Cycle inventory

inventory analysis

1. Managing Economies of Scale in the Supply Chain: Cycle Inventory

2. Role of Inventory in the Supply Chain Cost Availability Efficiency Responsiveness

3. Supply Sources: plants vendors ports Regional Warehouses: stocking points Field Warehouses: stocking points Customers, demand centers sinks Production/ purchase costs Inventory & warehousing costs Transportation costs Inventory & warehousing costs Transportation costs

4. Inventory Where do we hold inventory? Suppliers and manufacturers warehouses and distribution centers retailers Types of Inventory WIP raw materials finished goods Why do we hold inventory? Economies of scale Uncertainty in supply and demand

5. Goals: Reduce Cost, Improve Service By effectively managing inventory: Xerox eliminated $700 million inventory from its supply chain Wal-Mart became the largest retail company utilizing efficient inventory management GM has reduced parts inventory and transportation costs by 26% annually

6. Goals: Reduce Cost, Improve Service By not managing inventory successfully In 1994, “IBM continues to struggle with shortages in their ThinkPad line” (WSJ, Oct 7, 1994) In 1993, “Liz Claiborne said its unexpected earning decline is the consequence of higher than anticipated excess inventory” (WSJ, July 15, 1993) In 1993, “Dell Computers predicts a loss; Stock plunges. Dell acknowledged that the company was sharply off in its forecast of demand, resulting in inventory write downs” (WSJ, August 1993)

7. Understanding Inventory The inventory policy is affected by: Demand Characteristics Lead Time Number of Products Objectives Service level Minimize costs Cost Structure

8. Cost Structure Order costs Fixed Variable Holding Costs Insurance Maintenance and Handling Taxes Opportunity Costs Obsolescence

9. 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 is held primarily to take advantage of economies of scale in the supply chain and reduce cost within a supply chain. 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

10. Case of jeans at Jean Mart, a department store Inventory profile: plot of the inventory level over time It is assumed here that the demand is stable (while considering safety inventory , it is not so) Cycle inventory = Q/2 (depends directly on lot size) Average flow time = Average inventory / Average flow rate ( Little’s Law ) = average length of time that elapses between the time material enters the supply chain to the point at which it exits. But, for any supply chain, average flow rate equals demand Thus, average flow time from cycle inventory = Q/(2D)

11. Role of Cycle Inventory in a Supply Chain Q = 1000 units D = 100 units/day It takes 10 days for the entire lot to be sold Cycle inventory = Q/2 = 1000/2 = 500 = Avg inventory level from cycle inventory Avg flow time = Q/2D = 1000/(2)(100) = 5 days Thus, jeans spend in the supply chain an average time of 5 days Therefore, 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. The larger the cycle inventory, the longer is the lag time between when a product is produced and when it is sold. A lower level of cycle inventory is always desirable, because long time lags leave a firm vulnerable to demand changes in the marketplace. Working capital requirements are lower Lower inventory holding costs

12. Role of Cycle Inventory in a Supply Chain For this we first identify supply chain costs that are influenced by lot size. Supply chain costs influenced by lot size: Material cost = C (average price paid per unit purchased, increasing lot size might result in availing of price discounts and thus reduce material cost , $ per unit) Fixed ordering cost = S (such as administrative cost, trucking cost, labour cost, all costs that do not vary with the size of the order but are incurred every time an order is placed, e.g., $400 per truck, if a lot of 100 pairs, transportation cost will be $4/pair, whereas 1000 pairs means $0.40/pair, thus increasing the lot size decreases the fixed ordering cost per unit purchased, $ per lot) Holding cost = H = hC (a combination of the cost of capital, cost of physically storing the inventory, and the cost that results from the product being obsolete, reducing lot size and cycle inventory, reduces the holding cost, H: $ per unit per year, h = cost of holding $1 in inventory for one year)

13. Role of Cycle Inventory in a Supply Chain 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. This increases total cycle inventory and total costs in the supply chain

14. Economies of Scale to Exploit Fixed Costs How do you decide whether to go shopping at a convenience store or at Sam’s Club? When we need only a small quantity, we go to the nearby convenience store because the benefit of a low fixed cost outweighs the cost of the convenience store’s higher prices. When we are buying a large quantity, however, we go to Sam’s Club (located far away), where the lower prices over the larger quantity purchased more than make up for the increase in fixed cost.

