Case study: The Atlantic coast tire corp.

(ACT) problem

The Atlantic Coast Tire Corporation (ACT), who has 250 working days per year, is the
east coast distributor of Eversafe tires. ACT supplies 1,500 retail stores and auto service stations
with a dozen different sizes of Eversafe’s tires, and so must maintain an inventory of each. ACT
stores the tires in its warehouse, from which shipments are continually being made to its various
customers. When the inventory level of a particular size of tire gets low, ACT places a large
order by fax with Eversafe to replenish the inventory. Eversafe then ships the tires by truck to
arrive 9 working days after the placement of the order.
The following information about the 185/70 R13 size of Eversafe tires is given as an
example. These tires have been selling at a regular rate of about 500 per month. Therefore,
ACT’s policy has been to place an order with Eversafe for 1,000 tires as needed every couple
months. The order is placed just in time to have the delivery arrive as the inventory runs out.
Consequently, the inventory level roughly follows the saw-toothed pattern over a year’s time
shown in Figure 4.3. The graph begins at time 0 when a delivery has just arrived. Then, over
each two-month cycle, the inventory level drops at a steady rate from 1,000 to 0, so that the
average inventory level is 500.

Figure 4.3 – The pattern of inventory levels over time for the 185/70 R13 Eversafe tire under ACT’s current inventory policy

This saw-toothed pattern is a common one for inventory levels. This looks like a
reasonable inventory policy. However, the key question is whether 1,000 is the right amount for
the order quantity. Cutting this number down somewhat would reduce the average inventory
level by a proportional amount, but at the cost of increasing the frequency of placing orders.
What the order quantity should be will depend on the various cost factors. Therefore, ACT now
turn their attention to estimating the values of these various costs.
One major cost associated with maintaining the inventory of 185/70 R13 size tires is
ACT’s cost for purchasing the tires. Eversafe charges ACT $20 per tire.
In addition to this purchase price, ACT incurs some additional administrative costs each
time it places an order with Eversafe. A purchase order must be initiated and processed. The
shipment must be received, placed into storage, and recorded in the computerized information
processing system that monitors the status of the inventory. Then the payment to Eversafe must
be processed.
All these steps triggered by placing an order require a significant amount of time from
various employees of ACT. The labor charges (including both wages and benefits) average $15
per hour, and that approximately six hours of labor are associated with placing an order, resulting
in a labor cost of $90. In addition to these direct labor charges, there also are associated overhead
costs (supervision, office space, etc.), which are estimated to be $25. The sum of these two
figures is $115.
When ACT receives a shipment of tires from Eversafe, there are a number of additional
costs associated with holding these tires in inventory until they are sold. The most important of
these costs are the cost of capital tied up in inventory. For example, suppose that there currently
are 1,000 of the 185/70 R13 tires in inventory. The purchase of these 1,000 tires required an
expenditure of 1,000 ($20) = $20,000 (plus a bit more in administrative costs), and this money
will not be regained until the tires are sold. If this capital of $20,000 were not tied up in these
tires, ACT would have other opportunities to use the money that would earn an attractive return.
This lost return because alternate opportunities must be foregone is referred to as the
opportunity cost of this capital. Regardless of whether the $20,000 has been borrowed or comes
from the company’s own funds (or a combination), it is this opportunity cost that reflects the true
cost of tying up this capital in the inventory of tires.
The ACT Comptroller estimates that the cost of capital tied up is 15 percent per annum.
For example, if the average number of tires of this size in inventory during one year is 500, then
the cost of capital tied up in this inventory that year is 0.15 (500 tires) ($20 per tire) = $1,500.
The other kinds of costs associated with holding tires in inventory include:
a. The cost of leasing the warehouse space for storing the tires.
b. The cost of insurance against loss of inventory by fire, theft, vandalism, etc.
c. The cost of personnel who oversee and protect the inventory.
d. Taxes that are based on the value of inventory.
On an annual basis, the sum of these costs is estimated to be 6 percent of the average
value (based on ACT’s purchase price) of the inventory being held. (This is only a rough
estimate since some of these costs may not change when small changes occur in the average
inventory level.)
Adding this 6 percent to the 15 percent for the cost of capital tied up in inventory gives
21 percent per year. Therefore, the total annual cost associated with holding tires in inventory is
21 percent of the average value of these tires ($20 times the average number of tires). In other
words, for the tire size under consideration, this total annual cost per tire is 0.21*($20 per tire) =
$4.20 per tire.
The last major kind of cost that can be incurred as a result of ACT’s inventory policy is
the cost incurred when a shortage occurs. (Although the idealized pattern of inventory levels
shown in Figure 4.3 indicates that shortages do not occur, they actually can happen due to either
a delay in Eversafe’s delivery or larger-than-usual sales orders while the delivery is in transit).
What are the cost consequences when there are not enough tires in inventory to fill the incoming
orders from ACT’s customers immediately? Nearly all these customers are willing to wait a
reasonable period for the tires to become available again, so lost sales in the short run is not a
major consequence. Instead, the important consequences are:
o Customer dissatisfaction which results in the loss of good will and perhaps the
loss of some future sales.
o The potential necessity for ACT to drop its price for tires being delivered late
in order to placate its customers so that they will accept a delay.
o The acceptance of late payments for tires being delivered late, resulting in
delayed revenue.
o The costs of additional record keeping, and other labor costs, required for out-
of-stock tires.
o The total cost resulting from these consequences is roughly proportional to the
number of tires short and to the length of time the shortage continues. This
cost is estimated on an annual basis is $7.50 times the average number of tires
short throughout the year.
For example, in a typical year, suppose that ACT is out of stock for a total of 30 days
(essentially 1/12 of the year) and that the average number of tires short during these 30 days is
120. Since there is no shortage during the remainder of the year, the average number of tires
short throughout the year is 120*(1/12) = 10, so the annual cost is 10 ($7.50) = $75.

Questions:
 When a wholesaler (like ACT) places an order for goods, what can cause the cost
to exceed the purchase price?
 What are cost components of ACT inventory model?