Inventory Control Methods
Chapter 10: Chopra & Meindl, SCM 4e
1
Short-Term Discounting
(Trade Promotions)
• Manufacturers use trade promotions to offer a
discounted price to retailers and a time period
over which the discount is effective.
• In some cases, the manufacturer may require
specific actions from the retailers (displays,
advertising, promotion) to qualify for the
trade promotion.
• Common in the consumer packaged-goods
industry.
2
Goals of a Trade Promotion
• Key goals of a trade promotion from the
manufacturer’s perspective:
– 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
3
The Retailer’s Responses
1. Pass through some of all of the promotion to customers to
spur sales
▪ Increases sales for the entire supply chain
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: Purchasing in the promotional period for sales
in future periods.
▪ Increase demand variability
▪ Increase the amount of inventory held at retailer and hence the cycle
inventory and flow time in the supply chain
▪ It can also decrease supply chain profit.
4
Impact of Trade Promotions on Lot Size
• Assumptions:
– The discount is offered once, with no future
discounts
– The retailer takes no action to influence customer
demand. The customer demand thus remains
unchanged.
– The planning period is a period over which the
demand is an integer multiple of EOQ.
5
Short Term Discounting
Q*: Normal order quantity (EOQ)
C: Normal unit cost
d: Short term discount dD CQ *
Qd = +
D: Annual demand (C - d )h C - d
h: Cost of holding $1 per year
Qd: Short term order quantity
Forward buy = Qd - Q*
6
Example: Short Term Discounts − Forward Buying
Normal order size, Q* = 6,324 bottles Discount per bottle, d = $0.15
Normal cost, C = $3 per bottle Holding cost, h = 0.2
Annual demand, D = 120,000 bottles dD CQ *
Qd = +
Monthly demand = 10,000 bottles (C - d )h C - d
0.15 120,000 3.00 6,234
Qd = +
(3.00 − 0.15) 0.20 3.00 − 0.15
Qd =38,236 bottles
Normal TBO = 0.6324 months TBO = 3.8286 months
Cycle inventory Cycle inventory
= Q*/2 = 3,162 bottles = Q*/2 = 19,118 bottles
Average flow time Average flow time
= Q*/2D = 0.3162 months = Q*/2D = 1.9118 months
Forward buy = Qd – Q* = 38,236 – 6,324 = 31,912 bottles
7
Short Term Discounts − Forward Buying
• Forward buying as a result of trade promotions leads to a
fluctuation in orders.
• The retailer can justify this action because it decreases its
total cost (from the decrease in the cost of goods).
• The manufacturer can justify this action only if it has
– inadvertently built up a lot of excess inventory
– The forward buy allows the manufacturer to smooth demand by
shifting it from peak to off-peak demand periods.
• If the forward buy during trade promotions is a significant
fraction of total sales, the manufacturer’s revenues are
decreased because most of the product are sold at a discount.
• This also decreases total supply chain profits.
8
Example: Promotion Pass through
to Consumers
• Demand curve at retailer: 300,000 - 60,000p
• Suppose all inventory-related costs are ignored.
• Normal supplier price for retailer, CR = $3.00
– Profit (for retailer) = (300,000 - 60,000p) p – (300,000 - 60,000p) CR
– Optimal retail price p* = (300,000 + 60,000 CR ) /120,000 = $4.00
– Customer demand = 60,000
• Promotion discount = $0.15 per unit
– Optimal retail price p* = (300,000 + 60,000 2.85 ) /120,000 = $3.925
– Customer demand = 64,500
• It is optimal for the retailer to only passes through half the
promotion discount to the customers
• The demand increases by only 7.5%
9
Key Point − Promotion
Pass through to Consumers
• Faced with a short-term discount, it is optimal for
retailers
– To pass through only a fraction of the discount to
customer.
– To increase the purchase lot size and forward buy for
future periods.
• Therefore, trade promotion often lead to an increase
of cycle inventory in a supply chain without a
significant increase in customer demand.
10
Trade Promotions
• When a manufacturer offers a promotion, the goal for the
manufacturer is to take actions
– To discourage forward buying in the supply chain.
– To encourage the retailers to pass along more of discount to end
customers.
• The discount passed through by the retailer to the customer is
influenced by the retailer deal elasticity (i.e., the increase in retail
sales per unit discount in price).
• The higher deal elasticity, the more of the discount the retailer is
likely to pass through to the consumers.