15. Economies of Scale to Exploit Fixed Costs: different ways Lot sizing for a single product (EOQ) Aggregating multiple products in a single order Lot sizing with multiple products or customers Lots are ordered and delivered independently for each product Lots are ordered and delivered jointly for all products Lots are ordered and delivered jointly for a subset of products

16. Lot sizing for a single product (EOQ) The Purchasing Manager of Best Buy places a replenishment order for a new lot of Q number of HP computers. Including the cost of transportation, Best Buy incurs a fixed cost of $S per order. The purchasing manager must decide on the number of computers to order from HP in a lot. We assume the following inputs:

17. Economies of Scale to Exploit Fixed Costs Annual demand = D C = cost per unit H = holding cost per year as a fraction of product cost If no discount is available, the holding cost per unit per year, H = hC Number of orders per year = D/Q Three costs to decide on the lot size: Annual material cost = CD (purchase price is independent of lot size) Annual order cost = (D/Q)S Annual holding cost = (Q/2)H = (Q/2)hC (where average inventory or cycle inventory = Q/2) Total annual cost = TC = CD + (D/Q)S + (Q/2)hC

18. Fixed Costs: Optimal Lot Size and Reorder Interval (EOQ) D: Annual demand D: Monthly demand = D/12 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 (the optimal lot size that minimizes total cost = Q*, known as Economic Order Quantity, EOQ) T: Reorder interval n* = optimal ordering frequency AFT = average flow time Material cost is constant and therefore is not considered in this model

19. Example 1 Demand, D = 12,000 computers per year d = 1000 computers/month Unit cost, C = $500 Holding cost fraction, h = 0.2 (holding cost of 20%) Fixed cost, S = $4,000/order Q* = Sqrt[(2)(12000)(4000)/(0.2)(500)] = 980 computers Cycle inventory = Q*/2 = 490 Average flow time = average time each computer spends in inventory before it is sold = Q*/2d = 980/(2)(1000) = 0.49 month Reorder interval, T = 0.98 month No. of reorders per year = D/Q* = 12.24

20. Example 1 (continued) Annual ordering and holding cost = = (12000/980)(4000) + (980/2)(0.2)(500) = $97,980 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. Thus, if the fixed cost associated with each lot is reduced to $1000, the optimal lot size reduces to 490. Further, using a lot size of 1,100 (instead of 980), increases annual cost to $98,636. Even though the order size is more than 10% larger than the optimal order size Q*, the total cost increases by only 0.6%. Thus, total ordering and holding costs are relatively stable around the EOQ, that is, relatively insensitive to Q around Q*. Moreover, if demand increases by a factor k, the optimal lot size increases by a factor sqrt k. The number of orders placed per year should also increase by a factor sqrt k. However, flow time attributed to cycle inventory should decrease by a factor sqrt k.

21. Example 2 (Relationship between desired lot size and order cost) If desired lot size = Q* = 200 units, what would S have to be? D = 12000 units C = $500 h = 0.2 Use EOQ equation and solve for S: S = [hC(Q*) 2 ]/2D = [(0.2)(500)(200) 2 ]/(2)(12000) = $166.67 Thus, to reduce optimal lot size by a factor of k, the fixed order cost must be reduced by a factor of k 2

22. 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.

23. 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 Thus, lot size for each product, average flow time, inventory holding costs will be reduced

24. Aggregating Multiple Products in a Single Order Transportation is a significant contributor to the fixed cost per order. Can, therefore, 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 (allowing fixed transportation cost to be spread across multiple suppliers) or a single truck delivering to multiple retailers (allowing fixed transportation cost to be spread across 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. Wal-Mart achieves the above through cross-docking, but we cannot ignore receiving or loading costs – importance of Advanced Shipping Notices (ASN) and RFID technology.

25. Three models of Store Manager: Best Buy with multiple models of computers (Litepro (L), Medpro (M), and Heavypro (H)) If each product manager orders his model independently (no aggregation – high cost). The product managers jointly order every product in each lot (weakness – low demand products are aggregated with high demand products in each order, resulting in high costs if the product-specific order costs for the low demand products is large). Product managers order jointly but not every order contains every product; that is, each lot contains a selected subsets of the products. Let us consider all the models.

