Question: Cody Ltd. manufactures winter jackets for sale in the United States. Demand for jackets during the season is distributed as follows:
Probability Demand [thousands]
0.1 18
0.2 19
0.4 20
0.2 21
0.1 22
Each jacket sells for $60 and costs $30 to produce. Any leftover jackets at the end of the season are currently sold for $25 at the year-end clearance sale. Holding jackets until the year-end sale adds another $5 to their cost.
A recent recruit has suggested shipping leftover jackets to South America for sale in the winter there rather than running a clearance. Each jacket will fetch a price of $38 in South America and all jackets sent there are likely to sell. Shipping costs add $5 to the cost of any jacket sold in South America.
A. Would you recommend the South American option? How will it impact profitability at Cody Ltd.?
B. On average, how many jackets will Cody Ltd. ship to South America each season?
Hint. To solve the exercise, you need to compare the expected profit for the two options (Current policy; South American options).
Here you pay an inventory cost of $5 for each unit of left over. Therefore, any time you order an additional unit and you won't sell it (= Co) the additional cost for the company is the purchasing cost of the additional unit PLUS the inventory cost of the additional unit (since you don't sell it) MINUS the salvage value.
Moreover, in the South American option, you pay $5 to ship a unit of leftover to South America: this cost adds to the cost of overstocking (Co).