Order Point Inventory Control

Methods
Chapter 11: Jacobs, Berry, Whybark & Vollmann, MPC 6e
Chapter 10: Chopra & Meindl, SCM 4e
Krajewski & Ritzman, OM, 5e
 Basic Concepts
• The investment in inventory typically represents one
of the largest single uses of capital in a business, often
over 25% of total assets.
• Inventory investment as a percentage of total assets:
– Manufacturing Companies: 10-20%
– Wholesalers and Retailers: 20-50%
• The capital invested in inventories must compete with
other investment opportunities available to the firm.
• The out-of-pocket costs associated with holding
inventory can represent a significant cost.

2
 Basic Concepts (Cont)
• Inventory items
– Dependent demand items
• Raw materials & component parts used in the production of
end products
– Independent (random) demand items
• Finished goods in factories, field warehouse and DCs
• Spare-parts inventories
• Office & factories supplies
• Maintenance materials
• Items for which demand cannot be calculated from a
production schedule or other direct management program
• Items for which demand is primarily influenced by factors
outside of company decisions
3
 Independent Demand Inventories
• These external factors induce random variation in the
demand for these items.
• Demand forecasts are typically projections of
historical demand patterns.
• These forecasts estimate the average usage rate and a
pattern of random variation.
• Order point methods: The inventory management
techniques that are used to determine appropriate
order quantity (lot-sizing) and order timing decisions
for individual independent-demand items under time-
phased planning.

4
 Dependent Demand Inventories
• Demand for these items is directly dependent on
internal factors within the company’s control, such
as the master production schedule (MPS) or final
assembly schedule (FAS) – derived demands.
• These items include raw materials and component
parts used in the production of end products.
• Controlled through material requirements planning
(MRP).

5
 Functions of Inventory
• Transit stock
– Transit stock depends on the time to transport goods from
one location to another.
– Also called pipeline inventories.
– It can be modified by speeding the means of
transportation or decreasing the distance between places.
• Cycle Stock
– Cycle stock exists whenever orders are produced or
purchased in larger quantities than needed to satisfy
immediate requirements (to exploit economies of scale).
– Fixed costs in ordering and transporting items, quantity
discounts, trade promotion

6
 Cycle Inventory
• A lot size or batch size is the quantity that are either
produced or purchased at a time.
• When demand is steady,
Cycle inventory = lot size/2 = Q/2
• Lot sizes and cycle inventory influence the flow time of
material within the supply chain.
• Average flow time (resulting from cycle inventory)
= cycle inventory/demand = Q/2D
• The larger the cycle inventory, the longer is the lag time
between when a product is produced and when it is sold.
(lower cost & risk)

7
 Functions of Inventory (Cont)
• Safety Stock
– Safety stock provides protection against irregularities or
uncertainties in an item demand or supply
• When demand exceeds forecast, or
• When re-supply time is longer than anticipated.
– An important management concern is the amount of
safety stock actually required.
(How much protection is desirable?)
• Anticipation Stock (Seasonal Stock)
– This stock is needed for products with seasonal patterns
of demand and uniform supply.

8
 Routine Inventory Decisions
• How much to order? (size)
• When to order? (timing)
• Inventory decision rules
Order Quantity
Fixed Q Variable S
Order Frequency (quantity) (order-up-to level)
Variable r (reorder point) Q, r S, r
Variable s (s, Q) (s, S)
Fixed T (time between orders) Q, T S, T
Fixed R (review period) (Q,R) (R, S)

9
 Inventory Decision Rules
Rules Review Order Order
Frequency Quantity
(s, Q) Continuous review Reorder point (s) Fixed order quantity (Q)
(s, S) Continuous review Reorder point (s) Max inventory level (S)
(R, S) Periodic review Review period (R) Max inventory level (S)
(R, s, S) Periodic review Review period (R) Max inventory level (S)
& Reorder point (s)

 Q is an order for a fixed quantity Q.

