Managing Economies of Scale in the

Supply Chain: Cycle Inventory

Learning Objectives
Understand the role of cycle inventory in a
supply chain
Define the effects of quantity discounts on lot
size and cycle inventory
Identify the appropriate discounting schemes for
the supply chain, taking into account cycle
inventory
Understand the effects of trade promotions on
lot size and cycle inventory

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

Economies of Scale

Supply / Demand
Variability

Seasonal
Variability

Cycle Inventory

Safety Inventory

Seasonal Inventory

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
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)

Role of Cycle Inventory

in a Supply Chain: Example Jean-Mart
The demand for jeans at Jean-Mart, a department store, is
relatively stable at D= 100 pairs of jeans per day. The store
manager at Jean-Mart currently purchases in lots of Q =
1000 pairs. Calculate the cycle inventory and average flow
time for jeans.
Cycle inventory = lot size/2 = Q/2 = 1000/2 = 500
Avg flow time = avg inventory / avg flow rate
= cycle inventory / demand
= 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

Role of Cycle Inventory

in a Supply Chain [2]
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 ($C/unit)
Fixed ordering cost = S ($S/lot)
Holding cost = H = hC (h = cost of holding $1 in
inventory for one year or denoted by $H/unit/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

Estimating Cycle Inventory

Related Costs in Practice
Inventory Holding Cost
Cost of capital: holding cost for products that do not become obsolete
quickly
Obsolescence or spoilage cost: estimate the rate at which the value
of the stored product drops because of its market value or quality falls
(e.g. perishable products)
Handling costs: include only incremental receiving and storage costs
that vary with the quantity of product received
Occupancy costs: reflect the incremental change in space cost due to
changing cycle inventory
Miscellaneous costs: theft, security, damage, tax, insurance

Ordering Cost
Buyer time: incremental time of the buyer placing the extra order
Transportation costs: a fixed transportation cost if often incurred
regardless of the size of the order
Receiving costs: e.g. administration work cost such as purchase order
matching and any effort associated with updating inventory records

Economies of Scale
to Exploit Fixed Costs [2]
Annual demand = D
Number of orders per year = D/Q
Annual material cost = CD
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

Fixed Costs: Optimal Lot Size

and Reorder Interval (EOQ)
D: Annual demand
S: Setup or Order Cost
C: Cost per unit
h: Holding cost per year as a
fraction of product cost
H: Holding cost per unit per year
Q: Lot Size
Q*: Optimal Lot Size (Economic
Order Quantity or EOQ)
n*: Optimal order frequency
Material cost is constant and
therefore is not considered in
this model

H hC
2DS
Q*
H
DhC
n*
2S

Example Economic Order Quantity

Mr. Fu is the manager at Allied Electrics. He is planning to manage the stores
inventory costs more efficiently. In a pilot study, he asked the planning team
to apply the EOQ model to a particular model of Samsung television. Annual
demand for that product is 12000 units, with a monthly demand of 1000.
Administrative, transportation and receiving form the fixed cost of $4000 each
time an order is placed. Each television costs the wholesaler $500 to buy and
20 percent of the value of the item to hold each year. What would be the EOQ
in this case? How much the annual inventory holding cost?
Solution:
Demand, D = 1000 x 12 = 12,000 computers per year
Unit cost per television, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2
Order cost per lot, S = $4,000
Q* = Sqrt[2DS/hC] = Sqrt[(2)(12000)(4000)/(0.2)(500)] = 980 computers
Cycle inventory = Q*/2 = 490
Average Flow time = Q*/2D = 980/(2)(12000) = 0.041 year = 0.49 month
Optimal order frequency = n* = Sqrt[(12000)(0.2)(500)/(2)(4000)]
= 12.24 orders
Annual ordering and holding cost =
= (12000/980)(4000) + (980/2)(0.2)(500) = $97,980

Example Economic Order Quantity [2]

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

Example Relationship between Lot Size and

Ordering Cost
If desired lot size = Q* = 200 units, what would S (order cost) have
to be?
Desired lot size = Q* = 200
Annual demand = D = 12000 units
Unit cost per television = C = $500
Holding cost per year as a fraction of inventory value = h = 0.2
Use EOQ equation and solve for S:
S = [hC(Q*)2]/2D = [(0.2)(500)(200)2]/(2)(12000) = $166.67
KEY POINT: To reduce optimal lot size by a factor of k, the fixed
order cost must be reduced by a factor of k2

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.

