Unit -2

Managing Economies of Scale in the

Supply Chain: Cycle Inventory

10-1
Inventory
 Cycle Inventory
• purchasing is done in large lots and
consumption is done in smaller lots.
• When the order is received there is a
sharp increase in stock or inventory.
• This inventory or stock gets depleted
as consumption takes place gradually
and once again a big lot may be
ordered and received.
• Thus the cycle repeats and the
average inventory held by a firm
during each cycle is termed cycle
inventory.
•
 Economies of Scale to Exploit Fixed Costs
▪ Producing or purchasing in large lots allows a stage of supply chain
✔ to exploit economies of scale and
✔ lower cost.
▪ These economies of scale result due to
✔ fixed costs associated with ordering and transportation,
✔ quantity discounts on buying larger lots, and
✔ short-term discounts or
✔ trade promotions.
•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
•Lower cycle inventory is better because:
–Average flow time is lower
–Working capital requirements are lower
–Lower inventory holding costs
Economies of Scale to Exploit Fixed Costs
•Lot sizing for a single product (EOQ, Optimal lot size)
•Aggregating multiple products in a single order
•Lot sizing with multiple products or customers
–Lots are ordered and delivered independently for each product
–Lots are ordered and delivered jointly for all products
–Lots are ordered and delivered jointly for a subset of products
 Economies of Scale to Exploit Fixed Costs
The inventory holding results in
costs for a firm and this cost is
called inventory holding cost
or inventory carrying cost.

To reduce lot sizes that arise due

to presence of ordering costs,
a number of individual items
are ordered in a single order.
This will distribute the
transportation cost over a
number of items and lot sizes What is lot size or batch size?
for individual items can be Lot or batch size is the
small. quantity (Q) that a stage of a
supply chain either produces
of purchases(Order size) at a
time
 Costs Influenced by Lot Size

Annual Cost

Holding Cost
Ordering Cost Material Cost

Order Quantity
 Material Cost (C)
• Material cost ($/unit)
– The average price paid per unit

Annual Cost
Supply Chain Cost Influenced by Lot Size

CD
Order Quantity
 Holding Cost (H=hC)
• Holding cost ($/unit/year)
– Cost of carrying one unit in inventory for a
specified period of time
% of
Category Inventory Value
Warehousing/occupancy cost6%
Handling costs 3%
Obsolescence cost 3%
Cost of capital 11%
Miscellaneous cost 3%
Total holding cost 26%
 Supply Chain Cost Influenced by Lot Size

Annual Cost

(Q/2)H

Holding Cost
Material Cost

Order Quantity
 Ordering Cost (S)
• Ordering cost ($/lot)
– Fixed cost incurred each time an order is placed
(does not vary with the size of the order)
• Buyer time (order placement)
• Transportation cost
• Receiving cost
1000 Orders = $400,000
1 Order = $ 400 PurchaseOrder
Purchase Order
Purchase OrderQty.
Description
Purchase Order Purchase Order
Description Qty.
Description Qty. Description
Microwave
Description Qty.
Qty. 1
Microwave
Microwave 11 1
Microwave 1000 Microwave
Order
quantity
 Supply Chain Cost Influenced by Lot Size

Annual Cost

(D/Q)S
Holding Cost
Ordering Cost Material Cost

Order Quantity
 Supply Chain Cost Influenced by Lot Size

Annual Cost
CD + (D/Q)S + (Q/2)H
Total Cost Curve

Holding Cost
Ordering Cost Material Cost

Optimal Order Quantity

Order Quantity (Q*)
 Economic Order Quantity (EOQ)

• Optimal order quantity

Q*
hC
 Economies of Scale to Exploit Fixed Costs
Lot sizing for a single product (EOQ):
D: Annual demand (D/year)
S: Setup or Order Cost/order
C: Cost per unit
h: Holding cost per year as a fraction
of product cost
H: Holding cost per unit /year
Q: Lot Size; T:Reorder interval
Material cost is constant & hence not considered in this model
Annual demand = D (Demand=D/year); H=hc;