• Trade promotions are more effective with products with a high
deal elasticity and high holding costs (hence, low forward buying)
and strong brand products.
11
Trade Promotions (Cont)
• Trade promotions may be justified as a competitive
response.
• Suppose a competitor offers the retailers a trade
promotion which pass through to the customers.
• The supplier may loss some market share from the price-
sensitive customers without trade promotion offering.
• However, when both competitors offering trade
promotions, there is no real increase in demand for
either, unless customer consumption grows.
• Inventory in the supply chain does increase for both
brands, leading to reduced profit for all competitors.
12
Countermeasures to Limit
Forward Buying
• EDLP (every day low pricing)
– A pricing strategy promising consumers a low price without coupon
clipping, waiting for discount promotions, or comparison shopping.
– The price is fixed over time. No short-term discounts are offered.
– No incentive for forward buying.
– Adopted by Wal-Mart, Proctor & Gamble
• Offering discounts to the retailer that are based on actual sales to
customers rather than the amount purchased by the retailer
(perhaps unacceptable for weak brands).
– Scanner-based promotions (offering credit for the promotion
discount for every unit sold)
– Limiting the allocation to a retailer based on past sales
– Customer coupons
13
Aggregating Multiple Products
in a Single Order
• Transportation is a significant contributor to the
fixed cost per order.
• The company can combine shipments of different
products from the same supplier
– same overall fixed cost
– shared over more than one products
– effective fixed cost is reduced for each product
– lot size for each product can be reduced
14
Aggregating Multiple Products
in a Single Order (Cont)
• The company can also have a single delivery coming
from multiple suppliers or a single truck delivering to
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.
15
Example: Aggregating Multiple Products
• Suppose there are 4 products: A, B, C, and D.
• Assume demand for each is 1,000 units per month.
• C = $500; h = 0.2; Cp = $4,000/order
• If each product is ordered separately:
– Q* = 980 units for each product
– Total cycle inventory = 4(Q/2) = (4)(980)/2 = 1,960 units
• Aggregate orders of all four products:
– Combined Q* = 1,960 units
– For each product: Q* = 1,960/4 = 490 units
– Cycle inventory for each product is reduced to 490/2 = 245 units
– Total cycle inventory = 1960/2 = 980 units
– Average flow time, inventory holding costs will be reduced
16
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 (products or pickup points)
– A portion of the cost is related to transportation (dependent only on
the load, independent of product variety on the truck.)
– A portion of the cost is related to loading and receiving (not
independent of product variety)
• Three scenarios:
– Lots are ordered and delivered independently for each product
• High costs
– Lots are ordered and delivered jointly for all three models
• High costs if the product specific cost for low-demand products is large
– Lots are ordered and delivered jointly for a selected subset of models
17
Example: Lot Sizing with
Multiple Products
• Demand per year
– DH = 12,000; DM = 1,200; DL = 120
• Common transportation cost, Cp = $4,000
• Product specific order cost
(cost incurred for receiving and storage)
– CpH = $1,000; CpM = $1,000; CpL = $1,000
• Holding cost, h = 0.2
• Unit cost
– CH = $500; CM = $500; CL = $500
18
Delivery Options
• No Aggregation:
– Each product ordered separately
• Complete Aggregation:
– All products delivered on each truck
• Tailored Aggregation:
– Selected subsets of products on each truck
19
No Aggregation
H M L
Demand per year 12,000 1,200 120
Fixed cost / order $5,000 $5,000 $5,000
Optimal order size 1,095 346 110
Order frequency 11.0 / year 3.5 / year 1.1 / year
Cycle inventory 548 173 55
Average flow time 2.4 weeks 7.5 weeks 23.7 weeks
Annual holding cost $54,772 $17,321 $5,477
Annual ordering cost $54,772 $17,321 $5,477
Annual cost $109,544 $34,642 $10,954
Total cost = $155,140
20
Complete Aggregation
• Combined fixed order cost = Cp* = Cp + CpH + CpM + CpL
= 4,000 + 1,000 + 1,000 + 1,000 = $7,000
• n = number of orders placed per year
• Annual order cost = nCp*
• Annual holding cost
= (DH/2n)(hCH) + (DM/2n)(hCM) + (DL/2n)(hCL)
k
Di hC i DH hC H + DM hC M + DL hC L
n* = i =1
=
• 2C *p 2C *p = 9.75 orders/year
• QH = DH/n* = 12,000/9.75 = 1,230
• QM = DM/n* = 1,200/9.75 = 123
• QL = DL/n* = 120/9.75 = 12.3
21
Complete Aggregation
H M L
Demand per year (D) 12,000 1,200 120
Order frequency (n*) 9.75/year 9.75/year 9.75/year
Optimal order size (D/n*) 1,230 123 12.3
Cycle inventory 615 61.5 6.15
Average flow time 2.67 weeks 2.67 weeks 2.67 weeks
Annual holding cost $61,512 $6,151 $615
Annual holding cost = $68,278
Annual order cost = 9.75 × $7,000 = $68,250
Annual total cost = $136,528
22
Tailored Aggregation
• Main Idea:
Total costs can be reduced if low-demand products
are ordered less frequently.
