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LGT 3105 Operations Management

JAMIE CHANG Driving home in the frenetic rush-hour traffic, Jamie Chang was upset and discouraged about the events that had taken place that day. Chang’s first major assignment with Plastico, Inc., had involved spending two months reviewing the company’s inventory management procedures, with the aim of making recommendations for improvement. Based on a conversation late in the day with Lynn Rosen, Plastico’s Vice President of Manufacturing, Chang was frustrated that the study to date not only may have focused on the wrong problem, but also that the proposed solution to that problem might be of little value to the company. Jamie Chang was a recent MBA graduate who had accepted a position at Plastico as Lynn Rosen’s assistant for special projects. Rosen’s first assignment for Chang was to determine the validity of Rosen’s perception that the company was carrying far too much inventory of some items but not enough of others. Plastico produced specialty plastics products in a ten-department operation. Chang had been directed to look first at the products made in the five injection molding departments. This assignment was the first experience for Chang in working closely with manufacturing operations. Chang’s career plan, in fact, was to attain a high-level general management position. Plastico had convinced Chang that the company was a good one in which to fulfill that goal. The personal development plan that the company had outlined for Chang involved spending a couple of years in each major functional area of the business so that Chang would have a thorough familiarity with all of the company’s operations before assuming a management position. Chang was a bit uncomfortable with this first assignment in Manufacturing because of having taken no operations management courses other than a required MBA course that was only half as long as most of the other required courses. Being mathematically inclined, however, Chang did recall the brief coverage that had been given to economic order quantity (EOQ) calculations. Upon discovering that Plastico did not employ EOQ to determine inventory levels for specific products, Chang decided that application of EOQ concepts would be appropriate. In exploring this approach, Chang had encountered several data problems. The first was the lack of reliable cost data to use in the EOQ formula. Although this problem had been mentioned in the operations management course, Chang was surprised at the amount of effort required to actually dig out product-by-product cost data. Moreover, it was difficult to get agreement among different people that the resulting costs were reasonably accurate. Chang had spent several weeks in attempting to determine setup costs and inventory holding costs for each of 75 injectionmolded products that Chang had selected as important for study based on an “A-B-C” analysis. Although relatively satisfied with the setup cost estimates, Chang knew that the inventory holding cost rate estimate continued to be a matter of dispute among several people in the company, including some in Marketing and Finance.

testing. Chang understands that orders require processing by the administrative staff. Consequently. however. Having spent nearly two months gathering all of these data. Before sharing these results with Lynn Rosen. State tax is excluded because the tax liability is not . Sales had required only a few days to provide Chang with the new projected one-year estimates for the 75 products. it is easy for Chang to obtain the existing data and apply them. the setup cost per hour is $5*2+$9=$19. the variation during the previous four months had been relatively small for most products. with an annual salary equivalent to $9. It is estimated that any money tied down by them can earn a before-tax return of 12%. Chang deducts state tax. Unit cost: A full unit cost figure includes all direct expenses incurred in producing and selling an item plus an allocation of the company’s total fixed expenses. variable overhead. For setup cost per hour. These quantities had been determined judgmentally by the supervisors of the departments. These products are facing an expanding demand. Chang had arrived at numbers that were generally agreed to be the best possible estimates of future demand on the injection molding departments for each of these products.000 annual machine-hours capacity. Exhibit 3 is a breakdown of the full unit cost for the eight products in Department No. based on the standard 8 hours a day and 300 days a year.00 per hour. not included in the setup cost. Chang therefore took the average order size over this four-month period as the lot size currently in use. the order quantity indicated by the EOQ calculation was significantly lower than the lot size currently used. Chang had proceeded to calculate the EOQ for each product. After adjusting these figures by scrap. The results of these calculations convinced Chang that the great amount of data-gathering time had been well spent. and fixed overhead allocation from the full unit cost and uses the resulting figure as unit cost in the EOQ formula. Chang separated the products by department. five days a week. inspection cost. Chang had decided it would be a good idea first to get the reactions of some department supervisors.00. To facilitate these discussions. The cost parameters used in the EOQ calculation (Exhibit 1) are calculated as follows.1. Although the order quantities for certain items had varied a great deal from year to year. The next step in the analysis had been to determine the order quantities (lot sizes) currently used for each product. This department operated on a three-shift basis. Exhibit 1 is an example showing the current and EOQ lot sizes for eight items produced in Injection Molding Department 1. A quick analysis of the results suggested that Plastico could reduce its average inventory of these items by about 25 percent.By contrast. The other two are paid an hourly rate of $5. Chang bases his calculations on the payment to those working on the line. whose salaries are sunk cost and. giving it 6. thus. One of the three workers is a fulltime employee. Setup cost: Since the company has been monitoring setup hours per order for each of its products. and pilferage loss percentages supplied by Industrial Engineering. Setup cost per order is calculated as setup cost per hour multiplied by setup hours per order. Chang had found that estimates of annual demand for the 75 products were relatively easy to obtain and had been quite reliable over a period of several years. For almost every product.

