CH 11

Supply Chain Management
Dr. C.Phaneendra Kiran

Ph.D
BITS Pilani Department of Mechanical Engineering
Hyderabad Campus BITS Pilani Hyderabad Campus
BITS Pilani
Hyderabad Campus
Managing Economies of Scale in a Supply

Chain
Cycle Inventory
Content taken from Pearson material
Learning Objectives
1. Balance the appropriate costs to choose the optimal lot size

and cycle inventory in a supply chain.
2. Understand the impact of quantity discounts on lot size and
cycle inventory.
3. Devise appropriate discounting schemes for a supply chain.
4. Understand the impact of trade promotions on lot size and
cycle inventory.
5. Identify managerial levers that reduce lot size and cycle
inventory in a supply chain without increasing cost.
BITS Pilani, Hyderabad Campus

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

Role of Cycle Inventory in a Supply
Chain

Role of Cycle Inventory
in a Supply Chain

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
• Following costs considered in lot sizing decisions
• Average price per unit purchased, $C/unit
• Fixed ordering cost incurred per lot, $S/lot
• Holding cost incurred per unit per year,

• $H/unit/year = 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

Key Point
• Cycle inventory exists in a supply chain because different

stages exploit economies of scale to lower total cost. The
costs considered include material cost, fixed ordering cost,
and holding cost.

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

Costs in Practice
• Inventory Holding Cost
– Obsolescence cost
– Handling cost
– Occupancy cost
– Miscellaneous costs
Theft, security, damage, tax, insurance

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



Example
Demand for Deskpro computer at BestBuy is 1000 units per

month. BestBuuy incurs a fixed order placement,
transportation, and receive cost of $4000 each time an order
is placed. Each computer costs Best Buy $500 and the retailer
has a holding cost of 20 percent. Evaluate number of
computers that the store manager should order in each
replenishment lot.

EOQ Example

EOQ Example

Key Point
• Total ordering and holding costs are relatively stable around

the economic order quantity. A firm is often better served by
ordering a convenient lot size close to the EOQ rather than
the precise EOQ.

Key Point
• If demand increases by a factor of k, the optimal lot size

increases by a factor of k . The number of orders placed per
year should also increase by a factor of k . Flow time
attributed to cycle inventory should decrease by a factor of
.k

EOQ Example

Relationship between lot size and
ordering cost
The store manager at Best Buy would like to reduce optimal lot
size from 980 to 200. For this lot size reduction to be optimal,
the store manager wants to evaluate how much the ordering
cost per lot should be reduced?

Lot Size and Ordering Cost

Key Point
• To reduce the optimal lot size by a factor of k, the fixed order

cost S must be reduced by a factor of k2.

Production Lot Sizing

Lot Sizing with Capacity Constraint
• If order size is constrained to K units

and Q > K,
– Compare the cost of ordering K units and the EOQ

– Optimal order size is the minimum of EOQ and capacity K

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
• 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
Key Point
• Aggregating replenishment 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.

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
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

Example
Best buy sells three models of computers, The Litepro,

theMedpro and the Heavypro. Annual demand for the three
products are Dl=12000 for the Litepro, DM=1200 units for the
Medpro and DH=120 units for Heavypro. Each model cost Best
Buy $500. A fixed transportation cost of $4000 is incurred
each time an order is delivered. For each model ordered and
delivered on the same truck, an additional fixed cost of $1000
per model 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 lots for each product are
ordered and delivered independently. Also evaluate the
annual cost of such policy.

Multiple Products Ordered and
Delivered Independently
• 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

Multiple Products Ordered and
Delivered Independently

Lots Ordered and Delivered Jointly

Products Ordered and Delivered
Jointly

Jointly

Aggregation with Capacity
Constraint
WW Grainger sources from hundreds of suppliers and is
considering the aggregation of inbound shipments to lower
costs. Truckload shipping costs $500 per truck along with $100
per pickup. Average annual demand from each supplier is
10000 units. Each unit costs $50 and Grainger incurs a holding
cost of 20%. What is the optimal order frequency and order
size if Grainger decides to aggregate four supplier per truck?
What is the optimal order size and frequency if each truck has
a capacity of 2500?

