The Inventory Scenario

The managers of Delivery-on-Time, a manufacturing company specialising in household and small farm products, were given a mandate by the Board of Directors for the company to formulate an inventory policy for the company. However, they are not familiar with the various components of inventory management and control that could be considered in for this policy. They have expressed a desire to have a full understanding of concepts such as Economic Order Quantity (EOQ), Economic Production Lot size (ELS), EOQ Discount Model and News Vendor inventory model.

In addition, one of the new managers at Delivery-on-Time Company has suggested that the company reviews the economic feasibility of manufacturing a part that it currently purchases from a supplier. Forecasted annual demand for the part is 3,200 units.

The accounting department at Delivery-on-Time 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 one 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 one 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. The new manager 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 deviation of 20 units. Production costs are expected to be US$17 per part.

A concern of the new manager 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.

In addition to the above scenario, the new manager has also expressed the view the company could explore taking advantage of a proposed quantity discount offer from the supplier. Indications are that the supplier is willing to give the range of discount given in Table 1

Table 1: Discount Consideration for Part

Required

Management has asked that your group prepares and presents a policy framework for the company. Management has asked that the presentation should be in two parts: Part (a) and Part (b). In the spirit of full disclosure, management has informed your group that other groups have been given the same assignment and that any evidence of collaboration will result in the disqualification of your presentation. That is, you are required to present report that reflects independent thinking with your group, and not across groups1.

Part (a)
An overview of the essentials of inventory management and control, including the concepts mentioned in the scenario in this case. That is, an explanation of the following concepts:
1. Economic Order Quantity (EOQ),
2. Economic Production Lot size (ELS),
3. EOQ Discount Model
4. News Vendor inventory model
In discussion with the management team, your group has been made to understand that they are busy and really do not have time to read long presentations. Bearing this in mind, you have decided to keep this section of the presentation within 3000 words.

Part (b)
A report showing all the relevant calculations 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 will address the following:
1. an analysis of the holding costs, including the appropriate annual holding cost rate.
2. an analysis of ordering costs, including the appropriate cost per order from the supplier
3. an analysis of the set up for the production operation
4. an analysis of the following two alternatives:

i. Ordering a fixed quantity Q from the supplier
ii. Ordering a fixed quantity Q from in-plant production The analysis from the combination of 1-4 above will clearly show
(a) The different inventory costs (holding cost, ordering cost, set up cost)
(b) the optimal quantity (Q*),
(c) the number of production runs per year,
(d) the cycle time,
(e) reorder point,
(f) safety stock,
(g) expected maximum inventory level,
(h) annual cost of the units purchased or manufactured.
(i) the cost of purchasing versus the cost of producing,
(j) the optimal quantity under the discount policy.