Hilton Inc. manufactures electric space heaters. While the CEO, Azra Khan, is visiting the production facility, the following conversation takes place with the plant manager, Paul Lopez:
Azra: As I walk around the facility, I can’t help noticing all the materials inventories.
What’s going on?
Paul: I have found our suppliers to be very unreliable in meeting their delivery commitments. Thus, I keep a lot of materials on hand so as to not risk running out and shutting down production.
Azra: Not only do I see a lot of materials inventory, but there also seems to be a lot of finished goods inventory on hand. Why is this?
Paul: As you know, I am evaluated on maintaining a low cost per unit. The one way that I am able to reduce my unit costs is by producing as many space heaters as possible. This allows me to spread my fixed costs over a larger base. When orders are down, the excess production builds up as inventory, as we are seeing now. But don’t worry—I’m really keeping our unit costs down this way.
Azra: I’m not so sure. It seems that this inventory must cost us something.
Paul: Not really. I’ll eventually use the materials and we’ll eventually sell the finished goods. By keeping the plant busy, I’m using our plant assets wisely. This is reflected in the low unit costs that I’m able to maintain.
If you were Azra Khan, how would you respond to Paul Lopez? What recommendations would you provide Paul Lopez?