Constraint
W.W. Grainger example

Demand per product, Di = 10,000
Holding cost, h = 0.2
Unit cost per product, Ci = $50
Common order cost, S = $500
Supplier-specific order cost, si = $100

Constraint

Constraint
• Total required capacity per truck = 4 x 671 = 2,684 units

• Truck capacity = 2,500 units
• Order quantity from each supplier = 2,500/4 = 625
• Order frequency increased to 10,000/625 = 16
• Annual order cost per supplier increases to $3,600
• Annual holding cost per supplier decreases to $3,125

for a Selected Subset



Example
Best buy sells three models of computers, The Litepro,

theMedpro and the Heavypro. Annual demand for the three
products are Dl=12000 for the Litepro, DM=1200 units for the
Medpro and DH=120 units for Heavypro. Each model cost Best
Buy $500. A fixed transportation cost of $4000 is incurred
each time an order is delivered. For each model ordered and
delivered on the same truck, an additional fixed cost of $1000
per model 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 lots for each product are
ordered and delivered independently. Also evaluate the
annual cost of such policy.

Jointly

Ordered and Delivered Jointly –
Frequency Varies by Order




Key Point
• A key to reducing cycle inventory is the reduction of lot size. A

key to reducing lot size without increasing costs is reducing
the fixed cost associated with each lot. This may be achieved
by reducing the fixed cost itself or by aggregating lots across
multiple products, customers, or suppliers. When aggregating
across multiple products, customers, or suppliers, simple
aggregation is effective when product-specific order costs are
small, and tailored aggregation is best if product-specific order
costs are large.

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
• Two common schemes
– All-unit quantity discounts
– Marginal unit 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 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






Drugs online(DO) is an online retailer of prescription drugs and
health supplements. Vitamins represent a significant
percentage of its sales. Demand for vitamins is 10000 bottles
per month. DO incurs a fixed order placement, transportation,
and receiving cost of $100 each time an order for vitamins is
placed with the manufacturer. DO incurs a hold cost of 20
percent. The manufacturer uses following all unit discount
pricing schedule . Evaluate the number of bottles that the DO
manager should order in each lot
0-4999 $3.00
5000-9999 $2.96
10000 or more $2.92
All-Unit Quantity Discount Example



Marginal Unit Quantity Discounts






Marginal Unit Quantity Discount
Example

Example

Example

Why Quantity Discounts?
• Quantity discounts can increase the supply chain surplus for

the following two main reasons
1. Improved coordination to increase total supply chain
profits
2. Extraction of surplus through price discrimination

Demand for vitamins is 10000 bottles per month. DO incurs a
fixed order placement, transportation, and receiving cost of
$100 each time it places an order for vitamins with the
manufacturer. DO incurs a holding cost of 20 percent. The
manufacturer charges $3 for each bottle of vitamins
purchased. Evaluate optimal lot size for DO. Each time DO
places an order, the manufacturer must process, pack, and
ship the order. The manufacturer has a line packing bottles at
a steady rate that matches demand. The manufacturer incurs
a fixed-order filling cost of $250, production cost of $2 per
bottle, and a holding cost of 20%. What is the annual
fulfilment and holding cost incurred by the manufacturer as a
result of DO’s ordering policy?
Quantity Discounts for Commodity
Products

Locally Optimal Lot Sizes

Designing a Suitable Lot Size-Based
Quantity Discount
• Design a suitable quantity discount that gets DO to order in
lots of 9,165 units when its aims to minimize only its own total
costs
• Manufacturer needs to offer an incentive of at least $264 per
year to DO in terms of decreased material cost if DO orders in
lots of 9,165 units
• Appropriate quantity discount is $3 if DO orders in lots smaller
than 9,165 units and $2.9978 for orders of 9,165 or more

Key Point
• For commodity products for which price is set by the market,

manufacturers with large fixed costs per lot can use lot-size-
based quantity discounts to maximize total supply chain
profits. Lot-size-based discounts, however, increase cycle
inventory in the supply chain.

