Inventory Management: Cycle Inventory

Inventory Management:
Cycle Inventory

1
 Inventory
Inventory: a stock or store of goods Independent Demand

A Dependent Demand

B(4) C(2)

D(2) E(1) D(3) F(2)

Independent demand is uncertain.

Dependent demand is certain.
12-2
 Inventory Models

• Independent demand – finished goods, items that

are ready to be sold
– E.g. a computer
• Dependent demand – components of finished
products
– E.g. parts that make up the computer

12-3
 Types of Inventories

• Raw materials & purchased parts

• Partially completed goods called
work in progress
• Finished-goods inventories-products sold to
customers
– (manufacturing firms)
or merchandise
(retail stores)

12-4
 Types of Inventories (Cont’d)
• Replacement parts, tools, & supplies
• Goods-in-transit to warehouses or customers
• Distribution inventory – finished goods in the distribution system

12-5
Types of Inventory

6
 Functions of Inventory

• To meet anticipated demand

• To smooth production requirements
• To decouple operations
• To protect against stock-outs

12-7
 Functions of Inventory (Cont’d)

• To take advantage of order cycles

• To help hedge against price increases
• To permit operations
• To take advantage of quantity discounts

12-8
 Objective of Inventory Control
• To achieve satisfactory levels of customer
service while keeping inventory costs within
reasonable bounds
– Level of customer service
– Costs of ordering and carrying inventory

Inventory turnover is the ratio of

average cost of goods sold to
average inventory investment.
12-9
 Effective Inventory Management
• A system to keep track of inventory
• A reliable forecast of demand
• Knowledge of lead times
• Reasonable estimates of
– Holding costs
– Ordering costs
– Shortage costs
• A classification system

12-10
 Inventory Counting Systems
• Periodic System
Physical count of items made at periodic intervals
• Perpetual Inventory System
System that keeps track
of removals from inventory
continuously, thus
monitoring
current levels of
each item

12-11
 Inventory Counting Systems (Cont’d)
• Two-Bin System - Two containers of inventory;
reorder when the first is empty
• Universal Bar Code - Bar code
printed on a label that has
information about the item
to which it is attached
0

214800 232087768

12-12
 Key Inventory Terms
• Lead time: time interval between ordering and
receiving the order
• Holding (carrying) costs: cost to carry an item in
inventory for a length of time, usually a year
• Ordering costs: costs of ordering and receiving
inventory
• Shortage costs: costs when demand exceeds
supply

12-13
 Role of Inventory in the Supply Chain

Understocking: Demand exceeds amount available

–Lost margin and future sales

Overstocking: Amount available exceeds demand

– Liquidation, Obsolescence, Holding

14
Modeling Inventory in a Supply Chain…

Supplier
Retail
Warehouse
 How Companies Use Their Inventory

1. Anticipation or seasonal inventory

2. Fluctuation Inventory or Safety stock: buffer demand
fluctuations
3. Lot-size or cycle stock: take advantage of quantity
discounts or purchasing efficiencies
4. Transportation or Pipeline inventory
5. Speculative or hedge inventory protects against some
future event, e.g. labor strike
6. Maintenance, repair, and operating (MRO) inventories

16
 Objectives of Inventory Management

Provide desired customer service level

• Customer service is the ability to satisfy customer
requirements
– Percentage of orders shipped on schedule
– Percentage of line items shipped on schedule
– Percentage of $ volume shipped on schedule
– Idle time due to material and component shortages
 Inventory Objectives con’t

Provide for cost-efficient operations:

– Buffer stock for smooth production flow
– Maintain a level work force
– Allowing longer production runs & quantity discounts

• Minimum inventory investments:

– Inventory turnover
– Weeks, days, or hours of supply

18
 Customer Service Level Examples

• Percentage of Orders Shipped on Schedule

– Good measure if orders have similar value. Does not capture value.
– If one company represents 50% of your business but only 5% of your orders, 95%
on schedule could represent only 50% of value
• Percentage of Line Items Shipped on Schedule
– Recognizes that not all orders are equal, but does not capture
$ value of orders. More expensive to measure. Ok for finished goods.
– A 90% service level might mean shipping 225 items out of the total 250 line items
totaled from 20 orders scheduled
• Percentage Of Dollar Volume Shipped on Schedule
– Recognizes the differences in orders in terms of both line items and
$ value
 Inventory Investment Measures Example: The Coach Motor Home Company
has annual cost of goods sold of $10,000,000. The average inventory value at
any point in time is $384,615. Calculate inventory turnover and weeks/days of
supply.

• Inventory Turnover:
annual cost of goods sold $10,000,000
Turnover    26 inventory turns
average inventory value $384,615

• Weeks/Days of Supply:
average inventory on hand in dollars $384,615
Weeks of Supply    2weeks
average weekly usage in dollars $10,000,00 0/52

$384,615
Days of Supply   10 days
$10,000,000/260
20
 Relevant Inventory Costs

Item Cost Includes price paid for the item plus other
direct costs associated with the purchase

Holding Include the variable expenses incurred by

Costs the plant related to the volume of inventory
held (15-25%)
Capital The higher of the cost of capital or the
Costs opportunity cost for the company

21
 Relevant Inventory Costs

Ordering Fixed, constant dollar amount incurred for

Cost each order placed
Shortage Loss of customer goodwill, back order
Costs handling, and lost sales
Risk costs Obsolescence, damage, deterioration,
theft, insurance and taxes
Storage Included the variable expenses for space,
costs workers, and equipment related to the
volume of inventory held
22
 Determining Order Quantities
Lot-for-lot Order exactly what is needed