• Let us assume that each product is included in the
order at regular intervals.
23
• Product specific order cost: CpH = $1,000; CpM = $1,000; CpL = $1,000
Di hCi
• Order frequency if each product is ordered independently: ni =
(
2 C *p + C pi )
n H = 11.0; nM = 3.5; n L = 1.1
• Thus, H is the most frequently ordered product. Thus we set n = 11.0
Di hCi
• Next, evaluate the ordering frequency of the other product i: ni =
2C pi
nM = 7.7; n L = 2.4
• Evaluate the frequency with which product i is included with the most frequently ordered
product i*: mi = ni ni
mM = 1.4 = 2; mL = 4.5 = 5
• H is included in every order, M is included in every other order; and L is included in every
fifth order.
• Recalculate the ordering frequency of the most frequently ordered product i*:
n=
D hC m = 11.47 times per year
i i i
2(C + C m )
*
p pi i
• Thus, H is ordered 11.47 times per year, M is ordered nM = n mM = 11.47 2 = 5.74 times
per year; and L is ordered n L = n m L = 11.47 5 = 2.29 times per year.
Tailored Aggregation
H M L
Demand per year (D) 12,000 1,200 120
Order frequency (n*) 11.47/year 5.74/year 2.29/year
Optimal order size (D/n*) 1,046 209 52
Cycle inventory 523 104.5 26
Average flow time 2.27 weeks 4.53 weeks 11.35 weeks
Annual holding cost $52,307 $10,461 $2,615
Annual holding cost = $65,383
25
Tailored Aggregation
• Ordering cost Order for H Order for M Order for L Order cost
1 1 1 $ 7,000
2 $ 5,000
3 2 $ 6,000
4 $ 5,000
5 3 $ 6,000
This is not totally accurate as
6 2 $ 6,000
the company supposes to
order H 11.47 times/year, 7 4 $ 6,000
M 5.74 times/year, 8 $ 5,000
and L 2.29 times/year 9 5 $ 6,000
10 $ 5,000
11 6 3 $ 7,000
12 $ 5,000
Total $ 69,000
• Approximate total cost = $65,383 + $69,000 = $134,383
26
Aggregating Multiple Products
in a Single Order
• Aggregation allows firms to lower lot size
without increasing cost.
• Complete aggregation is effective if product
specific fixed cost is a small fraction of joint
fixed cost.
• Tailored aggregation is effective if product
specific fixed cost is a large fraction of joint
fixed cost.
27
Aggregation with Capacity Constraint
• A producer sources its raw materials from four suppliers.
• It is considering the aggregation of inbound shipments
to lower its costs.
• Demand per source: Di = 1,000 tons
• Common transportation cost, Cp = $100/truck
• Supplier-specific order cost (for pickup): Cpi = $30
• Holding cost, h = 0.2
• Unit cost: Ci = $150/tons
• Truck capacity = 40 tons
28
Aggregation with Capacity Constraint
• Combined order cost from 4 suppliers = $220 per order
• n* = 16.51 orders/year
• Annual order cost = 16.51 220/4 = $908.30
• Optimal order size Q = 1,000/16.5 = 60.57 tons per order
• Annual holding cost per supplier = $908.55
• This requires a total capacity per truck of 4 60.57 = 242.28
tons (> 40 tons).
• With a truck capacity of 40 tons, Q from each supplier = 40/4
= 10 tons.
• The order frequency = 1,000/10 = 100 orders/year → increase
the annual order cost to $22,000/year
• The annual holding cost per supplier is decreased to $150.
29