 S is an order up to a fixed expected opening inventory quantity S.
 s is a reorder point.
An order will be placed when the inventory balance drops to s.
 R is a review period.
The inventory will be reviews and ordered every R periods.
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(s, Q) or (Q, r)

11
(s, S)

12
(R, S) or (S, T)

13
 Inventory System Performance
Inventory turnover
• Relates inventory levels to the product’s sales volume.
• Inventory turnover is computed as annual sales volume
divided by average inventory investment.
• Example: Inventory turnover
= (Sales $200,000) / (Inventory investment $50,000) = 4
That is, the inventory was replaced (turned) 4 times during a
year.
• High inventory turnover suggests a high rate of return on
inventory investment.
• The measure does not reflect benefits of having the
inventory.

14
 Impact of Inventory Turnover
Inventory Turns Average Inventory Carrying Cost at 30% Carrying Cost Savings
1 750,000 225,000 -
2 375,000 112,500 112,500
3 250,000 75,000 37,500
4 187,500 56,250 18,750
5 150,000 45,000 11,250
6 125,000 37,500 7,500
7 107,143 32,143 5,357
8 93,750 28,125 4,018
9 83,333 25,000 3,125
10 75,000 22,500 2,500
11 68,182 20,455 2,045
12 62,500 18,750 1,705
13 57,692 17,308 1,442
14 53,571 16,071 1,236
15 50,000 15,000 1,071
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Impact of Inventory Turnover (Cont)

Inventory Turns vs. Carrying Costs

300,000
Inventory Carrying Costs
250,000

200,000

150,000

100,000

50,000

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Inventory Turns

The improvement in the number of inventory turns has the

greatest impact if inventory is turned less than 8 times per
year.

16
Impact of Inventory Turnover (Cont)
• If the variable manufacturing cost of an item
is $100.
• Inventory carrying cost = 30%
• Annual turns of 1 would consume $30 in
carrying costs per unit per year.
• 2 turns/year would cost $15.
• 4 turns/year would cost $7.50.
• 8 turns/year would cost $3.75.

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Impact of Inventory Turnover (Cont)

Inventory Turns vs. Holding Costs per Unit

30.00

25.00
Holding Costs per Unit

20.00

15.00

10.00

5.00

0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Inventory Turns

Inventory turns affect the profitability of each item sold.

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Inventory System Performance (Cont)
Fill Rate
• One common measure of inventory-related customer service
performance.
• The fill rate is the percentage of units immediately available
when requested by the customer.
• Example:
– If the annual demand for an items is 1,000 units and 950 units are
supplied directly from inventory, a 95% fill rate is achieved.
– A 95% fill rate means 5% of units requested were not on the shelf
when the customer requested it.
• Some firms now use a dissatisfaction measure to focus
attention on continuous improvement of customer service.

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Inventory System Performance (Cont)
Other measures
• Percentage of different items ordered that were
available
• Number of times shortages occurred in a time period
• Length of time before an item was made available
• Percentage of customers who suffered a lack of
availability

• All these measures attempt to formalize trade-offs in

cost and benefits.

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 Inventory Related Costs
• Order preparation costs
• Inventory carrying costs
• Shortage and customer service costs

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 Order Preparation Costs
• Costs are incurred each time an inventory
replenishment order is placed.
• Included are the variable clerical costs associated
with issuing the paperwork, plus any one time costs
involved in (e.g., transportation costs,
administration work in receiving, buyer time).
• Work measurement techniques can be used to
measure the labor content of order preparation.
• Other order preparation costs may be difficult to
measure
22
 Inventory Carrying Costs
• Costs that are related to inventory quantity, item’s
value and length of time the inventory is carried.
• Included costs are:
1. Cost of capital (opportunity cost) incurred on the
inventory investment, (expressed as an annual interest
rate)
2. Taxes & insurance on inventories
3. Costs of inventory obsolescence (products with short-life
cycles) or spoilage costs (perishable products with shelf
life limitations)

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 Inventory Carrying Costs (Cont)
• Included costs are:
4. Operating costs involved in receiving and storing
inventory
• Occupancy cost / storage space rental costs
• Cost of owning & operating warehouse facilities (costs for
heat, light, refrigeration, and labor)
5. Shrinkage & pilferage

Examples on inventory carrying cost estimation can be found in Stock, J.R. and
Lambert, D.M. 2001. Strategic Logistics Management, 4e. McGraw-Hill.

