DGD 3

Managing Economies of Scale

in a Supply Chain
 Agenda

CYCLE ECONOMIES AGGREGATING QUANTITY BULLWHIP

INVENTORY OF SCALE ORDERS DISCOUNTS EFFECT
Cycle Inventory

Cycle inventory = lot size/2

It is the average inventory in a supply chain

Lower is better to avoid demand fluctuations and reduce working capital

Higher takes advantage of economies of scale; Larger order sizes reduce material
costs
 • Lot/batch size (Q) – the quantity being ordered
• Safety inventory – inventory held in excess of demand
• Material cost (C) – average price per unit purchased
• Ordering cost (S) – cost of placing an order (regardless of
size)
Understand • Holding cost (H) – cost of carrying one unit in inventory
These:
• The primary role of cycle inventory is to allow different
stages in a supply chain to purchase product in lot sizes
that minimize the sum of the material (C), ordering (S), and
holding costs (H).
Economic
Order
Quantity
(Q*)

Q*

In this case we are assuming

material costs remain fixed
Lot Sizing with
Capacity Constraint

• The optimal order size is whichever's smaller,

EOQ or truck capacity
Aggregatin
g Products
• Aggreation reduces the lot
in a Single size of individual products

Order • Fixed costs are shared

between multiple products

Ex. Cross docking

 Aggregation Types

Order and Deliver

Order and Deliver Tailored Order
Separately (No
Jointly and Delivery
Aggregation)

Most expensive, Better for

basically just Minimizes total product with
using EOQ ordering cost large differences
formula in ordering cost
 Example from my
assignment

No aggregation

Jointly Tailored
Exercise 11-9
• An electronics company has two contract manufacturers in Asia:
Foxconn assembles its tablets and smart phones and Flextronics
assembles its laptops. Monthly demand for tablets and
smartphones is 10,000 units, whereas that for laptops is 4,000.
Tablets cost the company $100, laptops cost $400, and the
company has a holding cost of 25 percent. Currently the company
has to place separate orders with Foxconn and Flextronics and
receives separate shipments. The fixed cost of each shipment is
$10,000. What is the optimal order size and order frequency with
each of Foxconn and Flextronics? The company is thinking of
combining all assembly with the same contract manufacturer. This
will allow for a single shipment of all products from Asia. If the fixed
cost of each shipment remains $10,000, what is the optimal order
frequency and order size from the combined orders? How much
reduction in cycle inventory can the company expect as a result of
combining orders and shipments?
Input Data and Compare
Quantity Discounts
• Lot-size based if the pricing schedule offers
discounts based on the quantity ordered in a
single lot
• All unit quantity discounts
• Marginal unit quantity discount or multi-
block tariffs
Exercise 11-15 Fixed cost per order =
Monthly demand =
Holding percentage =
$ 500.00 per order
5,000
25%

Pricing:
• Demand for phones at Amazon is 5,000 per Min Qty Max Qty Price per sq. ft.
month. Holding cost Amazon is 25 percent and 0
10,000
9,999
19,999
$
$
200.00
195.00
the company incurs a fixed cost of $500 for 20,000 $ 190.00
each order placed. The supplier offers an all
Range
unit quantity discount with a price of $200 per i Q Adjust to q Total Cost
phone for all orders under 10,000, a price of 0 1,095 1,095 $ 12,054,772
$195 for all orders of 10,000 or more but under 1
2
1,109
1,124
10,000
20,000
$ 11,946,750
$ 11,876,500
20,000 and a price of $190 for all orders of
20,000 or more. How many phones should Without Quantity Discount
Price per unit Q Total Cost
Amazon order per replenishment? $ 200.00 1,095 $ 12,027,660
Exercise 11-12
• Prefab, a furniture manufacturer, uses 20,000 square feet of
plywood per month. Its trucking company charges Prefab $400 per
shipment, independent of the quantity purchased. The
manufacturer offers an all unit quantity discount with a price of $1
per square foot for orders under 20,000 square feet, $0.98 per
square foot for orders between 20,000 square feet and 40,000
square feet, and $0.96 per square foot for orders larger than 40,000
square feet. Prefab incurs a holding cost of 20 percent. Now
consider the case where the manufacturer now offers a marginal
unit quantity discount for the plywood. The first 20,000 square feet
of any order are sold at $1 per square foot, the next 20,000 square
feet are sold at $0.98 per square foot, and any quantity larger than
40,000 square feet is sold for $0.96 per square foot. What is the
optimal lot size for Prefab given this pricing structure? How much
cycle inventory of plywood will Prefab carry given the ordering
policy?
 Volume Based Discounts (to increase SC
coordination)

• Volume based is when the discount is based on the total quantity purchased over a given period, regardless of the
number of lots purchased over that period
• Two Part Tariff - the manufacturer charges its entire profit as an upfront franchise fee and then sells to the
retailer at cost
• The retailer pays a lower average unit cost as it purchases larger quantities each year (the franchise fee is
amortized over more units).

• 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.
• For products for which a firm has market power, lot-size–based discounts are not optimal for the supply chain
even in the presence of inventory costs. In such a setting, either a two-part tariff or a volume-based 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.
Short Term Discounting: Trade Promotions

• The goal of trade promotions is to influence retailers to act in a way that helps the
manufacturer achieve its objectives.
• Induce retailers to use price discounts, displays, or advertising to spur sales.
• Shift inventory from the manufacturer to the retailer and the customer.
• Defend a brand against competition.
• In response to a trade promotion, the retailer has the following options:
• Pass through some or all of the promotion to customers to spur sales. (Increases sales
for entire supply chain)
• 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) (Increases cycle inventory+flow time)
 Bullwhip Effect
• A lack of coordination occurs either
because different stages of the supply chain
have local objectives that conflict or
because information moving between
stages is delayed and distorted.
• The bullwhip effect is an amplification of
demand variability in each stage moving
back towards the manufacturer then a
subsequent return up the supply chain with
quantities that drastically exceeds demand.
Root Beer
Game