Week 4: Economies of scale

01-03-2022 and 02-03-2022

The objective of these lectures is to balance the appropriate costs to choose the optimal lot size
and cycle inventory in a supply chain. As well as that, the lectures help understand the impact of
quantity discounts on lot size and cycle inventory.

Lecture 1: Balancing costs

1. The role of cycle inventory

Lot or batch size: the quantity that a stage purchases or produces in one go.

Cycle inventory: the average inventory in a supply chain. For example, half of the lot size.

Example: Suppose demand is stable and has no variability. The cycle inventory of jeans at Jean-
Mart:

• The demand for jeans is stable at D = 100/day. The manager currently purchases in lots
of Q = 1000
• It takes 10 days for an entire lot to be sold: Starting from 1000 units when the lot arrives.
Ends at 0 when the last unit is sold.
Average flow time: the flow time a product spends in the supply chain. The larger the
cycle inventory, the longer the lag time between when a product is purchased and
when it is sold.

• Higher cycle inventory —> longer time log —> vulnerable demand changes in
the market.
• Lower cycle inventory has shorter average low times, lower working capital
requirements and lower inventory holding costs
• Cycle inventory is held to take advantage of economies of scale, smooth the
supply between different stages, protect against stock-outs.

2. The cost associated w cycle inventory

Inventory Holding (Carrying) Cost (H): is the cost to physically carry an item in
inventory.

• Holding cost increases as the following cost items increase: opportunity cost
capital (most important). Insurance, tax, storage. Obsolesce and spoilage.

Ordering Cost (S): cost of the actual placement of an order (not including purchase
cost). Charged every time an order is placed. Independent of the site of the order.

• Fixed cost increases in the following cost items: administrative, and

transportation. Receiving, inspecting and moving the goods to storage.
• The average price paid per unit purchased is a key in the lot-sizing decision:
material cost or purchase cost = C.
Example: Lot sizing for a single product:

• Demand for the “Deskpro computer” at Best Buy is 1,000 units per month. Best
Buy incurs a fixed order placement, transportation, and receiving cost of $6,000
each time an order is placed. Each computer costs Best Buy $500 and the retailer
has a holding cost rate of 20 percent.
• Evaluate the number of computers that the store manager should order in each
replenishment lot.
• D= 12; h= 0.2; C= $500 } H= 0.2 x 500 = 100 and S = $ 6 000.

Example: D = 12 000; h= 0.2; C= $500 } H= 0.2 x $500= 100.

• S = $6 000 } Q* = sqrt [(2 X 12 000 x 6000)/ 100] = sqrrt (1 440 000) = 1200
• n* = 12 000 / 1200 = 10.
• Cycle inventory = 1200/ 2= 600.

Example: A company has an annual demand of 16,000 units for one of its products. The
annual holding cost per unit is €2.50 and the cost to place an order is €50.

• What is the economic order quantity? Q* = sqrt [(2x 16000 x 50 )/ 2.5] = 800.
• Using the same holding and ordering costs as above, suppose the demand for the
product would double to 32,000. Does the EOQ also double? Explain what
happens: Q* = 1131.
Example: The annual demand for a company’s single item of stock is 1000 units. It costs
the company €6 to hold one unit of stock for 1 year. Each time that an order is placed,
the company incurs a fixed cost of €75. Determine the EOQ Suppose that the company’s
supplier introduces a condition: there shall be no more than 5 orders for replenishment
per year. How much would the total cost of the company change?

• Q* = sqrt [ (2x1000 x 75) / 6] = 158. Under this condition, purchasing costs would
not change, since the company still needs to buy 1000 units over the course of a
year.
• We conclude the following numbers: S= 75 (fixed ordering cost), D=1000 units,
H= 6 (cost of holding per year), Q= 158.
• Annual ordering and holding cost = S (D/Q) + H (Q/2) = 75 (1000/ 158) + 6 (158/
2) = 474.68 + 474 = 948. 68
• No more than 5 orders per year: n= D/Q <= 5 —> q>= 200
• Annual ordering and holding cost= S (D/Q) + H (Q/2) = 75 (1000/ 200) + 6 (200/
2)= 375 + 600= 975
• Change= 975 - 948.68 = 26.32.

3. Production lot sizing

Product lot sizing: In the EOQ formula, it is assumed that the entire lot arrives at the
same time. This is a reasonable assumption for retailers; Best Buy receives all
computers to sell at the same time.

• How about in a manufacturer site where production occurs at a specified rate;

namely P. Inventory builds up at a rate of P – D
Example: D= 18 000, Prod rate= 2500/ month, setup cost= $800, holding cost= $18/
unit.

• Optimal production quantity= sqrt[(2 x 18 000 x $800)/ ((1- 18 000/(2500x 12))

x 18] = sqrt (28 800 000 / 7.2= 1 972 or around 2000.
• Max level of inventory = (1 - 18 000/ (2500x 12)) x 1972 = 788. 8 or around 800.
• Annual setup and holding cost= 800 x (18 000/ 2000) + 18 (2000/ 2) (1 - 18 000/
(2500x12))= 7 200 + (18 000 x 0.4) = 14 400.
Lecture 2: Exploiting quantity discounts
Lot sizing with multiple products (or customers) there are two approaches:

1. Each product inventory system could be independently optimised

2. A manager can jointly order multiple items.

1. Aggregating multiple products orders

Transportation is a significant contributor to the fixed cost per order. Joint lot sizing
allows for a reduction in lot size for individual products because fixed ordering and
transportation costs are spread across these products, retailers, or suppliers.

• Saving in transportation costs: reduces fixed cost for each product, the lot size
for each product can be reduced, cycle inventory is reduced.
• Possible ways of aggregating: combining shipments of different products from
the same supplier, combining deliveries from multiple suppliers to a facility.
• Objective: to find lot sizes and ordering policy that minimises total cost.

Example: Best-buy. They have independent lot sizing: Litepro, Medpro and Headypro.
B2B transactions: on these types of transactions, the pricing schedule displays
economies of scale with prices decreasing as lot sizes increase.

Figure 1 values (used to explain the steps on all unit discounts and marginal unit quantity
discounts)

2. All unit quantity discounts

the retailer’s objective is to decide on lot sizes to minimize the sum of material, order,
and holding costs. The solution procedure has four steps, using values in figure 1:
Example: drugs online. (use figure 2)

Figure 2: values of drugs online

3. Marginal unit quantity discount or multi-block tariffs

The retailer’s objective is to decide on lot sizes to minimize the sum of material, order,
and holding costs. The solution procedure has four steps, using values in figure 1:
Example: drugs online (use figure 2 ).