Fixed-order Specifies the number of units to order

quantity whenever an order is placed
Min-max Places a replenishment order when the
system on-hand inventory falls below the
predetermined minimum level.
Order n Order quantity is determined by total
periods demand for the item for the next n
periods
23
Classification of Inventory Techniques
 ABC Inventory Classification

ABC classification is a method for determining level of control and

frequency of review of inventory items
• A Pareto analysis can be done to segment items into value
categories depending on annual dollar volume
• A Items – typically 20% of the items accounting for 80% of the
inventory value-use Q system
• B Items – typically an additional 30% of the items accounting for
15% of the inventory value-use Q or P
• C Items – Typically the remaining 50% of the items accounting for
only 5% of the inventory value-use P

25
The AAU Corp. is considering doing an ABC analysis on its entire inventory
but has decided to test the technique on a small sample of 15 of its SKU’s.
The annual usage and unit cost of each item is shown below

26
(A) First calculate the annual dollar volume for each
item
 B) List the items in descending order based on annual dollar volume. (C) Calculate
the cumulative annual dollar volume as a percentage of total dollars. (D) Classify the
items into groups
 Graphical solution for AAU Corp showing the ABC
classification of materials

• The A items (106 and 110) account for 60.5% of the value and 13.3% of the items
• The B items (115,105,111,and 104) account for 25% of the value and 26.7% of the items
• The C items make up the last 14.5% of the value and 60% of the items
• How might you control each item classification? Different ordering rules for each?

29
 ABC Analysis
100 — Class C
Class B
90 —
Percentage of dollar value Class A
80 —

70 —

60 —

50 —

40 —

30 —

20 —

10 —

0—
10 20 30 40 50 60 70 80 90 100
Percentage of SKUs
Figure 12.1 – Typical Chart Using ABC Analysis
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
 Why hold inventory?
► Economies of scale

》 Batch size and cycle time

► Stochastic variability
》 Quantity discountsof supply and demand
》 Short term
》Service leveldiscounts / Trade
given safety promotions
inventory
》Evaluating Service level given safety inventory

31
 Role of Inventory in the Supply Chain
Improve
ImproveMatching of Supply
Matching of Supply
and
and Demand

Improved Forecasting

Cost Reduce Material Flow Time Availability

Efficiency Responsiveness
Reduce Waiting Time

Reduce Buffer Inventory

Supply / Demand
Economies of Scale Variability Seasonal Variability

Cycle Inventory Safety Inventory Seasonal Inventory

32
 Cycle Inventory
Cycle inventory
Improve is the average
Matching inventory that built up in the supply
of Supply
chain because anda stage of the supply chain either produces or
Demand
purchases in lots that are larger than those demanded by the customer.
Improved Forecasting
Inventory
Cost Reduce Material Flow Time Availability
Efficiency Responsiveness
QReduce Waiting Time

Reduce Buffer Inventory

Time t
Supply
Cycle / Demand= lot size/2 = Q/2
inventory
Economies of Scale Variability Seasonal Variability

Cycle Inventory Safety Inventory Seasonal Inventory

33
 Little’s Law
► Average flow time = Average inventory / Average
flow rate
► For any supply chain, average flow rate equals the
demand,
Average flow time resulting from cycle inventory
= Cycle inventory / Demand
= Q / 2D
Q: Lot size
D: Demand per unit time

34
 Holding Cycle Inventory for
Economies of Scale
► Fixed costs associated with lots

► Quantity discounts

► Trade Promotions

35
 Economics of Scale to Exploit Fixed Costs
— Economic Order Quantity—

» 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

» H=Holding cost per unit per year =hC

» Q=Lot size

» n=Order frequency

36
 Mathematical Models for
Determining Order Quantity
• Economic Order Quantity (EOQ)
– An optimizing method used for determining order quantity and
reorder points
– Part of continuous review system which tracks on-hand inventory
each time a withdrawal is made
• Economic Production Quantity (EPQ)
– A model that allows for incremental product delivery
• Quantity Discount Model
– Modifies the EOQ process to consider cases where quantity
discounts are available
37
 EOQ Assumptions

• Demand is known & constant - no safety

stock is required
• Lead time is known & constant
• No quantity discounts are available
• Ordering (or setup) costs are constant
• All demand is satisfied (no shortages)
• The order quantity arrives in a single
shipment

38
 Total Annual Inventory Cost with
EOQ Model
Total annual cost= annual ordering cost + annual
holding costs
 D Q 2DS
TCQ   S   H; and Q 
Q  2  H

39
 Inventory Order Cycle
Demand
Order rate
quantity, Q

Inventory Average
Level amount of
inventory
Reorder held = Q/2
point, R

0 Lead Lead
Time time time
Order Order Order Order
Placed Received Placed Received
 Reorder Point

The point in time by which stock must be ordered to

replenish inventory before a stockout occurs

R  dL
R = Reorder point
d = average demand per period
L = lead time (in the same units as above)
 EOQ Model Cost Curves
Minimum
Annual Total Cost
Total Cost
cost ($)
Holding Cost = h*Q/2

Ordering Cost = o*D/Q

Optimal Order
Quantity, Q
Order Quantity
2Do 2(Annual Demand)(Order or Setup Cost)
QOPT = =
h Annual Holding Cost
 EOQ Model Insights

• As holding costs increase, the optimal order

quantity decreases. (Order smaller amounts more
often because inventory is expensive to hold.)
• As ordering costs increase, the optimal order
quantity increases. (Order larger amounts less
often because it is expensive to order.)
 EOQ Model Implications
Total Cost
Annual
Cost ($) Holding Cost

Ordering Cost

Q* Q*

Order Quantity
 EOQ Model Implications
Total Cost
Annual
Cost ($)

Holding Cost

Ordering Cost

Q* Q*

Order Quantity
 Continuous (Q) Review System Example: A computer company has annual
demand of 10,000. They want to determine EOQ for circuit boards which have
an annual holding cost (H) of $6/unit, and an ordering cost (S) of $75. They want
to calculate TC and the reorder point (R) if the purchasing lead time is 5 days.

