Question

Polar Express Railroad keeps a $5 million inventory of spare parts on hand for repairing unexpected breakdowns and equipment failures. The inventory is held in one centralized warehouse at a storage cost of $330000 per year. The inventory has been financed by a short-term bank loan at 6.5% interest.

The Operations manager has proposed moving the parts from the centralized warehouse to ten storage locations at hubs of the Polar Express network. The required total inventory would increase to $7 million because some parts would have to be held in inventory at all 10 locations. Storage cost would increase to $600000 per year. But having the parts at the hubs would save $400000 per year in labor cost of repairs. Also repairs would be completed quicker, improving customer service.

Evaluate the operation manager's proposal. Assume the opportunity cost of capital is the interest rate on the bank loan.

Answer 1

Answer.

Value of Inventory = $5000000

Rate of Interest=6.5%

Interest on Loan= 6.5% of $5000000

= (5000000*6.5*1)/100

= $325000 p.a.

Centralized storage cost =$ 330000 p.a.

Therefore,

Total Annual Storage Cost of Inventory including Interest=($325000+$330000)= $655,000/- p.a.

After Operation Manager's Proposal

Value of Inventory = $7000,000

Rate of Interest=6.5% (** It is assumed that all the incremental Working capital requirement will also be financed by bank at the same rate of interest)

Interest on Loan= 6.5% of $7000000

= (7000,000*6.5*1)/100

= $455,000 p.a.

Centralized storage cost =$ 600,000 p.a.

Saving in Labour Cost = $ 400,000/- p.a.

So,

Net Annual Storage cost of inventory= ($455,000+$600,000-$400,000)= $655,000/-

Now it is clear from the above two cases that annual storage cost of inventory are same in both cases so if we looking towards the financial perspective i.e. cash flow both the option are neutral so we can accept either of the above two.

However, It is given that in the case of Operation manager's proposal , Company would Complete quicker repairs service and also there is improvement in costumer services which could result in improvement in customer satisfaction so, if we are looking towards the long term perspective Operation Manager's proposal should be accepted. Hence Manager's option is best.

Note :- Opportunity Cost is same in both the cases.