24
 Example: Inventory Carrying Costs
Cost (and range)
Category as a percent of inventory value
Housing costs 6% (3-10%)
(building rent or depreciation, operating costs,
taxes, insurance)
Material handling costs 3% (1-3.5%)
(equipment lease or depreciation, power,
operating cost)
Labor cost 3% (3-5%)
Investment costs 11% (6-24%)
(borrowing costs, taxes, and insurance on
inventory)
Pilferage, scrap, and obsolescence 3% (2-5%)
Overall carrying cost 26%

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 Shortage & Customer Service Costs
• The costs are incurred when demand exceeds the
available inventory for an item.
• Shortage costs may equal
– The product’s contribution margin (lost sales), or
– Only paperwork required to keep track of a backorder
until a product becomes available.
• The shortage costs tend to be more difficult to
measure if significant customer goodwill is lost.
(customer patronage )
• These are critical in assessing inventory
measurement.

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 Customer Service Measures
• Customer service measures are frequently used as
surrogate measures for inventory shortage cost.
– The fill rate achieved in meeting product demand
• Customer service costs can be estimated by the level
of investment necessary to provide the desired level
of service.
• This is useful in determining customer service
level/inventory trade-offs.

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 Incremental Inventory Costs
• Two criteria for determining which costs are
relevant to a particular inventory
management decisions:
– Does the cost represent an actual out-of-pocket
expenditure or a forgone profit?
– Does the cost actually vary with the decision
being made?
(i.e., purchase cost: fixed or variable? discounts?)

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 Incremental Inventory Costs (Cont)
Example 1:
Determining the item cost used in calculating inventory
carrying cost.

• The item’s cost should represent the actual out-of-pocket

cost of purchasing or producing the item and place it in
inventory. (i.e., an item’s variable material, labor and
overhead costs).
• An element of the overhead cost, such as a cost allocation
for general administrative expenses is not an actual out-of-
pocket expenditure for the item’s cost.

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 Incremental Inventory Costs (Cont)
Example 2:
Measuring the clerical costs incurred in preparing
replenishment orders.

• If the clerical staff size remains constant throughout

the year, regardless of the number of replenishment
orders placed, this cost is not relevant to decision
being made (i.e., the order quantity).

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 Cost Trade-Off
• Order quantity decisions primarily affect the amount of
inventory held in cycle stocks at various points along the
supply chain.
• Large order quantities mean orders placed infrequently
and lead to low annual costs of preparing replenishment
orders
• But it means higher cycle inventory costs of carrying
excessive inventory.
• Determining order quantities focuses on the question of
what quantity provides the most economic trade-off
between order preparation and inventory carrying costs.

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 Cost Trade-Off Example
A LCD TV Set Stocked in a DC
• Average demand at retail stores is 5 units per
weekday or 1,250 units per year
• Replenishment lead time from the DC is one day
(e.g., time for preparing an order and faxing it to the
DC).
• The variable order preparing cost is estimated to be
$6.25
• The inventory carrying cost is estimated to be $25
per unit per year.
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 Cost Trade-Off Example (Cont)
Q = 5 units
• Avg. inventory level = Q/2 = 2.5 units
• Carrying cost = 2.5 units × $25/unit/year
= $62.50/year
• Order every day
• Ordering cost = $6.25/order × 250 order/year
= $1,562.50/year
• Total Cost = $1,625/year
Q = 25 units
• Avg. inventory level = Q/2 = 12.5 units
• Carrying cost = 12.5 units × $25/unit/year
= $312.50/year
• Order every week
• Ordering cost = $6.25/order × 50 order/year
= $312.50/year
• Total Cost = $625/year
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Economic Order Quantity (EOQ) Model
• EOQ model describes the relationship between costs of
placing orders, cost of carrying inventory and the order
quantity.
• EOQ assumptions:
– The demand rate is constant.
– The costs remain unchanged.
– Production and inventory capacity are unlimited.
No constraints on the size of each lot.
– Decision for one item can be made independently of decisions
for other items.
– There is no uncertainty in lead time or supply.