Average Flow Time = Average inventory/Demand=Q*/2D

Reorder Interval =Q*/D
Annual order cost = (D/Q*)S
Annual holding cost = (Q*/2)H = (Q*/2)hC
Total annual cost = TC = (D/Q*)S + (Q*/2)hC
Figure shows variation in different costs with lot sizes
 Why Order in Large/Small Lots?
• Fixed ordering cost: S (cost incurred per order/lot)
– Increase the lot size to decrease the fixed ordering cost per unit
• Holding cost: H (cost of carrying one unit in inventory)
– Decrease the lot size to decrease holding cost
• Material cost: C (cost per unit)
 Example: Economic Order Quantity
• Example 1
– Demand for the Deskpro computer at Best Buy is 1,000
units per month. Best Buy incurs a fixed order
placement, transportation, and receiving cost of $4,000
each time an order is placed. Each computer costs Best
Buy $500 and the retailer has an annual holding cost of
20 percent. Evaluate the number of computers that the
store manager should order in each replenishment lot.

D = 1,000 x 12 = 12,000
S = $4,000
C = $500
h = 0.2
 Example: Economic Order Quantity
• Example 1

D = 12,000
S = 4,000 Q*
C = 500 hC
h = 0.2

Q* = sqrt((2DS)/(hC))
= sqrt((2 x 12,000 x 4,000)/(0.2 x 500))
= 980
 Example: Economic Order Quantity

• Example -1
Order frequency = D/Q *
D = 12,000 = 12,000 / 980 = 12.24
S = 4,000
C = 500 Cycle inventory = Q * /2
h = 0.2 = 980 / 2 = 490
Q* = 980
Average flow time = Q * /(2D)
= 980 / (2 x 12,000) = 0.041
 Example: Economic Order Quantity
• Example -1
Annual ordering and holding cost
D = 12,000 = (D/Q*)S + (Q*/2)hC
S = 4,000 = $48,990 + $48,990
C = 500 = $97,980
h = 0.2
What if Q = 1,000 cost = $98,000
Q* = 980 What if Q = 900 cost = $98,333
What if Q = 200 cost = $250,000

Inference :Total ordering and holding costs are

relatively stable around the economic order quantity
 Example: Economic Order Quantity
• Example -2
– The store manager at Best Buy would like to reduce the
optimal lot size from 980 to 200. For this lot size
reduction to be optimal, the store manager wants to
evaluate how much the order cost per lot should be
reduced (currently $4,000)
Q* = sqrt((2DS)/(hC))
200 = sqrt((2 x 12,000 x S)/(0.2 x 500))
S = (hC(Q*)2)/2D = (0.2 x 500 x 2002)/(2 x 12,000) = $166.7
Q* = 980 /200~ 1000/200=5; k=5
S= 4000/167=24 ~ 25; k=25
Inference:To reduce the optimal lot size by a factor of k,
the fixed order cost S must be reduced by a factor k2
 Example: Economic Order Quantity
• How can the store manager reduce the
fixed ordering cost?
– Aggregate multiple products in a single
order
• Can possibly combine shipments of different
products from the same supplier
• Can also have a single delivery coming from
multiple suppliers
Aggregating replenishment (Refilling) across products in a
single order allows for a reduction in lot size for individual
products because fixed ordering and transportation cost
are now spread across multiple products
 Summary
Description Formula
Optimal order quantity Q* sqrt((2DS)/H)
Order frequency n D/Q
Cycle inventory Q/2
Average flow time (Avg inventory)/(Avg demand)
Order cost (D/Q)S
Holding cost (Q/2)H
Material cost CD
 Key Points from EOQ Model
1. 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.
Inference:If demand increases by a factor
k, the optimal lot size increases by a
factor √k

Q*
hC
 Key Points from EOQ Model
2. If lot size is to be reduced, one has to
reduce fixed order cost. To reduce lot size
by a factor of 2, order cost has to be
reduced by a factor of 4(=22).
To reduce the optimal lot size by a factor of k,
the fixed order cost S must be reduced by a
factor k2

Q*
hC
 Key Points from EOQ Model
1. Total ordering and holding costs are relatively
stable around the economic order quantity
2. If demand increases by a factor k, the optimal
lot size increases by a factor √k
3. To reduce the optimal lot size by a factor of k,
the fixed order cost S must be reduced by a
factor k2

