Question

Iron-Bit is a manufacturer of industrial drill bits. The management is concerned about the adequacy of the firm’s working capital in funding daily operations.

a) The average collection period and average payment period are 35 days and 30 days respectively. The firm turns over its inventory 20 times each year (assume 365 days year), and currently has annual sales of $185 million.

(i) Calculate the firm’s operating cycle (OC) and cash conversion cycle (CCC), correct to 1 decimal place.

(ii) Determine the amount of resources needed to support the firm’s cash conversion cycle.

b) Iron-Bit purchases 2 million units per year of a component used in drill bits production. The cost per order is $55, while the carry cost is $6 per unit per year.

(i) Calculate the economic order quantity.

(ii) Using your answer in (i), calculate the ordering cost, carrying cost and total inventory cost.

c) Suppose Iron-Bit operates a 250 days per year, and maintains a minimum inventory level of 1500 units of safety stock. If the lead time to receive orders of the component is 3 days, calculate the reorder point.

Answer 1

a)

• Average Collection period = 35 days
• Average Payment period = 30 days
• Inventory holding period = 18 day (365 days/ Inventory Turnover ratio)

i) Operating cycle = Inventory holding period + Average collection period = 18 days + 35 days = 53 days

Cash Conversion cycle = Operating cycle - Average payment period = 53 days - 30 days = 23 days

ii) Calculation of amount of resources to support the firm's cash conversion cycle

Total sales = $ 185 million

Receivables = Total sales x Average collection period / 365 = $ 185 million x 35/365 = $ 17,739,726

Amount of resources to support the firm's cash conversion cycle is $ 17,739,726

b) i) Economic order quantity (EOQ)

EOQ =  

Hear, Annual demand = 2,000,000 units, Order cost per order = $ 55 and Carrying cost per unit = $ 6

EOQ = = 6055.33, EOQ = 6055 Units ( Rounded off)

ii) Ordering cost = Total no. of orders X $ ordering cost per order = 330 orders x $ 55 = $ 18,150

[ Total no. of orders = Total Units/ EOQ = 2,000,000/6055 = 330 Orders (Rounded off) ]

ii) Carrying Cost = 1/2 x EOQ x carrying cost per unit = 1/2 x (6055 x $ 6) = $ 18,165

(iii) Total inventory cost = Total units x cost per unit + Total ordering cost + Total carrying cost

= 2,000,000 x cost per unit + $ 18,150 + $ 18,165

Note : In the given question, cost per unit is missing.

c) Re-order point = (Demand per year / working days per year) x Lead time

= (2,000,000 / 250) x 3 days = 24,000 units

2 X ANNUAL DEMAND X ORDER COST PER ORDER CARRYING COST PER UNIT PER YEAR

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2 X 2,000,000 X S 5.5 S 6