Garcia had left the room. and year-end inventory tax. Because most of them are smaller than the quantities I’m now running. that’s a 40 percent increase! Rosen would hit the ceiling if I asked for 40 percent more budget for setup labor just to get the same amount of product out the door! If you want to be really helpful to me. shrinkage and obsolescence cost. “Jamie. show me how I can cut inventory without increasing my setup costs. Chang had carefully studied Garcia’s calculations. Chang was careful to point out that the calculations were “rough and tentative” and needed further analysis before they could be used.” With that. After Garcia’s exit. “I’ve been doing some work with these numbers you showed me. two days ago Chang had shown the data in Exhibit 1 to Pat Garcia. Garcia asked to make a copy of the results in order to study them further.” the manufacturing vice president had said with a slight note of mirth. With a sense of great self confidence. “Mind if I have a look at them?” Showing Rosen a portion of the results. Trying several hours to find a way around the problem proved fruitless. I now need only about 540 hours of setup time per year.incurred until the sale of the finished products. . but had shown little reaction to Chang’s assertion that nearly a 25 percent reduction in the average inventory levels for these products was a worthwhile goal. then these EOQ numbers don’t mean a thing to me.” Garcia said. which is the prevailing interest rate for debt available to Plastico. Lynn Rosen had stopped in this afternoon. but I do know that I can’t operate with these new lot sizes of yours. and inspection costs are omitted because Plastico passes per item inspection cost directly to customers at the time of sale. Garcia continued. This morning. Then. I’d have to make a lot more production runs to make the same total number of units. Jamie. The cost of capital is assumed to be 12%. insurance. That would be okay with me if it weren’t for the increase in total setup time that would be required. Garcia had listened patiently to Chang’s explanation of how the new order quantities had been calculated. If you can’t do that. no matter how you calculated them. Chang realized that some way was needed to demonstrate the relationship of total lot-size inventory holding cost to total setup cost. so Chang decided not to show similar results to other supervisors until hearing back from Garcia. I don’t understand all of the EOQ math. Chang was unhappy not to have noticed this before giving Garcia the figures. Garcia had come into Chang’s office carrying several pages of calculations in addition to the ones Chang had done. “I hear you’ve gotten some results on your inventory study. Holding cost percentage: Holding cost is the sum of the cost of capital. Chang concludes that 12%+10%=22% is the appropriate holding cost percentage for the EOQ model. “As you can see. whereas your EOQ numbers would result in more than 750 hours of setup time per year. There was something about Garcia’s reaction and body language that was bothersome. There was no doubt that Garcia’s statement about a 40-percent increase in total setup time was correct. the Department 1 supervisor. The other costs sum up to 10%. although Rosen did not mention it. Overhead costs are left out because they are not production but administrative costs.” Handing Chang a copy of the numbers shown in Exhibit 2. Chang suspected that Rosen already had heard from Garcia the implications of the EOQ calculations. to make matters worse. When Chang had finished presenting the information.