26. 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

27. Lot Sizing with Multiple Products Demand per year D L = 12,000; D M = 1,200; D H = 120 Common transportation cost, S = $4,000 Product specific order cost (for each model ordered and delivered on the same truck, an additional fixed cost of $1000 is incurred for receiving and storage) s L = $1,000; s M = $1,000; s H = $1,000 Holding cost, h = 0.2 Unit cost C L = $500; C M = $500; C H = $500

28. Delivery Options First model: No Aggregation: Each product ordered separately. Because each model of the computer is ordered and delivered independently, a separate truck delivers each model. Thus, a fixed ordering cost of $4000 + $1000 = $5000 is incurred for each product delivery. Annual ordering cost = ((S + s L ) + (S + s M ) + (S + s H )) x n (ordering frequency). Second model: Complete Aggregation: All products delivered on each truck. All three models are included each time an order is placed. So the annual ordering cost here is (S* x n) = (S + s L + s M + s H ) x n. Third model: Tailored Aggregation: Lots are ordered and delivered jointly for a selected subsets of the products on each truck Aggregate across products, supply points or delivery points.

29. No Aggregation: Order Each Product Independently Total cost = $155,570

30. Aggregation: Order All Products Jointly S* = S + s L + s M + s H = 4000+1000+1000+1000 = $7000 n* = Sqrt[(D L hC L + D M hC M + D H hC H )/2S*] = 9.75 (formula obtained by minimizing total annual cost), where hC L = hC M = hC H = 20% of $500 = $100 Annual order cost = 9.75 x $7000 = $68, 250 Q L = D L /n* = 12000/9.75 = 1230 Q M = D M /n* = 1200/9.75 = 123 Q H = D H /n* = 120/9.75 = 12.3 Cycle inventory = Q/2 Average flow time (in weeks) = (Q/2)/(weekly demand)

31. Complete Aggregation: Order All Products Jointly Annual order cost = 9.75 × $7,000 = $68,250 Annual total cost = $136,528 (down from $155,570, by about 13 per cent)

32. Case of W.W. Grainger: Aggregating four suppliers (each supplier, one product) per truck D i = 10,000 h = 0.2 C i = $50 Common order cost = S = $500 Supplier-specific order cost = $100 Combined order cost = S* = ($500+$100+$100+$100+$100) =$900 n* = Sqrt[( Σ D i hC i, i=1,..k)/2S*] = 14.91 (k = 4 here) Annual order cost per supplier = 14.91 x (900/4) = $3,354 Quantity ordered from each supplier = Q = 10,000/14.91 = 671 units per order Annual holding cost per supplier =(h C i Q)/2 = (0.2x50x671)/2 = $3,355 Thus, total capacity per truck = 4 x 671 = 2,684

33. Case of W.W. Grainger: Aggregating four suppliers (each supplier, one product) per truck: Introducing Capacity constraint Compare the total load for the optimal n* with truck capacity. If the optimal load exceeds the truck capacity, n* is increased until the load equals the truck capacity. Further, by applying the formula n* = Sqrt[(SUM D i hC i, i=1,..k)/2S*] for different values of k, we can also find the optimal number of items or suppliers to be aggregated in a single delivery. Thus, if truck capacity limit is 2500 units, the order frequency must be increased to ensure that the order quantity from each supplier is 2,500/4 = 625. Thus, W.W. Grainger should increase the order frequency to 10,000/625 = 16. This would increase the annual cost order cost per supplier to $3,600 and decrease the annual holding cost per supplier to #3,125.

34. Tailored aggregation The first step is to identify the product that is to be ordered most frequently, assuming each product is ordered independently. For each successive product, we then identify orders in which it is included. Assumption: each product is included in the order at regular intervals . Once we have identified the most frequently ordered model, for each successive product i, we identify the frequency m i , where model i is ordered every m i deliveries. Each product i has an annual demand D i , a unit cost C i , and a product specific order cost s i . The common order cost is S. Using the same Best Buy data, product managers have decided to order jointly, but to be selective about which models they include in each order.