• EOQ (Q)
2DS 2 * 10,000* $75
Q   500 units
H $6
• Reorder Point (R)
10,000
R  Daily Demand x Lead Time  * 5 days  200 units
250 days

• Total Inventory Cost (TC)

 10,000  500 
TC   $75   $6  $1500  $1500  $3000
 500   2  46
 Reorder Point with Safety Stock

Order
quantity (Q)

Inventory
level
Reorder
point (R)

Safety stock
(SS)
0
Lead Lead
time Time time
 Reorder Point with Safety Stock

Reorder point
R  d L  SS
Safety stock
SS  z   L
where
z is the z-score associated with the desired service level
(number of standard deviations above the mean)
L= standard deviation of demand during lead time
 Normal(100, 20)

2.5

2.0
Safety Stock Normal(100, 20)

2.5

1.5

Probability of2.0
BestFit Student Version
For Academic Use Only Reorder point
meeting demand during
1.0

lead time = service level = 84%

1.5

0.5 BestFit Student Version

For Academic Use Only

1.0

0.0
Probability of
a stockout = 16%

100

120

140

160
40

60

80
0.5
< 84.1% 15.9% >
-Infinity 120.0

0.0

100

120

140

160
40

60

80

Example units <

100 84.1%
120 15.9% >
-Infinity 120.0

Average demand during

Lead time = dL
Z
0 1
 Model Insights

• As the desired service level increases, the amount

of safety stock increases. (If fewer stockouts are
desired, more inventory must be carried.)
• As the variation in demand during lead time
increases, the amount of safety stock increases. (If
demand variation or lead time can be decreased,
less safety stock is needed.)
 Economic Production
Quantity (EPQ)

Same assumptions as the EOQ except: inventory arrives in

increments & draws down as it arrives

51
 EPQ Problem Solution

2DS 2(50)(100,000 )( 200 )

EPQ  EPQ   77,850 Bags
 d  100,000 
H 1   .551  
 p
 250000 

 
 d  100 , 000 
I MAX  Q 1   I MAX  77 , 850  1   46 , 710 bags
 250 , 000 
 p

 5,000,000   46,710 
D  I 
TCEPQ   S    MAX H  TC   200    .55  $25,690
Q   2   77,850   2 

52
 Quantity Discount Model
• Same as the EOQ model, except:
– Unit price depends upon the quantity ordered

• The total cost equation becomes:

TCQ D
 D  Q 
  S   H
Q   2 
 CD
53
 Quantity Discount Procedure

• Calculate the EOQ at the lowest price

• Determine whether the EOQ is feasible at that
price
– Will the vendor sell that quantity at that price?
• If yes, stop – if no, continue
• Check the feasibility of EOQ at the next higher
price

54
 QD Procedure con’t
• Continue until you identify a feasible EOQ
• Calculate the total costs (including total item cost) for the
feasible EOQ model
• Calculate the total costs of buying at the minimum
quantity required for each of the cheaper unit prices
• Compare the total cost of each option & choose the
lowest cost alternative
• Any other issues to consider?

55
Quantity Discount Example: Collin’s Sport store is considering going to a different
hat supplier. The present supplier charges $10/hat and requires minimum
quantities of 490 hats. The annual demand is 12,000 hats, the ordering cost is
$20, and the inventory carrying cost is 20% of the hat cost, a new supplier is
offering hats at $9 in lots of 4000. Who should he buy from?

• EOQ at lowest price $9. Is it feasible?

2(12,000)(20)
EOQ$9   516 hats
$1.80
• Since the EOQ of 516 is not feasible, calculate the total cost (C) for each price
to make the decision

C$10 
12,000
$20  490 $2  $1012,000  $120,980
490 2
C$9 
12,000
$20  4000
$1.80  $912,000  $101,660
4000 2

• 4000 hats at $9 each saves $19,320 annually. Space?

56
 Why Companies Don’t Always Use
Optimal Order Quantity

It is not unusual for companies to order less or more

than the EOQ for several reasons:
• They may not have a known uniform demand;
• Some suppliers have minimum order quantity that
are beyond the demand.

57
 Justifying Smaller Order
Quantities

JIT or “Lean Systems” would recommend reducing order quantities to the lowest
practical levels
• Benefits from reducing Q’s:
– Improved customer responsiveness (inventory = Lead time)
– Reduced Cycle Inventory
– Reduced raw materials and purchased components
• Justifying smaller EOQ’s:
2DS
Q
H

• Reduce Q’s by reducing setup time (S). “Setup reduction” is a well documented,
structured approach to reducing S

58
 Periodic Review Systems: Calculations for TI

• Targeted Inventory level:

TI = d(RP + L) + SS
d = average period demand
RP = review period (days, wks)
L = lead time (days, wks)
SS = zσRP+L
• Replenishment Quantity (Q)=TI-OH

59
 Inventory Systems

• Simple
• JIT
• MRP
• ERP

13-60
Two-Bin System
When the first bin is empty, stock
is taken from the second bin and
an order is placed. There should
be enough stock in the second bin
to last until more stock is
delivered.
 JIT—Kanbans