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

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

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

Lot Sizing with Multiple Products

Applied Electrics, the electrical wholesaler, wants to expand
inventory ordering system to 3 models of its Samsung
televisions: L, M, H.
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

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

No Aggregation: Order Each Product

Independently

D em a n d p er
y ea r
F ix ed co st /
o rd er
O p tim a l
o rd er size
O rd er
freq u en cy
A n n u a l co st

L itep ro

M ed p ro

H ea vyp ro

1 2 ,0 0 0

1 ,2 0 0

120

$ 5 ,0 0 0

$ 5 ,0 0 0

$ 5 ,0 0 0

1 ,0 9 5

346

110

1 1 .0 / y ea r

3 .5 / y ea r

1 .1 / y ea r

$ 1 0 9 ,5 4 4

$ 3 4 ,6 4 2

$ 1 0 ,9 5 4

Total cost = $155,140

Aggregation: Order All

Products Jointly
Combined order cost = S* = S + sL + sM + sH
= 4000+1000+1000+1000 = $7000
Optimal order frequency = n*
= Sqrt[(DLhCL+ DMhCM+ DHhCH)/2S*] = 9.75
Optimal order size:
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)
Annual holding cost = QhC / 2

Complete Aggregation:
Order All Products Jointly

Demand per
year
Order
frequency
Optimal
order size
Annual
holding cost

Litepro

Medpro

Heavypro

12,000

1,200

120

9.75/year

9.75/year

9.75/year

1,230

123

12.3

$61,512

$6,151

$615

Annual order cost = 9.75 $7,000 = $68,250

Annual total cost = $136,528

Lessons from Aggregation

Aggregation allows firms 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

Discounts
Lot size based

Discounts based on the quantity ordered in

a single lot
Volume based

Discounts based on the total quantity

purchased over a given period, regardless
of the number of lots purchased over that
period
How should buyer react?
What are appropriate discounting schemes?

What is the appropriate discounting

schemes?
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

This however, increase cycle inventory

in the supply chain
For products for which the firm has market
power (product has demand curve), twopart tariffs or volume-based quantity
discounts can be used to achieve coordination in
the supply chain and maximize supply chain
profits

Economies of Scale to
Exploit Quantity Discounts
All-unit quantity discounts
Marginal unit quantity discounts
Why quantity discounts?
Improved coordination to increase total supply
chain profits
Extraction of surplus through price
discrimination

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
The unit cost generally decreases as the
quantity increases, i.e., C0>C1>>Cr
The objective for the company (a retailer in our
example) is to decide on a lot size that will
minimize the sum of material, order, and
holding costs

All-Unit Quantity Discount Procedure

Step 1: Calculate the EOQ for the lowest price. If it is
feasible (i.e., this order quantity is in the range for that
price), then stop. This is the optimal lot size. Calculate
total cost (TC ) for this lot size.
Step 2: If the EOQ is not feasible, calculate the TC for
this price and the smallest quantity for that price.
Step 3: Calculate the EOQ for the next lowest price. If it
is feasible, stop and calculate the TC for that quantity and
price.
Step 4: Compare the TC for Steps 2 and 3. Choose the
quantity corresponding to the lowest TC.
Step 5: If the EOQ in Step 3 is not feasible, repeat Steps
2, 3, and 4 until a feasible EOQ is found.

All-Unit Quantity Discount: Example

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 10,000
bottles per month. The price charged by the manufacturer is
as follows:
Order quantity
0-4,999
5,000-9,999
10,000-

Unit Price
$3.00
$2.96
$2.92

q0 = 0, q1 = 5,000, q2 = 10,000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120,000 units/year, S = $100/lot, h = 0.2

All-Unit Quantity Discount: Example

Step 1: Calculate Q2* = Sqrt[(2DS)/hC2]
= Sqrt[(2)(120,000)(100)/(0.2)(2.92)]=6,410
Not feasible (6,410 < 10,000)
Calculate TC2 using C2 = $2.92 and q2 = 10,000
TC2 = (D/Q2)S + (Q2/2)hC2 + DC2
=(120,000/10,000)(100)+(10,000/2)(0.2)(2.92)+(120,000)(2.92)
= 1,200 + 2,920 + 350,400 = $354,520
Step 2: Calculate Q1* = Sqrt[(2DS)/hC1]
= Sqrt[(2)(120,000)(100)/(0.2)(2.96)]=6,367
Feasible (5,000<6,367<9,999) Stop
TC1 = (120,000/6,367)(100)+(6,367/2)(0.2)(2.96)+(120,000)(2.96)
= $358,969
TC2 < TC1 The optimal order quantity Q* is q2 = 10,000

All-Unit Quantity Discounts

What is the effect of such a discount schedule?

