Supply Chain Management: Strategy, Planning, and Operation: Seventh Edition

Supply Chain Management: Strategy,
Planning, and Operation

Seventh Edition
Chapter 11
Managing Economies of
Scale in a Supply Chain
Cycle Inventory
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Learning Objectives (1 of 2)
11.1 Describe the role of cycle inventory in a supply chain.

11.2 Choose the optimal lot size given fixed ordering costs in a
supply chain.
11.3 Evaluate how aggregation is best implemented to reduce
cycle inventory in a supply chain.
11.4 Understand the impact of quantity discounts on lot size and
cycle inventory.
Learning Objectives (2 of 2)
11.5 Devise appropriate discounting schemes for a supply chain.

11.6 Understand the impact of trade promotions on lot size and
cycle inventory.
11.7 Develop replenishment policies to improve synchronization
in multiechelon supply chains.
11.8 Identify managerial levers that reduce lot size and cycle
inventory in a supply chain without increasing cost.
Role of Cycle Inventory in a Supply
Chain (1 of 8)
• 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
Figure 11-1 Inventory Profile of Jeans at Jean-Mart
Chain (2 of 8)
lot size Q
Cycle inventory  
2 2
average inventory
Average flow time 
average flow rate
Average flow time

cycle inventory Q
resulting from cycle  
demand 2D
inventory
Chain (3 of 8)
For lot sizes of 1,000 pairs of jeans and daily demand of 100
pairs of jeans
Average flow time

Q 1,000
resulting from cycle    5 days
2D 2  100
inventory
Chain (4 of 8)
• Lower cycle inventory
– Decreases vulnerability to demand changes
– Lowers working capital requirements
– Lowers inventory holding costs
• Cycle inventory is held to
– Take advantage of economies of scale
– Reduce costs in the supply chain
Chain (5 of 8)
• 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
Chain (6 of 8)
• 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
Chain (7 of 8)
• 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
Chain (8 of 8)
• 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
Summary of Learning Objective 1
Cycle inventory builds up in a supply chain because product is
produced or purchased in large lots to lower the sum of material,
ordering, and holding costs by exploiting economies of scale.
Opportunities to exploit economies of scale arise if a fixed cost is
incurred each time an order is placed or produced, the supplier
offers price discounts based on the quantity purchased per lot, or
the supplier offers short-term price discounts. A reduction in
cycle inventory improves a supply chain’s ability to match supply
with demand.
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
Estimating Cycle Inventory Related Costs
in Practice (1 of 3)
• Inventory Holding Cost
– Cost of capital
E D
WACC  (Rf    MRP)  Rb (1  t)
DE DE
Where
E = amount of equity
D = amount of debt
Rf = risk-free rate of return
β = the firm’s beta
MRP = market risk premium
Rb = rate at which the firm can borrow money
t = tax rate
• Inventory Holding Cost
– Obsolescence (or spoilage) cost
– Handling cost
– Occupancy cost
– Miscellaneous costs
 Theft, security, damage, tax, insurance
• Ordering Cost
– Buyer time
– Transportation costs
– Receiving costs
– Other costs
Lot Sizing for a Single Product (Economic
Order Quantity)
• 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)
• Minimize
– Annual material cost
– Annual ordering cost
– Annual holding cost
Lot Sizing for a Single Product (1 of 3)
Annual material cost  CD
D
Number of orders per year 
Q
D
Annual ordering cost    S
Q 
Q  Q 
Annual holding cost    H    hC
2 2
D Q 
Total annual cost, TC    S    hC  CD
Q  2
Figure 11-2 Effect of Lot Size on Costs at Best Buy
• The economic order quantity (EOQ)
2DS
Optimal lot size, Q* 
hC
• The optimal ordering frequency
D DhC
n*  
Q* 2S
EOQ Example (1 of 3)
Annual demand, D  1,000  12  12,000units
Order cost per lot, S = $4,000

Unit cost per computer, C = $500
Holding cost per year as a fraction of unit cost, h = 0.2
2  12,000  4,000
Optimal order size  Q*   980
0.2  500
Q * 980
Cycle inventory    490
2 2
D 12,000
Number of orders per year    12.24
Q* 980
D Q* 
Annual ordering and holding cost  S  hC  $97,980
Q*  2 
Q* 490
Average flow time    0.041  0.49 month
2D 12,000
Key Point (1 of 3)
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 EO
Q.
Key Point (2 of 3)
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 .
• Lot size reduced to Q = 200 units
D Q 
Annual inventory - related costs  S    hC  $250,000
Q 2
Lot Size and Ordering Cost
• If the lot size Q* = 200, how much should the ordering cost be
reduced?
Desired lot size, Q* = 200