34
 EOQ Model (Cont)
• The total annual cost equation for the EOQ:
TAC = Annual Ordering Cost
+ Annual Inventory Carrying Cost
= (D/Q) CP + (Q/2) CH

D = Annual demand for the item

Q = Order quantity
CP = Cost of order preparation or Setup cost
Q/2 = Average inventory
CH = Inventory carrying cost per unit per year

35
 The LCD TV Set Example (Cont)
• D = 1,250; CP = 6.25; CH = 25
• TAC = (1,250/Q)(6.25) + (Q/2)(25)
• Q = 25 units gives a minimum total
cost.
• As Q is increased,
– Inventory carrying costs increase in
a straight line,
– Ordering cost diminishes rapidly at
first and then at a slower rate as it is
allocated over an increasing
number of units.
• The minimum cost solution exists
where the annual ordering cost
equals annual inventory carrying
cost.

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 EOQ Model (Cont)
EOQ:
Annual Ordering Cost
= Annual Inventory
dTAC  D  C Carrying Cost
= − C P 
2 
+ H
=0
dQ  Q  2
(D/Q) CP = (Q/2)  DC  CH
− C P  2 
H =
Q  2
Q2 = 2 CPD/ CH Q 2
=
2C P D
CH

Q * = EOQ = 2C P D / C H

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 EOQ Model (Cont)
• Differentiate TAC = (D/Q) CP + (Q/2) CH with respect to Q &
solve by setting the resulting equation equal to 0.

dTAC  D  CH
= − C P  2  + =0
dQ Q  2
 D  CH
− C P  2  =
Q  2
2
2C P D
Q =
CH

Q * = EOQ = 2C P D / C H

* EOQ = The optimal value of Q

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EOQ Model (Cont)

Slope = 0
dTAC/dQ = 0

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 Economic Time Between Order
• Time Between Order (TBO) is the average elapsed
time between receiving (or placing) replenishment
orders of Q units.
TBOEOQ (in year) = (EOQ/D)
TBOEOQ (in month) = (EOQ/D)(12 months/year)
TBOEOQ (in week) = (EOQ/D)(52 week/year)
TBOEOQ (in days) = (EOQ/D)(365 days/year)

Number of operating
D = Annual demand periods per year

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 Example (Cont)
• EOQ = 2(6.25)(1,250) / 25 = 25
• Number of orders = D/EOQ = 1,250/25
= 50 orders per year
• TBO = 1/ Number of orders = EOQ/D
= (25/1,250)(250) = 25/5
= 5 weekdays (or once every week)
• The rule is (Q,R). Buy 25 units every week.
• Total cost per year = TAC = (D/Q) CP + (Q/2) CH
= (1,250/25)($6.25) + (25/2)($25) = $625

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 Key Point
• Total ordering and holding costs are relatively
stable around the EOQ.
• A firm is often better served by ordering a
convenient lot size close to the EOQ rather
than the precise EOQ.

