Question

Patty’s Pots (PP) manufactures large plastic pots for nurseries to grow large tropical plants for hotels and offices. Demand for the pots is fairly even throughout the year.

The pots are manufactured at PP’s plant in Chilliwack, BC. The company has enjoyed significant growth over its five years of operations. As such, Patty Wong, the owner, and CEO of the company would like to ensure the plant is operating efficiently. She has hired you, as a consultant to review the company’s manufacturing and inventory practices.

To assist with your analysis, Patty asked her cost accountant to summarize some of the key financial figures relating to inventory:

• Plastic pellets are the major direct material in the production of the pots. It makes up 85% of the inventory value. Annual current requirements for plastic pellets are 182,160 kg per year.
• Plastic pellets are ordered monthly from Nikolay Plastics Inc. PP has a purchasing agent who contracts with PP to order in the plastic. The agent, who works away from PP’s office, writes up the order on a paper document, faxes it to the supplier and follows up via phone to ensure the order is filled. He charges $380 per order. This is the only order cost incurred.
• Plastic pellet prices for the year average around $1.20 per kilogram.
• Annual costs of warehouse leasing, insurance, utilities and management are $8.80 per kilogram of plastic pellets.

Patty is considering the installation of a just-in-time (JIT) manufacturing system to reduce PP’s costs and be responsive to demand. She has already consulted with an industrial engineer to learn more about how to rearrange her shop floor and create a lean manufacturing environment. Costs and resulting benefits of implementing JIT are as follows:

• The one-time cost to rearrange the shop floor to create manufacturing workstations is $475,000
• Retrain the existing workforce for the JIT required skills is $60,000
• Anticipated defect reduction is 40%. Currently there is a cost of quality defect assessment listed as $150,000 per year.
• PP manufactures its pots using a batch process. The setup time for each of the batches will be reduced by 40% under a JIT system. The current annual setup costs are $350,000.
• A 16% premium on production supplies will be charged as supplies will be delivered on a more frequent schedule. Currently production supplies are $520,000 per year.

Overall, PP expects a return of 15% on all its investments.

(Required begins on the next page)

Required:

1. Inventory control.
   1. Current system: Given current ordering practices, what is the total annual relevant cost of ordering and carrying an inventory.
      
      
      
      
      
      
      
      
      
      
      
   2. Using Economic Order Quantity, what is the optimal order size (in kilograms) PP should use to minimize total annual order and carrying costs.
      
      
      
      
      
      
      
      
      
      
      
   3. Calculate the savings incurred in order using the order quantity calculated in part (ii)
      
      
      
      
      
      
      
      
      
      
      
      

4. Patty informs you that the industrial engineer, hired to assess PP’s manufacturing system, suggested that total inventory carrying costs can be reduced by 50% if inventory is ordered in quantities of 1,380 kilograms.
   
   Explain to Patty the effect this will have on total inventory costs (carrying and ordering) and provide a potential solution to reduce total inventory costs. (Calculations are not necessary).

2. Proposed JIT manufacturing system.
   Determine whether it is in the best interest of Patty’s Pots to install a JIT manufacturing system.
   Focus on:
   1. Relevant manufacturing costs/savings (exclude inventory) and the ability to show a return on the cost. (Remember to identify annual and one-time costs/savings)
   2. The advantages and disadvantages of JIT for PP

Show all calculations and provide a response to Patty which includes pertinent figures from your calculations.

Answer 1

a) Inventory control

i) Total annual relavent cost of ordering and carrying inventory

A relevant cost is a cost that differs between alternatives being considered. In order for a cost to be a relevant cost it must be:

• Future
• Cash Flow
• Incremental

Therefore total relevant cost of ordering and carrying inventory includes;

Cost	$
Ordering cost(380*12)	4560
Carrying cost(182160 kg * 8.80)	1603008
Total relevant cost of ordering and carrying inventory	1607568

Notes-:

• Ordering cost includes those cost which is incurred on ordering a material. Here the only ordering cost is ordering charges.
• Carrying cost are those cost incurred on holding the inventory. That is, it include warehouse leasing, insurance, utilities and management, etc..

ii) Optimal order size using EOQ

EOQ= √((2CoD)/CH)

Where:

D- Annual demand

Co - Cost of one order

CH - Holding cost(one unit per year)

Given;

D=182160

Co= 380 per order

CH= 8.80 per kg

Therefore,

EOQ = √((2*380*182160)/8.8)

=√15732000

= 3966.36 kg

So, the optimal order size using EOQ is 3966.36kg per order

iii) The savings incurred in ordering while implementing JIT

Savings	$
40% savings in cost of quality defectassessment(150000*40%)	60000
40% savings in setup cost(350000*40%)	140000
Total savings	200000

The savings incurred in ordering while implementing JIT inventory system is $.20000

iv) Effect on inventory ordering and carrying cost & solution to reduce it

There will be no effect on the inventory carrying and ordering cost through hiring an industrial engineer. Hiring an industrial engineer can only help in improving the manufacturing efficiency and thereby product quantity. He cannot able to reduce the cost of ordering and carrying the inventory.

The solution to reduce ordering and carrying cosy of inventory are;

• Avoid Minimum Order Quantities
• Know Your Reorder Point
• Organize Your Warehouse
• Get Rid of Obsolete Stock
• Implement a Just-in-Time Inventory System
• Reduce Your Lead Time
• Monitor KPIs
• Use a Perpetual Inventory System

b)Proposed JIT manufacturing system

i.Relevant manufacturing costs/savings;

Cost/(Savings)	$
One time cost to rearrange the floor	475000
Savings in cost of defects assessment (40%*150000)	(60000)
Savings in setup cost(40%*350000)	(140000)
16% premium on production supplies (16%*520000)	83200
Cost of retaining the workforce (not relevant)	0

ii. Advantage and disadvantage of JIT

Advantage	Disadvantage
There is no holding cost.	Higher ordering cost as orders have to be placed frequently.
Better quality of outputs.	Cannot plan production in advance.
Less risk of obsolescence as there is no holding of inventory.	May face inventory shortage situation.