Empty Empty
Kanban Kanban

Full Full
Kanban Kanban

Task 1 Task 2
Customer
Workstation Workstation
Order
1 2
 Flow and Pull

• Continuous or single piece flow—move items (jobs,

patients, products) through the steps of the process one
at a time without interuptions or waiting.
• Pull or just-in-time (JIT)—products or services are not
produced until the downstream customer demands them.
• Heijunka (i.e., “make flat and level”)—eliminate variation
in volume and variety of production.
– Level patient demand
Enterprise Information Technology Trends

E-Business
E-Commerce
Automation
Collaborative
Data Processing
Engineering
Concurrent
Computer Engineering
Integrated Business Webs
Manufacturing
SCM
ERP
MRP II Appliances
MRP I Handheld
CAD/CAM Microcomputer
Minicomputer Mobile Networks
Mainframe Networks TCP/IP

1960 1970 1980 1990 2000 2010

 MRP Product Structure

Table
(end item)
Lead time = 1 week

Table top Leg

(1) (4)
Lead time = 2 weeks Lead time = 3 weeks
 MRP Logic

Order
table tops

Order
table legs

Week 1 2 3 4 5
ERP Systems Link Functional Areas
 Lot Sizing for a Single Product (EOQ)
► Annual order cost =(D/Q)S=ns
Annual holding cost = (Q/2)H =(Q/2)hC
Annual material cost = CD

TC =CD + (D/Q)S + (Q/2)hC

Cost
Total Cost
Holding Cost

Order Cost
Material Cost
Lot Size
68
 Lot Sizing for a Single Product
Total annual cost, TC =CD + (D/Q)S + (Q/2)hc
Optimal lot (EOQ)
size, Q is obtained by taking the first derivative
► Annual order
d (cost
TC) =(D/Q)S
DS hC
  0 *
 2DS
Annual holdingdQcost =Q(Q/2)H
2 =(Q/2)hc Q
2 hC
Annual material cost = CD‧
*
 D  DhC Average flow time = Q*/2D
n
Q* 2S
TC =CD + (D/Q)S + (Q/2)hc
Cost
Total Cost
Holding Cost

Order Cost
Material Cost
Lot Size
69
 Example
 Demand， D =1,000 units/month
= 12,000 units/year
 Fixed cost, S = $4,000/order
 Unit cost, C = $500
 Holding cost, h = 20% = 0.2

2X12000X4000
》Optimal order size Q= = 980
0.2X500

》Cycle inventory Q/2 =490

》Numbers of orders per year D / Q = 12000 / 980 =12.24

》Average flow time Q / 2D = 490 / 12000 =0.041 (year)
=0.49(mounth)

70
 Example - Continued
 Demand， D =1,000 units/month
► If we want to reduce the optimal lot size from 980 to 200,
= 12,000 units/year
 Fixed cost, Sthen how much the order cost per lot should be.
= $4,000/order
 Unit cost, C = $500 h C ( Q * ) 2
0.2X500X2002
S = = 0.2
 Holding cost, h = 20% = = $166.7
2D 2X12000

2X12000X4000
》Optimal
order
If wesize
increase theQlot=size by 10% (from 980 to
= 1100),
980 what
the 0.2X500
total cost would be.
》Cycle
Annual cost = $ 98,636
inventory (from $ 97,980)(an increase by only 0.6%)
Q/2 =490
(Note: material cost is not included)
》Numbers of orders per year D / Q = 12000 / 980 =12.24
》Average flow time Microsoft。
Q / 2D = 490 / 12000 =0.041
Microsoft。 (year)
CoolCLIPS
=0.49(mounth)Microsoft。
Microsoft。
Microsoft。

71
 Key Points from EOQ

 Total order 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.

 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 .
 To reduce the optimal lot size by a factor of k, the fixed order cost
S must be reduced by a factor of k2 .

72
 Aggregating Multiple Products in a Single Order

► One of major fixed costs is transportation

► Ways to lower the fixed ordering and transportation costs:
► Ways to lower receiving
》Aggregating across theorproducts
loadingfrom
costs:
the same supplier
》Single delivery from multiple suppliers
》ASN (Advanced Shipping Notice) with EDI
》Single delivery to multiple retailers

Microsoft。

Microsoft。
Microsoft。

73
 Products
 Three computer models (L, M, H) are sold and the demand per year:

–DL = 12,000; DM = 1,200; DH = 120

L M
► Common fixed (transportation) cost, S = $4,000 H
► Additional product specific order cost
》sL = $1,000; sM = $1,000; sH = $1,000
Microsoft。 Microsoft。 Microsoft。
► Holding cost, h = 0.2
► Unit cost
》CL = $500; CM = $500; CH = $500

74
 Delivery Options
► No aggregation
► Complete
》Each product
aggregation
is ordered separately
► Tailored
》All products
aggregation
are delivered on each truck

》Selected subsets of products on each truck

75
 Option 1: No Aggregation Result

► No aggregation
► Complete aggregation
Litepro Medpro Heavypro
► Tailored aggregation
Demand per year 12000 1200 120
Fixed cost / order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Order frequency 11.0/year 3.5/year 1.1/year
Annual holding cost $109,544 $34,642 $10,954
Annual total cost = $155,140 (no material cost)

76
 Option 2: Complete Aggregation

► No aggregation
► Complete aggregation
► Tailored
》Combinedaggregation
fixed cost per order is given by
*2DS
S  S  sL  sM  sH
* Q
hC
》Let n be the number of orders placed per year. We have
Total annual cost = Annual order cost + Annual holding cost
=
(S n )  [(DL hCL / 2n )  (DM hCM / 2n )  (DH hCH / 2n )]
*