Quantity Discounts When
Firm Has Market Power

Quantity Discounts When
Firm Has Market Power

Key Point
• The supply chain profit is lower if each stage of the supply

chain makes its pricing decisions independently, with the
objective of maximizing its own profit. A coordinated solution
results in higher profit.

Two-Part Tariff
• Manufacturer charges its entire profit as an up-front franchise

fee ff
• Sells to the retailer at cost
• Retail pricing decision is based on maximizing its profits
• Effectively maximizes the coordinated supply chain profit

Volume-Based Quantity Discounts
• Design a volume-based discount scheme that gets the retailer

to purchase and sell the quantity sold when the two stages
coordinate their actions

Lessons from Discounting
Schemes
• Quantity discounts play a role in supply chain coordination
and improved supply chain profits
• Discount schemes that are optimal are volume based and not
lot size based unless the manufacturer has large fixed costs
associated with each lot
• Even in the presence of large fixed costs for the manufacturer,
a two-part tariff or volume-based discount, with the
manufacturer passing on some of the fixed cost to the retailer,
optimally coordinates the supply chain and maximizes profits

Lessons from Discounting
Schemes
• Lot size–based discounts tend to raise the cycle inventory in
the supply chain
• Volume-based discounts are compatible with small lots that
reduce cycle inventory
• Retailers will tend to increase the size of the lot toward the
end of the evaluation period, the hockey stick phenomenon
• With multiple retailers with different demand curves optimal
discount continues to be volume based with the average price
charged to the retailers decreasing as the rate of purchase
increases

Key Point
• For products for which the firm has market power, two-part
tariffs or volume-based quantity discounts can be used to
achieve coordination in the supply chain and maximize supply
chain profits.

Key Point
• For products for which a firm has market power, lot-size-

based discounts are not optimal for the supply chain even in
the presence of inventory costs. In such a setting, either a
two-part tariff or a volume-based discount, with the supplier
passing on some of its fixed cost to the retailer, is needed for
the supply chain to be coordinated and maximize profits.

Price Discrimination to Maximize
Supplier Profits
• Firm charges differential prices to maximize profits
• Setting a fixed price for all units does not maximize profits for
the manufacturer
• Manufacturer can obtain maximum profits by pricing each
unit differently based on customers’ marginal evaluation at
each quantity
• Quantity discounts are one mechanism for price
discrimination because customers pay different prices based
on the quantity purchased

Key Point
• Price discrimination to maximize profits at the manufacturer

may also be a reason to offer quantity discounts within a
supply chain.

Short-Term Discounting:
Trade Promotions
• Trade promotions are price discounts for a limited period of
time
• Key goals
– Induce retailers to use price discounts, displays, or
advertising to spur sales
– Shift inventory from the manufacturer to the retailer and
the customer
– Defend a brand against competition

Short-Term Discounting:
Trade Promotions
• Impact on the behavior of the retailer and supply chain
performance
• Retailer has two primary options
– Pass through some or all of the promotion to customers to
spur sales
– Pass through very little of the promotion to customers but
purchase in greater quantity during the promotion period
to exploit the temporary reduction in price (forward buy)

Forward Buying Inventory Profile

Forward Buy
• Costs to be considered – material cost, holding cost, and order

cost
• Three assumptions
– The discount is offered once, with no future discounts
– The retailer takes no action to influence customer demand
– Analyze a period over which the demand is an integer
multiple of Q*

Forward Buy

DO is a retailer that sells Vitaherb, a popular vitamin diet
supplement. Demand for Vitaherb is 120000 bottles per year.
The manufacturer currently charges $3 per each bottle, and
DO incurs a holding cost of 20%. DO currently orders in lots of
Q*=6325 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?