Q*
hC
 Aggregating Multiple Products in a Single Order
• Example -1 (continued)
– Assume Best Buy sells 4 different models of Deskpro
each with demand of 1,000 units per month (all costs
are same)
– 4 single orders
• Q* for each model equals 980
• Annual order and holding cost equal 97,980 x 4 = $391,920
– 1 aggregate order
• D = 12,000 x 4 = 48,000
• Q* = sqrt((2 x 48,000 x 4,000)/(0.2 x 500))
= 1,960 (= 490 for each model)
•Annual order and holding cost = (D/Q)S + (Q/2)hC
= ((48,000/1,960) x 4,000) + (1,960/2) x 0.2 x 500= $244,918
• (=37.5% savings! )
Lot Sizing with Multiple Products or Customers

• Ordering cost has two components

– Common (to all products)
– Individual (to each product)
• Example
– It is cheaper for Wal-Mart to receive a truck
containing a single product than a truck containing
many different products
• Inventory and restocking effort is much less for a single
product
 Aggregating Multiple Products in a Single Order

Aggregating replenishment (Refilling)

across products in a single order
allows for a reduction in lot size for
individual products because fixed
ordering and transportation cost are
now spread across multiple products
Aggregating Multiple Products in a Single Order
•Wal-Mart has facilitated aggregation across multiple
supply and delivery points without storing intermediate
inventories through the use of cross-docking.
•Each supplier sends full truckloads to the distribution
center (DC), containing an aggregate delivery destined for
multiple retail stores. At the DC, each inbound truck is
unloaded, product is cross-docked, and outbound trucks
are loaded.
•Each outbound truck now contains product aggregated
from several suppliers for one retail store.
 Aggregating Multiple Products in a Single Order
• Transportation is a significant contributor to the fixed
cost per order
• Can possibly combine shipments of different products
from the same supplier
– same overall fixed cost
– shared over more than one product
– effective fixed cost is reduced for each product
– lot size for each product can be reduced
• Aggregating across products, retailers, or suppliers in a
single order allows for a reduction in lot size for individual
products because fixed ordering and transportation costs
are now spread across multiple products, retailers, or
suppliers
Aggregating Multiple Products in a Single Order
• Transportation is a significant contributor to the fixed
cost per order
• Can possibly combine shipments of different products
from the same supplier
• Can also have a single delivery coming from multiple
suppliers
OR
a single truck delivering to multiple retailers
• Aggregating across products, retailers, or suppliers in a
single order allows for a reduction in lot size for
individual products because fixed ordering and
transportation costs are now spread across multiple
products, retailers, or suppliers
Aggregating Multiple Products in a Single Order

• Savings in transportation costs

– Reduces fixed cost for each product
– Lot size for each product can be reduced
– Cycle inventory is reduced
• Single delivery from multiple suppliers or
single truck delivering to multiple
retailers
• Receiving and loading costs reduced
Aggregating Multiple Products in a Single Order
• In practice, the fixed ordering cost is dependent at
least in part on the variety associated with an
order of multiple models
✔A portion of the cost is related to transportation
(independent of variety)
✔A portion of the cost is related to loading and
receiving (not independent of variety)
• Two scenarios:
✔Lots are ordered and delivered independently
for each product
✔Lots are ordered and delivered jointly for all
three models
Lot Sizing with Multiple Products or Customers

• Ordering, transportation, and receiving costs grow

with the variety of products or 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
SC manager may consider three approaches to the
lotsizing decision:

1. No Aggregation :Each product manager orders his

model independently.
2. Complete Aggregation: The product managers
jointly order every product in each lot.
3. Tailored Aggregation: Product managers order
jointly but not every order contains every product;
that is, each lot contains a selected subset of the
products.
 Lot Sizing with Multiple Products or Customers

• Multiple products
– Independent orders
• No aggregation: Each product ordered separately
1 2 3
– Joint order of all products
• Complete aggregation: All products delivered on each truck
1 2 3 1 2 3 1 2 3
– Joint order of a subset of products
• Tailored aggregation: Selected subsets of products on each
truck
1 1 2 1 2 3

Which option will likely have the lowest cost?