35. Calculations: Tailored aggregation n L = sqrt ((D L hC L )/2(S+ s L )) = 11.0; similarly, n M = 3.5 and n H = 1.1 (L is most frequently ordered model, 11 times a year). (Put 1bar). The frequency with which M and H are included in L order are given as follows: n M = sqrt ((D M hC M /2 s M )) = 7.7 and n H = 2.4 (Put 2 bars) m M = n L / n M (2 bars) = 11.0/7.7 = 1.4 (= 2) and similarly, m H = 4.5 (= 5) Therefore, L is included in every order, M in every 2 nd order and H in every 5 th order. Recalculate n L = n = sqrt ((D L hC L m L + D M hC M m M + D H hC H m H )/2(S + s L /m L + s M / m M + s H / m H )) = 11.47

36. Calculations: Tailored aggregation Thus, recalculated n M = 11.47/2 = 5.74/year and n H = 11.47/5 = 2.29/year Thus, L will be ordered 11.47 times, L, 5.74 times, and H, 2.29 times/year. The annual holding cost of this policy = (((D L /2 n L ) hC L ) + ((D M /2 n M ) hC M ) + ((D H /2 n H ) hC H ) = $65,385.5 The annual order cost = nS + n L s L + n M s M + n H s H , (n = n L ) For each, order size = D/n, cycle inventory = D/2n Total (annual order + holding) cost = $130,767

37. Lessons from Aggregation Aggregation allows a firm to lower lot size without increasing cost Complete aggregation is effective if product specific fixed cost is a small fraction of joint fixed cost (all customers, all products, all trips). Tailored aggregation is effective if product specific fixed cost is a large fraction of joint fixed cost. Here, larger customers get more frequent deliveries. Tailored aggregation differentiates between high volume and low volume items, orders low volume items less frequently, and is suitable when product specific order cost is high. For instance, the total cost in the last example was $130,767. Tailored aggregation results in a cost reduction of $5,761 (about 4%) compared to the joint ordering of all models. The cost reduction results because each model specific fixed cost of $1,000 is not incurred with every order. On the transportation end, the product-specific order costs can be reduced by locating supply points or delivery points close to one another.

38. 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. A supply chain is coordinated if the decision the retailer and supplier make maximize total supply chain profits. However, in reality, each stage has a separate owner and considers its own costs in an effort to maximize its own profit. Thus, the question is how can a manufacturer use appropriate quantity discount to ensure that coordination results even if the retailer is acting to maximize its own profits? Price discrimination to maximize supplier profits through extraction of surplus

39. Quantity Discounts Commodity products - Lot size based: a discount is lot-sized based if the pricing schedule offers discounts based on the quantity ordered in a single lot. All units Marginal unit, also known as multi-block tariffs. In this case, the pricing schedule contains specified break points q , q 1 , q 2 , …qr. If an order size of q is placed, the first q 1 -q units are priced at C , the next q 2 -q 1 are priced at C 1 , and so on, C >C 1 >C 2 … Products with demand curve - Volume based: a discount is volume-based if the discount is 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?

40. All-Unit Quantity Discounts Pricing schedule has specified quantity break points q , q 1 , …, q r , where q = 0 If an order is placed that is at least as large as q i but smaller than q i+1 , then each unit has an average unit cost of C i The unit cost generally decreases as the quantity increases, i.e., C >C 1 >…>C r 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

41. All-Unit Quantity Discount Procedure (different from what is in the textbook) 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 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.

42. All-Unit Quantity Discounts: Example Cost/Unit $3 $2.96 $2.92 Order Quantity 5,000 10,000 Order Quantity 5,000 10,000 Total Material Cost

43. All-Unit Quantity Discount: Example Order quantity Unit Price 0-5000 $3.00 5001-10000 $2.96 Over 10000 $2.92 q = 0, q 1 = 5001, q 2 = 10001 C = $3.00, C 1 = $2.96, C 2 = $2.92 D = 120000 units/year, S = $100/lot, h = 0.2

44. All-Unit Quantity Discount: Example Step 1: Calculate Q 2 * = Sqrt[(2DS)/hC 2 ] = Sqrt[(2)(120000)(100)/(0.2)(2.92)] = 6410 Not feasible (6410 < 10001) Calculate TC 2 using C 2 = $2.92 and q 2 = 10001 TC 2 = (120000/10001)(100)+(10001/2)(0.2)(2.92)+(120000)(2.92) = $354,520 Step 2: Calculate Q 1 * = Sqrt[(2DS)/hC1] =Sqrt[(2)(120000)(100)/(0.2)(2.96)] = 6367 Feasible (5000<6367 < 10000)  Stop TC 1 = (120000/6367)(100)+(6367/2)(0.2)(2.96)+(120000)(2.96) = $358,969 TC 2 < TC 1  The optimal order quantity Q* is q 2 = 10001