Retailers are encouraged to increase the size of
their orders
Average inventory (cycle inventory) in the
supply chain is increased
Average flow time is increased
Is an all-unit quantity discount an advantage in
the supply chain?

Marginal Quantity Discount: Example

(optional)
Drugs online is an online retailer of prescription drugs and
health supplements. Vitamins represent a significant
percentage of its sales. Demand for vitamins is 10,000
bottles per month. The price charged by the manufacturer is
as follows:
Order quantity
0-4999
5000-9999
10000-

Unit Price
$3.00
$2.96
$2.92

q0 = 0, q1 = 5,000, q2 = 10,000
C0 = $3.00, C1 = $2.96, C2 = $2.92
D = 120,000 units/year, S = $100/lot, h = 0.2
Let Vi be the cost of ordering qi units;
Vi = C0(q1-q0) + C1(q2-q1) + + ci-1(qi-q0-1)

Marginal Quantity Discount: Example

(optional)
Let Vi be the cost of ordering qi units;
Vi = C0(q1-q0) + C1(q2-q1) + + ci-1(qi-q0-1)
Optimal lot size for price, Ci, is Qi =

2 D( S Vi qiCi )
hCi

TCi = (D/Qi)S+[Vi+(Qi-qi)Ci]h/2 + D/Qi[Vi+(Qi-qi)Ci]

V0 = 0;
V1 = 3(5,000-0)=15,000;
V2 = 3(5,000-0)+2.96(10,000-5,000)=29,800
Start with i=2

Marginal Quantity Discount: Example

(optional)
Step 1: Calculate Q2* = Sqrt[(2D(S+V2-q2C2))/hC2]
= Sqrt[(2)(120,000)(100+29,80029,200)/(0.2)(2.92)] = 16,961
Feasible ( 16,961 > 10,000) Stop
Calculate TC2 using C2 = $2.92 and Q2 = 16,961; q2 = 10,000
TC2 = (D/Q2)S+[V2+(Q2-q2)C2]h/2 + D/Q2[V2+(Q2-q2)C2]
= $ 360,365

Volume-based Discounts
In the case of Drug Online (DO), consider the
scenario in which the manufacturer has invented a
new vitamin pill, Vitaherb, which is derived from
herbal ingredients, so it can be argued that the
price at which DO sells Vitaherb influences
demand given by
demand curve 360,000 60,000p;
where p is price at which DO sells Vitaherb.
The manufacturer incurs a production cost of
CS = $2 per bottle.
The manufacturer must decide on the price to
charge DO and DO in turn must decide on the
price to charge the customer.

Volume-based Discounts
When the two make their decisions independently,
it is optional for DO to charge a price of p $5 and
for the manufacturer to charge DO a price of CR
$4.
The total market demand for this case is

360,000 60,000p = 60,000 bottles of Vitaherb

The profit at DO = (ProfR)

60,000 (p-CR) = 60,000 x 1= $ 60,000

The profit at the manufacturer = (ProfM)

60,000 (CRCS) = 60,000 x 2 = $ 120,000

Total SC profit = $ 180,000

Volume-based Discounts
If the two stages coordinate and DO prices at p =
$4, market demand is 120,000
Total SC profit will be 120,000 x (4 2) =
$ 240,000
As a result of each stage settings its price
independently, the supply chain thus loses
$60,000
This is called double marginalization
There are two pricing schemes that the
manufacturer may use to achieve the coordinated
solution: two-part tariff and volume-based
quantity discount

Two-part tariff
In this case, the manufacturer charges its entire
profit as an up-front franchise fee and then sells
to the retailers at its suppliers cost
DO case: the manufacturer charges DO an upfront fee of $180,000 and gives DO CR = $2
DO maximizes its profit if it prices the vitamins at
p=$4

It has annual sales of 120,000

Profits = $ 60,000
Recall: the manufacturer makes a profit of
$180,000
Observe that two-part tariff is really a volumebased quantity discount

Volume-based Discount
DO case:
The average material cost for DO declines as it
increases the quantity it purchases per year

This observation can be made explicit by

designing a volume-based discount scheme that
also achieves coordination
The objective here is to price in such a way that the
retailer buys the total volume sold when the two stages
coordinate pricing.

