Question

Managers at Wagner Fabricating Company are reviewing the economic feasibility of manufacturing a part that the company currently purchases from a supplier. Forecasted annual demand for the part is 3,200 units. Wagner operates 250 days a year.

Wagner’s financial analysis established a cost of Capital of 14% for the use of funds for investments within the company. In addition, over the past year $600,000 was the average investment in the company’s inventory. Accounting information shows that a total of $24,000 was spent on taxes and insurance related to the company’s inventory. In addition, an estimated $9,000 was lost due to inventory shrinkage, which included damaged goods as well as pilferage. A remaining $15,000 was spent on warehouse overhead, including utility expenses for heating and lighting.

An analysis of the purchasing operation shows that approximately two (2) hours are required to process and coordinate an order for the part regardless of the quantity ordered. Purchasing salaries average $28 per hour, including employee benefits. In addition, a detailed analysis of 125 orders showed that $2,375 was spent on telephone, paper, and postage directly related to the ordering process.

A one-week lead time is required to obtain the part from the supplier. An analysis of demand during the lead time shows it is approximately normally distributed with a mean of 64 units and a standard deviation of 10 units. Service level guidelines indicate that one stock-out per year is acceptable.

Currently, the company has a contract to purchase the part from a supplier at a cost of $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 the alternative of producing the parts itself.

Forecasted utilization 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 five months of production time available. Management believes that with a two-week lead time, schedules can be arranged so that the part can be produced whenever needed. The demand during the two-week lead time is approximately normally distributed with a mean of 128 units and a standard deviation of 20 units. Production costs are expected to be $17 per part.

A concern of management is that setup costs will be significant. The total cost of labor and lost production time is estimated to be $50 per hour, and a full eight-hour shift will be needed to setup the equipment for producing the part.

Managerial Report

Develop a report for management of Wagner Fabricating that will address the question of whether the company should continue to purchase the part from the supplier or being to produce the part itself. Include the following factors in your report:

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 ordering costs, including the appropriate cost per order from the supplier
4. A development of the inventory policy for the following two (2) alternatives:  
5. 1. Ordering a fixed quantity Q from the supplier
   2. Ordering a fixed quantity Q from in-plant production
6. Include the following in the policies of parts 4(a) and 4(b):
7. 1. Cycle time
   2. Reorder point
   3. Amount of safety stock
   4. Amount of safety stock
   5. Average inventory
   6. Annual holding cost
   7. Annual ordering cost
   8. Annual cost of units purchased or manufactured
   9. Total annual cost of the purchase policy and the total annual cost of the production policy
8. Make a recommendation as to whether the company should purchase or manufacture the part. What savings are associated with your recommendation as compared with the other alternative?

Answer 1

Holding Cost

Cost of capital 14.0%

Taxes/Insurance (24,000/600,000) 4.0%

Shrinkage (9,000/600,000) 1.5%

Warehouse overhead (15,000/600,000) 2.5%

Annual rate 22.0%

Holding Cost

Cost of capital 14.0%

Taxes/Insurance (24,000/600,000) 4.0%

Shrinkage (9,000/600,000) 1.5%

Warehouse overhead (15,000/600,000) 2.5%

Annual rate 22.0%

Holding Cost

Cost of Capital 14%

Taxes/Insurance+Shrinkage+Warehouse Overhead

24,000+9,000+15,000/600,000=8%

Total Annual Rate= 22%

Ordering Cost

2 hours @$28 $56.00

Other Expenses

(2,375/125) + $19.00

______________________________

Total Cost per Order $75.00

Set-up Cost

8 hours @ $50.00

$400.00 per set-up

Inventory policy for the following two alternative:

Ordering from suppliers

Ch=IC=0.22($18.00)=$3.96

Q * = Square root> 2DCo/Ch = Square root>2(3200)75/3.96

= 348.16 units

Number of orders= D/Q= 9.19/year

Re-order point:

r = 64 + 1.24(10)= 76.4

Safety stock = 76.4 - 64= 12.4

Maximum inventory = Q+12.4= 360.56

Average inventory = Q/2+12.4= 186.48

Annual holding cost = 186.48($3.96)= $738.46

Annual ordering cost = 9.19($75) = $689.35

Purchase cost = 3200($18) = $57,600.00

Total annual cost = $59,027.81

Manufacturing

Ch=IC= 0.22($17.00)= $3.74

P= 1000(12) = 12,000/year

Q* = Square root > 2DCo/(1-D/P)Ch= Square root > 2(3200)(400)/(1-3200/1200)3.74= 966.13

Number of production run= D/Q= 3.31/year

Cycle time = 250Q/ D = 250(966.13)/3200= 75.48 days

Re-order point:

r = 128 + 0.52(20) = 138.4

Safety stock= 138.4 - 128= 10.4

Maximum inventory = ( 1- 3200/12000)966.13 + 10.4 = 718.89

Annual holding cost = (354.25 + 10.4)(3.74) = $1,363.79

Annual set up cost = 3.31(400) = $1,324.00

Manufacturing cost= 3200($17)= $54,400.00

Total Annual Cost = $57,087.79

Team Recommendation = Manufactured Part

$59,027.81 – $57,087.79 = $1,940.02 (3.3%)