DL hCL DM hCM DH hCH DhC

n*  n 
*

2S* 2S

77
 Option 2: Complete Aggregation

► No aggregation
► Complete aggregation
► Tailored
》Combinedaggregation
fixed cost per order is given by

S  S  sL  sM  sH
*

》Let n be the number of orders placed per year. We have

Total annual cost = Annual order cost + Annual holding cost
=
(S n )  [(DL hCL / 2n )  (DM hCM / 2n )  (DH hCH / 2n )]
*

DL hCL DM hCM DH hCH DhC

n*  n 
*

2S* 2S

78
 Option 2: Complete Aggregation Result

► No aggregation
► Complete aggregation
► Tailored aggregation

Litepro Medpro Heavypro

Demand per year 12000 1200 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 = 9.75×$7,000 = $68,250
Annual total cost = $68,250+$61,512+$6,151+$615=$136,528

79
 Option 3: Tailored aggregation

► No aggregation
► Complete aggregation
► Tailored aggregation

A heuristic that yields an ordering policy whose cost is close to optimal.

► Step 1: Identify most frequently ordered product.

► Step 2: Identify frequency of other products as a multiple of the order
frequency of the most frequently ordered product.

► Step 3: Recalculate order frequency of most frequently ordered product.

► Step 4: Identify ordering frequency of all products.

80
 Option 3: Tailored aggregation hCiDi
n  Max { ni  }
i 2(S+si)
► No aggregation
hC L D L
nL   11 . 0, n  3.5, n H  1.1 \ n  11 . 0
2( S  s L )
► Complete aggregation M

► Tailored aggregation

►A heuristic that yields an ordering policy whose cost is close to optimal.

► Step 1: Identify most frequently ordered product.

► Step 2: Identify frequency of other products as a multiple of the order

frequency of the most frequently ordered product.

► Step 3: Recalculate order frequency of most frequently ordered product.

► Step 4: Identify ordering frequency of all products.

81
 Option 3: Tailored aggregation
► Step 1: Identify most frequently ordered product.
► No aggregation
hC L D L
nL   11 . 0, n  3.5, n H  1.1 \ n  11 . 0
2( S  s L )
► Complete aggregation M

►►Tailored
Step 2: aggregation
Identify frequency of other products as a multiple of the order
frequency of the most frequently ordered product.
 optimal.
A heuristic that yields an ordering policy whose cost is close to hC D i i
hCM DM
n=
nM   7 .7 nH  2.4 2si
2sM
 Step 2: Identify frequency of other products as a multiple of the order
mM ofthe
frequency 11 . 0 / 7ordered
nM  frequently
n / most . 7   1product.
. 4   2 mH  4 . 5   5
► Step 3: Recalculate order frequency of most frequently ordered product.

► Step 4: Identify ordering frequency of all products.

82
 aggregationof n
Option 3: TailoredDerivation
►
► No
Stepaggregation
1: Identify most frequently
TC= order orderedcost
cost + holding product.

► Complete aggregation
hC L D L
nL   11 . 0, n  3.5, n H  1.1 \ n  11 . 0
2( S  s L )
► Tailored aggregation
M

 Step 2: Identify
A heuristic frequency
that yields of other
an ordering products
policy whoseas a multiple
cost is close of
to the order
optimal.
frequency of the most frequently ordered product.

hCM DM
n   7 .7 nH products
2.4
► StepM 2: Identify
2sM frequency of other as a multiple of the order
frequency of the most frequently ordered product.
mM   n / nM  11 . 0 / 7 . 7   1 . 4   2 mH  4 . 5   5
► Step 3: Recalculate order frequency of most frequently ordered product.
► Step 3: Recalculate order frequency of most frequently ordered product.
 Step 4: Identify ordering frequency of all products.
hCi Di mi
n
2 [ S  (si / mi )]

83
 aggregationof n
Option 3: TailoredDerivation
►
► No
Stepaggregation
1: Identify most frequently
TC= order orderedcost
cost + holding product.

► Complete aggregation
hC nSD 
n L  TC=( L L i  11
+ n i s i  (hC
)+. 0, n i ) Di
 3.5, n H  1.1 \ n  11 . 0
i 2n
2( S  s L )
► Tailored aggregation
M i

 hCiDiMi
 Step 2: Identify
A heuristic that =
yields
nS + ordering
an
n
frequency sof
i
other
 i products
policy whoseas a multiple
cost is close of
to the order
optimal.
frequency of the most i m
frequently
i ordered
2n product.

mM hCMnD/MnM  11 . 0 / 7 . 7   1 . 4   2 mH  4 . 5   5
n 
► StepM 2: Identify
 7 .7
frequency of
nH products
other
2.4 as a multiple of the order
2sM
frequency of the most frequently ordered product.
mM   n / nM  11 . 0 / 7 . 7 
 Step 3: Recalculate order frequency of most frequently ordered product.
 Step 3: Recalculate order frequency of most frequently ordered product.
► Step 4: Identify ordering frequency of all products.
hCi Di mi
n
2 [ S  (si / mi )]

84
 aggregationof n
Option 3: TailoredDerivation

► No
Stepaggregation
1: Identify most frequently
TC= order orderedcost
cost + holding product.