Annual demand, D  1,000  12  12,000units
Unit cost per computer, C = $500
Holding cost per year as a fraction of inventory value,

h = 0.2
hC(Q*)2 0.2  500  2002
S   $166.7
2D 2  12,000
Key Point (3 of 3)
To reduce the optimal lot size by a factor of k, the fixed order
cost S must be reduced by a factor of k 2.
Production Lot Sizing
• The entire lot does not arrive at the same time
• Production occurs at a specified rate P
• Inventory builds up at a rate of P−D
• Inventory depleted at a rate of D
2DS
QP 
(1  D P )hC
Annual setup cost Annual holding cost

 D 
 P S
Q 
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
In deciding on the optimal lot size, the supply chain goal is to
minimize the total cost—the order cost, holding cost, and
material cost. As lot size increases, so does the annual holding
cost. However, the annual order cost and, in some instances, the
annual material cost decrease with an increase in lot size. The E O
Q balances the three costs to obtain the optimal lot size. The
higher the order and transportation cost, the higher the lot size
and cycle inventory. The optimal lot size can be decreased if the
fixed cost associated with each lot is reduced.
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
• Reduce receiving and loading costs to reduce cycle inventory
Lot Sizing with Multiple Products or
Customers (1 of 2)
• 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 (2 of 2)
• 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
Multiple Products Ordered and Delivered
Independently (1 of 2)
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 (2 of 2)
Table 11-1 Lot Sizes and Costs for Independent Ordering
Blank Litepro Medpro Heavypro

Demand per year 12,000 1,200 120
Fixed cost/order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Cycle inventory 548 173 55
Annual holding cost $54,772 $17,321 $5,477
Order frequency 11.011.0 year
per year 3.5 3.5
per year
year 1.1year
1.1 per year
Annual ordering cost $54,772 $17,321 $5,477
Average flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual cost $109,544 $34,642 $10,954
Total annual cost = $155,140

Lots Ordered and Delivered Jointly
S *  S  sL  sM  sH Annual order cost = S * n
DL hCL DM hCM DH hCH

Annual holding cost   
2n 2n 2n
DL hCL DM hCM DH hCH

Total annual cost    S*n
2n 2n 2n

k
DL hCL  DM hCM  DH hCH Di hCi
n*  n*  i 1
2S * 2S *
Products Ordered and Delivered
Jointly (1 of 2)
S *  S  sA  sB  sC  $7,000 per order
12,000  100  1,200  100  120  100

n*   9.75
2  7,000
Annual order cost  9.75  7,000  $68,250
Annual ordering
and holding cost = $61,512 + $6,151 + $615 + $68,250
= $136,528
Products Ordered and Delivered
Jointly (2 of 2)
Table 11-2 Lot Sizes and Costs for Joint Ordering at Best Buy

Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 9.75 peryear
9.75 year 9.75 peryear
9.75 year 9.75 peryear
9.75 year
Optimal order size (D/n∗) 1,230 123 12.3
Cycle inventory 615 61.5 6.15
Annual holding cost $61,512 $6,151 $615
Aggregation with Capacity Constraint (1 of 3)
• 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
S   S  s1  s2  s3  s4  $900 per order

4

D1hC1 4  10,000  0.2  50
n  i 1

  14.91
2S 2  900
900
Annual order cost  14.91  $3,355
4
Annual holding hCi Q 671
  0.2  50   $3,355
cost per supplier 2 2
Total required capacity per truck  4  671  2,684 units
Truck capacity = 2,500 units

2,500
Order quantity from each supplier   625
4
10,000
Order frequency increased to  16
625
Annual order cost per supplier increases to $3,600

Annual holding cost per supplier decreases to $3,125
Lots Ordered and Delivered Jointly for a
Selected Subset (1 of 3)
Step 1: Identify the most frequently ordered product assuming
each product is ordered independently
hCi Di
ni 
2(S  si )

