Case Background
Peabody Fabricating Company is currently reviewing the benefits of producing its component over purchasing an identical product from a supplier in the future. The annual demand is 3,200 units, and the cost of capital is 14%, according to financial analysis. According to the accountants from the case study, the insurance and tax bill should be around $24,000. Inventory losses of $9,000 and warehouse operating costs of $15,000.
No matter the quantity bought, a purchase order takes 2 hours to process and arrange. The picture becomes more evident when analyzing the price of 125 orders and considering the average salary of $28 per hour. The typical cost of ordering through phone, paper, and postage was $2,375.
The potential manufacturer will have access to equipment capacity forecasts. There will be five months of production time and a capacity of 1,000 units per month. Those in charge of operations know how to rearrange priorities to make time for manufacturing the component. The average unit cost of production is estimated to be $17.
Management only worries about the high price of preparing everything for this production. Labor and delayed production time are expected to cost an average of $50 per hour. Manufacturing equipment setup to generate the devices will also take 8 hours. This report will analyze whether or not Wagner Fabricating Company can afford to continue purchasing the item from the supplier or whether manufacturing the part in-house would be more efficient.
Analysis of Holding Costs
The analysis of holding costs and factoring in a suitable holding cost rate. First, an investment in inventory yields $0.14 due to a cost of capital of 14%. The second step is dividing $600,000 by $24,000 for taxes and insurance on the stock equaling 0.04 or 24,000. In addition, the overall stock level is used to determine the shrinkage (Heizer et al., 2008). This is 9000 divided by 600,000 to become about 0.015.
The next step is to allocate the warehouse’s operating costs to the total inventory. When 15,000 divided by 600,000 equals 0.025. As a last step in the analysis, the sum of all fractions representing the holding costs to obtain the holding cost percentage is 0.14 + 0.014 + 0.015 + 0.025 = 0.22. By multiplying 0.22 by 100, the annual cost of storing inventory is 22%.
Analysis of the Ordering Costs
This analysis will provide an accurate estimate of the cost per order the supplier charges. To achieve this, it will start by calculating the ordering costs based on the information provided in the report. The ordering costs comprise two components: two hours spent on purchasing operations, which are charged at $28 per hour (Najib et al., 2019). Multiplying $28 by 2 hours gives a value of $56. The second component is the additional processing costs of $2,375 for 125 units. Dividing $2,375 by 125 units gives $19 per unit. Adding the purchase operation cost of $56 to the processing cost of $19, the total cost per order is $75.
Analysis of the Setup Costs
The third section analyzes the costs associated with setting up the industrial activity. The production setup costs are used to compute this amount (Heizer et al., 2008). This is based on an hourly rate of $50, multiplied by the 8 hours that were projected to be necessary to set up the equipment in the provided report. When these numbers, 50 and 8, are multiplied, the result is 400. Hence, in the end, a total of $400 is considered for each configuration.
Development of the Inventory Policy
Cost Reduction for Components Purchased from External Suppliers
Step four (4a) involves creating an inventory policy that minimizes costs for parts purchased at a fixed quantity from an external supplier.
Economic Order Quantity
The information provided allows one to derive an economic order quantity (EOQ). Demand (D) on an annual basis is 3,200, the cost of placing an order is $75, the cost of maintaining the inventory is 22%, and the unit purchase cost (C) for the part is $18. After performing the calculation for the formula, which is (2*3,200*75) divided by (0.22*18), take the square root of the formula. This comes out to 121,212.10. When the square root of this number (121,212.10) is taken, it yields 348.16. Hence, the quantity that should be ordered should be 348.16 parts annually.
Number of Orders Runs Per Year
To calculate the number of orders or production runs per year (N), as well as the demand for the manufactured part that occurs in a given year (D), which equals 3,200 pieces, and the economic order quantity (EOQ) that was discovered above. The EOQ is 348.16 pieces per order. Dividing 3,200 by 348.16 equals 9.19 units.
Cycle Time
To determine the cycle time (T), there is a certain period that the business operates at, which is the equivalent of 250 days every year. We are using the information obtained in the previous paragraph regarding the number of orders placed annually. Take the number of days, 250, and divide it by 9.19. That N equals 250 divided by 9.19, which results in a cycle time of 27.2 days.
Reorder Point (Average Demand)
To get the reorder point (R), take the mean value of the data, which is 64, add 1.24, and then multiply that by the standard deviation, 10. This can be represented mathematically as follows: r = 64 + 1.24 * 10. This will bring the total up to 76.4. This indicates that the ordering point will be set at 76.4 parts.
