managing economies of scale in the supply chain: cycle inventory
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Managing Economies of Scale in the Supply Chain: Cycle Inventory. Fall, 2014 Supply Chain Management: Strategy, Planning, and Operation Chapter 10 Byung-Hyun Ha. Contents. Introduction Economies of scale to exploit fixed costs Economies of scale to exploit quantity discount - PowerPoint PPT PresentationTRANSCRIPT
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Managing Economies of Scale in the Supply Chain: Cycle Inventory
Fall, 2014
Supply Chain Management:Strategy, Planning, and Operation
Chapter 10
Byung-Hyun Ha
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Contents
Introduction
Economies of scale to exploit fixed costs
Economies of scale to exploit quantity discount
Short-term discounting: trade promotions
Managing multiechelon cycle inventory
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Cycle inventory
Notation D: demand per unit time Q: quantity in a lot or batch size (order quantity)
Cycle inventory management (basic) Determining optimal order quantity Q* that minimizes total
inventory cost, with demand D given
Introduction
inventorylevel
time
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Basic analysis of cycle Average inventory level (cycle inventory) = Q/2 Average flow time = Q/2D
Little’s law: (arrival rate) = (avg. number in system)/(avg. flow time)
Example• D = 2 units/day, Q = 8 units
• Average inventory level
• (7 + 5 + 3 + 1)/4 = 4 = Q/2
• Average flow time
• (0.25 + 0.75 + 1.25 + 1.75 + 2.25 + 2.75 + 3.25 + 3.75)/8 = 2 = Q/2D
Introduction
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Introduction
Costs that influence total cost by order quantity C: (unit) material cost ($/unit)
• Average price paid per unit purchased
Quantity discount
H: holding cost ($/unit/year)• Cost of carrying one unit in inventory for a specific period of time
• Cost of capital, obsolescence, handling, occupancy, etc.
• H = hC
Related to average flow time
S: ordering cost ($/order)• Cost incurred per order
• Assuming fixed cost regardless of order quantity
• Cost of buyer time, transportation, receiving, etc.
10.2 Estimating cycle inventory-related costs in practice SKIP!
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Assumptions Constant (stable) demand, fixed lead time, infinite time horizon
Cycle optimality regarding total cost Order arrival at zero inventory level is optimal. Identical order quantities are optimal.
Introduction
?
?
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Introduction
Determining optimal order quantity Q* Economy of scale vs. diseconomy of scale, or Tradeoff between total fixed cost and total variable cost
Q1
Q2
?
D
D
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Economies of Scale to Exploit Fixed Costs
Lot sizing for a single product Economic order quantity (EOQ) Economic production quantity (EPQ)
• Production lot sizing
Lot sizing for multiple products Aggregating multiple products in a single order Lot sizing with multiple products or customers
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Economic Order Quantity (EOQ)
Assumptions Same price regardless of order quantity
Input D: demand per unit time, C: unit material cost S: ordering cost, H = hC: holding cost
Decision Q: order quantity
• D/Q: average number of orders per unit time
• Q/D: order interval
• Q/2: average inventory level
Total inventory cost per unit time (TC)TO: total order costTH: total holding costTM: total material costhC
QS
Q
DTMTHTOTC
2)(
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Economic Order Quantity (EOQ)
Total cost by order quantity Q
Optimal order quantity Q* that minimizes total cost
Opt. order frequency
Avg. flow time
TC
QQ*
hCQ
SQ
DTC
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Economic Order Quantity (EOQ)
Robustness around optimal order quantity (KEY POINT) Using order quantity Q' = Q* instead of Q*
0.5 0.6 0.7 0.8 0.9 1.0 1.2 1.4 1.6 1.8 2.0
1/2( + 1/)
1.250 1.133 1.064 1.025 1.006 1.000 1.017 1.057 1.113 1.178 1.250
TC*
TC' = 1.25TC*
10.5 2
*1
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QS
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DCT
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Economic Order Quantity (EOQ)
Robustness regarding input parameters Mistake by indentifying ordering cost S' = S instead of real S
• Misleading to
0.5 0.6 0.7 0.8 0.9 1.0 1.2 1.4 1.6 1.8 2.0
1/2( + 1/) 1.061 1.033 1.016 1.006 1.001 1.000 1.004 1.014 1.028 1.043 1.061
TC*
10.5 2
TC' = 1.061TC*
Robustness?
