Introduction

Good connections are a very large manufacturer and distributer of fastener products such as nails, screws, bolts, rivets, and an assortment of fasteners for specialized applications. It also carries a complete line of tools for commercials applications and is an authorized repair station for most leading brands. One of the most important considerations for retaining customers loyalty and expanding the sales of the company is the inventory management system. In fact the bottom line profitability of Good Connections depends directly on how well the inventory control system functions. On the one hand, if a particular part is not in stock when a customers needs it, the sales will be lost. On the other hand, the fastener industry is very competitive, so if too much inventory is carried, operating cost will also be high and the pricing flexibility of Good Connections will be eroded. Good Connections Carries over 500,000 different items in inventory, ranging from air compressor systems for automatic nailing machines to upholstery tacks. These items vary widely in price, the required ordering lead time, and in the terms of the consequences of a stock out. Each inventory item is arrayed from highest to lowest stocking value. The inventory item are separated into three classes, labeled A, B, and C. The 10% of the inventory item in the A category involves 50% of the cumulative inventory value, and that the 40% of the items in A and B constitutes 82% of the total dollar value. These items tend to be concentrated in class A and class B. Based on the information on the value of each class A and B component, a rational, tailor made safety stock and ordering policy can be established. For most class C items, either the two-bin system or the red line method is used. A red line is painted toward the bottom of the storage bin, and an order is placed as soon as usages depletes the supply to the point where the line is visible. For Class A inventory, Good Connections has the policy of ordering a two-month supply every two months. Similarly, a three-month supply of class B inventory is order every three months. Class C items are order in accordance with the two-bin system; usually a quantity equal to six months usages is ordered. The control process thus concentrates attentions on all class A and Class B inventory, where dollar values are high, ordering lead times are long, or stock out penalties are high.
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Although the process has worked reasonably well for over 10 years, Susan Thortan, the new vice president of finance, beliefs that too much capital is waste fully employed in excess inventory. She points to the fact that the firm has never ever been close to a stock, even when strikes has shut off deliveries critical items. She believes that ordering points and ordering quantities for Class A items should be determined by more sophisticated techniques than are now employed, and that safety stock levels should be reviewed in light of experience. Her preliminary calculation show that turnover can be increased by about 25% if this is done. Manufacturer A is currently the primary supplier of compressed air riveting guns.

Question No. 1
Calculate the economic order quantity for compressed air riveting guns under the assumption of ordering from: a. Manufacturer A ( the current Suppliers) b. Manufacturer B. Which manufacturer should be chosen? Solution:

Annual Requirement (A) Carrying Cost (C)

= = =

12,500 units 26% of $250 $65

Ordering Cost (O)

from Manufacturer A: 15 days delivery (C1) = $120 From Manufacturer B: 20 days delivery (C2) = $ 90

Now Economic Order Quantity (EOQ) = For manufacturer A:

EOQA

= 214.8344622~215 units

For manufacturer B:

EOQB

= 188.1079886 ~ 188 units

Economic Order Quantity from manufacturer A is greater than that from manufacturer from B. So the manufacturer A should be chosen because it refers to the order size or quantity of inventory at which total inventory cost is minimum. It takes the carrying and ordering cost of inventory into considerations to determine the order quantity that minimizes total inventory costs.

Question 2
How many orders should be placed every year under the assumption that they are made: (a) through manufacturer A or (b) through manufacturer B ? assume that the company has a large enough stock on hand to permit deliveries to arrive and note that in a steady state situation there will be always be goods in transit. Solution: Case 1 through manufacturer A Calculation of no. of orders. No of order = = = 58.139 times

Case 1 through manufacturer B Calculation of no. of orders.

No of order =

= 67.204 times

Interpretation: Simply number of orders shows how many times in a year should order must b made in a organization. Talking about manufacturer A and B, As no of order is 58.139times and Bs no. of order is 67.204 times. Therefore manufacturer B should order more than manufacturer A. in case of larger enough stock on hand to permit deliveries to arrive and note that in steady state situation A is best.

Question 3
Assuming that 1,050 riveting guns are now on hand, what is the initial reorder point that is, how low should inventories be permitted to fall before a new order is placed, assuming that is placed with (a) Manufacturer A or (b) Manufacturer B? Use 360 days in a year and assume the absence of safety stock. In how many days, an order should be placed? Also indicate if the inventory is on higher side. Determine the number of orders in transit? Solution: Particulars Initial Reorder Point (units) No. of days to place the order (days) Maximum Inventory Level (units) No. of Order in Transit According to the case we have given, Good connections, Inc have 1050 riveting guns on hand There is 360 days in a year and absence of safety stock, According to manufacturing A, Inventory delivery time=15 According to manufacturing B, Inventory delivery time=20 Now the formula for reorder point is = Safety stock + (Average daily usage x Lead time) According to the case safety stock is zero so putting zero for safety stock ROP for manufacturer A= Safety stock + (Average daily usage x Lead time) = 0 + 12500/360*15 = 521 units ROP for manufacturer A= Safety stock + (Average daily usage x Lead time) =0 + 12500/360*20 = 694 units
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Manufacturing A 521 6.19 736 2