Stock Level
The average demand can then be used to determine the stock level (S). Find the ordering point by subtracting it from the mean demand (64). From this, it seems that S = -76.4%64. It adds up to 12 and a half. This results in a 12.4-part buffer stock.
Estimated Maximum Inventory
Add the OEQ 348.16 and the safety stock level to compute the estimated maximum inventory. One can find both of these numbers in part E. This 348.16 + 12.4 is equivalent to 360.56 individual parts.
Average Stock
With a maximum level of 360.56 parts, the inventory is reduced to the safety stock level of 12.4 on an average cycle calculation and with an average of 360.56 and a buffer of 12.4, divided by 2. 360.56 + 12.4 + 2 = this value. Thus, we can expect an average stock of 186.48 units.
Annual Holding Cost
For calculating the annual holding cost, the typical inventory is above, which is 186.48 components. The holding fees amount to 22% of the total investment, while the unit cost is $18. The calculation is 186.48 times 0.22 times 18, which is $738.46. As a result, the annual holding costs amount to $738.46.
Annual Ordering Costs
The annual ordering costs can be determined by multiplying the number of orders per year, which is 9.19, by the cost per order, which is $75. Thus, the resulting calculation is 9.19 multiplied by 75, which equals $689.25. Therefore, the total ordering cost per year amounts to $689.25.
Annual Manufacturing Costs
The annual requirement of 3,200 units is multiplied by the purchase price of $18 per unit to calculate the cost of purchasing from the outsourced supplier. When this calculation is performed, 3,200 multiplied by 18 equals $57,600. Therefore, the annual cost of the manufactured units amounts to $57,600 if purchased from the outsourced supplier.
Total Annual Outsourcing Costs
The total cost of outsourcing parts is determined by multiplying 3,200 parts per year by $18 per part, adding the annual holding costs, which were determined to be 738.46. The result is then added to the overall ordering expenses, which were determined to be 689.25. This looks like 3,200 * 18 + 738.46 + 689.25 equaling 59,027.71. Thus, the total annual expenditures of outsourcing parts amount to $59,027.71.
Cost Efficiency in Internal Production of Components
In step four (4b), the objective is to create an inventory policy that minimizes costs when a fixed quantity of a part is ordered from an in-plant production.
Economic Order Quantity
The economic order quantity or EOC will be computed whenever the optimal quantity order for in-plant production is determined. The notation for this formula is the square root of the product of the number 2 and the products of demand and the cost of placing an order. The total is then divided by the sum of the product of the holding cost and the number obtained by subtracting the demand from one and dividing that result by the production order (Najib et al., 2019).
Calculate the square root of the result obtained by multiplying two by 3, dividing the product of 3,200 and 400 by the difference between 1 and 3,200 divided by 12,000, and then multiplying the quotient by 0.22 and 17. The optimum number of units to order based on output levels inside the factory equals 966.13 units.
Number of Order Runs
The number of order runs is calculated by dividing the annual demand by optimal quantity, i.e., 3,600 / 98 = 36.73. In addition, the number of production runs is derived by dividing the yearly market by Production capacity per month; 3,600 / (1,000 x 5) = 0.72. Therefore, the number of order runs per year is 37, and the number of production runs per year is 1.
Reorder Point
The reorder point is given by:
where,
- L = Lead time = seven days
- Z = Z-value for one stock-out per year at 95% service level = 1.65
- σ = Standard deviation of demand during lead time = 10 units
Substituting the values;
Therefore, the reorder point is 191 units.
Recommendations and Conclusion
Peabody Fabricating Company should manufacture the part rather than buy it from the supplier because of the high holding cost, ordering cost, and setup cost. The purchasing price of $18 is more than the production cost of $17 (Heizer et al., 2008). In addition, the corporation has spare capacity in its manufacturing departments, and the anticipated machinery usage indicates that production capacity will be available for the component.
The company can improve its inventory policy and cut its overall annual cost of production by making the part in-house. Since the facility can produce 1,000 units per month and can do so for up to five months, this is the optimal quantity Q* for in-plant production (Heizer et al., 2008). There should be five production cycles per year, with a 2-month cycle period. The average demand during a two-week lead time suggests that a reorder point of 128 units is appropriate. The recommended safety stock is 40 units, and the SLA for a single stock-out each year.
References
Heizer, J., Render, B., & Munson, C. (2008). Operations management. Prentice-Hall.
Najib, H., Kurnia, C., & Rimawan, E. (2019). Analysis of Operational Management of Forwarder Service Companies PT. Jaya Lautal Global. International Journal of Innovative Science and Research Technology, 4(1), 212-218. Web.