*ββ22
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Economic Order Quantity (EOQ)
Sensitivity regarding demand (KEY POINT) Demand change from D to D1 = kD
Opt. order frequency
Avg. flow time
*1
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Economic Order Quantity (EOQ)
Effect of reducing order quantity Using order quantity Q' = Q* instead of Q* (revisited)
Reducing flow time by reducing ordering cost (KEY POINT) Efforts on reducing S to S1 = S Hoping Q1
* = kQ*
How much should S be reduced? (What is ?)
= k2 (ordering cost must be reduced by a factor of k2)
**1*1 γ
2γ
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Production of lot instead of ordering P: production per unit time
Total cost by production lot size Q
Optimal production quantity Q* When P goes to infinite, Q* goes to EOQ.
Economic Production Quantity (EPQ)
Q
x(P – D)
D
Q/P Q/D – Q/P = Q(1/D – 1/P)
1/(D/Q) = Q/D
hCQ
P
DS
Q
DTC
21
hCPD
DSQ
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2*
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Aggregating Products in a Single Order
Multiple products m products D: demand of each product S: ordering cost regardless of aggregation level All the other parameters across products are the same.
All-separate ordering
All-aggregate ordering
Impractical supposition (for analysis purpose)
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Lot Sizing with Multiple Products
Multiple products with different parameters m products Di, Ci, hi: demand, price, holding cost fraction of product i
S: ordering cost each time an order is placed• Independent of the variety of products
si: additional ordering cost incurred if product i is included in order
Ordering each products independently?
Ordering all products jointly Decision
• n: number of orders placed per unit time
• Qi = Di /n: order quantity of item i
Total cost and optimal number of orders
nChDnsSTCm
iiii
m
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Lot Sizing with Multiple Products
Example 10-3 and 10-4 Input
• Common transportation cost, S = $4,000
• Holding cost fraction, h = 0.2
Ordering each products independently• ITC* = $155,140
Ordering jointly• n* = 9.75
• JTC* = $136,528
i LE22B LE19B LE19A
Di
Ci
si
12,000$500
$1,000
1,200$500
$1,000
120$500
$1,000
0
20,000
40,000
60,000
80,000
100,000
120,000
140,000
160,000
180,000
200,000
LE22B LE19B LE19A
i LE22B LE19B LE19A
Qi*ni* T
Ci*
1,09511.0
$109,544
3463.5
$34,642
1101.1
$10,954
i LE22B LE19B LE19A
Qi* 1,230 123 12.3
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Lot Sizing with Multiple Products
How does joint ordering work? Reducing fixed cost by enjoying robustness around optimal orde
r quantity
Is joint ordering is always good? No!
Then, possible other approaches? Partially joint
• NP-hard problem (i.e., difficult)
Number of all possible ways
• http://en.wikipedia.org/wiki/Bell_number
A heuristic algorithm• Subsection: “Lots are ordered and delivered jointly for a selecte
d subset of the products”
• SKIP!
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Exploiting Quantity Discount
Total cost with quantity discount
Types of quantity discount Lot size-based
• All unit quantity discount
• Marginal unit quantity discount
Volume-based
Decision making we consider Optimal response of a retailer Coordination of supply chain
TO: total ordering costTH: total holding costTM: total material cost
DChCQ
SQ
DTMTHTOTC
2
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Pricing schedule Quantity break points: q0, q1, ..., qr , qr+1
• where q0 = 0 and qr+1 =
Unit cost Ci when qi Q qi+1, for i=0,...,r
• where C0 C1 Cr
It is possible that qiCi (qi + 1)Ci
All Unit Quantity Discount
averagecost
per unit
C0
C1
C2
Cr
...
q0 q1 q2 q3 qr
...
