Cycle Inventory

Lot or batch size is the quantity that a stage of the supply chain either produces or purchases at a
given time.

Cycle inventory is the average inventory that builds up when a stage of supply chain procures or
purchases a batch size that is higher than that demanded by the customer.

A large batch size is pursued to avail economies of scale.

Assume that demand is 100 but the lot size is 500.

Then average inventory or cycle inventory is 500/2 = 250

Cycle inventory = Q/2 (depends directly on lot size)

Average flow time = Avg inventory / Avg flow rate

Average flow time from cycle inventory = Q/(2D)

Q = 1000 units

D = 100 units/day

Cycle inventory = Q/2 = 1000/2 = 500 = Avg inventory level from cycle inventory

Avg flow time = Q/2D = 1000/(2)(100) = 5 days

Cycle inventory adds 5 days to the time a unit spends in the supply chain

Lower cycle inventory is better because:

Average flow time is lower

Working capital requirements are lower

Lower inventory holding costs

Safety Inventory

It is held to meet the demand when demand exceeds expectations.

The safety inventory may go unsold incurring unnecessary holding costs. But absence of it may
lead to lose of sales.

Hence choosing safety inventory involves a trade off between costs of having too much
inventory and cost of losing sales.
Safety stock simply is inventory that is carried to prevent stock outs. Stock outs stem from
factors such as fluctuating customer demand, forecast inaccuracy, and variability in lead times
for raw materials or manufacturing.

Safety stock determinations are not intended to eliminate all stock outs—just the majority of
them.

For example, when designing for a 95 percent service level, expect that 50 percent of the time,
not all cycle stock will be depleted and safety stock will not be needed. For another 45 percent of
cycles, the safety stock will suffice. But in approximately 5 percent of replenishment cycles,
expect a stock out

If the variability needed to protect against is demand variability, and good historical data are
available , the safety stock needed to give a certain level of protection is the standard deviation of
demand variability multiplied by the Z-score.

σd x Z = safety stock.

Imagine that no safety stock is carried. In this situation, the numerator is zero and also the Z-
score is zero. Even so, there will be enough inventory to meet demand in 50 percent of cycles.

If Z-score equals 1, the safety stock will protect against one standard deviation; there will be
enough inventory 84 percent of the time.

This percentage of cycles where safety stock prevents stock outs is called the cycle service level.
It is the percentage of the cycles when the customer demand will be met . Even if the safety stock
is zero 50 % of the cycle will meet the demand. Only 50 % of the times the demand will exceed
average demand leading to stock out.

Relationship between Z value and service level is not linear. Higher service levels requires
disproportionately higher values of z.

Typical goals fall between 90 and 98 percent, and—statistically — a cycle service level of 100
percent is unattainable

Cost of Inventory

Holding inventory has cost implications.

The cost components are material cost , holding cost, and ordering costs.

Material cost ( C ) is the cost incurred per unit of the inventory of materials held.

Holding cost (H) is the cost incurred for storing the material which includes fixed and variable
cost elements. Cost of capital , cost of physically storing the inventory and the cost resulting
from product becoming obsolete. It is measured as a percentage (h) of the cost of material. H = h
xC

Ordering cost (S) is the cost incurred per order . One has to place orders for purchasing the
inventory. Every order has cost involved. As the number of orders (n)increases the ordering cost
increases proportionately.

EOQ

Therefor the total cost of Inventory TC when D is the demand per year and Q is the lot size is
given by

TC = DC + Ch (Q/2) + ( D/Q )S

Normally the purchase quantities are kept more than the demand with an intention to avail
advantages of economies of scale.

EOQ is the optimum quantity to be purchased in a lot to optimise the total cost for cycle
inventory for a fixed period say year.

D is the demand for the product per year , which is purchased in lots of size Q each. On an
average Q/2 items are stored as inventory incurring holding cost.

Economies of Scale to Exploit Fixed Costs

Annual demand = D
Lot size =Q

Number of orders per year = D/Q

Annual material cost = CD

Annual order cost = (D/Q)S

Annual holding cost = (Q/2)H = (Q/2)hC

Total annual cost = TC = CD + (D/Q)S + (Q/2)hC

Figure shows variation in different costs for different lot sizes

TC = DC + (Q/2) Ch+ (D/Q)S

d(TC) / d(Q) = Ch/2- DS/Q²

At minimum cost d(TC)/d(Q) = 0 and Q = Q*

DS/Q*² = Ch/2
Q*= √(2DS/hC) or EOQ = √(2DS/hC)

= √(2DS/H)

S = Q*²H/2D

n* = D/Q*

= √(DhC/2S) = √(DH/2S)

To reduce optimal lot size by a factor of k, the fixed order cost must be reduced by a factor of k2
If demand increases by a factor of 4, it is optimal to increase batch size by a factor of 2 and
produce (order) twice as often.

