Question

1. Consider a retail store importing unlocked smart phones from overseas. The monthly demand for phones is 100. The store carries half the lead time demand as safety inventory. Each phone costs $450 and the annual holding cost is estimated at 20% of phone value. Assume that the retail store owns the pipeline inventory and that there are 30 days per month. The manufacturer of the phones offers two different shipment options:

i. Ocean freight: Each container carries 500 phones and the cost is $2000 per container. The delivery lead time for this option is 30 days.

ii. Air freight: The total annual cost (inventory + transportation) of this option is $20,000.

a. If cost is the only criterion for the store, which transportation option should they choose?

b. Is your answer to part (a) likely to change if the product in question were a toy that cost $10 per unit? Please answer this question qualitatively without solving the problem again.

Answer 1

Question a

The question essentially is economic order quantity.

Monthly Demand = 100 units

Annual Demand = 1200 units

Ordering Cost = $2000 per order

Holding Cost = 20% * 450 = $90

EOQ = squareroot(2 * Demand * order cost/Annual holding cost)

Under Ocean Freight

The economic order quantity = squareroot(2*1200*2000/90)= 231 units

This would mean 1200/231 = 5.2 or 6 orders would need to be placed during the year. Hence the total ordering cost would amount to $2000*6 = $12,000

The holding costs would is the (lead time inventory + safety stock) X holding cost per unit

= (231/2 + 50) X 90 = $14,892.30

Total Cost = 26,892.30

If the company chooses Air Freight the total cost would be only $20,000. Hence it is advisable to use Air freight.

Question b

Yes. If the cost per unit of the product decrease the carrying cost per unit will fall as well. This would increase the economic order quantity and in turn reduce the number of orders. As a result the total ordering cost will decrease. The Total Carrying cost will also decrease. Hence the answer is likely to change to Ocean freight in case the value of the product is $10.