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Solution procedure1. Evaluate the optimal lot size for each Ci.
2. Determine lot size that minimizes the overall cost by the total cost of the following cases for each i.
• Case 1: qi Qi* qi+1 , Case 2: Qi* qi , Case 3: qi+1 Qi*
All Unit Quantity Discount
ii hC
DSQ
2*
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Example 10-7 r = 2, D = 120,000/year S = $100/lot, h = 0.2 Q* = 10,000
335,000
340,000
345,000
350,000
355,000
360,000
365,000
370,000
375,000
380,000
385,000
390,000
0 2000 4000 6000 8000 10000 12000 14000 16000
All Unit Quantity Discount
i 0 1 2
qi
Ci
0$3.00
5,000$2.96
10,000 $2.92
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All Unit Quantity Discount
Example 10-7 (cont’d) Sensitivity analysis
• Optimal order quantity Q* with regard to ordering cost
(no discount)C = $3
(discount)
(original) S = $100/lot 6,324 10,000
(reduced) S' = $4/lot 1,256 10,000
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Marginal Unit Quantity Discount
Pricing schedule Quantity break points: q0, q1, ..., qr , qr+1
• where q0 = 0 and qr+1 =
Marginal unit cost Ci when qi Q qi+1, for i=0,...,r
• where C0 C1 Cr
Price of qi units
Vi = C0(q1 – q0) + C1(q2 – q1) + ... + Ci–1(qi – qi–1)
Ordering Q units Suppose qi Q qi+1 .
marginalcost
per unitC0
C1
C2
Cr
...
q0 q1 q2 q3 qr
...
...
iii
iii
CqQVQ
D
hCqQV
SQ
D
TMTHTOTC
2
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Example 10-8 r = 2, D = 120,000/year S = $100/lot, h = 0.2 Q* = 16,961
350,000
355,000
360,000
365,000
370,000
375,000
380,000
385,000
390,000
395,000
0 4000 8000 12000 16000 20000 24000 28000
Marginal Unit Quantity Discount
i 0 1 2
qi
Ci
Vi
0$3.00
$0
5,000$2.96
$15,000
10,000 $2.92
$29,800
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Marginal Unit Quantity Discount
Example 10-8 (cont’d) Sensitivity analysis
• Optimal order quantity Q* with regard to ordering cost
Higher inventory level (longer average flow time)
(no discount)C = $3
(discount)
(original) S = $100/lot 6,324 16,961
(reduced) S' = $4/lot 1,256 15,775
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Why Quantity Discount?
1. Improve coordination to increase total supply chain profit Each stage’s independent decision making for its own profit
• Hard to maximize supply chain profit (i.e., hard to coordinate)
How can a manufacturer control a myopic retailer?• Quantity discounts for commodity products
• Quantity discounts for products for which firm has market power
2. Extraction of surplus through price discrimination Revenue management (Ch. 15)
Other factors such as marketing that motivates sellers Munson and Rosenblatt (1998)
Manufacturer(supplier)
Retailer customers
supply chain
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Coordination for Total Supply Chain Profit
Quantity discounts for commodity products Assumptions
• Fixed price and stable demand fixed total revenue
Max. profit min. total cost
Example case• Two stages with a manufacture (supplier) and a retailer
Manufacturer(supplier)
Retailer customers
D = 120,000SR = 100hR = 0.2CR = 3
SS = 250hS = 0.2CS = 2
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Coordination for Total Supply Chain Profit
Quantity discounts for commodity products (cont’d) (a) No discount
• Retailer’s (local) optimal order quantity ( supply chain’s decision)
• Q(a) = (2120,000100/0.23)1/2 = 6,325
• Total cost (without material cost)
• TC0(a) = TCS
(a) + TCR(a) = $6,008 + $3,795 = $9,803
() Minimum total cost, TC*, regarding supply chain (coordination)• Q* = 9,165
• TC0* = TCS* + TCR* = $5,106 + $4,059 = $9,165
• Dilemma?