42
 Effect of Changes
• EOQ = 2C p D / C H
• A change in the demand rate:
– When demand rises, the lot size (and the average
inventory) also rises, but more slowly than actual demand.
– If demand increases by a factor of k, the optimal lot size
increases by a factor of k
– The number of orders placed per year should also increase
by a factor of k
– Flow time attributed to cycle inventory should decrease
by a factor of k

43
 Effect of Changes
• EOQ = 2C p D / C H
• A change in the ordering costs:
– Reducing the ordering costs reduces the EOQ size (and
the average inventory).
– Inventory turns increase.
– This explains why manufacturers are so concerned about
cutting setup time and costs.
– To reduce the optimal lot size by a factor of k, the fixed
ordering cost must be reduced by a factor of k2.
• A change in the holding costs:
– Larger lot sizes are justified by lower holding costs.
44
 Economic Production Quantity (EPQ)
• In EOQ, it is implicitly assumed that the entire lot
arrives at the same time (a replenishment lot
received at a retailer).
• In a production environment, the production
occurs at a specified rate, p.
• Finished units may be used or sold as soon as
they completed at a demand rate, d, where p > d.
• Inventory is thus replenished gradually rather
than in lots.

45
Economic Production Quantity (Cont)
• Inventory builds up at a rate of (p – d) units during
the time when both production and demand occur.
• This buildup continues until the lot size, Q, has been
produced.
• Thus, the (p - d) buildup continues for Q/p days
(i.e., a production time during each cycle).
• The maximum cycle inventory = Imax = (Q/p)(p-d)
• Cycle inventory = Imax/2
• The inventory is then depleted at a rate of d
afterward.
46
Economic Production Quantity (Cont)

p = production rate; d = demand rate; with p > d

TAC = Annual Setup Cost + Annual Inventory Carrying Cost

D  I max 
=  C P +  C H
Q  2 
D Q p−d 
=  C P +  C H
Q 2 p 
47
 Economic Production Quantity (EPQ)
• EPQ = 2C p D p
CH p−d

• EOQ = 2C p D
CH

• Since the second term is a ratio greater than 1, the

EPQ results in a larger lot size than EOQ.
• Cycle length = TBOEPQ = EPQ/D
• Production time per lot = EPQ/p

48
 Quantity Discount Model
• Quantity discounts are price incentives to purchase large
quantities. (Price decreases as lot size increases.)
• A discount is lot size-based if the pricing schedule offers
discounts based on the quantity ordered in a single lot.
• A discount is volume-based if the discount is based on
the total quantity purchased over a given period.
• Basic questions:
– Given a pricing schedule with quantity discounts, what is
the optimal purchasing decision?
– Under what conditions should a supplier offer a quantity
discounts?
49
 All Unit Quantity Discounts
• In all unit quantity discounts, the pricing schedule
contains specifies price breaks.
• A price break is the minimum quantity needed to get a
discount.
• The retailer’s objective is to decide on a lot size that
balances the advantages of lower prices for purchased
materials against the disadvantage of the increased
inventory carrying cost.
• TACi = Annual Purchase Cost + Annual Ordering Cost
+ Annual Inventory Carrying Cost
= (Ci)D + (D/Qi)CP + (Qi/2)hCi
50
Quantity Discount Model (Cont)

51
 Quantity Discount Model (Cont)
• As shown in the graph,
– The EOQ at a particular price level may not be
feasible in the quantity discount model.
– The EOQ at a particular price level may be
feasible but may not be the best lot size.
– A feasible EOQ is the best order quantity is when
it is on the curve for the lowest price level.

52
 Find the Best Lot Size
for the Quantity Discount Model
• Step 1:
– Beginning with lowest price, calculate the EOQ for each
price level until a feasible EOQ is found.
• Step 2:
– If the first feasible EOQ found is for the lowest price level,
this quantity is the best lot size.
– Otherwise, calculate the total costs
• For the first feasible EOQ
• For the larger price break quantity at each lower price level.
The quantity with the lowest total cost is optimal.

53
 Example
Order Quantity Unit Price
0-299 units $60.00
300-499 units $58.80
Over 500 units $57.00

• Annual demand = 936 units

• Ordering cost = $45 per order
• Annual holding cost is 25% of the unit price
• What is the optimal order quantity?