Manufacturing B 694 5.36 880 3

For manufacturer A,

= 6.19 days For manufacturer B,

= 5.36 days

For Manufacturer A

= 736 units For Manufacturer B

= 880 units

For Manufacture A:

= 2.42 i.e. 2 orders in transit

For Manufacture B:

= 3.73 i.e. 3 orders in transit

Question 4
Assume that a safety stock of two months' sales must be kept on hand at all times to provide insurance against running out of stock because of strikes or shipping delays, or because of abnormally high sales during a period when the firm is awaiting receipt of shipments. How this affect should: (a) average inventory held (b) the cost of ordering and carrying inventory and (c) the reorder point? Solution: Managing assets of all kinds is basically an inventory problem, the same method of analysis applies to cash and fixed assets as to inventories themselves. First, a working stock must be on hand to meet expected needs for the item, with the size of the stock depending on expected production and sales levels. Second, because demand may be greater than expected, it is necessary to have a safety stock on hand. The additional costs of holding the safety stock must be balanced against the costs of sales lost due to inventory shortages. A) Here, Carrying cost = = 65 Ordering cost of A = $120 Ordering cost of B = $ 90 Now, Safety Stock = *2

= 2083.33 Economic Order Quantity (EOQ) of A = = =214.83

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Economic Order Quantity (EOQ) of B = = = 186.05

Average Inventory of A = =

+ Safety Stock + 2083.33

= $2190.745 Average Inventory of B = = + Safety Stock + 2083.33

= $2176.3 Safety stock: Safety stock simply is inventory that is carried to prevent stock outs. Safety stock is a term used by logisticians to describe a level of extra stock that is maintained to mitigate risk of stock outs (shortfall in raw material or packaging) due to uncertainties in supply and demand. Adequate safety stock levels permit business operations to proceed according to their plans. Safety stock is held when there is uncertainty in the demand level or lead time for the product; it serves as an insurance against stock outs. Safety stock is normally required by companies to ensure that they have sufficient quantities of material in stock. The safety stock is there to provide coverage for unexpected customer demand, damage in the warehouse or required due to quality issues found in production. However, there are situations where companies do not require inventory to be in stock. These out of stock situations should not be confused with the highly undesirable stock-out predicament where customers orders cannot be shipped or production is halted due to lack of lack of components.

The out of stock situation is beneficial to companies when the company has no demand for certain items and zero inventory means a no warehouse costs. b) Ordering cost Ordering costs include all the costs incurred while placing an order and receiving the order, it does not include the actual cost of the goods. These costs include cost of preparing the order or the invoice, the stationery used, salary of the clerks, telephone costs etc. There is a cost involved in placing each order so firms try to avoid ordering for items individually so what they do is that they place the combined order for many items in one order to reduce the costs. Each order has a fixed costs associated with it and it is independent of the number of items in the order. If the ordering cost is C, the total demand or the number of units required is D and the number of items in an order is Q then:

Total Ordering cost = C D/Q Carrying cost of inventory Because of the increase in the safety stock, the ordering cost will be decrease. As safety stock increases the Reordering point will large and there will incurred less ordering cost. Carrying cost of inventory The cost of carrying inventory is used to help companies determine how much profit can be made on current inventory. The cost is what a business will incur over a certain period of time, to hold and store its inventory. The carrying cost of inventory is often described as a percentage of the inventory value. This percentage can include taxes, employee costs, depreciation, insurance, and the cost of insuring and replacing items. There are four main components to the carrying cost of inventory; capital cost, storage space cost, inventory service cost, and inventory risk cost. Due to large safety stock, there will be large carrying cost of inventory. As safety stock increases, cost to hold and store its inventory will increase which lead to an increase in carrying cost of inventory.