 Complete aggregation
hC nSD 
n L  TC=( L L i  11
+ n i s i  (hC
)+. 0, n i ) Di
 3.5, n H  1.1 \ n  11 . 0
i 2n
2( S  s L )
 Tailored aggregation
M i

 hCiDiMi
 Step 2: Identify
A heuristic that =
yields
nS + ordering
an
n
frequency sof
i
other
 i products
policy whoseas a multiple
cost is close of
to the order
optimal.
frequency of the most i m
frequently
i ordered
2n product.

  hCiDiMi
hCM DM  0  S+ 
TC s i
 i
n    7 . 7 n m 2.4 2n 2 =0
 Step 2: Identify
M n i
H
2s frequency of other products as a multiple of the order
i
M
frequency of the most frequently ordered product.
mM   n / nM\  11 . 0 /7hC
. iD
7  i mi
n
 Step 3: Recalculate order  frequency of most frequently ordered product.
2 [ S  of
► Step 3: Recalculate order frequency
(si most
/ mi )]frequently ordered product.
 Step 4: Identify ordering frequency of all products.
hCi Di mi
n
2 [ S  (si / mi )]

85
 aggregation of n
Option 3: Tailored Derivation
►
► No
Stepaggregation
1: Identify
TC= most
orderfrequently ordered cost
cost + holding product.

► Complete aggregation
hC D
nS  n s  (hC
n L  TC=( L L i  11)+. 0,i n M 2n
+ i i i ) Di
 3.5, n H  1.1 \ n  11 . 0
2( S  s L )
► Tailored aggregation i

 hCiDiMi
► Step 2: Identify
A heuristic that yields
=nS ordering
an
+
n
frequency of
si other
 i products as a multiple of the order
policy whose cost is close to optimal.
mi
frequency of the mosti frequently ordered
2n product.

  hCiDiMi
hCM DM  0  S+ 
TC s i
 i
n    7 . 7 n 
m 2.4 2n 2 =0
► Step 2: Identify
M n Hi
2s frequency of other products as a multiple of the order
i
M
frequency of the most frequently ordered product.
mM   n / nM\  n11
 .0 / . 7iDi m1i . 4   2 mH  4 . 5   5
7 hC
 Step 3: Recalculate order frequency of most frequently ordered product.
2 [ S of(smost
► Step 3: Recalculate order frequency i / mi )]
frequently ordered product.
 Step 4: Identify ordering frequency of all products.
hCi Di mi L
n =11.47
2 [ S  (si / mi )]
Microsoft。

86
 Option 3: Tailored aggregation

► No aggregation
Step 1: Identify most frequently ordered product.
 Complete aggregation
hC L D L
nL   11 . 0, n  3.5, n H  1.1 \ n  11 . 0
2( S  s L )
 Tailored aggregation
M

► Step 2: Identify
A heuristic frequency
that yields of other
an ordering products
policy whoseas a multiple
cost is close of
to the order
optimal.
frequency of the most frequently ordered product.

hCM DM
n   7 .7 nH products
2.4
 StepM 2: Identify
2sM frequency of other as a multiple of the order
frequency of the most frequently ordered product.
mM   n / nM  11 . 0 / 7 . 7   1 . 4   2 mH  4 . 5   5
 Step 3: Recalculate order frequency of most frequently ordered product.
► Step 3: Recalculate order frequency of most frequently ordered product.
 Step 4: Identify ordering frequency of all products.
hCi Di mi
n =11.47
2 [ S  (si / mi )]

► Step 4: nL=11.47/year, nM=11.47/2=5.74/year,

nH=11.47/5=2.29/year .
87
 Option 3: Tailored Aggregation Result

► No aggregation
► Complete aggregation
► Tailored aggregation

Litepro Medpro Heavypro

Demand per year 12000 1200 120
Order frequency 11.47/year 5.74/year 2.29/year
Optimal order size 1,046 209 52
Annual holding cost $52,310 $10,453 $2620
Annual order cost = nS + nLsL+ nMsM + nHsH =$65,380
Annual total cost = $130,763
Complete aggregation (Annual total cost) =$136,528
88
 Option 3: Tailored aggregation

► No aggregation
► Complete aggregation
► Tailored aggregation

A heuristic that yields an ordering policy whose cost is close to optimal.

► Step 1: Identify most frequently ordered product.

► Step 2: ─ A fixedfrequency
Identify cost of (S+si) is allocated
of other productstoaseach productofi,the
a multiple andorder
frequency of the most frequently ordered product.  hCi Di 
The most frequently order frequency  n  Max  ni  
i

► Step 3: Recalculate order frequency of most frequently ordered 
2(S si ) 
product.

► Step 4: Identify ordering frequency of all products.

89
 Option 3: Tailored aggregation

► No aggregation
► Complete aggregation
► Tailored aggregation

A heuristic that yields an ordering policy whose cost is close to optimal.

► Step 1: Identify most frequently ordered product.

► Step 2: Identify frequency of other products as a multiple of the order
frequency of the most frequently ordered product.

► Step 
 3: Recalculate order frequency of most frequently ordered product.
ni  hCi Di mi  n / ni mi  mi
2si ordering frequency of all products.
► Step 4: Identify

90
 Option 3: Tailored aggregation

► No aggregation
► Complete aggregation
► Tailored aggregation

A heuristic that yields an ordering policy whose cost is close to optimal.

► Step 1: Identify most frequently ordered product.

► Step 2: Identify frequency of other products as a multiple of the order
frequency of the most frequently ordered product.

► Step 3: Recalculate order frequency of most frequently ordered product.

hCordering
► Step 4: Identify i Di mi frequency of all products.
n
2 [ S  (si / mi )]

91
 Option 3: Tailored aggregation

► No aggregation
► Complete aggregation
► Tailored aggregation

A heuristic that yields an ordering policy whose cost is close to optimal.

► Step 1: Identify most frequently ordered product.

► Step 2: Identify frequency of other products as a multiple of the order
frequency of the most frequently ordered product.

► Step 3: Recalculate order frequency of most frequently ordered product.