54
 Example (Cont)
• Step 1:
EOQ$57.00 = 2  936  $45 (25%  $57.00) = 77 units → Infeasible EOQ

EOQ$58.80 = 2  936  $45 (25%  $58.80) = 76 units → Infeasible EOQ

EOQ$60.00 = 2  936  $45 (25%  $60.00) = 75 units → Feasible EOQ

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 Example (Cont)
• Step 2:
TACEOQ = TAC75 units
= ($60.00)(936) + (936/75)($45)
+ (75/2)(0.25$60.00) = $ 57,824
TAC300 units = ($58.80)(936) + (936/300)($45)
+ (300/2)(0.25$58.80) = $ 57,382
TAC500 units = ($57.00)(936) + (936/500)($45)
+ (500/2)(0.25$57.00) = $ 56,999 *
• The best purchase quantity is 500 units.
* When discounts are small, holding cost is large, and
demand is small, small lot sizes are better.

56
 Quantity Discount Model
61,000

60,000
Total Annual Cost ($)

59,000
TAC = $57,284
TAC = $57,382
TAC = $56,999
58,000 EOQ = 75

57,000 EOQ = 76

56,000 Feasible @ $60.00

EOQ = 77 Feasible @ $58.80

55,000
Feasible @ $57.00
54,000
0 100 200 300 400 500 600

Q (units)

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 A Cutoff Price (C*)
• Goyal (1995) has determined a cutoff price, C*
above which the optimal solution for all unit
quantity discounts cannot occur.
• Cr = the lowest unit cost above the final
threshold quantity qr
• The cutoff is obtained as follows:
1 DC p h 
C* =  DCr + + qr Cr − 2hCr DC p 
D qr 2 
1  936(45) 25% 
C* = 936(57 ) + + (500 )(57 ) − 2  25%  57  936  45  = $59.73
936  500 2

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 Example: Drugs Online
Order Quantity Unit Price
0-4,999 $3.00
5,000-9,999 $2.96
Over 10,000 $2.92

• Monthly demand = 10,000 bottles

• Ordering cost = $100 per order
• Annual holding cost is 20% of the unit price
• What is the optimal order quantity?

59
 Example: Drugs Online (Cont)
q0 = 0; q1 = 5, 000; q2 = 10, 000; C0 = $3.00; C1 = $2.96; C2 = $2.92
D = 120, 000; CP = $100; h = 20%
2 120, 000 100
Q0 = = 6,324  q1 = 5, 000 (Infeasible)
20%  3
TAC5,000 = $363,900
2 120, 000 100
Q1 = = 6,367  q2 = 10, 000 (Feasible)
20%  2.96
TACEOQ =6,367 = $358,969
2 120, 000 100
Q2 = = 6, 410  q2 = 10, 000 (Infeasible)
20%  2.92
TAC10,000 = $354,520*

• The optimal lot size is much larger than the original EOQ of 6,324
bottles in the case that the manufacturer does not offer any discount.
60
 The Cutoff Price (C*)
1 DC p h 

C* =  DCr + + qr Cr − 2hCr DC p 
D qr 2 

 120,000(100) 20% 
C* =
1
120,000(2.92 ) + + (10,000 )(2.92 ) − 2  20%  2.92  120,000  100
120,000  10,000 2 


= $2.92

• The optimal solution (for all unit quantity discounts) cannot

occur above the cutoff price, C* of $2.92.

61
 Marginal Unit Quantity Discounts
• Marginal unit quantity discounts are also
referred to as multi-block tariffs.
• The pricing schedule specified break points.
• But in this case, the marginal costs of a unit
decreases at a breakpoint (in contrast to the
all unit discount scheme).
• If an order of size q is place, the first q1 units
are priced at C0, the next q2 units are priced at
C1, and so on.
62
 Marginal Unit Quantity Discounts
(Cont)
• Let Vi be the cost of ordering qi units. q0 = 0. V0 = 0.
• Vi = C0 (q1 − q0 ) + C1 (q2 − q1 ) + ... + Ci −1 (qi − qi −1 )
• Consider an order of size Q in the range qi to qi+1 units; the
material cost of each order of Q is given by
Vi + (Q - qi)Ci
• Annual ordering cost = (D/Q)Cp
• Annual holding cost = [Vi + (Q - qi)Ci](h/2)
• Annual material cost = (D/Q) [Vi + (Q - qi)Ci]
• The optimal lot size for price Ci is Qi , if it is feasible,
otherwise one of the break points. 2 D(C + V − q C )
Qi =
p i i i

hCi
63
 Example: Drugs Online (2)
Order Quantity Marginal Unit Price
0-5,000 $3.00
5,000-10,000 $2.96
Over 10,000 $2.92