• Manufacturer saving by $902, but retailer cost increase by $264
• How to coordinate (decision maker is the retailer)?
RRSSRS
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Coordination for Total Supply Chain Profit
Quantity discounts for commodity products (cont’d) (b) Lot size-based quantity discount offering by manufacturer
• Price schedule of CR
• q1 = 9,165, C0 = $3, C1 = $2.9978
• Retailer’s (local) optimal order quantity (considering material cost)
• Q(b) = 9,165
• Total cost (without material cost)
• TC0(b) = TCS
(b) + TCR(b) = $5,106 + $4,057 = $9,163
• Savings (compared to no discount)
• Manufacturer: $902
• Retailer: $264 (material cost) – $262 (inventory cost) = $2
KEY POINT• For commodity products for which price is set by the market, manuf
acturers with large fixed cost per lot can use lot size-based quantity discounts to maximize total supply chain profit.
• Lot size-based discount, however, increase cycle inventory in the supply chain.
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Coordination for Total Supply Chain Profit
Quantity discounts for commodity products (cont’d) (c) Other approach: setup cost reduction by manufacturer
• Retailer’s (local) optimal order quantity
• Q(c) = Q(a) = 6,325
• Total cost (without material cost): no need to discount!
• TC0(c) = TCS
(c) + TCR(c) = $3,162 + $3,795 = $6,957
Same with optimal supply chain cost when material cost is considered
Expanding scope of strategic fit• Operations and marketing departments should be cooperate!
Manufacturer(supplier)
Retailer customers
D = 120,000SR = 100hR = 0.2CR = 3
S'S = 100hS = 0.2CS = 2
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Coordination for Total Supply Chain Profit
Quantity discounts for products with market power Assumption
• Manufacturer’s cost, CS = $2
• Customer demand depending on price, p, set by retailer
• D = 360,000 – 60,000p
Profit depends on price.
Manufacturer(supplier)
Retailer customers
D = 360,000 – 60,000p
CR = ?CS = 2 p = ?
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Coordination for Total Supply Chain Profit
Quantity discounts for products with market power (cont’d) (a) No coordination (deciding independently)
• Manufacturer’s decision on CR
• Expected retailer’s profit, ProfR
» ProfR = (p – CR)(360 – 60p)
• Retailer’s optimal price setting (behavior) when CR is given
» p = 3 + 0.5CR
• Demand by p (supplier’s order quantity)
» D = 360 – 60p = 180 – 30CR
• Expected manufacturer’s profit, ProfS
» ProfS = (CR – CS)(180 – 30CR)
CR(a) that maximizes ProfS (manufacturer’s decision)
» CR(a) = $4
• Retailer’s decision on p(a) with given CR(a)
• p(a) = $5 (D(a) = 360,000 – 60,000p(a) = 60,000)
• Supply chain profit, Prof0(a)
• Prof0(a) = ProfS
(a) + ProfR(a) = $120,000 + $60,000 = $180,000
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Coordination for Total Supply Chain Profit
Quantity discounts for products with market power (cont’d) () Coordinating supply chain
• Optimal supply chain profit, Prof0*
• Prof0 = (p – CS)(360 – 60p)
• p* = $4
• D* = 120,000
• Prof0* = $240,000
Double marginalization problem (local optimization)
• But how to coordinate?
• i.e., ProfS* = ?, ProfR* = ?
