Sunday, August 17, 2008

Economies of scale

Managers may also allow an accumulation of inventory to achieve economies of scale, either in production
or transportation. For example, set-up costs in a given stage of production can drive a manufacturer to produce in large lots. If demand does not occur in similarly large lots, supply demand imbalances and inventories are created. That is, a "clump" of supply is added to the inventory which is only slowly depleted by a more-or-less constant demand, followed by the arrival of another "clump" of supply, etc.. These "waves" of inventory, or cycle stocks, can be a major contributor to the total inventory of a supply chain.
Transportation economies of scale can also cause cycle stocks.
Because the demand process is uncertain, the demand on the inventory during the review period is also uncertain. If demand is weaker than expected, we can end the period with excess inventory; if demand runs unexpectedly high, we may end the period with a signi¯cant number of back-orders.
Note that periodic review introduces cycle stocks, since we must order, on average, enough product to satisfy average demand in a period.
Because of the demand uncertainty, we may want to start the week with more than this average amount of inventory. This excess over the average is called safety stock, since it serves as a hedge against uncertain variations in demand. The presence of a delay (lead time) in the supply process has a similar effect. To see why, suppose we continuously monitor the inventory and suddenly notice that a surge of orders has just come in. We begin increasing the supply to make up for the loss, but the new supplies take some time to arrive. Since the supply cannot exactly track demand, the inventory drops (or perhaps back-orders rise). Alternatively, if suddenly demand drops, we may stop ordering. However, past orders in the pipeline will still arrive, causing the inventory to surge.

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