• Monthly demand = 10,000 bottles

• Ordering cost = $100 per order
• Annual holding cost is 20% of the unit price
• What is the optimal order quantity?

64
 Example: Drugs Online (2) (Cont)
q0 = 0; q1 = 5,000; q2 = 10,000; C0 = $3.00; C1 = $2.96; C2 = $2.92
V0 = 0; V1 = 3(5,000 − 0 ) = $15,000; V2 = 3(5,000 − 0 ) + 2.96(10,000 − 5,000) = 29,800
D = 120,000; C P = $100; h = 20%
2 120,000  (100 + 0 − (0)(3) )
Q0 = = 6,324  q1 = 5,000 (Infeasible)
20%  3
TAC5,000 = $363,900
2 120,000  100 + 15,000 − (5,000)(2.96)
Q1 = = 11,028  q2 = 10,000 (Infeasible)
20%  2.96
TAC10,000 = $361,780
2 120,000  100 + 29,800 − (10,000)(2.92)
Q2 = = 16,961  q2 = 10,000 (Feasible)
20%  2.92
TACQ*=16,961 = $360,365 *

• The optimal lot size is much larger than the original EOQ of 6,324
bottles in the case that the manufacturer does not offer any discount.
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 Quantity Discounts
• Quantity discounts lead to a significant buildup of
cycle inventory in a supply chain.
• In many supply chains, quantity discounts contribute
more to cycle inventory than fixed ordering cost.
• However, quantity discounts are valuable in supply
chain for two main reasons:
– Improved coordination to increase the total supply chain
profits.
– Extraction of surplus through price discrimination

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 Improved Coordination
• A supply chain is coordinate if the decisions
the retailer and supplier make maximize total
supply chain profits.
• With an appropriate quantity discounts, a
manufacturer may ensure that total supply
chain profits are maximized even if the
retailer is acting to maximize its own profits.

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 Quantity Discounts
for Commodity Products
• For commodity products, a competitive market
exists and cost are driven down to the products’
marginal cost.
• The market sets the price and the firm’s objective is
to lower costs.
• Reconsider Drugs Online (DO) example.
– Monthly demand = 10,000 bottles
– Ordering cost = $100/order placed with the manufacturer
– Annual holding cost is 20% of the unit price of $3.
– EOQ = 6,324 bottles with a total annual cost (ordering +
holding) = $3,795.
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 Quantity Discounts
for Commodity Products (Cont)
• Each time DO places an order, the manufacturer has
to process, pack, and ship the order. (MTS product)
– A fixed order filling cost = $250
– A production cost = $2/bottle
– A holding cost = 20%
• If DO orders in lot sizes of 6,324 bottles, the total
annual cost for the manufacturer is:
– Annual order filling cost = (120,000/6,324) × $250 = $4,744
– Annual holding cost = (6,324/2) × 20% × $2 = $1,265
– TAC = $6,009
– TAC across the supply chain = $6,009 + $3,795 = $9,804
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 Quantity Discounts
for Commodity Products (Cont)
• As the DO’s order quantity (lot size) increases, the
manufacturer’s costs decreases, but the DO’s cost
increases.
• Thus, the manufacturer must offer DO a suitable
inventive for DO to raise the lot size.
• The quantity discount reduces the material cost for
the retailer (DO) by just enough to offset the
increase in the ordering and holding cost.
• The manufacturer’s and the total supply chain's
profits increase.
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 Key Point
• For commodity products for which price is set
by the market,
– Manufacturers with large fixed costs per lot can
use lot size-based quantity discounts to maximize
total supply chain profits.
– However, this will increase cycle inventory in the
supply chain.

