The Role of Cycle Inventory in a Supply Chain

A lot or batch size is the quantity that a stage of a supply chain either produces or purchases at a
time.
Eg: 80 printers -20 days
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

When demand is steady, cycle inventory and lot size are related as follows:
Cycle inventory =lot size/2 =Q/2

The average price paid per unit purchased is a key cost in the lot-sizing decision. In many practical
situations, material cost displays economies of scale—increasing lot size decreases material cost.

The 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. A fixed trucking cost to transport the order and a fixed labour cost to
receive the order. The fixed ordering cost per lot or batch is denoted by S (commonly thought of as a
setup cost) and is measured in rupees per lot. The ordering cost also displays economies of
scale—increasing the lot size decreases the fixed ordering cost per unit purchased.

Holding cost is the cost of carrying one unit in inventory for a specified period of time, usually one
year. It is a combination of the cost of capital, the cost of physically storing the inventory, and the cost
that results from the product becoming obsolete. The holding cost is denoted by H and is measured in
rupees per unit per year. It may also be obtained as a fraction, h, of the unit cost of the product. Given
a unit cost of C, the holding cost H is given by H = hC. The total holding cost increases with an
increase in lot size and cycle inventory.

The primary role of cycle inventory is to allow different stages in a supply chain to purchase product in
lot sizes that minimize the sum of the material, ordering, and holding costs. If a manager considers
the holding cost alone, he or she will reduce the lot size and cycle inventory. Economies of scale in
purchasing and ordering, however, motivate a manager to increase the lot size and cycle inventory. A
manager must make the trade-off that minimizes total cost when making lot-sizing decisions.

Any stage of the supply chain exploits economies of scale in its replenishment decisions in the
following 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

Inventory Holding Cost
Holding cost is estimated as a percentage of the cost of a product and is the sum of the following
major components:
  Cost of capital:

Where
E = amount of equity
D = amount of debt
Rf = risk-free rate of return (which is usually in the mid-single digits)
b = the firm’s beta, a measure of volatility of stock price
MRP = market risk premium (which is around the high single digits)
Rb = rate at which the firm can borrow money (related to its debt rating)
t = tax rate
WACC: weighted-average cost of capital

Most of these numbers can be found in a company’s annual report and in any equity research report
on the company.
 Obsolescence (or spoilage) cost:
The obsolescence cost estimates the rate at which the value of the stored product drops because its
market value or quality falls.
 Handling cost:
Handling cost should include only incremental receiving and storage costs that vary with the
quantity of product received.
 Occupancy cost:
The occupancy cost reflects the incremental change in space cost due to changing cycle inventory.
Occupancy costs often take the form of a step function, with a sudden increase in cost when
capacity is fully utilized and new space must be acquired.
 Miscellaneous costs:
The final component of holding cost deals with a number of other relatively small costs. These costs
include theft, security, damage, tax, and additional insurance charges that are incurred

Ordering Cost
The ordering cost includes all incremental costs associated with placing or receiving an extra order
that are incurred regardless of the size of the order. Components of ordering cost include the
following:
 Buyer time:
Buyer time is the incremental time of the buyer placing the extra order.
 Transportation costs:
A fixed transportation cost is often incurred regardless of the size of the order.
 Receiving costs:
Some receiving costs are incurred regardless of the size of the order.
 Other costs:
Each situation can have costs unique to it that should be considered if they are incurred for each
order regardless of the quantity of that order.

The ordering cost is estimated as the sum of all its component costs.

Economies of Scale to Exploit Fixed Costs

E.g. our purchases from a nearby store to going for a big mall
A purchasing manager wants to minimize the total cost of satisfying demand and must therefore
make the appropriate cost trade-offs when making the lot-sizing decision. We start by considering
the lot-sizing decision for a single product.

Lot Sizing for a Single Product (Economic Order Quantity)

D = Annual demand of the product

S = Fixed cost incurred per order
C = Cost per unit of product
h = Holding cost per year as a fraction of product cost

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).

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:

• Annual material cost

• Annual ordering cost
• Annual holding cost

Because purchase price is independent of lot size, we have

Annual material cost = CD

The number of orders must suffice to meet the annual demand D. Given a lot size of Q, we thus have

Given a lot size of Q, we have an average inventory of Q/2. The annual holding cost is thus the cost
of holding Q/2 units in inventory for one year and is given as
The optimal lot size is referred to as the economic order quantity (EOQ). It is denoted by Q* and is
given by the following equation: (Deduce the formula)

The optimal ordering frequency is given by n* , where

Problem:

Demand for a product at a retail store is 1,000 units per month. It incurs a fixed order placement,
transportation, and receiving cost of Rs. 4,000 each time an order is placed. Each product costs to
the retailer Rs. 500 and the retailer has a holding cost of 20 percent.
Evaluate:
(i) The number of products that the store manager should order in each replenishment lot.
(ii) Cycle inventory
(iii) No. of orders per year
(iv) Annual ordering and holding cost
(v) Average flow time
(vi) Total annual cost
(vii) If you use a lot size of 1,100, what is the impact on the annual cost
Solution:
(i) 980
(ii) 490
(iii) 12.24
(iv) Rs. 97,980
(v) 0.49 month
(vi) Rs. 5,880,000

Points to remember:
 1. 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.
2. If demand increases by a factor of k, the optimal lot size increases by a factor of 1k. The
number of orders placed per year should also increase by a factor of 1k. Flow time attributed
to cycle inventory should decrease by a factor of 1k.
3. To reduce the optimal lot size by a factor of k, the fixed order cost S must be reduced by a
factor of k2 .

Problem

Demand for a product at a retail store is 1,000 units per month. It incurs a fixed order placement,
transportation, and receiving cost of Rs. 4,000 each time an order is placed. Each product costs to
the retailer Rs. 500 and the retailer has a holding cost of 20 percent. Now, The store manager 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 ordering cost per lot should be reduced.

Sol:

In this case, we have Desired lot size, Q* = 200 Annual demand, D = 1,000 : 12 = 12,000 units

Unit cost per computer, C = Rs. 500

Holding cost per year as a fraction of inventory value, h = 0.2

Using the EOQ formula, the desired order cost is –

Rs.166.7

The store manager would have to reduce the order cost per lot from Rs. 4,000 to Rs. 166.7 for a lot
size of 200 to be optimal.

Production Lot Sizing

In the EOQ formula, we have implicitly assumed that the entire lot arrives at the same time. While
this may be a reasonable assumption for a retailer receiving a replenishment lot, it is not reasonable
in a production environment in which production occurs at a specified rate, say, P. In a production
environment, inventory thus builds up at a rate of P - D when production is on, and inventory is
depleted at a rate of D when production is off.

With D, h, C, and S as defined earlier, the EOQ formula can be modified to obtain the economic
production quantity (EPQ) as follows: