Nov 26, 2020 in Business

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Example of Inventory Cost Analysis


Inventory management is a crucial aspect of any organization that wants to succeed in the market. A business will not be able to deliver the required products within the depicted time frame if it does not adopt inventory management approaches. Inventory management seeks to answer the question of what products are required; in what quantities and time frame; who needs these products and what costs are associated with them. This paper analyses the inventory management techniques adopted by Wagner Fabricating Company.

1. Analysis of Holding Cost

The inventory holding cost consists of the cost of capital that would be incurred by tying up the capital in the inventory. This forms the opportunity cost of capital, which denotes the cost in the adoption of a given product in the market. The other elements include insurance and tax costs incurred by keeping the inventory safe; the pilferage and damage costs on inventory; and warehouse overheads such as utility expenses consisting of lighting and heating. Generally, the holding costs are majorly associated with the products held by the company, so that if they are high the company will be compelled to increase the price of the products to offset the costs incurred. However, if the company does not concede price increments it will lead to a reduction in its overall profit margins. This is because the costs will be going up while the price remains the same, which means that in the long run, the profits will decrease immensely (costs are inversely proportional to the profits generated by the company).

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In the case of the company the opportunity cost is 14% of 600,000 = 84,000; insurance and taxes costs = 24, 000; damage and pilferage costs = 9,000; and warehouse overheads = 15,000. The total annual holding cost will therefore be $132,000. The appropriate annual holding cost rate = (purchase cost/ holding cost)*100% = (18/132000)*100% = 0.014%.

2. Analysis of Ordering Cost

Ordering cost includes purchasing salaries such as payment to employees, telephone calls cost, paper, and postage costs. Ordering cost denotes the costs associated with making purchase orders. They include such aspects as salaries, telephone calls, papers, and postages used in making the orders and other payments that may be made to initiate the ordering process in a company. In the case purchasing salaries = 28; the costs of telephone calls, paper, and postage add up to 2375. Thus the total annual ordering cost = 28+2375 = $2,403. Several orders = 125. The annual ordering cost rate = (ordering cost/number of orders) = 2403/125 = $19.22.

3. Analysis of Set Up Cost

This is the same as the ordering cost for the merchandising model. It includes the time taken to set up the equipment during the production process, cost of lost production time, and cost of labor. Often, the setup cost is not well represented in companies. This is because many firms tend to believe that it has an insignificant role in the overall performance. However, the time the employees take to place the equipment and facilities counts because any resources they use are paid for adequately, which means that there is a high cost if more time is taken. Some employees also tend to be paid on a timely basis. Thus, the more such employees work the more money a company has to pay them for the work done. In the case of this company, there is an eight-hour shift for setting up the machines. The total set up cost = ($50*8) = $400.

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4. Developing Inventory Policy

There are two key policies that the company needs to consider; ordering a fixed quantity Q from the supplier and ordering a fixed quantity Q from? plant production.

a) Ordering a Fixed Quantity Q in the Purchase Policy

The inventory policy that will be used is a fixed replenishment point or quantity inventory policy. In this policy, there are two important elements, which are the specific replenishment point and order quantity of a product, R and Q respectively. Replenishment is triggered by R. The range between R to Q represents the reordered number of a product.

b) Ordering a Fixed Quantity Q the In-plant Production

The policy that will be used is a maximum/minimum inventory policy. When the level of inventory available becomes less than the minimum level (s), the company will request a replenishment order to bring back the available inventory to a maximum level (S). The policy will ensure that the company will never run/operate without a maximum level of inventory, this policy aims to avoid shortages that may accrue.

5. Calculations

The in-plant and the purchase ordering fixed quantity policies include the following aspects matched with their respective computations

i. Optimal Quantity Q

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The purchase policy.


(2*3200*2403)/3.92= 1980.7 units

The in-plant production.

Daily usage, U, =3200/250=12.8

P= 1000

Co, Set up cost= 400

CPi= 14%*17=2.38


(2*3200*400)/ (2.38[1-12.8/1000])=1,043 Units

ii. Number of Orders/Production Runs

Number of orders for purchase policy=D/Q=3200/1980.7=1.6= 2 orders

Production runs per year for the in-plant production= Q/P= 1043/ 1000= 1

iii. Cycle Time (Lead Time)

For the purchase policy.

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Lead time = 7 days

For in plant production.

Cycle time =14 days

iv. Reorder Point

Reorder point for the purchase policy.

Daily usage *lead time

(3200/250)*7=90 units

For in-plant production.

ROP= (3200/250)*14=179 Units

v. Safety Stock

Amount of safety stock for purchase policy.




= Safety stock=90-64=26 units

For in-plant production.




= Safety stock= 179-128=51 units

vi. Maximum Inventory/Stock

Maximum stock for the purchase policy= EOQ= 1980.7 Units

Maximum stock/inventory in the in-plant production

Maximum inventory/stock, S, =

1043(1-[12.8/1000]) =1,029.6 Units

vii. Average Inventory/Stock

Average stock for the purchase policy= Q/2= 1980.7/2= 990.35 Units

Average inventory/stock=

1043/2(1-[12.8/1000]) =514.8 Units

viii. Holding Cost

Annual holding cost for purchase policy.

Holding cost=Q/2*Ch=(1980.7/2)*3.92= $3,882.17

Annual holding cost for in-plant production.

Holding cost = Q/2*Ch= (1043/2)*2.38= $1241.17

ix. Ordering Cost

Annual ordering cost for purchase policy.

Ordering cost=D/Q*Co=(3200/1980.7)*2403= $3,882.26

Annual set up cost for in-plant production.

Set up cost=D/Q*Co=(3200/1043)*400= $1227.23

x. Purchase Cost and Manufacturing Cost

Annual purchase cost for the purchase policy.

Purchase cost=D*Cp=3200*18= $57,600

Annual variable/manufacturing cost for the in-plant production.

Variable cost=D*Cp =3200*17

Note: Cp=production/variable cost per unit

Manufacturing cost= $54,400

xi. Total Cost of the Two Policies

Total cost for the purchase policy.

Total cost of inventory = Holding cost + Ordering cost + Purchase cost (Q/2*Ch + D/Q*Co + DCp) = ($3,882.17 + $3,882.26 + $57,600) = $65,364.43.

Total cost for the production policy.

Total cost of inventory = Holding cost + Set up cost + variable/manufacturing cost (Q/2*Ch + D/Q*Co + DCp) = ($1241.17 + $1227.23 + $54,400) = $56,868.40

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6. Recommendation

The company would want to ensure that it adopts the most cost-effective and productive policy. This policy must benefit the firm both in the short term and long term scales otherwise it would prove to be not effective to the company overall. Another aspect the firm takes into consideration is the ease of adopting a given policy to initiate its operations in the market. Thus, in this case, management must answer the questions on whether the policy is productive; easy to implement; And cost superior as compared to the other one. Based on the above premises, since the cost of the production policy is lower than that of the purchase policy, the company should manufacture or produce the parts in its in-plant production. The associated savings from this production policy will be ($65,364.43- $56,868.40) = $8496.03. The amount denotes a huge sum of money that the company will save each financial period. At the same time, it will help the firm better price its products and ensure that it has a better chance to sell its products in the market as compared to other companies that sell the same products.

7. Conclusion

From the analysis denoted above the purchase, policy cost proves to be higher than the cost of production policy. This makes the production policy a better alternative than the purchase policy. Wagner Fabricating Company should adopt the approach that ensures that it incurs the least to increase its profit margins.

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