Step 2: For all products i  i , evaluate the ordering
frequency
hCi Di
ni 
2si
Step 3: For all i  i  , evaluate the frequency of product i
relative to the most frequently ordered product i* to be mi
mi  n ni 
Step 4: Recalculate the ordering frequency of the most

frequently ordered product i* to be n

l
hCi mi D
n i 1

2 S   i 1si / mi
l

Step 5: Evaluate an order frequency of ni  n mi and the
total cost of such an ordering policy

l
 Di l

TC  nS   ni si     hC1
i 1 i 1  2ni 
Tailored aggregation – higher-demand products ordered more

frequently and lower-demand products ordered less frequently
Ordered and Delivered Jointly – Frequency
Varies by Order (1 of 4)
• Applying Step 1
hCLDL
nL   11.0
2(S  sL ) Thus
n  11.0
hCM DM
nM   3.5
2(S  sM )
hCH DH
nH   1.1
2(S  sH )
• Applying Step 2
hCM DM hCH DH
nM   7.7 and nH   2.4
2sM 2sH
• Applying Step 3
n  11.0   n  11.0 
mM      2 and mH       5
 nM   7.7   nH   2.4 
• Applying Step 4
n = 11.47
• Applying Step 5
nL  11.47 / yr nM  11.47 / 2  5.74 / yr
nH  11.47 / 5  2.29 / yr
Annual order cost Total annual cost

nS  nL sL  nM sM  nH sH  $65,383.50 $130,767
Table 11-3 Lot Sizes and Costs for Ordering Policy Using Heuristic

Demand per year (D) 12,000 1,200 120
Order frequency (n∗) 11.4711.47
per year
year 5.745.74
per year
year 2.292.29
per year
Optimal order size (D/n∗) 1,046 209 52
Cycle inventory 523 104.5 26
Annual holding cost $52,307 $10,461 $2,615
A key to reducing lot size without increasing costs is reducing the
fixed cost associated with each lot. This may be achieved by
aggregating lots across multiple products, customers, or
suppliers. Complete aggregation, where all products are included
in each order, is very effective when product-specific order costs
are small. If product-specific order costs are large, tailored
aggregation, where only a subset of products is included in each
order, is more effective.
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 (1 of 6)
• 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
Figure 11-3 Average Unit Cost with All Unit Quantity Discounts
Step 1: Evaluate the optimal lot size for each price Ci ,0  i  r
as follows
2DS
Qi 
hCi
Step 2: We next select the order quantity Q*i for each price Ci
1. qi  Qi  qi 1
2. Qi  qi
3. Qi  qi 1
• Case 3 can be ignored as it is considered for Qi +1
• For Case 1 if qi  Qi  qi 1, then set Q i  Qi
*
• If Qi  qi , then a discount is not possible


• Set Q i  qi to qualify for the discounted price of Ci
Step 3: Calculate the total annual cost of ordering Q i units
D  Qi* 
Total annual cost, TCi   *  S    hCi  DCi
 Qi   2 
Step 4: Select Qi* with the lowest total cost TCi
• Cutoff price
1 DS h 
C *   DCr   qr Cr  2hDSCr 
D qr 2 
All-Unit Quantity Discount Example (1 of 3)
Order Quantity Unit Price

0–4,999 $3.00
5,000–9,999 $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
D  120,000 year, S  $100 lot, h  0.2
Step 1
2DS 2DS 2DS

Q0   6,325; Q1   6,367; Q2   6,411
hC0 hC1 hC2
Step 2
Ignore i = 0 because Q0 = 6,325 > q1 = 5,000

For i = 1, 2
Q1*  Q1  6,367; Q2*  q2  10,000
Step 3
D   Q1* 
TC1   * S    hC1  DC1  $358,969; TC2  $354,520
 Q1   2 
Lowest total cost is for i = 2
Order Q *2 = 10,000 bottles per lot at $2.92 per bottle
Marginal Unit Quantity Discounts (1 of 6)
• Multi-block tariffs – the marginal cost of a unit that
decreases at a breakpoint
For each value of i, 0  i  r , let Vi be the cost of
ordering qi units
Vi  C0 (q1  q0 )  C1 (q2  q1 )  ...  Ci –1 (qi  qi –1 )
Figure 11-4 Marginal Unit Cost with Marginal Unit Quantity Discount
Material cost of each order Q is Vi   Q  qi  Ci
D
Annual order cost    S
Q 
Annual holding cost   Vi  (Q  qi )C i  h / 2
D
Annual materials cost   Vi  (Q  qi )Ci 
Q
D
Total annual cost    S   Vi  (Q  qi )C i  h / 2
Q 
D
  Vi  (Q  qi )Ci 
Q
Step 1: Evaluate the optimal lot size for each price Ci
2D(S  Vi  qi Ci )
Optimal lot size for Ci is Qi 
hCi
Step 2: Select the order quantity Qi* for each price Ci
1. If qi  Qi  qi 1 then set Qi*  Qi

