A Make or Buy Analysis
Managers at Wagner Fabricating Company are reviewing the economic feasibility of manufacturing a part that it currently purchases from a supplier. Forecasted annual demand for the project is 3,200 units.
The accounting department at Wagner has established a cost of capital of 14%, for the use of funds for investments within the company. In addition, over the past year US$600,000 has been the average investment within the company’s inventory. Accounting information shows that a total of US$24,000 was spent on taxes and insurance related to company’s inventory. In addition, an estimated US$9,000 was lost due to inventory shrinkage, which included damaged goods as well as pilferage. A remaining US$15,000 was spent on warehouse overhead, including utility expense for heating and lighting.
An analysis of the purchasing operation shows that approximately 2 hours are required to process and co-ordinate an order for the part regardless of the quantity ordered. Purchasing salaries average US$28 per hour, including employee benefits. Also, a detailed analysis of 125 orders showed that US$2,375 was spent on telephone, paper and postage directly related to the ordering process.
Currently, the company has a contract to purchase the part from a supplier at a cost of US$18 per unit. However, over the past few months, the company’s production capacity has been expanded. As a result, excess capacity is now available in certain production departments, and the company is considering that alternative of producing the parts itself.
A 1-week lead-time is required to obtain the part from the supplier. An analysis of the demand during the lead-time shows that lead-time demand is approximately normally distributed with a mean of 64 units. The standard deviation was estimated to be the square root of the mean. Service level guidelines indicate that the company frowns upon more than 1 stock-out per year.
Forecasted utilisation of equipment shows that production capacity will be available for the part being considered. The production capacity is available at the rate of 1,000 units per month, with up to 5 months of production time available. Management believes that with a 2-week lead-time, schedules can be arranged so that the part can be produced whenever needed. The demand during the 2-week lead-time is approximately normally distributed, with mean 128 units and a standard of 20 units. Production costs are expected to be US$17 per part.
A concern of management is that set-up costs will be significant. The total cost of labour and lost production time is estimated to be US$50 per hour. Contractual arrangement and demands of union dictate that the company operates 250 days for the year. Also, an 8-hour shift will be needed to set up the equipment for producing the part
Management has also expressed the desire to take advantage of talk about a quantity discount offer from the supplier. Indications are that the supplier is willing to give the following discount:
Table 1
Order Size Unit Cost
0 - 399 US$18.00
400 - 999 US$17.00
1000 - 1799 US$15.85
1800 and over US$15.00
Required
1. Develop a report for Wagner Fabricating that addresses the question of whether the company should continue to purchase the part from the supplier or begin to produce the part itself. The report should address the following:
a. An analysis of the holding costs, including the appropriate annual holding cost rate.
b. An analysis of ordering costs, including the appropriate cost per order from the supplier
c. An analysis of the set up for the production operation
d. A development for the inventory policy for the following two alternatives:
i. Ordering a fixed quantity Q from the supplier
ii. Ordering a fixed quantity Q from in-plant production
e. The report should include the optimal quantity Q*, the number of production runs per year, the cycle time, reorder point, safety stock, expected maximum inventory level, annual cost of the units purchased or manufactured. You need to give a comparative analysis of the cost of purchasing versus the cost of producing, and the optimal quantity under the discount policy.
2. The push and pull systems of inventory management and control need to understood fully, in order to apply their principles effectively. Discuss, in the context of any manufacturing entity in Jamaica (using appropriate examples, as seen fit). Note, stay within the following word range (WR): 1200 = x = 1600.