Supply Chain Management

(3rd Edition)

Chapter 10
Managing Economies of Scale in the
Supply Chain: Cycle Inventory

© 2007 Pearson Education 10-1

 Role of Inventory in the Supply Chain
Improve Matching of Supply
and Demand
Improved Forecasting

Reduce Material Flow Time

Reduce Waiting Time

Reduce Buffer Inventory

Supply / Demand Seasonal

Economies of Scale Variability Variability

Cycle Inventory Safety Inventory Seasonal Inventory

Figure Error! No text of

© 2007 Pearson Education 10-2

 Role of Cycle Inventory
in a Supply Chain
Lot, or batch size: quantity that a supply chain stage either
produces or orders at a given time
Cycle inventory: average inventory that builds up in the
supply chain because a supply chain stage either produces
or purchases in lots that are larger than those demanded by
the customer
– Q = lot or batch size of an order
– D = demand per unit time
Inventory profile: plot of the inventory level over time
(Fig. 10.1)
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)
© 2007 Pearson Education 10-3
 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

© 2007 Pearson Education 10-4

 Role of Cycle Inventory
in a Supply Chain
Cycle inventory is held primarily to take advantage of
economies of scale in the supply chain
Supply chain costs influenced by lot size:
– Material cost = C
– Fixed ordering cost = S
– Holding cost = H = hC (h = cost of holding $1 in inventory for one year)
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, but in practice, each stage generally
makes its own supply chain decisions – increases total cycle
inventory and total costs in the supply chain
© 2007 Pearson Education 10-5
 Economies of Scale
to Exploit Fixed Costs
How do you decide whether to go shopping at a
convenience store or at Sam’s Club?
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

© 2007 Pearson Education 10-6

 Economies of Scale
to Exploit Fixed Costs
Annual demand = D
Number of orders per year = D/Q
Annual material cost = CR
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 10.2 shows variation in different costs for
different lot sizes

© 2007 Pearson Education 10-7

 Fixed Costs: Optimal Lot Size
and Reorder Interval (EOQ)
D: Annual demand
S: Setup or Order Cost H = hC
C: Cost per unit
h: Holding cost per year as a 2 DS
fraction of product cost Q* =
H: Holding cost per unit per year H
Q: Lot Size
T: Reorder interval 2S
Material cost is constant and n* =
therefore is not considered in DH
this model

© 2007 Pearson Education 10-8

 Example 10.1
Demand, D = 12,000 computers per year
d = 1000 computers/month
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
© 2007 Pearson Education 10-9
 Example 10.1 (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

© 2007 Pearson Education 10-10

 Example 10.2
If desired lot size = Q* = 200 units, what would S have
to be?
D = 12000 units
C = $500
h = 0.2
Use EOQ equation and solve for S:
S = [hC(Q*)2]/2D = [(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
© 2007 Pearson Education 10-11
 Key Points from EOQ Model
In deciding the optimal lot size, the tradeoff 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.
© 2007 Pearson Education 10-12
 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
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
© 2007 Pearson Education 10-13
 Example: 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
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
© 2007 Pearson Education 10-14
 Lot Sizing with Multiple
Products or Customers
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)
Three scenarios:
– 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
© 2007 Pearson Education 10-15
 Lot Sizing with Multiple Products
Demand per year
– DL = 12,000; DM = 1,200; DH = 120
Common transportation 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

© 2007 Pearson Education 10-16

 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

© 2007 Pearson Education 10-17

 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

© 2007 Pearson Education 10-18
 Aggregation: Order All
Products Jointly
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)

© 2007 Pearson Education 10-19

 Complete Aggregation:
Order All Products Jointly
Litepro Medpro Heavypro

Demand per 12,000 1,200 120

year
Order 9.75/year 9.75/year 9.75/year
frequency
Optimal 1,230 123 12.3
order size
Annual $61,512 $6,151 $615
holding cost
Annual order cost = 9.75 × $7,000 = $68,250
Annual total cost = $136,528
© 2007 Pearson Education 10-20
 Excel sheet example
VIBGYOR example

© 2007 Pearson Education 10-21

 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

© 2007 Pearson Education 10-22

 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
© 2007 Pearson Education 10-23
 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

© 2007 Pearson Education 10-24