CASE IN FINANCIAL MANAGEMENT

CASE 18 – INVENTORY (ECONOMIC ORDER

QUANTITY)

1

BACKGROUND OF BOWEN BUILT, INC.

• Founder - Tim Bowen in 1978

• Custom manufacturer for recreational vehicle (RV)

• Produce 11 trailer models for sale in four states through dealers

• Produce certain models for inventory

• Peak period is during mid-spring to mid-fall (6 months)

• Sales credit term 2/10, net 90

• Last year sales $24 million

• Just-in-time system for items costing more than $100

• Two-bin system for items costing less than $20

• Items costing between $20 to $100 has a total inventory of $800,000 (example item is brake pumps)

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INVENTORYBrake pumps

- used at constant rate,

- Uses 12,000 units per year

- Operating time: 50 weeks

- Order cost per order, O: $60

- Carrying cost, c: 20%

- Safety stock: 2 weeks

- Interval time: 2 weeks

3

SUPPLIER

Precision engineering

Kentech Manufacturing, Inc

Option 1 Option 2

Item cost $30 $29 $28.5

Order Quantity/ Standard shipping unit

100 1,000 2,000

Carrying Cost $6 $5.8 $5.7

Ordering Cost $60 $60 $60

Handling cost $300 if more than 100 units

- -

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FORMULA

5

ANSWERSQuestion 1

The total EOQ cost is,

However, Bowen currently ordering 500 units per order. Hence, the total cost of the current order is as follows:

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For Dr. Tareq’s further review

ANSWERS

Question 2

Option 1 Option 2

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ANSWERS

Question 3

Yes, Bowen should use Kentech because they offer pump with lower price than Precision. The lower the price, the lower the carrying cost. Also, there no handling fee per order for Kentech. Bowen can save $300 per order if he use Kentech.

=

H 𝑎𝑛𝑑𝑙𝑖𝑛𝑔 𝑓𝑒𝑒=24×$300=$7200

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ANSWERS

Question 4

Bowen should order 1,000 units with the price $29 per unit. He can save up to $2440.

Option 1 Option 2

Q= 1,000 Q= 2,000

TC (28.5) –TC (29) = $6060-$3620 =$2440

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For Dr. Tareq’s further review

ANSWERS

Question 5

EOQ Assumptions:

• Constant or uniform demand

• Constant unit price

• Constant carrying costs

• Constant ordering cost

• Instantaneous delivery

• Independent orders

• The assumption is reasonable, because Bowen Built Inc use "make-to-stock" strategy and the item has relatively stable demand. Carrying costs and setup or ordering costs are known and relatively stable.

These assumptions have been pointed out to illustrate the limitations of the basic EOQ model and the ways in which it can be easily modified to compensate for them.

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ANSWERS

Question 6

Factors besides EOQ in determining a supplier.

• Terms of credit

• Location of the supplier

• Credit worthiness of the supplier

• Warehousing facilities available with the supplier

• Size of the supplier’s firm and their product quality control

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ANSWERS

Question 7

Cost Reduction by Adjusting Reorder Point:

• Perry decided to study in detail a single item, brake pumps, to help him learn more about the potential savings. Therefore, the specific item that is examined is the brake pumps.

• Annual usage of Brake Pump: 12,000 units

• Operation Time in a Year: 50 weeks

• Weekly usage of Brake Pump: 240 units

• Lead time: 2 weeks 

• Reorder Point when safety stock is generously 2 weeks:

RP = (2 * 240) + 2 * 240 = 960

• Reorder point whe safety stock is trimmed into 1 week:

RP = (2 * 240) + 1* 240 = 720

• Number of orders in a year:

RP (Safety Stock 2 weeks) 12,000 / 960 = 12.5 times

RP (Safety Stock 1 week) 12,000 / 720 = 16.67 times

• Units of safety stock annually:

RP (Safety Stock 2 weeks) 12.5 * 2* 280 = 6,000 units

RP (Safety Stock 1 week) 16.67 *1* 280 = 4,000 units

 

• Total amount of reduction of safety stock: 6,000 – 4,000 = 2,000 units

Total cost reduction by adjusting safety stock : 2,000 units * $30 = $60,000

Cost reduction: $60,000 – ((16.67-12.5)*$300) = $58,750

 

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ANSWERS

Question 8

Carrying Cost:

• Total cost of holding inventory over some period of time

• Short term

• Warehousing costs rent, utilities and salaries, financial costs such as opportunity cost, and inventory costs related to perishability, pilferage, shrinkage and insurance.

• Utilized to help determine how much profit can be made on current inventory

• Helps to find out if there is a need to produce more or less

Carrying cost is expected to be a short term because cost like rent, utilities, insurance, breakage is paid not in a long term basis.

Often the costs are computed for annually and then expressed as a percentage of the cost of

the inventory items [http://www.accountingcoach.com/blog/calcula

te-inventory-carrying-cost] Therefore, the figures that Perry listed includes generally all

of the carrying costs.

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ANSWERS

Question 9

Change in Carrying Cost Affecting EOQ:

• Surely a change in carrying cost will affect the EOQ

• The more carrying cost needed, the lower rate of EOQ will be generated.

• Suppose the carrying cost is now 30 percent, surely this would affect the EOQ. The EOQ will be reduced by around 41% from the EOQ with the carrying cost of 20 percent

• Formula:

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ANSWERS• However, even though a change in

carrying cost influence the overall EOQ, the change will not affect the choice of supplier in this case.

• Because the preference of supplier does not rely on the carrying cost but to the Order Cost per order.

• Carrying cost is a constant in determining such preference in this case.

• Carrying Cost is calculated as Carrying Cost percentage x Cost per unit

• So in this case, we can see the increment in Carrying cost percentage will increase the overall Carrying cost for both of the supplier.

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ANSWERS• We can compare the

calculation of the Carrying Cost of 30 percent carrying cost percentage with the previous level of 20 percent and it will generate the ratio of 1:1.5 equally for all options.

• We can see that the preference choice depends on the Cost per unit instead of the percentage of carrying cost.

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ANSWERS

Question 10

How a growing firm could be profitable but have cash flow problem

• Low profits or losses

• Over-investment in capacity

• Too much stock and poor inventory management

• Allowing customers too much credit

• Overtrading and growing too fast

• Seasonal demand

• Over investment in fixed assets

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ANSWERS

Question 11

Should separate parts inventory into groups according to value?

• It is appropriate to group similar or related parts for inventory relating to the same product and for inventory that cannot be evaluated separately from other parts in that product line because it is not yet considered as finished goods

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SCENARIO ANALYSIS

1. If Precision Engineering dissolve the handling fee, which supplier should Bowen choose?

𝑇𝐶 (30 )=60×12000500

+6×5002

=$2940

𝑇𝐶 (29 )=60×12,0001,000

+5.8×1,000

2=$ 3620

𝑇𝐶 (28.5 )=60×12,0002,000

+5.7×2,000

2=$6060

Bowen should choose Precision

Engineering.

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For Dr. Tareq’s further review

2. If Kentech also apply the special handling fee, which supplier should Bowen choose?

𝑇𝐶 (30 )=360×12000500

+6×5002

=$10140

𝑇𝐶 (29 )=360×12,0001,000

+5.8×1,000

2=$7220

𝑇𝐶 (28.5 )=360×12,0002,000

+5.7×2,000

2=$7860

Bowen should choose Kentech and order 1,000

units.

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For Dr. Tareq’s further review