2. If Qi  qi then set Qi*  qi
3. If Qi  qi 1 then set Qi*  qi 1
Step 3: Calculate the total annual cost of ordering Qi*
D  D
TCi   *  S  V
 i  (Qi
*
 q i )C 
i h / 2  V
*  i
 (Q 
i  q i )C i 
*
 Qi  Qi
Step 4: Select the order size Qi* with the lowest total
cost TCi
Marginal Unit Quantity Discount
Example (1 of 3)
• Original data now a marginal discount
Order Quantity Unit Price

0−4,999 $3.00
5,000−9,999 $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
D  120,000 year, S  $100 lot, h  0.2
Example (2 of 3)
V0  0; V1  3(5,000 – 0)  $15,000
V2  3(5,000 – 0)  2.96(10,000 – 5,000)  $29,800
Step 1
2D(S  V0  q0C0 )
Q0   6,325
hC0
2D(S  V1  q1C1 )
Q1   11,028
hC1
2D(S  V2  q2C2 )
Q2   16,961
hC2
Example (3 of 3)
Step 2
Q0*  q1  5,000 because Q0  6,324  5,000
Q1*  q2  10,000; Q2  Q2  16,961
Step 3
D  D
TC0   *  S  
V0  (Q0
*
 q 0 )C 0

 h / 2  *

V0  (Q0
*
 q0 )C0   $363,900
 Q0  Q0
D  D
TC1   *  S  
V1  (Q1
*
 q1 )C 1

 h / 2  
* 
V1  (Q1
*
 q1 )C1   $361,780
 Q1  Q1
D  D
TC2   *  S  V
 2  (Q2
*
 q 2 )C 
2 h / 2  V
*  2
 (Q 
2  q 2 )C2   $360,365
*
 Q2  Q2
Lot-size–based quantity discounts increase the lot size and cycle

inventory within the supply chain because they encourage buyers
to purchase in larger quantities to take advantage of the decrease
in price. The relative increase in cycle inventory because of
quantity discounts increases as the buyer reduces fixed costs per
order.
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
Quantity Discounts for Commodity Products
D = 120,000 bottles/year, SR = $100, hR = 0.2, CR = $3 SM =

$250, hM = 0.2, CM = $2
2DSR 2  120,000  100

QR    6,325
hR CR 0.2  3
 D   QR 
Annual cost for DO   S 
 R   hR CR  $3,795
 QR   2 
 D   QR 
Annual cost for manufacturer   S 
 M   hMCM  $6,008
 QR   2 
Annual supply chain cost
 $6,008  $3,795  $9,803
(DO and manufacturer)
Locally Optimal Lot Sizes
Annual cost for D Q  D Q 

   SR    hR CR    SM    hM CM
DO and manufacturer Q  2 Q  2
2D(SR  SM )
Q*   9,165
hR CR  hM CM
 D  Q * 
Annual cost for DO    SR    hR CR  $4,059
Q *   2 
 D  Q * 
Annual cost for manufacturer    M  2  hM CM  $5,106
S 
 Q *   
Annual supply chain cost
 $5,106  $4,059  $9,165
 DO and manufacturer 
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
Quantity Discounts When Firm Has
Market Power (1 of 3)
Demand curve = 360,000−60,000p
Production cost = CM = $2 per bottle
ProfR  ( p  CR )(360,000  60,000 p )

ProfM  (CR  CM )(360,000  60,000 p )
CR
p to maximize ProfR p  3 
2
  CR 
ProfM  (CR  CM )  360,000  60,000  3  
  2 
 (CR  2)(180,000  30,000CR )
CR = $4 per bottle, p = $5 per bottle
Total market demand = 360,000 − 60,000p = 60,000
ProfR   5  4   360,000  60,000  5   $60,000
ProfM   4  2   360,000  60,000  5   $120,000
ProfSC   p  CM   360,000  60,000 p 
CM 2
Coordinated retail price p 3  3   $4
2 2
ProfSC   $4  $2   120,000  $240,000
Prices coordinated at p = $4
Market demand = 360,000 − 60,000p = 120,000 bottles
Total supply chain profit
ProfSC   $4  $2   120,000  $240,000
Prices set independently, supply chain loses

