni si +   hCi
i =1 i =1  2ni 
Tailored aggregation – high demand or value

products ordered more frequently and low
demand/value products ordered less frequently

Ordered and Delivered Jointly –
Frequency Varies by Order
• Applying Step 1
hC L DL
nL = = 11.0
2(S + sL )
Thus
n = 11.0
hCM DM
nM = = 3.5
2(S + sM )
hC H DH
nL = = 1.1
2(S + sH )

• Applying Step 2
hCM DM hC H DH
nM = = 7.7 and nH = = 2.4
2sM 2sH
• Applying Step 3
é ù é ù é ù é
ê n ú 11.0 ê n ú 11.0 ù
mM = =ê ú = 2 and mH = =ê ú=5
ê n ú ê 7.7 ú ê n ú ê 2.4 ú
ê Mú ê Hú


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
Table 11-3

• Applying Step 4 n = 11.47
• Applying Step 5
nL = 11.47 / yr nM = 11.47 / 2 = 5.74 / yr nH = 11.47 / 5 = 2.29 / yr
Annual order cost and inventory cost
nS + nL sL + nM sM + nH sH = $65,383.5
 DL  D  D 
 hCL +  M hCM +  H hCH = 65,383.5
 2nL   2 nM   2nH  Total annual cost
$130,767
Key points in lot sizing
• Reduce fixed cost in order to reduce the
cycle inventories in the system.
• In multi item case, a way to reduce fixed
costs and cycle inventory is joint
replenishment which effectively reduces
the fixed costs.

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 (e.g. year)
• Two common schemes
– All-unit quantity discounts
– Marginal unit (incremental) 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 cost, 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
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

Figure 11-3

Step 1: Evaluate the optimal lot size for each

price Ci,0 ≤ i ≤ r as follows
2DS
Qi =
hCi

Step 2: We next select the order quantity Q*i for
each price Ci
1. qi £ Qi < qi+1
2. Qi < qi
3. Qi ³ 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

Step 3: Calculate the total annual cost of

ordering Q*i units
æDö æ Q* ö
Total annual cost, TCi = çç * ÷÷ S + çç i ÷÷ hCi + DCi
è Qi ø è 2ø

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

All-Unit Quantity Discount
Example 11-7
DO –drugs on line sells drugs and help supplements on line
- Consider vitamins. The demand for vitamins is 10000 bottles
per month
- The manufacturer uses the following price schedule.
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 = = 6,324; Q1 = = 6,367; Q2 = = 6,410
hC0 hC1 hC2
Step 2
Ignore i = 0 because Q0 = 6,324 > 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;
 Q1   2 
 D   Q2* 
TC 2 =  *  S +  hC2 + DC2 = $354,520
 Q2   2 
Lowest total cost is for i = 2

Order Q2* = 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)

FIGURE 11-4

Material cost of each order Q is Vi + (Q – qi)Ci
æ Dö
Annual order cost = ç ÷ S
èQø
Annual holding cost = éëVi + (Q – qi )C i ùû h / 2
Dé
Annual materials cost = ëVi + (Q – qi )Ci ùû
Q
æ Dö
Total annual cost = ç ÷ S + éëVi + (Q – qi )C i ùû h / 2
èQø
Dé
+ ëVi + (Q – qi )Ci ùû
Q
Step 1: Evaluate the optimal lot size for each

price Ci
2D(S +Vi – qiCi )

Optimal lot size for Ci is Qi =
hCi

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

Step 3: Calculate the total annual cost of

ordering Qi*
æDö D
TCi = çç * ÷÷ S + éëVi + (Qi* – qi )C i ùû h / 2 + * éëVi + (Qi* – qi )Ci ùû
è Qi ø 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

Example
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
Example
Step 2
Q0* = q1 = 5,000 because Q0 = 6,324 > 5,000
Q1* = q2 = 10,000; Q2 = Q2 = 16,961
Step 3
æDö D
TC0 = çç * ÷÷ S + éëV0 + (Q0* – q0 )C 0 ùû h / 2 + * éëV0 + (Q0* – q0 )C0 ùû = $363,900
è Q0 ø Q0
æDö D
TC1 = çç * ÷÷ S + éëV1 + (Q1* – q1)C 1ùû h / 2 + * éëV1 + (Q1* – q1)C1ùû = $361,780
è Q1 ø Q1
æDö D
TC2 = çç * ÷÷ S + éëV2 + (Q2* – q2 )C 2 ùû h / 2 + * éëV2 + (Q2* – q2 )C2 ùû = $360,365
è Q2 ø Q2

• Observe that the lowest cost is for i = 2.
Thus, it is optimal for DO to order in lots of
Q*2 = 16,961 bottles. This is much larger
than the optimal lot size of 6,325 when the
manufacturer does not offer any discount.

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Managing Economies of Scale in a

Supply Chain: Cycle Inventory

Hasin Md. Muhtasim Taqi

Copyright ©2013 Pearson Education. 11-1

A company makes bicycles. It produces 450 bicycles a month. It

PowerPoint presentation to accompany

Little’s Law states that I = R * T

Average flow time cycle inventory Q

Copyright ©2013 Pearson Education. 11-3

• Unit price depends upon the quantity ordered

How can you apply the EOQ model?

Copyright ©2013 Pearson Education. 11-4

Copyright ©2013 Pearson Education. 11-7

Copyright ©2013 Pearson Education. 11-8

Copyright ©2013 Pearson Education. 11-9

Average flow time cycle inventory Q

Copyright ©2013 Pearson Education. 11-10

• Lower cycle inventory has

Copyright ©2013 Pearson Education. 11-11

Copyright ©2013 Pearson Education. 11-14

Copyright ©2013 Pearson Education. 11-15

Copyright ©2013 Pearson Education. 11-16

Copyright ©2013 Pearson Education. 11-18

Copyright ©2013 Pearson Education. 11-19

Copyright ©2013 Pearson Education. 11-20

• The economic order quantity (EOQ)

• The optimal ordering frequency

Copyright ©2013 Pearson Education. 11-21

Best Buy Retail chain selling Deskpro computers

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

Copyright ©2013 Pearson Education. 11-22

Copyright ©2013 Pearson Education. 11-23

If Q=1100 is used instead of 980 (10% increase) annual

If the demand in a month increases to 4000 unites

- EOQ figure doubles (increases by k )

• Lot size reduced to Q = 200 units

Copyright ©2013 Pearson Education. 11-25

hC(Q*)2 0.2 ´ 500 ´ 2002

Copyright ©2013 Pearson Education. 11-26

• Single delivery from multiple suppliers or

Copyright ©2013 Pearson Education. 11-29

Copyright ©2013 Pearson Education. 11-30

Copyright ©2013 Pearson Education. 11-31

Copyright ©2013 Pearson Education. 11-32

Copyright ©2013 Pearson Education. 11-33

S* = S + sA + sB + sC = $7,000 per order

12,000 ´100 +1,200 ´100 +120 ´100

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

Copyright ©2013 Pearson Education. 11-34

Litepro Medpro Heavypro

Copyright ©2013 Pearson Education. 11-35

Copyright ©2013 Pearson Education. 11-36

Step 4: Recalculate the ordering frequency of the

Tailored aggregation – high demand or value

Copyright ©2013 Pearson Education. 11-39

Copyright ©2013 Pearson Education. 11-40

Copyright ©2013 Pearson Education. 11-41

Litepro Medpro Heavypro