Economies of Scale in Buying and Production Lots
Producing or purchasing in large lots allows a stage of supply chain to exploit economies of scale and lower cost. These economies of scale result due to fixed costs associated with ordering and transportation, quantity discounts on buying larger lots, and short-term discounts or trade promotions.
If purchasing is done in large lots and consumption is done in smaller lots, when the order is received there is a sharp increase in stock or inventory. This inventory or stock gets depleted as consumption takes place gradually and once again a big lot may be ordered and received. Thus the cycle repeats and the average inventory held by a firm during each cycle is termed cycle inventory.
The inventory holding results in costs for a firm and this cost is called inventory holding cost or inventory carrying cost.
Economic Order Quantity or Production Quantity Formulas
(1) Q = SQRT(2RS/hC)
R = demand in a period (usually a year)
S = Ordering cost
h = holding cost per year per dollar of inventory
C = unit price of the item
To reduce lot sizes that arise due to presence of ordering costs, a number of individual items are ordered in a single order. This will distribute the transportation cost over a number of items and lot sizes for individual items can be small.
To take decisions in case of quantity discounts, the total inventory cost when discount is taken is compared with total inventory cost when discount is not taken and appropriate decision is taken.
In case of trade promotions also retailers compare the total inventory cost when the trade promotion is used to accumulate inventory with the total inventory cost when the trade promotion is not utilized.
Estimating Cycle Inventory Related Costs
Inventory holding cost
Cost of capital
Sunil Chopra and Peter Meindl, Supply Chain Management: Strategy, Planning and Operations, Prentice Hall, 2001. Supply Chain Management: Chopra and Meindl - Book Information and Review
Lee, Hau L., and Corey Billington, "Managing Supply Chain Inventories: Pitfalls and Opportunities," Sloan Management Review, Spring 1992, pp. 65-73
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