Chapter 11- Managing Economies of Scale in a Supply Chain Cycle Inventory

Cycle Inventory in Supply Chains

• Cycle inventory is the average inventory held in a supply chain due to production or purchases in lot sizes exceeding customer demand.
• Lot size (Q) is the quantity produced or purchased at a time.
• Demand (D) is the demand per unit time.

Economies of Scale and Lot Sizing

• Economic Order Quantity (EOQ): A method for optimizing lot size for a single product. It minimizes annual material, ordering, and holding costs.
• Factors considered in EOQ:
  • Annual demand (D)
  • Fixed cost per order (S)
  • Cost per unit (C)
  • Holding cost per year (h) as a fraction of product cost
• Key assumptions for EOQ:
  • Steady demand (D units per unit time).
  • No shortages allowed.
  • Fixed replenishment lead time.

Estimating Cycle Inventory Costs

• Inventory Holding Cost: Involves various costs:
  • Cost of capital (influenced by equity (E), debt (D), risk-free rate (Rf), firm's beta (β), market risk premium (MRP), borrowing rate (Rb), and tax rate (t)).
  • Obsolescence/spoilage costs.
  • Handling costs.
  • Occupancy costs.
  • Miscellaneous costs (theft, security, damage, tax, insurance).
• Ordering Cost: Includes costs related to placing and receiving orders:
  • Buyer time.
  • Transportation costs.
  • Receiving costs.
  • Other related costs.

Aggregating Multiple Products

• Combining multiple products in a single order can reduce transportation and receiving costs, thus lowering cycle inventory.
• This may involve a single delivery from multiple suppliers or a single truck delivering to multiple retailers.

Quantity Discounts

• Lot size-based discounts: Discounts based on the quantity ordered in a single lot.
• Volume-based discounts: Discounts based on the total quantity purchased over a given period.
• All-unit quantity discounts.
• Marginal unit quantity discount / multi-block tariffs.
• Quantity discounts can improve coordination, increasing total supply chain profits. They can also extract surplus through price discrimination.

Two-Part Tariff

• A pricing scheme where a manufacturer charges a fixed upfront fee (franchise fee).
• This scheme can maximize coordinated supply chain profit.

Volume-Based Discounts

• Schemes aim to achieve optimal quantity purchased by retailers.

Lessons from Discounting Schemes

• Volume-based discounts are beneficial for reducing inventory and improving coordination.
• Retailers often buy more toward the end of a promotional period, a "hockey stick" phenomenon.
• Average prices for the retailers may decrease with increased purchase rates.

Price Discrimination

• Setting different prices for different units based on marginal willingness to pay maximizes profit for the manufacturer.
• Quantity discounts are a common price discrimination mechanism.

Trade Promotions

• Short-term price discounts for a limited time to induce retailer sales efforts.
• Goals include: boosting sales, shifting inventory, and defending against competitors.
• Retailers may:
  • Pass through discounts to customers.
  • Purchase in large quantities (forward buying).
• Trade promotions can increase cycle inventory and negatively impact performance. Strategies to counter that include:
  • EDLP (everyday low pricing).
  • Discounts linked to customer sell-through, not retailer buy-in.
  • Scanner-based promotions.

Managing Multiechelon Cycle Inventory

• Multiechelon supply chains have multiple stages with many players. Poor coordination in lot sizing increases cycle inventory.
• Coordination across the supply chain can reduce overall costs.

Integer Replenishment Policy

• A system for synchronizing reorders within a supply chain stage and across stages using integer multiples of reorder intervals.
• This policy works best for predictable demand and high initial cycle inventory.

Managerial Levers for Reducing Cycle Inventory

• Lot sizing decisions are driven by:
  • Fixed costs.
  • Quantity discounts.
  • Short-term discounts.
• Methods for reducing cycle inventory include:
  • Reducing fixed costs, changeover times, coordinating orders, using aggregation points (e.g., milk runs).
  • Employing appropriate technologies like electronic order placement, advanced shipping notices, and RFID.
• Tactics for handling short-term discounts:
  • Limiting forward buys.
  • EDLP.
  • Linking discounts to customer sell-through, not sell-in.
  • Limiting quantity purchased.