Managing Economies of Scale in a

Supply Chain: Cycle Inventory

 Role of Cycle Inventory in a Supply Chain

Economies of Scale: Cycle Inventory

Cycle inventory: exists as a result of producing or purchasing in large
lots or batches.
Lot, or batch size: quantity that a supply chain stage either produces or
orders at a given time.

Q = lot or batch size of an order

D = demand per unit time
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)
Role of Cycle Inventory in a Supply Chain
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
Role of Cycle Inventory in a Supply Chain
Economies of Scale to Exploit Fixed Costs

Lot sizing for a single product (EOQ)

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
 Lot Sizing for Single products
The purchasing manager places a replenishment order for a new lot of
Q computers from HP. Including the cost of transportation, the manager
incurs a fixed cost of $S per order. The purchasing manager must decide
on the number of computers to order from HP in a lot.
Assume that HP doesn’t provide any discount. To find the order
quantity, we develop a model. The model is developed using the
following basic assumptions:
1. Demand is steady at D units per unit time.
2. No shortages are allowed—that is, all demand must be supplied from stock.
3. Replenishment lead time is fixed (initially assumed to be zero).
 Lot Sizing for Single products

 The purchasing manager makes the lot-sizing decision to minimize the total
cost for the store. He or she must consider three costs when deciding on the
lot size such as material cost, ordering cost and inventory holding cost or
carrying cost
Lot Sizing for Single products
 Lot Sizing for Single products

 Observe that the annual holding cost

increases with an increase in lot size.
 In contrast, the annual ordering cost
declines with an increase in lot size.
 The material cost is independent of lot
size because we have assumed the
price to be fixed.
 The total annual cost thus first
declines and then increases with an
increase in lot size

 From the perspective of the manager, the optimal lot size is one that minimizes
the total cost
Optimal Lot Size for Single products
Example 1
 Example 1 continued
 Annual ordering and holding cost
= (12000/980)(4000) + (980/2)(0.2)(500) = $97,980
Suppose lot size is reduced to Q=200, which would reduce flow
time:
Annual ordering and holding cost =
= (12000/200)(4000) + (200/2)(0.2)(500) = $250,000
To make it economically feasible to reduce lot size, the fixed cost
associated with each lot would have to be reduced
Example 2
If desired lot size = Q* = 200 units, what would ordering cost (S) have
to be?
D = 12000 units, C = $500, h = 0.2
Use EOQ equation and solve for S:
S = [hC(Q*)2]/2R = [(0.2)(500)(200)2]/(2)(12000) = $166.67
To reduce optimal lot size by a factor of k, the fixed order cost must
be reduced by a factor of k2
 Key Points from EOQ model

• In deciding the optimal lot size the trade off is between setup (order) cost and
holding cost.

• 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. Cycle inventory (in days of
demand) should decrease as demand increases.

• 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.
 Lot Sizing with capacity constraint

 So far we have assumed that the economic order quantity for a retailer will fit on
the truck.
In reality the truck has a limited capacity, say K. If the economic order quantity Q
is more than the K, the retailer will have to pay for more than one truck.
In this case, the optimal order quantity is obtained by comparing the cost of
ordering K units (a full truck) and Q units ([Q/K] trucks).
If the setup cost S arises primarily from the cost of a truck, it is never optimal to
order more than one truck. In this case, the optimal order size is the minimum of
the EOQ and the truck capacity (K).
 Aggregating Multiple Products in a Single Order
In several companies, the array of products sold is divided into families or
groups, with each group managed independently by a separate product
manager. This results in separate orders and deliveries for each product family,
thus increasing the overall cycle inventory.
Aggregating orders and deliveries across product families is an effective
mechanism to lower cycle inventories.
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
Can also have a single delivery coming from multiple suppliers or a single truck
delivering to multiple retailers
Aggregating Multiple Products in a Single Order
Suppose there are 4 types of computer products: A, B, C, and D
Assume demand for each is 1000 units per month. Unit cost, C = $500, Holding
cost fraction, h = 0.2, Ordering cost, S = $4,000/order
If each product is ordered separately:
Q* = 980 units for each product (Based on EOQ)
Total cycle inventory = 4(Q/2) = (4)(980)/2 = 1960 units
Aggregate orders of all four products:
•Combined Q* = 1960 units (where, S = $4,000/order, D = 4*12000 = 48000,
and h*c = 0.2*$500)
•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.
Lot Sizing with Multiple Products or Customers
 Lot Sizing with Multiple Products

Let us consider the case in which retail store purchases multiple

models of a product. The store manager may consider three
approaches to the lot-sizing decision
• Lots are ordered and delivered independently for each product
• Lots are ordered and delivered jointly for all three models
• Lots are ordered and delivered jointly for a selected subset of models
Lot Sizing with Multiple Products
 Lot Sizing with Multiple Products
In this model, each type of product is ordered and delivered independently, a
separate truck delivers each model.
Thus, a fixed ordering cost of $5,000 ($4,000 + $1,000) is incurred for each
product delivery. As ordered is placed independently for each product type, so we
can easily apply EOQ model for three different product type.

Type A Type B Type C

Demand per year 12000 units 1200 units 120 units
Fixed cost/order $5000 $5000 $5000
Total Annual cost =
Optimal order size 1095 346 110 $155,140
Cycle Inventory 548 173 55
Annual holding cost $54772 $17,321 $5,477
Order frequency 11.0/year 3.5/year 1.1/year
Annual ordering cost $54,772 $17,321 $5,477
Annual cost $ 109,544 $34, 642 $10,954
Lot Sizing with Multiple Products
Lot Sizing with Multiple Products
 Lot Sizing with Multiple Products

 Annual order cost = 9.75×$7,000 = $68,250

 Annual total cost = $68250+$61512+$6151+$615=$136,528
 Observe that the product managers at retail store lower the annual cost from $155,140
to $136,528 by ordering all products jointly. This represents a decrease of about 12
percent.
 The disadvantage of this method is we considered both high and low demand
product in a single order.
Aggregation with Capacity Constraint
Aggregation with Capacity Constraint
 Economies of Scale to Exploit Quantity
Discounts
A discount is lot-size based if the pricing schedule offers discounts based on
the quantity ordered in a single lot. A discount is volume based if the discount
is based on the total quantity purchased over a given period, regardless of the
number of lots purchased over that period.
Two commonly used lot-size–based discount schemes are:
• All-unit quantity discounts
• Marginal unit quantity discounts
Why quantity discounts?
• Coordination in the supply chain
• Price discrimination to maximize supplier profits
 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 q i+1, then each
unit has an average unit cost of Ci.
The unit cost generally decreases as the quantity increases, i.e., C 0>C1>…>Cr
The objective for the company (a retailer in our example) is to decide on a lot
size that will minimize the sum of material, order, and holding costs
All-Unit Quantity Discount--Example
All-Unit Quantity Discount--Example
 Quantity discount exercise
A hospital buys disposable surgical packages from a supplier. The price
schedule and other relevant information is shown below:
Order quantity Unit Price
0-299 $60.00
300-499 $58.80
500 or more $57.00

R = 1000 units/year, S = $45/lot, h = 0.25

What is the optimal order quantity?
 All-Unit Quantity Discounts
• What is the effect of such a discount schedule?
• Retailers are encouraged to increase the size of their orders
• Average inventory (cycle inventory) in the supply chain is increased
• Average flow time is increased
• Is an all-unit quantity discount an advantage in the supply chain?
Two-Bin System