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Coordination for Total Supply Chain Profit
Quantity discounts for products with market power (cont’d) Two pricing schemes that can be used by manufacturer
• (b) Two-part tariff
• Up-front fee $180,000 (fixed) + material cost $2/unit (variable)
• Retailer’s decision
» ProfR = (p – CR)(360 – 60p) – 180,000
» p(b) = 3 + 0.5CR = $4
• Prof0(b) = Prof S
(b) + ProfR(b) = $180,000 + $60,000 = $240,000
Retailer’s side: larger volume more discount
• (c) Volume-based quantity discount
• Pricing schedule of CR
» q1 = 120,000, C0 = $4, C1 = $3.5
• p(c) = $4
• Prof0(c) = ProfS
(c) + ProfR(c) = $180,000 + $60,000 = $240,000
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Coordination for Total Supply Chain Profit
Quantity discounts for products with market power (cont’d) KEY POINT
• 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 maximizing supply chain profits.
• For those products, lot size-based discounts cannot coordinate the supply chain even in the presence of inventory cost.
• In such a setting, either a two-part tariff or a volume-based quantity discount, with the supplier passing on some of its fixed cost to the retailer, is needed for the supply chain to be coordinated and maximize profits.
Lot size-based vs. volume-based discount Lot size-based: raising inventory level suitable for supplier’s
high setup cost
Hockey stick phenomenon & rolling horizon-based discount
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Short-term Discounting: Trade Promotion
Trade promotion by manufacturers Induce retailers to use price discount, displays, or advertising to
spur sales. Shift inventory from manufactures to retailers and customers. Defend a brand against competition.
Retailer’s reaction? Pass through some or all of the promotion to customers to spur
sales. 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 demand variability increase inventory & flow time increase supply chain profit decrease
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Short-term Discounting: Trade Promotion
Analysis Determining order quantity with discount Qd
• Unit cost discounted by d (C' = C – d)
Assumptions• Discount is offered only once.
• Customer demand remains unchanged.
• Retailer takes no action to influence customer demand.
Q*
Qd
Qd/D 1 – Qd/D
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Short-term Discounting: Trade Promotion
Analysis (cont’d) Optimal order quantity without discount Q* = (2DS/hC)1/2
Optimal total cost without discount TC* = CD + (2DShC)1/2
Total cost with Qd
Example 10-9 C = $3 Q* = 6,324 d = $0.15 Qd* = 38,236 (forward buy: 31,912 500%)
KEY POINT Trade promotions lead to a significant increase in lot size and cy
cle inventory, which results in reduced supply chain profits unless the trade promotion reduces demand fluctuation.
dC
CQ
dCh
dDQ
D
QTCQdC
D
QdCh
QSTC
d
dd
dd
**
* 12
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Short-term Discounting: Trade Promotion
Retailer’s action of passing discount to customers Example 10-10 Assumptions
• Customer demand: D = 300,000 – 60,000p
• Normal price: CR = $3
• Ignoring all inventory-related cost
Analysis• Retailer’s profit, ProfR
• ProfR = (p – CR)(300 – 60p)
• Retailer’s optimal price setting with regard to CR
• p = 2.5 + 0.5CR
(a) No discount: CR = $3
• p(a) = $4, D(a) = 60,000
(b) Discount: C'R = $2.85
• p(b) = $3.925, D(b) = 64,500 p(a) – p(b) = 0.075 < 0.15 = CR – C'R
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Short-term Discounting: Trade Promotion
Retailers’ response to short-term discount Insignificant efforts on trade promotion, but High forward buying
• Not only by retailers but also by end customers
• Loss to total revenue because most inventory could be provided with discounted price
KEY POINT Trade promotions often lead to increase of cycle inventory in
supply chain without a significant increase in customer demand.
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Short-term Discounting: Trade Promotion
Some implications Motivation for every day low price (EDLP) Suitable to
• high elasticity goods with high holding cost
• e.g., paper goods
• strong brands than weaker brand (Blattberg & Neslin, 1990)
Competitive reasons Sometimes bad consequence for all competitors
Discount by not sell-in but sell-through• Scanner-based promotion
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Managing Multiechelon Cycle Inventory
Configuration Multiple stages and many players at each stage
General policy -- synchronization Integer multiple order frequency or order interval Cross-docking
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