Lot Sizing with Multiple Products or Customers
• Example -3
–Best buy sells three models of computers, the Litepro,
the Medpro, and the Heavypro. Annual demands for the
three products are DL = 12,000 units for the Litepro, DM =
1,200 units for the Medpro, and DH = 120 units for the
Heavypro. Each model costs Best Buy $500. A fixed
transportation cost of $4,000 is incurred each time an
order is delivered. For each model ordered and delivered
on the same truck, an additional fixed cost of $1,000 is
incurred for receiving and storage. Best Buy incurs a
holding cost of 20 percent. Evaluate the lot sizes that the
Best Buy manager should order if
1.lots for each product are ordered and delivered
independently.
Lot Sizing with Multiple Products or Customers

•Ordering cost is considered

independent for each product
–Apply EOQ to each product
Lot Sizing with Multiple Products or Customers

• Example -3
– DL = 12,000 (demand per year)
– DM = 1,200
– DH = 120
– S = $4,000 (common order cost)
– sL = sM = sH = $1,000 (product specific order cost)
– h = 0.2 (holding cost)
– cL = cM = cH = $500 (material cost)
Lot Sizing with Multiple Products or Customers

• Example -3 Cycle inventory = Q * /2

= 1095 / 2 = 548
D = 12,000
S = 5,000 Order frequency N*= D/Q *
C = 500 = 12,000 / 1095 = 11/year
h = 0.2
Q* = 1095
Average flow time = Q * /(2D)
= 1095 / (2 x 12,000) = 0.0456years
=2.4 weeks (1 year=52 weeks)
Lot Sizing with Multiple Products or Customers
• Example -3
Annual ordering and holding cost
D = 12,000 = (D/Q*)S + (Q*/2)hC
S = 5,000 = $54772 + $54772
C = 500 = $109,544
h = 0.2
Q* = 1095
 Independent Orders Q*
hC
1 2 3

Litepro Medpro Heavypro

Demand per year D 12,000 1,200 120
Fixed cost/order S $5,000 $5,000 $5,000
Optimal order size Q* 1,095 346 110
Cycle inventory Q*/2 548 173 55
Order frequency n* 11.0/year 3.5/year 1.1/year
Average flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual holding cost $54,772 $17,321 $5,477
Annual order cost $54,772 $17,321 $5,477
Total cost $109,544 $34,642 $10,945
Total cost = $155,140
 Joint Orders of all Products
• Joint order of all products
– Complete aggregation: All products delivered on
each truck
• An order frequency is calculated by aggregating the
ordering costs and assuming that all products will be
ordered at the same time
Products Ordered and Delivered Jointly
• Best buy sells three models of computers, the Litepro, the
Medpro, and the Heavypro. Annual demands for the three
products are DL = 12,000 units for the Litepro, DM = 1,200 units
for the Medpro, and DH = 120 units for the Heavypro. Each
model costs Best Buy $500. A fixed transportation cost of
$4,000 is incurred each time an order is delivered. For each
model ordered and delivered on the same truck, an additional
fixed cost of $1,000 is incurred for receiving and storage. Best
Buy incurs a holding cost of 20 percent. Evaluate the lot sizes
that the Best Buy manager should order if
1.lots for each product are ordered and delivered independently
2.lots for each product are ordered and delivered jointly.
(The three product managers have decided to aggregate and
order all three models each time they place an order.
Evaluate the optimal lot size for each model
 Joint Orders of all Products

• Inputs
– DL = 12,000 (demand per year)
– DM = 1,200
– DH = 120
– S = $4,000 (common order cost)
– sL = sM = sH = $1,000 (product specific order cost)
– h = 0.2 (holding cost)
– cL = cM = cH = $500 (material cost)
• S* = S + sL + sM + sH = $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
Products Ordered and Delivered Jointly
• Joint order of all products
– Complete aggregation: All products delivered on
each truck
• An order frequency is calculated by aggregating the
ordering costs and assuming that all products will be
ordered at the same time
Lots Ordered and Delivered Jointly
 Products Ordered and Delivered Jointly

