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Q6.10
Question:
Computer Co uses 25,000 components at an even rate during a year. Each order placed with the supplier of the components is for 2,000 components, which is the Economic Order Quantity. The company holds a buffer inventory of 500 components. The annual cost of holding one component in inventory is $2. What is the total annual cost of holding inventory of the component?
Solution:
Annual holding cost
=[buffer (safety) inventory + reorder level/2] × holding cost per unit
=[500 + (2000/2)] × $2
=$3000My question is, why do we not also average the buffer (safety) inventory? It will fluctuate between 0 and 500 due to variations in lead time and customer demand. If we assume that these variations are even, we can assume there is an average buffer inventory of 500/2 = 250.
Thank you!
Please bear with me as I will attempt to use an analogy to answer your question. I don’t know if you have ever seen the movie “Top Gun”. In said movie, a lot of the movie involves “dogfighting” fighter aircraft training. One of the rules of these simulated Aircraft training is that planes engaged in these battles can’t continue to engage below a “hard deck” altitude of a certain level. This level is say 10000 feet. The reason for this is for this level to represent the ground level. In this way there is margin of safety built into combat aircraft practice. If the pilots make mistakes they “crash” at the “hard deck” level. They lose the engagement but not their lives and aircraft.
In the above stock model the 500 component buffer stock inventory is the equivalent of the “hard deck”. Computer Co never wants to go below this level. It has effectively reset zero to five hundred. This is why the BPP answer is correct. In any normal situation it will never go below 500.
Of course these stock models are simplifications of reality. The key to the question is the following-“Computer Co uses 25,000 components at an even rate during a year. ” This gives a saw tooth style decline and replenishment of stock.
Hi mrjonbain,
Thank you for your reply! However, the stock will actually go below 500. We only reorder at the 500 units level. Then, while waiting for the next delivery of 2000 units, we will deplete at least some of the 500 units, the extent to which will vary depending on lead time and customer demand.
The Top Gun analogy doesn’t hold – the fighters don’t wait until they drop to 1000 feet before activating an intervention, and drop even further below 1000 feet while waiting for their intervention to work.
I was assuming the reoder point was before the point at which the stock was depleted to 500. I don’t see anything specific about the timing of the reorder point. I was working on the assumption that if no buffer or safety stock existed the reorder point would be lead time x demand. The assumption of the model is that demand is constant and predictable as is lead time. If this were really the case then the need for buffer stock would be moot. The whole model is a vast oversimplification of reality but still has some utility.
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