45. All-Unit Quantity Discounts If all units are sold for $3 (no discount), Q * = 6,324 units. Since 6,324>5000, we should set q 1 = 5001 for getting it at $2.96 per unit, and TC = $359,080. However, the optimal quantity to order is 10,001 with discounts. Thus, the quantity discount is an incentive to order more. Suppose fixed order cost were reduced to $4 (from $100) Without discount, Q * would be reduced to 1265 units, that is, if fixed cost of ordering is reduced, lot size reduces sharply. With discount, optimal lot size would still be 10001 units Thus, the average inventory (flow time) increases. 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?

46. All unit quantity discount vs. marginal unit quantity discount The marginal unit quantity discount results in a larger lot size than an all-unit quantity discount. As the lot size is increased beyond the last break point, the material cost continues to decline. Quantity discounts often contribute more to cycle inventory. So, why quantity discounts?

47. Why Quantity Discounts? Improved coordination in the supply chain Commodity products: for commodity products such as milk, a competitive market exists, and costs are driven down to the product’s marginal cost. In this case, the market sets the price and the firm’s objective is to lower costs. Products with demand curve 2-part tariffs Volume discounts

48. Commodity products case A retail company DO sells a commodity product (vitamins). Do incurs a fixed order placement, transportation, and receiving cost of $100 every time it places an order with the manufacturer, plus a holding cost of 20%. The manufacturer charges $3 per bottle of vitamins. Every time DO places an order, the manufacturer has to process, pack, and ship the order. The manufacturer incurs a fixed order filling cost of $250, production cost of $2 per bottle, plus a holding cost of 20%.

49. Coordination for Commodity Products D = 120,000 bottles/year S R = $100, h R = 0.2, C R = $3 S S = $250, h S = 0.2, C S = $2 Retailer’s (DO) optimal lot size (EOQ) = 6,324 bottles. Annual holding + ordering costs of Retailer = $3,795; Annual order cost at manufacturer = (120,000/6,324) x 250 = $4,744, annual holding cost of supplier = (6,324/2) x 2 x 0.2 = $1,265, thus total supplier cost = $6,009 Therefore, supply chain cost = $3,795 + $6,009 = $9,804 A lot size-based quantity discount is appropriate in this case. When the lot size increases, manufacturer’s cost relatively decreases due to large lot size, but order and holding costs (cycle inventory increases) increase for the retailer although the total supply chain cost also decreases. Therefore, the manufacturer must induce the retailer to buy in larger quantity, by sharing some benefits with the retailer. Q* for the manufacturer = sqrt ((2 x 120,000 x 250)/0.2 x 2)) = 9,165. Thus, if the supplier offers each bottle for $2.9978 for all orders in lots of 9,165 or more. The manufacturer’s and the total supply chain profit increases by $638, by offering quantity discount of $264, when DO has an incentive to order in lots of 9,165.

50. Coordination for Commodity Products What can the supplier do to decrease supply chain costs? Coordinated lot size: 9,165; Retailer cost = $4,059; Supplier cost = $5,106; Supply chain cost = $9,165 Effective pricing schemes All-unit quantity discount $3 for lots below 9,165 $2.9978 for lots of 9,165 or more Pass some fixed cost to retailer (enough that he raises order size from 6,324 to 9,165) On the contrary, for a low enough set-up or order cost (fixed cost per order reduces from $250 to $100), the manufacturer gains very little from using a lot size-based quantity discount; it makes sense for him to eliminate all quantity discounts. This brings out the importance of marketing and sales on the one hand, and operations, on the other hand, working in close coordination.

51. Quantity Discounts When Firm Has Market Power A new vitamin pill whose properties are highly valued has been introduced into the market by the manufacturer. It can be thus be argued that the price at which DO sells this drug influences demand. Assume that the annual demand faced by DO is given by the demand curve 360,000 – 60,000p, where p is the price DO sells this drug. The manufacturer incurs a cost C S = $2 per bottle. The manufacturer must decide what to charge DO, and DO, in turn, must decide on the price to charge the customer.