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

QM = DM/n* = 1200/9.75 = 123
QH = DH/n* = 120/9.75 = 12.3
Annual order cost = 9.75 x 7,000 = $68,250

Total Annual Cost= Annual ordering and holding cost

= $61,512 + $6,151 + $615 + $68,250 = $136,528; saving=??%
 Joint Orders of all Products
1 2 3 1 2 3 1 2 3

Litepro Medpro Heavypro

Demand per year 12,000 1,200 120
Order frequency 9.75/year 9.75/year 9.75/year
Optimal order size 1,230 123 12.3
Annual holding cost $61,512 $6,151 $615
Annual order cost $68,278

Total cost = $136,556

 Supply Chain Cost Influenced by Lot Size

Annual cost
Holding cost
(Q1/2)H1 + (Q2/2)H2 + (Q3/2)H3

Order cost
(D1/Q1)S + (D2/Q2)S + (D3/Q3)S

Material cost Order quantity

C 1 D1 + C 2 D2 + C 3 D3
 Supply Chain Cost Influenced by Lot Size

Annual cost
Holding cost
(D1/2n)H1 + (D2/2n)H2 + (D3/2n)H3

Order cost
nS*

Material cost Order quantity

C 1 D1 + C 2 D2 + C 3 D3
 Joint Order of a Subset of Products

• Joint order do not include all products

• Ordering frequency may be different for each
product
– It is based on the product that has the highest
frequency

Total cost = $130,767

 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
 Economies of Scale in Replenishment Decisions

• Economies of Scale to Exploit Fixed Costs (using CI)

• Economies of Scale to Exploit Quantity Discounts
• Short-Term Discounting: Trade Promotions
 Quantity Discounts
• Material cost was constant in previous discussion
• Pricing schedule displays economies of scale with
price decreasing as lot size increases or as volume
increases.
• Very common in business to business transactions.

• How should a buyer react?

• What are appropriate discounting schemes?
• How does this decision affect the SC in term of
lot sizes, cycle inventory and flow times?
 Quantity Discounts
• 1.Lot size based: If pricing schedule offers discounts
based on quantity ordered in a single lot.
– Case 1: All unit Quantity Discount: Average unit cost varies
with the quantity ordered.
– Case 2: Marginal unit Quantity Discount (Multi-Block
Tariff): Marginal cost decreases at break points.
• 2.Volume based: If discount is based on total quantity
purchased over a given time period regardless of
number of lots purchased over that period.
 All-Unit Quantity Discounts
• Pricing schedule has specified quantity break points
q0, q1, …, qr, where q0 = 0
• 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.
• For each value of evaluate the following:
There are three possible cases for
Case 1: If then a lot size of Qi units will result
in the discounted price of Ci per unit. In this case the total
annual cost of ordering Qi is given as follows: Total annual
cost,
Case 2: If Qi < qi , then a lot size of Qi does not result in a
discount. Raising the lot size to qi units results in the discounted
price of Ci per unit. It is thus optimal to order a lot size of qi
units to get a unit price Ci. The annual cost is given by
Total annual cost,
Case 3: If Qi> qi+1, then a lot size of qi+1 units will result in the
discounted price of Ci+1 per unit. The annual cost is given by
Total annual cost, TCi =
The solution is to order the lot size that minimizes the total
annual cost across all prices in the schedule.
All Unit Quantity Discount –Example Problem
Demand for vitamins is 10000 bottles per month in
Drugs Online (DO). DO incurs a fixed order
placement, transportation and receiving cost of
Rs. 100 each time an order for vitamins is placed
with the manufacturer. DO incurs a holding cost
20%. The price charged by the manufacturer
varies according to the all unit discount pricing
schedule shown. Evaluate the no. of bottles that
DO manager should order in each lot.
Order Quantity Unit price
0-5000 Rs. 3.0
5000-10000 Rs. 2.96
10000 or above Rs. 2.92
 All Unit Quantity Discount –Example Problem
Data:
Annual demand, D = 10000 x12= 1,20,000 units/year.
Ordering cost, S = Rs. 100. Holding charges, h =0.20.
Identify q, C values; q 0 = 0, q 1 = 5,000, q 2 = 10,000
Co = $3.00, C1 = $2.96, C2 = $2.92
q🡪 data given, Q 🡪 calculated EOQ