c) Reorder point
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The reorder point ("ROP") is the level of inventory when an order should be made with suppliers to bring the inventory up by the Economic order quantity ("EOQ"). The reorder point for replenishment of stock occurs when the level of inventory drops down to zero. In view of instantaneous replenishment of stock the level of inventory jumps to the original level from zero level. In real life situations one never encounters a zero lead time. There is always a time lag from the date of placing an order for material and the date on which materials are received. As a result the reorder point is always higher than zero, and if the firm places the order when the inventory reaches the reorder point, the new goods will arrive before the firm runs out of goods to sell. The decision on how much stock to hold is generally referred to as the order point problem, that is, how low should the inventory be depleted before it is reordered. The two factors that determine the appropriate order point are the delivery time stock which is the Inventory needed during the lead time (i.e., the difference between the order date and the receipt of the inventory ordered) and the safety stock which is the minimum level of inventory that is held as a protection against shortages due to fluctuations in demand. Therefore: Reorder Point = Normal consumption during lead-time + Safety Stock Several factors determine how much delivery time stock and safety stock should be held. In summary, the efficiency of a replenishment system affects how much delivery time is needed. Since the delivery time stock is the expected inventory usage between ordering and receiving inventory, efficient replenishment of inventory would reduce the need for delivery time stock. And the determination of level of safety stock involves a basic trade-off between the risk of stock out, resulting in possible customer dissatisfaction and lost sales, and the increased costs associated with carrying additional inventory. When the safety stock increases, there will be increase in Reorder point. If there is large safety stock then it leads to an increase in Reorder point.

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Question 5
Assume a safety stock of two months sales. What is the average inventory, including the safety stock, in both dollar amounts ( at cost) and units under each of two alternatives? Solution: One of the most embarrassing situations for a company is to run out of stock. It is very important to calculate safety stock. Safety stock is used as a buffer to protect organizations from stock outs caused by inaccurate planning or poor schedule by suppliers. Safety stock (SS) is extra

inventory held to help prevent stockouts . Stockout cost include loss of profit associate with order not being filled., intangible loss of customer good will.

Annual sales (A) = 12500 units per year Ordering Cost (O) From Manufacturer A: 15 days delivery (O1) = $120 From Manufacturer B: 20 days delivery (O2) = $ 90

Inventory carrying cost (in %) = 26 Carrying Cost (C) = 26% of $250 = $65 Calculation of safety stock Safety Stock = ( Sales/12) *2 [ Two months sales] = (12500 units/12)*2 =$2083.33 Calculation of EOQ for Different Alternatives EOQ shows in what unites order should be placed in 3o days. Under alternative A ( 15 days delivery time) EOQ in units = (2AO/C)
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=(2*12500*120)/65 = 215 Units EOQ in dollar =EOQ in units *cost per unit = 215 units* 250 =$ 53,750 Here EOQ is 215 units which shows that order should be placed for 215 units 12 times a year.

Under alternative B ( 20 days delivery time) EOQ in units = (2AO/C) =(2*12500*90)/65 = 186 Units EOQ in dollar =EOQ in units *Annual sales =186 units*250 =$ 46500 Here EOQ is 186 units which shows that order should be placed for 186 units 12 times a year.

Average Inventory Average inventory consists of the materials, components, work-in-process, and finished product typically stocked in the logistical system. From a policy viewpoint target inventory levels must be planned.

Calculation of Average Inventory for Different Alternatives

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Under alternative A ( 15 days delivery time) Average Inventory in units = Safety Stock +(EOQ in units/2) = $2083.33 +(215/2) = 2190.83 units Average Inventory in dollar= Safety Stock +(EOQ in dollar/2) = $2083.33 +(53750/2) = $ 28958.33 Under alternative B ( 20 days delivery time) Average Inventory in units = Safety Stock +(EOQ in units/2) = $2083.33 +(186/2) = 2176.33units Average Inventory in dollar= Safety Stock +(EOQ in dollar/2) = $2083.33 +(46500/2) = $ 25333.33 EOQ is necessary to identify costs typically associated with ordering and maintaining inventory. If demand is unusually high during lead time, a stock out will occur if there is no safety stock The average inventory can be compared between two alternatives and the alternative A has high average inventory compared to alternative B. From the above table it is seen that alternative A has higher Average inventory i.e 2190.83 units and in dollar $ 1345833.33 as compared to alternative B i.e 186 Units and in dollar =$ 1345833.33 So we should go for alternative B .

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Question 6
What is the total cost of ordering and carrying inventories under each of the two new alternatives and under the present method? Assume that the current safety stock is set at two months' sales, and that the firm orders two months supply every two months, so that the current average inventory is 3,150 units. What is the magnitude of the savings that could be enjoyed by shifting from the present to the EOQ methodology in terms of both dollars and increased turnover of the item. What is the percentage improvement in turnover? Solution:
Particulars Present Manufacturing A No. of Order (times) Average Inventory (units) Total Cost ($) Inventory Turn Over (times) Magnitude of Saving ($) Magnitude Of ITR (times) Improvement of ITR (%) 205470 3.97 6 3150 205290 Manufacturing B Alternative Manufacturing A 58 2191 149375 5.71 $56,095 1.74 43.83 Manufacturing B 67 2177 147535 5.74 57,755 1.77 44.58