52. Quantity Discounts When Firm Has Market Power No inventory related costs Demand curve 360,000 - 60,000 p What are the optimal prices and profits in the following situations? The two stages coordinate the pricing decision Price = $4, Profit = $240,000, Demand = 120,000 The two stages make the pricing decision independently Price = $5, Profit = $180,000, Demand = 60,000

53. Quantity Discounts When Firm Has Market Power Independent decision-making : it is optimal for DO to sell the drug at $5 per bottle (= p) and for the manufacturer to charge C R = $4 per bottle . Total market demand = 360,000 – 60,000p = 60,000 Profit R = p(360,000 – 60,000p) - (360,000 – 60,000p) x $4 = ($5 x 60,000) – ($4 x $60,000) = $60,000 Profit M = ($4 x 60,000) – ($2 x 60,000) = $120,000 Thus, the total supply chain profit in this case = $60,000 + $120,000 = $180,000

54. Double marginalization If the two stages coordinate pricing, p = $4, and let C R = $3.25 per bottle, market demand is 120,000, the total supply chain profit = 120,000 x ($4 - $2) = $240,000 = Profit R + Profit M = (120,000 x (4 – 3.25)) + (120,000 x (3.25-2)) We can thus realize that if each stage sets its price independently, the supply chain thus loses $240,000 - $180,000 = $60,000 in profit. This phenomenon is referred to as double marginalization . Double marginalization leads to a loss of profit because the supply chain margin is divided between two stages but each stage makes its decision considering only its local margin. There are two pricing schemes that the manufacturer may use to achieve the coordinated solution and maximize supply chain profits even though the retailer firm DO acts in a way that maximizes its own profit: two-part tariff and volume-based quantity discounts.

55. Two-Part Tariffs Design a two-part tariff that achieves the coordinated solution: the manufacturer charges its entire profit as an up-front franchise fee and then sells to the retailer at its cost price. In the case here, the manufacturer charges DO a franchise fee of $180,000 (its profit) and material cost of C S = C R = $2 per bottle. DO maximizes its profit if p = $4 per bottle. It has annual sales of 360,000 – 60,000p = 120,000 and profits of $60,000 = ([120,000 x $4] – [(120,000 x 2) + 180,000)]).

56. Volume Discounts Design a volume discount scheme that achieves the coordinated solution. We 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. The manufacturer thus offers a price C R = $4 per bottle if the quantity purchased by DO is less than 120,000 and C R = $3.50 per bottle if the volume is 120,000 or higher. It is then optimal for DO to order 120,000 units and offer them at $4 per bottle to the customers. The total profit earned by DO is (360,000-60,000p) x (p – C R ) = $60,000. The total profit earned by the manufacturer is 120,000 x (C R - $2) = $180,000, the total supply chain profit remaining unchanged.

57. Impact of inventory costs 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 (order and holding). In such a setting, a two-part tariff or volume-based discount, with the supplier passing on some fixed costs with above pricing to the retailer, is needed for the supply chain to be coordinated and maximize profits, given the assumption that customer demand decreases when the retailer increases price.

58. Lessons from Discounting Schemes Lot size-based discounts increase lot size and cycle inventory in the supply chain. Lot size-based discounts are justified to achieve coordination for commodity products. Lot-sized discounts are based on quantity purchased per lot, not the rate of purchase. Volume-based discounts are based on the rate of purchase or volume purchased on average per year or month. Volume-based discounts are compatible with small lots that reduce cycle inventory. Lot size-based discounts make sense only when the manufacturer incurs a very high fixed cost per order. Volume based discounts with some fixed cost passed on to retailer are more effective in general Volume based discounts are better over rolling horizon, for instance, each week the manufacturer may offer DO the volume discount based on sales over the last 12 weeks.

59. 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 manufacturer’s 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 Goals are not always achieved by a trade promotion 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

60. Short-Term Discounting: Trade Promotions The first action lowers the price of the product for the end customer, leading to increased purchases and thus increased sales for the entire supply chain. The second action does not increase purchases by the customer but increases the amount of inventory held at the retailer increasing the cycle inventory and the flow time within the supply chain. A forward buy occurs in the latter case helping reduce the retailer’s cost of goods after the promotion ends but it usually increases demand variability and can decrease supply chain profitability.