Order Quantity Unit price

0- 5000 Rs. 3.0
5000 -10000 Rs. 2.96
10000 or above Rs. 2.92
Formulae to be used:

2. Total Annual Cost TCi =

i = 0; Ci = C0 = 3; q i = q 0 = 0, q i+1 =q 1 = 5,000

Case 3: If Qi> qi+1, then a lot size of qi+1 units will result in the
discounted price of Ci+1 per unit. The annual cost is given by
Total annual cost, TCi =
q i+1 =q 1 = 5,000 Ci+1 = C0+1 = C1=2.96
Formulae to be used:

2. Total Annual Cost TCi =

i = 1; Ci = C1 = 2.96; q i = q 1 = 5000, q i+1 =q 2 = 10,000

Case 1: If then a lot size of Qi units will result

in the discounted price of Ci per unit. In this case the total
annual cost of ordering Qi is given as follows: Total annual
cost,
Qi = Q1 =6367 Ci = C1 =2.96
 Formulae to be used:

2. Total Annual Cost TCi =

i = 2; Ci = C2 = 2.92; q i = q 2 = 10000,

Case 2: If Qi < qi , then a lot size of Qi does not result in a discount.

Raising the lot size to qi units results in the discounted price of Ci per
unit. It is thus optimal to order a lot size of qi units to get a unit price
Ci. The annual cost is given by Total annual cost,

qi = q2 =10000 Ci = C2 =2.92
Formulae to be used:

2. Total Annual Cost TCi =

i = 0; Q0 =6324 units, put Quantity=5000 units for

total cost calculation as Qi> qi+1 TC0 =$359080
i = 1; Q1 =6367 units, put Quantity=6367 units for
total cost calculation as TC1 =$358969
i = 2; Q2 =6410 units, put Quantity=10000 units for
total cost calculation as Qi< qi TC2 =$354520
Decision: Since TC2 is least, No. of
bottles to be ordered = 10000 units
 All unit quantity discount-Procedure
1.Extract Data such as D, S and h, identify no. of price breaks, q, C values
2. q🡪 data given, Q 🡪 calculated EOQ
3 For i=0; calculate, Q0 using
4. There are 3 cases possible for Q0 :
q ≤ Q 0< q 1 .
Case 1: If 0 then consider lot size= Q0 units & calculate
Total annual cost,
Case 2: If Q0 < q0 , then don’t consider Q0 consider a lot size of qi units &
calculate Total annual cost,

Case 3: If Q0> q1, then don’t consider Q0 consider a lot size of qi+1 units
& calculate total annual cost,
 All unit quantity discount-procedure
5. Repeat the same procedure for all cases of i.
6. Select that lot size corresponding to which TC is
minimum.

Formulae to be used:

2. Total Annual Cost TCi =

Example-2
 Marginal unit Quantity Discount
• In this case, the pricing schedule contains
specified break points q0 , q1, ... , qr.
• It is not the average cost of a unit but the marginal
cost of a unit that decreases at a breakpoint
• If an order of size q is placed, the first q1 - q0 units
are priced at C0, the next q2 – q1 are priced at C1
and so on.
• The marginal cost per
unit varies with the quantity
purchased.
 Lessons from Discounting Schemes
• Lot size based discounts increase lot size(Q)
cycle inventory and flow time in the supply
chain
• Lot size based discounts are justified to
1. achieve coordination
2. Extract surplus (=profit)from SC
• Volume based discounts are more effective
for products having market power and lot
based discounts for products not having
market power (Commodities=RM)
 Short-Term Discounting: Trade Promotions
• Trade promotions are price discounts for a limited period of time
• Key goals for promotions from a manufacturer’s perspective:
– Induce retailers to use price discounts, displays, advertising to increase sales
– Shift inventory from manufacturer to retailer and customer
– Defend a brand against competition M R
• What is the impact on the behavior of the retailer
• Retailer has two primary options in response to a promotion:
1. Pass through some or all of promotion to customers to spur sales
2. Purchase in greater quantity during promotion period to take
advantage of temporary price reduction, but pass through very little
of savings to customers
• Impact on the performance of the supply chain?
✔ The first action lowers price of the product for end customer, leading
to increased purchases & thus increased sales for entire SC.
✔ The second action increases the amount of inventory held at retailer.
As a result, cycle inventory & flow time within SC increase.
 Forward Buy
• A forward buy is the amount that
retailer purchases in promotional
period for sales in future periods.
• A forward buy helps reduce the
retailer's future cost of goods for
product sold after promotion
ends.
• It increases demand variability
• Increase in inventory and flow
times within the SC
• It can decrease SC profits unless
it reduces demand fluctuations.
 Forward Buy
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