► Step 4: Identify ordering frequency of all products.

ni=n/mi

92
 Impact of Product Specific Order Cost

Product specific Product specific

order cost =$1,000 order cost =$3,000

No aggregation $155,140 $183,564

Complete aggregation $136,528 $186,097

Tailored aggregation $130,763 $165,233

?
93
 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 large

fraction of joint fixed cost

94
 Why hold inventory?
► Economies of scale

》 Batch size and cycle time

► Stochastic variability
》 Quantity discountsof supply and demand
》 Short term discounts / Trade promotions

95
 Quantity Discounts
► Lot size based
》Based on the quantity ordered in a single lot
> All units
► Volume based
> Marginal unit
》Based on total quantity purchased over a given period

 How should buyer react? How does this decision affect the supply chain
in terms of lot sizes, cycle inventory, and flow time?
 What are appropriate discounting schemes that suppliers should offer?

96
 All Unit Quantity Discounts
Average Cost per Unit Total Material Cost

C0
C1
C2

Quantity Purchased Order Quantity

q1 q2 q3 q1 q2 q3

If an order that is at least as large as qi but smaller than qi+1 is placed,

then each unit is obtained at the cost of Ci.
97
 Evaluate EOQ for All Unit Quantity
Total Cost Discounts
Lowest cost in the range

► Evaluate EOQ for price in range qi to qi+1 , Qi  2DS

hCi
Total Cost
Lowest cost in the range
》 Case 1:If qi  Qi < qi+1 , evaluate cost of ordering Qi EOQi

Q
TCi  D S  i hCi  DCi
Qi 2 qi qi+1 Order Quantity
Total Cost Lowest cost in the range
》 Case 2:If Qi < qi, evaluate cost of ordering qi EOQi

q
TCi  D S  i hCi  DCi
qi 2 qi qi+1

》 Case 3:If Qi  qi+1 , evaluate cost of ordering qi+1 EOQi

D qi+1
TCi  S hCi  DCi+1 Order Quantity
qi+1 2 qi qi+1

► Choose the lot size that minimizes the total cost over all price ranges.

98
 Example
 Assume the all unit quantity discountsAverage Cost per Unit
Order Quantity Unit Price D = 120,000/ year
CS0 = $100/lot
0-5,000 $ 3.00
h = 0.2
C 1
5,000-10,000 $ 2.96
C2
10,000 or more $ 2.92
 Based on the all unit quantity discounts, we have Quantity
q0=0, q1=5,000, q2=10,000 Purchased

C0=$3.00, C1=$2,96, C2=$2.92 q1 q2 q3

 If i = 0, evaluate Q0 as Q0 2DS = 6,324

hC0
Since Q0 > q1, we set the lost size at q1=5,000 and the total cost

99
 Evaluate EOQ for All Unit Quantity Discounts

 Evaluate EOQ for price in range qi to qi+1 , Qi  2DS

hCi
》 Case 1:If qi  Qi < qi+1 , evaluate cost of ordering Qi

Q
TCi  D S  i hCi  DCi
Qi 2

》 Case 2:If Qi < qi, evaluate cost of ordering qi

q
TCi  D S  i hCi  DCi
qi 2

》 Case 3:If Qi  qi+1 , evaluate cost of ordering qi+1

D qi+1
TCi  S hCi  DCi+1
qi+1 2

 Choose the lot size that minimizes the total cost over all price ranges.
10
0
 Example
 Assume the all unit quantity discounts
Order Quantity Unit Price D = 120,000/ year
S = $100/lot
0-5,000 $ 3.00
h = 0.2
5,000-10,000 $ 2.96
10,000 or more $ 2.92
 Based on the all unit quantity discounts, we have
q0=0, q1=5,000, q2=10,000
C0=$3.00, C1=$2,96, C2=$2.92

 If i = 0, evaluate Q0 as Q0 2DS = 6,324

hC0
Since Q0 > q1, we set the lost size at q1=5,000 and the total cost

q
TC0 D S  1 hC1 DC1 = $359,080
q1 2
10
1
 Example
 Assume the all unit quantity discounts
Order Quantity Unit Price D = 120,000/ year
S = $100/lot
0-5,000 $ 3.00
h = 0.2
5,000-10,000 $ 2.96
10,000 or more $ 2.92
 Based on the all unit quantity discounts, we have
q0=0, q1=5,000, q2=10,000
C0=$3.00, C1=$2,96, C2=$2.92

 If i = 0, evaluate Q0 as Q0 2DS = 6,324

hC0
Since Q0 > q1, we set the lost size at q1=5,000 and the total cost

q
TC0 D S  1 hC1 DC1 = $359,080
q1 2
10
2
 All Unit Quantity Discounts
Average Cost per Unit Total Material Cost

C0
C1
C2

Quantity Purchased Order Quantity

q1 q2 q3 q1 q2 q3

If an order is placed that is at least as large as qi but smaller than qi+1,

then each unit is obtained at a cost of Ci.
10
3
 Example
 Assume the all unit quantity discounts
Order Quantity Unit Price D = 120,000/ year
S = $100/lot
0-5,000 $ 3.00
h = 0.2
5,000-10,000 $ 2.96
10,000 or more $ 2.92
 Based on the all unit quantity discounts, we have
q0=0, q1=5,000, q2=10,000
C0=$3.00, C1=$2,96, C2=$2.92

 If i = 0, evaluate Q0 as Q0 2DS = 6,324

hC0
Since Q0 > q1, we set the lost size at q1=5,000 and the total cost

q
TC0 D S  1 hC1 DC1 = $359,080
q1 2
10
4
 Example - Continued
 For i = 1, we obtain Q1 = 6,367
Since 5,000 < Q1 <10,000 , we set the lot size at Q1 = 6,367.