$240,000 − $180,000 = $60,000
Double marginalization – supply chain margin divided between
two stages
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 (1 of 2)
• 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 (2 of 2)
• 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
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 willingness to pay at
each quantity
• Quantity discounts are one mechanism for price discrimination
because customers pay different prices based on the quantity
purchased
Quantity discounts are justified to increase total supply chain
profits when independent lot-sizing decisions in a supply chain
lead to suboptimal solutions from an overall supply chain
perspective. If suppliers have large fixed costs, suitable lot-size–
based quantity discounts can be justified because they help
increase supply chain profits. 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. Volume-based discounts are
more effective than lot-size–based discounts in increasing supply
chain profits without increasing lot size and cycle inventory.
Short-Term Discounting: Trade
Promotions (1 of 2)
• Trade promotions are price discounts for a limited period of
time
• Key goals
1. Induce retailers to use price discounts, displays, or

advertising to spur sales
2. Shift inventory from the manufacturer to the retailer and
the customer
3. Defend a brand against competition
Short-Term Discounting: Trade
Promotions (2 of 2)
• Impact on the behavior of the retailer and supply chain
performance
• Retailer has two primary options
1. Pass through some or all of the promotion to customers to

spur sales
2. 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
Figure 11-5 Inventory Profile for Forward Buying
Forward Buy (1 of 2)
• Costs to be considered – material cost, holding cost, and order
cost
• Three assumptions
1. The discount is offered once, with no future discounts

2. The retailer takes no action to influence customer demand
3. Analyze a period over which the demand is an integer
multiple of Q*
Forward Buy (2 of 2)
• Optimal order quantity
dD CQ *
Qd  
(C – d )h C – d
• Retailers are often aware of the timing of the next

promotion
Forward buy  Q d  Q *
Impact of Trade Promotions on Lot
Sizes (1 of 2)
Q *  6,325 bottles,C  $3 per bottle
d  $0.15, D  120,000, h  0.2
Q* 6,324
Cycle inventory at DO    3,162.50 bottles
2 2
Q * 6,324
Average flow time    0.3162 months
2D  2D 
dD CQ *
Qd  
(C – d )h C – d
0.15  120,000 3  6,325
   38,236
(3.00 – 0.15)  0.20 3.00 – 0.15
Impact of Trade Promotions on Lot
Sizes (2 of 2)
• With trade promotions
Qd 38,236
Cycle inventory at DO    19, 118bottles
2 2
Qd 38,236
Average flow time  
2D  20,000 
 1.9118 months
Forward buy  Q d – Q *  38,236 – 6,325  31,911 bottles
How Much of a Discount Should the
Retailer Pass through?
• Profits for the retailer
ProfR = (300,000 − 60,000p)p − (300,000 − 60,000p)CR
• Optimal price
p = (300,000 + 60,000CR ) / 120,000
• Demand with no promotion

DR = 30,000 − 60,000p = 60,000
• Optimal price with discount

p = (300,000 + 60,000  2.85) / 120,000 = $3.925
• Demand with promotion
DR = 300,000 − 60,000p = 64,500
Trade Promotions (1 of 2)
• 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)
– Scanner-based promotions
Trade Promotions (2 of 2)
• Trade promotions may make sense
– When deal elasticity and holding costs are high
– With strong brands
– As a competitive response
Faced with a short-term discount, it is optimal for retailers to pass
through only a fraction of the discount to the customer, keeping the rest
for themselves. Simultaneously, it is optimal for retailers to increase the
purchase lot size and forward buy for future periods. Thus, trade
promotions often lead to an increase of cycle inventory in a supply
chain without a significant increase in customer demand. This generally
results in reduced supply chain profits unless the trade promotion
reduces demand fluctuations. Trade promotions may be justified as a
competitive necessity or a one-time discount to eliminate built up
inventory at the supplier. Trade promotions may also be justified for
products where consumer demand is very sensitive to price discounts.
Managing Multiechelon Cycle Inventory (1 of 2)
• 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 (2 of 2)
Figure 11-6 Inventory Profile at Retailer and Manufacturer with No