Exercise

d = 1000 computers/month

Demand, D = 12,000 computers per year. Find EOQ, , Flow time and re order interval if lead
time is Zero. Find the total cost.

Unit cost, C = $500

Holding cost fraction, h = 0.2

Fixed cost, S = $4,000/order

Q* = Sqrt[(2)(12000)(4000)/(0.2)(500)] = 980 computers

Cycle inventory = Q/2 = 490

Flow time = Q/2d = 980/(2)(1000) = 0.49 month

Reorder interval, T = 0.98 month

Annual ordering and holding cost =

= (12000/980)(4000) + (980/2)(0.2)(500) = $97,980

There are two basic approaches to build up inventory.

Inventory may be topped up at the end of a fixed period System – P system

Inventory replenishment may be done for fixed quantities irrespective of the time elapsed Fixed
Quantity system – Q system.
ROP
Economies of Scale when multiple products are handled

1 Lot sizing for a single product (EOQ)

In a supply chain main products will move. EOQ is different for different products.The products
may be ordered separately be each product manager. When the products are ordered separately
there is separate cost associated with each product which is optimum for that product. But there
is a possibility of sharing cost of transportation cost of different products if they are brought
together.

2 Aggregating multiple products in a single order

Suppose there are 4 computer products in the previous example: Deskpro, Litepro, Medpro, and
Heavpro

Assume demand for each is 1000 units per month h=.2 C=500 S=4000

If each product is ordered separately:

Q* = 980 units for each product

Total cycle inventory = 4(Q/2) = (4)(980)/2 = 1960 units

Aggregate orders of all four products:

Combined Q* = 1960 units

For each product: Q* = 1960/4 = 490

Cycle inventory for each product is reduced to 490/2 = 245

Total cycle inventory = 1960/2 = 980 units

Average flow time, inventory holding costs will be reduced

3 Lot sizing with multiple products or customers

aLots are ordered and delivered independently for each product (No Aggregation: Each product
ordered separately)

b Lots are ordered and delivered jointly for all products (Complete Aggregation: All products
delivered on each truck)

S* = S + sL + sM + sH = 4000+1000+1000+1000 = $7000

n* = Sqrt[(DLhCL+ DMhCM+ DHhCH)/2S*]

= 9.75

QL = DL/n* = 12000/9.75 = 1230

QM = DM/n* = 1200/9.75 = 123

QH = DH/n* = 120/9.75 = 12.3

Cycle inventory = Q/2

Average flow time = (Q/2)/(weekly demand)

c Lots are ordered and delivered jointly for a few products from the lot or a subset of
products (Tailored Aggregation: Selected subsets of products on each truck)

When all the products are carried in every shipment the number of pieces of a particular product
that is shipped could be very low. In fact we are adding unnecessary ordering cost to the low
demanded product.

To avoid this, one can follow a different policy. Here we assume that the repeat orders for less
demanded products can be made at less frequent but regular intervals , the frequency of which
can be heuristically determined.

The procedure is as follows

Identify the most frequently ordered product present in every order assuming independent
ordering , calculating the frequency of each order using the formula √hCiDi/2(S+si). Let N be its
frequency.

. For each of the rest of the products the ordering frequency is

recalculated by considering only the product specific ordering

 cost , ni = √hiCiDi/2 Si

3. Find the relative frequency of each of the product wrt the most

frequently ordered product pi as equal to N/ ni rounded up

to the next integer.

4. Each of these product is ordered along with the most frequently ordered product in every Pi th
order.

5. Having calculated the ordering frequency of every product recalculate the ordering frequency
of the most frequently ordered product N* such that N* = √ (∑hXCiXpixDi/(2(S+ ∑Si/pi)) as
effective ordering cost for each product per order is now S + Si/pi.

6. Now recalculate the order frequency for each product as ni* = N*/pi to the exact value.

7. The annual ordering cost is given by N*S+ ∑ ni*Si

8. Add total holding cost as per the lot size to get the total cost.

The method described above is tailored aggregation where order for each product is tailored to
its demand

The above are the steps of the photos given below

Quantity Discounts

Quantity Discounts A quantity discount is an incentive offered to a buyer that results in a

decreased cost per unit of goods or materials when purchased in greater numbers.

A quantity discount is often offered by sellers to entice buyers to purchase in larger quantities.
Our objective is to minimize the total annual costs

TC = SxD/Q + HxQ/2 + PxD