Forward buy = Q d - Q*
 Forward Buy - Example
DO is a retailer that sells vitaherb, a popular
vitamin diet supplement. Demand for
vitaherb is 120,000 bottles per year. The
manufacturer currently charges $3 for each
bottle and DO incurs a holding cost of 20
percent. DO currently orders in lots of Q* =
6,324 bottles. The manufacturer has
offered a discount of $0.15 for all bottles
purchased by retailers over the coming
month. How many bottles of vitaherb
should DO order given the promotion?
 Forward Buy - Example
• 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
Sol:

Qd = $38,236
• Forward buy = Q d - Q* = 38,236 -6324=$31,912
 Trade Promotions
• When a manufacturer offers a promotion, the goal
to discourage forward buying in the supply chain
as it hurts the performance and increases cycle
inventory
• Counter measures
− EDLP: Here the price is fixed over time and no
short-term discounts are offered. This eliminates
any incentive for forward buying.
− Scan based promotions: retailer receives credit
for the promotion discount for every unit sold
– Customer coupons
− Trade promotions are more effective with strong
brands relative to weak brands.
 Managing Multi-Echelon -Cycle Inventory

A SERIAL
SUPPLY CHAIN

A multi-echelon
supply chain
 Managing Multi-Echelon -Cycle Inventory

A multi-echelon
supply chain
 Managing Multi-Echelon -Cycle Inventory
• Multi-echelon supply chains have multiple stages, with
many players at each stage & 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
• Figure 10.6: Inventory profile at retailer and
manufacturer with no synchronization
• Figure 10.7: Illustration of integer replenishment policy
• Figure 10.8: An example of a multi-echelon distribution
supply chain
• In general, each stage should attempt to coordinate
orders from customers who order less frequently and
cross-dock all such orders. Some of the orders from
customers that order more frequently should also be
cross-docked.
Inventory Profile at Retailer & Manufacturer with No Synchronization
 Managing Multi-Echelon -Cycle Inventory
• Consider a simple multiechelon system with one manufacturer
supplying one retailer.
• Assume that production is instantaneous (produce a lot when
needed)
• If the two stages are not synchronized, the manufacturer may
produce a new lot of size Q right after shipping a lot of size Q to the
retailer.
• In this case the retailer carries an average inventory of Q/2 and the
manufacturer carries an average inventory of about Q.
• Overall supply chain inventory can be lowered if the manufacturer
synchronizes its production to be ready just in time to be shipped to
the retailer.
• In this case manufacturer carries no inventory and the retailer carries
an average inventory of Q/2.
• Synchronization of production and replenishment allows SC
to lower total cycle inventory from about 3Q/2 to Q/2.
 Integer replenishment policy
• Divide all parties within a stage into groups
such that all parties within a group order from
the same supplier and have the same reorder
interval .
Integer replenishment policy
 Integer replenishment policy
• Distributor places a replenishment order every two weeks.
• For retailers ordering more frequently than the distributor,
the retailers' ordering frequency is an integer multiple of the
distributor's frequency.
• For retailers ordering less frequently than the distributor, the
distributor's ordering frequency is an integer multiple of the
retailers‘ frequency.
• If an integer replenishment policy is synchronized across the
two stages, the distributor can cross-dock part/full of its
supply on to the next stage.
• All shipments to retailers ordering no more frequently than
the distributor (every two or four weeks) are crossdocked. For
retailers ordering more frequently (every week) than the
distributor, half the orders are cross-docked, with the other
half shipped from inventory.