What I’d really like to see is some sort of graph that would show the relationship between customer-service level and inventory investment. Chang had a sudden change of heart: “I’ve had enough of this inventory stuff for today. “The real trouble with this EOQ approach is that it seems to keep you thinking about inventory on a product-byproduct basis. “These EOQ calculations are okay.Rosen had then stood up and said. as that’s becoming more important for us to maintain our competitiveness. You’ve put a lot of time into developing them. Jamie. Rosen had concluded. Chang mused. apparently with a little impatience. The focus on EOQ was a natural one because of remembering that topic from the required MBA operations management course. Pulling into the driveway at home.” Turning to walk out the door. hoping to find a way to overcome Garcia’s objections and salvage at least some of the time and effort that Chang had already invested in this project.” . I’m just going to order a pizza and sip some ‘delightful beverage’ before spending the rest of the evening watching mindless sitcoms on the tube. and I’m sure you’ll be able to make the appropriate adjustments so that they can be used. Chang decided that the first order of business after having some dinner would be to review all of the calculations for Pat Garcia’s department.” Reflecting on the events of the day while driving home. but it was not something that Chang could remember having been discussed in business school. And I’d like to know how much it will cost us to improve our service. I want to know how much unnecessary investment in inventory we’re making now at our present customer-service levels. I hope you’ll give some thought to that. Garcia’s concern about total setup time seemed obvious in retrospect. But your EOQ numbers don’t help me much with some of the other inventory questions I’ve been concerned about. Chang’s mood varied from discouragement to anger. In fact. it was hard to remember having learned anything about inventory control other than how to do EOQ calculations for a particular item. and you end up missing the big picture. Chang also realized that some different approach would be necessary to address Rosen’s concerns. but Chang was not sure where to begin. For example.

065 0.000 Present Order Quantity Setup Product EOQ** Hrs.5 3.000 160.453 23.275 0.0 2.000 5.000 2.5 4.000.000 1.000 960.200.000 180.000 40.156 191.0 $0.501 0.0 × 19 0.5 4.655 0.000 60.200.000 320.000 300.000 1.440. per Unit Cost* Order 6.074 46. For example.060.638 units .047 0.EXHIBIT 1 8 Products from Department no.010 67.00 (same rate for all items in this department). Inventory holding cost = 20% of product unit cost for all items in this department.5 4.000 × 6.000 *Figured on basis of direct labor and material costs **Calculated using the standard EOQ formula with: Setup cost per hour = $18.487 69.205 0.000 400.338 71.655 = 72.200.704 311.836 30. 1 Product Yearly Demand (Units) 3.000 1.0 5.0 6.705 A B C D E F G H 140.085 0.000 80.600.22 × .986 811. for product A the EOQ = 2 × 3.000 100.

9 91.4 47.0 24.3 54.4 .1 hours Note: Yearly setup hours = Product A B C D E F G H Setup Hrs.1 Yearly demand x Setup hrs. Req'd 137.1 34.EXHIBIT 2 Calculation of Setup Time for Present and New Order Quantities Shown in Exhibit 1 Present Order Quantities New Order Quantities (EOQ Calculation) Product A B C D E F G H Setup Hrs.0 80.1 68.0 26.000 = 137.000 × 6.0 539.0 121.2 117.1 125.7 15.8 52.0 For example. item A setup hours = 140.0 36. per order Order quantity 3.200. Req'd 269.9 761.

338 Questions: 1. 4.275 H $ 0. How do you balance your costs with your desire to have the right products for customers? What relationships is Lynn Rosen taking about? Draw it out (and briefly justify).040 $ 0.787 $ 0.500 $ 1.205 E $ 0.395 $ 0.500 $ 1.040 $ 0.050 $ 0.245 $ 0.150 $ 4.500 $ 1. What did Jaime Change overlook in the EOQ study shown to Garcia? 3.040 $ 0.030 $ 2.078 $ 0.050 $ 0.030 $ 2. Are the EOQ calculations correct? 2.040 $ 0.085 G $ 0.050 $ 0.150 $ 4.945 $ 0.500 $ 1.825 $ 0.150 $ 4.030 $ 2.030 $ 2.241 $ 0.500 $ 1.150 $ 3.150 $ 3.EXHIBIT 3 Product Material Direct labor State tax Inspection cost Variable overhead Fixed overhead allocation Full unit cost EOQ unit cost A $ 0.150 $ 4.500 $ 1.030 $ 2.030 $ 2.501 F $ 0.175 $ 0. What factors determine the “right” amount of inventory? .065 D $ 0.047 C $ 0.040 $ 0.055 $ 0.655 B $ 0.030 $ 2.030 $ 2.500 $ 1.040 $ 0.040 $ 0.050 $ 0.040 $ 0.050 $ 0.805 $ 0.500 $ 1.035 $ 0.471 $ 0.017 $ 0.308 $ 0.150 $ 3.015 $ 0.150 $ 3.050 $ 0.625 $ 0.050 $ 0.050 $ 0.