Impact of Trade Promotions
on Lot Sizes

Impact of Trade Promotions
on Lot Sizes

Key Point
• Trade promotions lead to a significant increase in lot size and

cycle inventory because of forward buying by the retailer. This
generally results in reduced supply chain profits unless the
trade promotion reduces demand fluctuations.

How Much of a Discount Should
the Retailer Pass Through?
Assume that DO faces a demand curve for Vitaherb of 30000-
60000p. The normal price charged by the manufacturer to the
retailer is CR=$3 per bottle. Ignoring all inventory related
costs, evaluate optimal response of DO to discount of $0.15.

How Much of a Discount Should
the Retailer Pass Through?

Trade Promotions
• Trade promotions generally increase cycle inventory in a

supply chain and hurt performance
• Counter measures
– EDLP (every day low pricing)
– Discount applies to items sold to customers (sell-through)
not the quantity purchased by the retailer (sell-in)
– Scan based promotions

Managing Multiechelon
Cycle Inventory
• Multiechelon supply chains have multiple stages with possibly
many players at each stage
• Lack of coordination in lot sizing decisions across the supply
chain results in high costs and more cycle inventory than
required
• The goal is to decrease total costs by coordinating orders
across the supply chain

Managing Multiechelon
Cycle Inventory

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
• Set reorder intervals across stages such that the receipt of a
replenishment order at any stage is synchronized with the
shipment of a replenishment order to at least one of its
customers
• For customers with a longer reorder interval than the supplier,
make the customer’s reorder interval an integer multiple of
the supplier’s interval and synchronize replenishment at the
two stages to facilitate cross-docking

• For customers with a shorter reorder interval than the

supplier, make the supplier’s reorder interval an integer
multiple of the customer’s interval and synchronize
replenishment at the two stages to facilitate cross-docking
• The relative frequency of reordering depends on the setup
cost, holding cost, and demand at different parties
• These polices make the most sense for supply chains in which
cycle inventories are large and demand is relatively
predictable



Key Point
• Integer replenishment policies can be synchronized in

multiechelon supply chains to keep cycle inventory and order
costs low. Under such policies, the reorder interval at any
stage is an integer multiple of a base reorder interval.
Synchronized integer replenishment policies facilitate a high
level of cross-docking across the supply chain.

Summary of Learning Objectives
1. Balance the appropriate costs to choose the optimal lot size

and cycle inventory in a supply chain
2. Understand the impact of quantity discounts on lot size and
cycle inventory
3. Devise appropriate discounting schemes for a supply chain
4. Understand the impact of trade promotions on lot size and
cycle inventory

Summary of Learning Objectives
5. Identify managerial levers that reduce lot size and cycle

inventory in a supply chain without increasing cost
– Reduce fixed ordering and transportation costs incurred
per order
– Implement volume-based discounting schemes rather than
individual lot-size-based discounting schemes
– Eliminate or reduce trade promotions and encourage EDLP.
Base trade promotions on sell-through rather than sell-in
to the retailer

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Supply Chain Management

Dr. C.Phaneendra Kiran

Managing Economies of Scale in a Supply

1. Balance the appropriate costs to choose the optimal lot size

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

• Average price per unit purchased, $C/unit

• Fixed ordering cost incurred per lot, $S/lot

• Holding cost incurred per unit per year,

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

• Cycle inventory exists in a supply chain because different

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

Demand for Deskpro computer at BestBuy is 1000 units per

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

• Total ordering and holding costs are relatively stable around

BITS Pilani, Hyderabad Campus

• If demand increases by a factor of k, the optimal lot size

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

• To reduce the optimal lot size by a factor of k, the fixed order

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

• If order size is constrained to K units

– Compare the cost of ordering K units and the EOQ

BITS Pilani, Hyderabad Campus

• Aggregating replenishment across products, retailers, or

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

Best buy sells three models of computers, The Litepro,

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus

W.W. Grainger example

BITS Pilani, Hyderabad Campus

BITS Pilani, Hyderabad Campus