Case Problem 6: Wagner Fabricating Company

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

Wagners financial analysts 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 companys inventory. Accounting information shows that a total of $24,000 was spent on taxes and insurance related to the companys 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 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 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 companys 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 the equipment shows that production capacity will be available for the part being considered. The production capacity is available at the rate of 1000 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 standard deviation of 20 units. Production costs are expected to be $17 per part.

A concern of management is that set up 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 set up the equipment for producing the part.

Managerial Report

Develop a report for management of Wagner Fabricating Company 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:

An analysis of the holding costs, including the appropriate annual holding cost rate.

An analysis of ordering costs, including the appropriate cost per order from the supplier.

An analysis of set up costs for the production operation.

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

Ordering a fixed quantity Q from the supplier

Ordering a fixed quantity Q from in-plant production.

Include the following in the policies of parts 4(a) and 4(b):

Optimal quantity Q*

Number of orders or production runs per year

Clcle time

Reorder point

Amount of safety stock

Expected maximum inventory

Average inventory

Annual holding cost

Annual ordering cost

Annual cost of the units purchased or manufactured

Total annual cost of the units purchased or manufactured

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

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?