Calculation: Assumption: Safety Stock is set at two months sales Firm orders two months supply every two months Current Average Inventory = 3150 units Soln, Present Method:

Manufacturer A ( )

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Manufacturer B ( )

Alternative Method: EOQA = 215 EOQB = 186 Safety Stock = 12500/12 2 = 2083.33 units Average Inventory= S.S. + EOQ/2 No. of Order = A/EOQ Total cost = TOC + TCC Manufacturer A: Average Inventory = 2083.33 + 215/2 = 2190.83 i.e. 2191 units No. of Order = 12500/215 = 58.14 i.e. 58 times Total Cost = 58 120 + 2191 (0.26*250) = $149,375 Manufacturer B: Average Inventory = 2083.33 + 186/2 = 2176.33 i.e. 2177 units No. of Order = 12500/186 = 67.20 i.e. 67 times Total Cost = 67 + 2177 (0.26*250)

= $147,535 Inventory Turnover Ratio = Sales/Avg. Inventory Present Condition: ITR = 12500/3150 = 3.97 times Alternative method: Manufacturing A: ITR = 12500/2191 = 5.71 times 15

Manufacturing B: ITR = 12500/2177 = 5.74 times

Total Cost Saving = (Present Alternate) Total Cost Manufacturing A: Saving = 205,470 149,375 = $56,095 Manufacturing B: Saving = 205,290 147,535 = $57,755

Increase ITR = Alternative ITR Present ITR Manufacturing A: Increase ITR = 5.71 3.97 = 1.74 times In Percentage Improvement = 43.83% Manufacturing B: Increase ITR = 5.74 3.97 = 1.77 times In Percentage Improvement = 44.58%

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Question 7 Which method of ordering inventories should be used? Solution: After looking into the case and solving the given question we found the use of Economic Order Quantity (EOQ) method is useful as the EOQ level is the point at which stocking costs are at their lowest point for a given item. Also EOQ balances supplier/vendor order size, order frequency, the timing of orders and storage and handling to minimize costs and improve efficiencies as orders flow through the supply chain system. Now as we calculated under the EOQ method for two alternatives Manufacturer A and Manufacturer B we find that Manufacturer B has superior advantage on the Total cost (i.e. Total cost of Manufacturer A is higher than Manufacturer B) as the Manufacturer B provides the inventory at a very low ordering cost and the carrying cost of both manufacturer is same. Also, the percentage improvement in inventory turnover ratio (ITR) of manufacturer B over Manufacturer A in comparison to current method is better. So, the company should select the manufacturing B for ordering inventories as per the EOQ method.

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Question 8
In calculating the cost of carrying inventories, the current rate of interest on bank loans was used. Is this an appropriate procedure? Explain your answer. Answer: Yes, it is appropriate. It is used as opportunity cost of the money invested in inventory. The cost of carrying or holding inventory is the sum of the following costs: 1. Money tied up in inventory, such as the cost of capital or the opportunity cost of the money. 2. Physical space occupied by the inventory including rent, depreciation, utility costs, insurance, taxes, etc. 3. Cost of handling the items. 4. Cost of deterioration and obsolescence.

The cost of carrying inventory will vary from company to company. For instance, if a company has a large cash balance with no attractive investment options, has excess space for storage, and its products have a low probability for deterioration or obsolescence, the companys holding or carrying costs are very low. A company with enormous debt, little space, and products subject to deterioration will have very high holding costs. When carrying cost increases, EOQ decreases. It means that when carrying cost increases firm is holding inventory for longer period, due to which all expenses related to carrying cost will increase viz. insurance cost, bank interest etc. Similarly, current rate of interest on bank loan are used while calculating the cost of carrying inventories because of following reasons: If you borrow money to finance your inventory, If you borrow money to finance warehouse equipment or improvements Therefore it is the cost related to carrying inventories. Moreover it is the expenses in the form of opportunity cost. Opportunity cost is the sacrifice related to the second best choice available to someone, or group, which has picked among several mutually exclusive choices. The opportunity cost is also the "cost" (as a lost benefit) of the forgone products after making a choice. Moreover when firm use internal equity to finance the carrying inventory it is expensive source of financing therefore firm use debt to finance. When debt is used firm need to bear interest.
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Question no- 9
Explain some of the lessons learnt from the case. Solution: Learned to calculate and interpret economic order quantity for the compressed air riveting guns under the assumptions of ordering from manufacturing A(the current supplier) and the manufacturer B. Learnt to derive the number of order placed every year under the assumption made I.e through manufacturer A or manufacturer B. Learned to calculate the number of orders in transit and interpret the result. Learned about the method of ordering inventories that can be used in company. Learned to calculate the average inventory including safety stock, inventory turnover, ordering cost and carrying cost.

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