Question

Wagner Fabricating Company 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 3200 units. Wagner operates 250 days per year. Wagner’s financial analysts established a cost of capital of 18% for the use of funds for investments within the company. In addition, over the past year $300,000 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 $6,000 was lost due to inventory shrinkage, which included damaged goods as well as pilferage. A remaining $16,000 was spent on warehouse overhead, including utility expenses for heating and lighting.

An analysis of the purchasing operation shows that approximately two 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 128 orders showed that $2375 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 11 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 1200 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 24 units. Production costs are expected to be $17 per part.

A concern of management is that setup costs will be substantial. The total cost of labor and lost production time is estimated to be $40 per hour, and a full eight-hour shift will be needed to set up the equipment for producing the part.

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 begin to produce the part itself. Include the following factors in your report:

1. A development of the inventory policy for the following two alternatives:

a. Annual holding cost

b. Annual ordering cost

c. Annual cost of the units purchased or manufactured

d. Total annual cost of the purchase policy and the total annual cost of the production policy

Answer 1

Answer:- A.1 Holding cost

Cost of capital. 18%

Taxes / Insurance. 24000/300000= 8%

Shrinkage 6000/300000 = 2%

Warehouse overhead. 16000/300000 = 5.3%

Annual rate. 33.3%

2. Ordering cost

2 hours at $28. $56

Other Expenses. (2375/128) = $18.5

Cost per order. $74.5

3. Set up cost

8 hours at $40. $320 per setup

4. Order from suppliers - EOQ Model

Ch = IC = 0.22($18) = $3.96

Q* = √2DCo / Ch = √2×(3200)74.5/3.96

= $346.99 units

Number of order = D/Q = 9.19/years

Cycle time = 250(Q) /D = 250(346.99)/3200

= $27.10 days

Reorder point

P(stakeout) =1/9.19 = 0.1088

r = 64 +1.24(11) = 77.64

Safety stock = 77.64 - 64 = 13.64

Maximum inventory = Q + 13.64 =346.99+13.64

= 360.63

Average Inventory = Q/2+13.64 = 173.49+13.64

= 187.13

Annual holding cost = 187.13(3.96) = $741

Annual ordering cost = 9.19(74.5)

= $684.65

Purchase cost = 3200(18) = $57600

Total annual cost = $59025.65

B. Manufacture production lot size model

Ch = IC = 0.22(17)= 3.74

P= 1200×12 = $14400

Five month capacity is 5000 Units is sufficient to handle Annual demand of 3200 Units

Q* = √2Dc /(1- D/ P)Ch

= √2×(3200×400)/(1-3200/1200)3.71

= 966.13

Number of production run = D/Q = 3200/966.13

= 3.31/years

Cycle run = 250(Q)/D = 250×966.13 /3200

= 74.48 days

Reorder point

P(stakeout) = 1/3.31 = 0.3021

r = 128+ 0.52(24) =140.48

Safety stock = 140.48 - 128 = 12.48

Maximum inventory = (1-3200/14400).966.13 +12.48

= 227.10

Annual holding cost =(354.25+12.48)3.74

= 1371.57

Annual set up cost = 3.31×400 = $1363.79

Manufacturing cost = 3200 × 17 = 54400

Total annual cost = $57135.36

Recommend the manufacturing part

Saving = 59025.65 - 57135.36

= 1890.29