Recall that 120,000 bottles are sold per year when

the supply chain is coordinated
The manufacturer must offer DO a volume
discount to encourage DO to purchase this
quantity

Volume-based Discount
The manufacturer thus offers a price of CR

$4 per bottle if the quantity of DO purchases

per year is less than 120,000
$3.5 if the total volume in the year is 120,000
or higher
It is then optimal for DO to order 120,000 and
price at p = $4 to the customers.
Total profit earned by DO = $ 60,000
Total profit earned by the manufacturer = $
180,000
Total SC profit = $ 240,000

Quantity vs Volume-based Discounts

Lot size-based discounts tend to raise the cycle
inventory in the supply chain by encouraging
retailers to increase the size of each lot.
Volume-based discounts in contrast, are
compatible with small lots that reduce cycle
inventory.
Lot size-based discounts make sense only when
the manufacturer incurs very high fixed cost per
order.
Otherwise, it is better to have volume-based
discounts

Short-Term Discounting:
Trade Promotions
Trade promotions are price discounts for a limited period
of time (also may require specific actions from retailers, such
as displays, advertising, etc.)
Key goals for promotions from a manufacturers perspective:
Induce retailers to use price discounts, displays, advertising
to increase sales
Shift inventory from the manufacturer to the retailer and customer
Defend a brand against competition

What is the impact on the behavior of the retailer and on the

performance of the supply chain?
Retailer has two primary options in response to a promotion:
Pass through some or all of the promotion to customers to spur
sales
Purchase in greater quantity during promotion period to take
advantage of temporary price reduction, but pass through very
little of savings to customers FORWARD BUYING

Short-Term Discounting:
Trade Promotions

dD
CQ *

(C d )h C d

When the retailer takes the second option i.e., forward buying
And the following assumptions hold:
Discount is offered once, with no future discounts
Retailer takes no action to influence customer demand
customer demand remain unchanged
In a period over which demand is an integer multiply of Q*,
then, the optimal order quantity at the discounted price is
given by
Qd =
Forward buy = Qd Q*

Q*: Normal order quantity

C: Normal unit cost
d: Short term discount
D: Annual demand
h: Cost of holding $1 per
year
Qd: Short term order quantity

Short Term Discounts:

Forward Buying
DO is retailer that sells Vitaherb, a popular vitamin diet
supplement.
Annual demand, D = 120,000
Normal cost, C = $3 per bottle
Holding cost, h = 0.2
Normal order size, Q* = 6,324 bottles
Discount per tube, d = $0.15
Optimal lot size during promotion:
Qd = dD/(C-d)h + CQ*/(c-d)
= [(0.15)(120000)/(3.00-0.15)(0.2)] + [(3)(6324)/(3.00-0.15)]
= 38,236 bottles
Forward buy = Qd Q* = 38,236 6,324 = 31,912 bottles

Trade Promotions
When a manufacturer offers a promotion, the goal for the
manufacturer is to take actions (countermeasures) to
discourage forward buying in the supply chain
Counter measures
EDLP (every day low pricing): price is fixed over time
and no short-term discounts are offered
Eliminates any incentive for forward buying
As a result, all stages of the supply chain purchase in
quantities that match demand

Scan based promotions: e.g. retailer receives credit

for the promotion discount for every unit sold
Customer coupons

Exercise All Unit Quantity Discount

Dominicks supermarket chain sell Nut Flakes, a popular cereal
manufactured by the Testee cereal company. Demand for NutFlake
is 1,400 bottles per month. Dominick incurs a fixed order
placement, transportation, and receiving cost of $200 each time an
order for cereal is placed with manufacture. The holding cost used
by the retailer is 20 percent. The price charged by the
manufacturer is as follows:
Order quantity
0-3,999
4,000-11,999
12,000-

Unit Price
$6.70
$6.60
$6.50

How many bottle should Dominick order in each lot? How much the
total annual cost?

References
Chopra S. and P. Meindl, Supply Chain
Management, 5e, Prentice Hall, 2013
Handfield, Monczka, Giunipero and Patterson,
Sourcing and Supply Chain Management, 4e,
South-Western, 2009
Cachon and Terwiesch, An Introduction to
Operations Management, 2e, McGraw-Hill, 2009