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 Quantity Discounts
When Firm Has Market Power
• A product with demand curve
– Such as a new product with few competitors
• Two pricing schemes that the manufacturer
may use to maximize the supply chain profits,
even though the retailer acts in a way that
maximizes its own profit:
– Two-part tariff
– Volume-based quantity discount
* Assumed no inventory-related cost
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 Example: Drugs Online
• Assume that the DO’s annual demand is given by
the demand curve 360,000 - 60,000p
(p = price at which DO sells the new product).
• Production cost = $2/bottle (same)
• Manufacturer: Price to charge DO?
• DO: Price to charge its customers?

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 Quantity Discounts
When Firm Has Market Power (Cont)
• When the two make their decision independently,
– DO sells the product at $5/bottle
– Manufacturer charges DO at $4/bottle
– Total market demand = 360,000 – 60,000p
= 360,000 – 60,000($5) = 60,000 bottles
– Profit at DO = ($5 – $4)(60,000) = $60,000
– Profit at Mfg. = ($4 – $2)(60,000) = $120,000
– The supply chain profits = $180,000

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 Quantity Discounts
When Firm Has Market Power (Cont)
• When the two coordinate pricing
– DO sells the product at $4/bottle
– Total market demand = 360,000 – 60,000p
= 360,000 – 60,000(4) = 120,000 bottles
– The supply chain profits = (4 – 2)(120,000) = $240,000
(increasing by $60,000)
• “Double Marginalization”
– A loss in profit occurs because the supply chain margin is
divided between two stages.
– Each stage makes its decision considering only its local
margin.

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 Two-Part Tariff
• The manufacturer charges its entire profit as an up-
front franchise fee and then sells to the retailer at
cost.
• It is then optimal for the retailer to price as though
the two stages are coordinated.
– Total SC profit with a price coordination = $240,000
– The profit made by DO when no coordination = $60,000
– Mfg. may construct a two-part tariff by which DO is
charged an up-front fee of $180,000 and material cost of
$2/bottle
– DO maximizes its profit if it prices the product at $4.
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 Volume-Based Quantity Discount
• Design a volume-based discount scheme that also
achieves coordination.
• The average material cost for the retailer declines as it
increases the quantity it purchases per year.
• The manufacturer can price the product in such a way that
the retailer buys the total volume sold when the two
stages coordinate pricing.
– With coordination, total demand = 120,000 bottles/year.
– The Mfg. offer a unit price of $4 for a quantity less than
120,000 bottles, and $3.50 for a quantity of 120,000 or more.
– It is then optimal for DO to order 120,000 bottles and sell
them at $4/bottle.
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 Quantity Discounts
When Firm Has Market Power (Cont)
• For products for which a firm has market power, lot size-
based discount are not optimal for the supply chain, even
in the presence of ordering cost and holding cost.
• With the manufacturer passing on some of the fixed cost
to the retailer, a two-part tariff or volume-based
discount optimally coordinates the supply chain and
maximizes profits, if a demand curve exists.
• More retailers, more complicated, but same basic form
of the optimal pricing scheme.
(Volume-based with average price charged decreasing as
the rate of purchase increases)

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Note on Volume-Based Discount
• With volume-based quantity discount, retailers will
tend to increase the size of lot towards the end of
the evaluation period.
“Hockey stick phenomenon”
• Cycle inventory in the supply chain goes up.
• One possible solution is to base the volume
discounts on a rolling horizon.
• For example, offering the volume discount based on
sales over the last 3 months.

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 Price Discrimination
• Price discrimination is the practice whereby a
firm charges differential prices to maximize
(supplier) profits in a market with multiple
customer segments.
• Airlines: Different airfares for different
seats/schedule.
• Quantity discounts are one of the mechanism
for price discrimination.

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