Synchronization
Integer Replenishment Policy (1 of 4)
• 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
Figure 11-7 Illustration of an Integer Replenishment Policy
Figure 11-8 A Multiechelon Distribution Supply Chain

Integer replenishment policies can be synchronized in
multiechelon supply chains to keep cycle inventory and 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.
Managerial Levers to Reduce Cycle
Inventory (1 of 4)
• Three factors drive lot sizing decisions
– Fixed costs associated with production or purchasing
– Quantity discounts offered by suppliers
– Short-term price discounts offered by suppliers
Inventory (2 of 4)
• If buildup is due to large lots associated with fixed costs –
reduce fixed costs
– Decrease changeover times
• If buildup is due to transportation – facilitate aggregation
– Coordinating orders
– Using intermediate locations to aggregate from multiple
suppliers
– Use milk runs for pickup and delivery
Inventory (3 of 4)
• If buildup is due to order placement and receiving – employ
appropriate technologies
– Electronic order placement
– Advanced shipping notices
– R FI D
• If buildup is due to lot sizing decisions – check supplier’s
fixed costs
– Reduce fixed costs
– Employ volume-based discounts
Inventory (4 of 4)
• If buildup is due to short-term discounts – limit forward buying
– ED LP
– Link discount to sell-through rather than sell-in
– Limit quantity purchased
• The key managerial levers for reducing lot size, and thus
cycle inventory, in the supply chain without increasing cost
are the following:
• 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: Strategy,

Planning, and Operation

11.1 Describe the role of cycle inventory in a supply chain.

11.5 Devise appropriate discounting schemes for a supply chain.

Figure 11-1 Inventory Profile of Jeans at Jean-Mart

Average flow time

Average flow time

Average price per unit purchased, $C unit

Fixed ordering cost incurred per lot, $S lot

1. A fixed cost is incurred each time an order is placed or

1. Demand is steady at D units per unit time.

Figure 11-2 Effect of Lot Size on Costs at Best Buy

• The optimal ordering frequency

Order cost per lot, S = $4,000

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

Desired lot size, Q* = 200

Unit cost per computer, C = $500

Holding cost per year as a fraction of inventory value,

Annual setup cost Annual holding cost

1. Each product manager orders his or her model

Blank Litepro Medpro Heavypro

Total annual cost = $155,140

S *  S  sL  sM  sH Annual order cost = S * n

DL hCL DM hCM DH hCH

DL hCL DM hCM DH hCH

S *  S  sA  sB  sC  $7,000 per order

12,000  100  1,200  100  120  100

Annual order cost  9.75  7,000  $68,250

Blank Litepro Medpro Heavypro

S   S  s1  s2  s3  s4  $900 per order

Truck capacity = 2,500 units

Annual order cost per supplier increases to $3,600

relative to the most frequently ordered product i* to be mi

Step 4: Recalculate the ordering frequency of the most

total cost of such an ordering policy

Tailored aggregation – higher-demand products ordered more

nL  11.47 / yr nM  11.47 / 2  5.74 / yr

Annual order cost Total annual cost

Blank Litepro Medpro Heavypro

1. What is the optimal purchasing decision for a buyer

• If an order is placed that is at least as large as qi but

• If Qi  qi , then a discount is not possible

Order Quantity Unit Price

2DS 2DS 2DS

Ignore i = 0 because Q0 = 6,325 > q1 = 5,000

Lowest total cost is for i = 2

Order Q *2 = 10,000 bottles per lot at $2.92 per bottle

Vi  C0 (q1  q0 )  C1 (q2  q1 )  ...  Ci –1 (qi  qi –1 )

1. If qi  Qi  qi 1 then set Qi*  Qi

Order Quantity Unit Price

Lot-size–based quantity discounts increase the lot size and cycle

1. Improved coordination to increase total supply chain

D = 120,000 bottles/year, SR = $100, hR = 0.2, CR = $3 SM =

2DSR 2  120,000  100

Annual cost for D Q  D Q 

ProfR  ( p  CR )(360,000  60,000 p )

ProfSC   p  CM   360,000  60,000 p 

ProfSC   $4  $2   120,000  $240,000

Prices set independently, supply chain loses