Q1
TC1 D S  hC1 DC1 = $358,969
Q1 2

 For i = 2, we obtain Q2 = 6,410

Since Q2 < q2 , we set the lot size at q2=10,000.

 Observe that the lowest total cost is for i = 2.

The optimal lot size = 10,000 (at the discount price of $2.92)
10
5
 Example - Continued
 For i = 1, we obtain Q1 = 6,367
Since 5,000 < Q1 <10,000 , we set the lot size at Q1 = 6,367.

Q1
TC1 D S  hC1 DC1 = $358,969
Q1 2

 For i = 2, we obtain Q2 = 6,410

Since Q2 < q2 , we set the lot size at q2=10,000.

q
TC2 D S  2 hC2 DC2 = $354,520
q2 2

► Observe that the lowest total cost is for i = 2.

The optimal lot size = 10,000 (at the discount price of $2.92)

10
6
 Example - Continued
 For i = 1, we obtain Q1 = 6,367
Since 5,000 < Q1 <10,000 , we set the lot size at Q1 = 6,367.

Q1
TC1 D S  hC1 DC1 = $358,969
Q1 2

 For i = 2, we obtain Q2 = 6,410

Since Q2 < q2 , we set the lot size at q2=10,000.

q
TC2 D S  2 hC2 DC2 = $354,520
q2 2

► Observe that the lowest total cost is for i = 2.

The optimal lot size = 10,000 (at the discount price of $2.92)

10
7
 Example - Continued
 For i = 1, we obtain Q1 = 6,367
Since 5,000 < Q1 <10,000 , we set the lot size at Q1 = 6,367.

Q1
TC1 D S  hC1 DC1 = $358,969
Q1 2

 For i = 2, we obtain Q2 = 6,410

Since Q2 < q2 , we set the lot size at q2=10,000.

q
TC2 D S  2 hC2 DC2 = $354,520
q2 2

► Observe that the lowest total cost is for i = 2.

The optimal lot size = 10,000 (at the discount price of $2.92)

10
8
 The Impact of All Unit Discounts on Supply Chain

► In the above example

》The optimal order size = 6,324 when there is no discount.

》The quantity discounts result in a higher order size = 10,000.

► If the fixed ordering cost S = $4,

》The optimal order size without discount = 1,265

》The optimal order size with all unit discounts = 10,000

► All unit quantity discounts encourage retailers to increase the size of

their lots.

► This also increases cycle inventory and average flow time.

10
9
 Marginal Unit Quantity Discounts

Marginal Cost per Unit Total Material Cost

C0
C1
C2

Quantity
Purchased Order Quantity
q1 q2 q3 q1 q2 q3

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.
11
0
 Evaluate EOQ for Marginal Unit Discounts

► Evaluate EOQ for each marginal price Ci (or lot size between qi and qi+1)
》 Let Vi be the cost of order qi units. Define V0 = 0 and
Vi=C0(q1-q0)+C1(q2-q1)+‧‧‧+Ci-1(qi-qi-1)

》 Consider an order size Q in the range qi to qi+1

Total annual cost = ( D/Q )S (Annual order cost)
+ (Q/2)‧h‧[ Vi+(Q-qi)Ci ] / Q (Annual holding cost)
+ D‧[ Vi+(Q-qi)Ci ] / Q(Annual material cost)

Optimal lot size

2D(S+Vi-qiCi)
Qi=
hCi

11
1
 Evaluate EOQ for Marginal Unit Discounts

► Evaluate EOQ for each marginal price Ci (or lot size between qi and qi+1)
》 Let Vi be the cost of order qi units. Define V0 = 0 and
Vi=C0(q1-q0)+C1(q2-q1)+‧‧‧+Ci-1(qi-qi-1)

》 Consider an order size Q in the range qi to qi+1

Total annual cost = ( D/Q )S (Annual order cost)
+ (Q/2)‧h‧[ Vi+(Q-qi)Ci ] / Q (Annual holding cost)
+ D‧[ Vi+(Q-qi)Ci ] / Q(Annual material cost)

Optimal lot size

2D(S+Vi-qiCi)
Qi =
hCi

11
2
 Example
 Assume the all unit quantity discounts
Order Quantity Unit Price D = 120,000/ year
S = $100/lot
0-5,000 $ 3.00
h = 0.2
5,000-10,000 $ 2.96
10,000 or more $ 2.92
 q0=0, q1=5,000, q2=10,000
C0=$3.00, C1=$2,96, C2=$2.92
V0=0 ; V1=3(5,000-0)=$15,000
V2=3(5,000-0)+2.96(10,000-5,000)=$29,800
2D(S+V0-q0C0)
 If i = 0, evaluate Q0 as Q0 = = 6,324
hC0
Since Q0 > q1, we set the lost size at q1=5,000 and the total cost
h D
TC0  D S +[ V1 +(q 1 1 1 2 + q [ V1+(q1-q1)C1]= $363,900
-q )C ]
11
q1 1
3
 Example - Continued
 For i = 1, evaluate Q1= 2D(S+V1-q1C1) = 11,028
hC1
Since Q1 > q2, we evaluate the cost of ordering q2=10,000

D h D
TC1  S +[ V2+(q 2 2 2 2 + q [ V2+(q2-q2)C2]=$361,780
-q )C ]
q2 2

2D(S+V2-q2C2)
 For i = 2, evaluate Q2= = 16,961
hC2

TC2 D S +[ V2+(Q2-q2)C2] h + D [ V2+(Q2-q2)C2 ]= $360,365

Q2 2 Q2

 Optimal order size = 16,961

11
4