Figi Fabricating Company is reviewing the economic feasibility of manufacturing a part that it currently purchases from a supplier. Forecasted annual demand for the part is 3200 units. Figi operates 250 days per year (50 weeks @ 5 days per week).
Figi's financial analysts have established a cost of capital of 14% on the use of funds for investments within the company. In addition, accounting information shows that a total of 4% of costs were spent on taxes and insurance related to the company's inventory. It has been estimated that another 1.5% was lost due to inventory shrinkage, which included damaged goods as well as pilferage. Finally, 2.5% 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 $2375 was spent on telephone, paper, and postage directly related to the ordering process.
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 company's 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 equipment shows that production capacity will be available for the part being considered. The production capacity is available at the rate of 250 units per week. It is felt that with a short lead-time, schedules can be arranged so that the part can be produced whenever needed. Production costs are expected to be $17 per part.
A concern of management is that setup costs will be significant. The total cost of labor and lost production time is estimated to be $50 per hour, and it will take a full 8-hour shift to set up the equipment for producing the part.
Requirements:
Develop a one-page report for Figi Fabricating 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:
1. Analysis of holding cost, ordering cost (when ordering from supplier), and set-up cost (when producing the part).
2. Develop an inventory policy (how many to order and how frequently) for the following two alternatives (a) ordering a fixed quantity Q from the supplier or (b) ordering a fixed quantity Q from in-plant production. Be sure to include the (1) Optimal quantity Q* and (2) the total annual cost for each option.
3. Make a recommendation as to whether the company should purchase or manufacture the part. What is the savings associated with your recommendation as compared with the other alternative? Besides the differences in cost, what other factors need to be considered?
4. Sensitivity Analysis: Would the decision change if production costs were increased by $0.50 per part (now the production cost would be $17.50)? If so, how?