Operations Management Assignment 3

Operations Management

Assignment 3

Weight: 15% of total grade for the course

Due: Class session week 10

By: Andrew Cheng

Date: 17/7/2007

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Question 1 (75 points, 5-10 pages)

Base on the information provided for the black leather couch from Best for Les Furniture
Store Company retail chain stores in Sydney, we understood that the black leather couch
is considerably a high value (raw cost per unit is c=$500), high turnover item with
average demand of D=50, 60, 80 units per week from the three stores: Boni Junction,
CBD, and Chatswood in Sydney respectively. The standard deviation of weekly demand
is σ =15 units per week for each of the stores. The stores has a structured inventory
system, where each of the stores have a small warehouse to store their inventory and the
stores orders direct from the china factory with a fixed ordering and transportation cost of
K= $10,000, and the holding cost of this particular item is h=$125 (25% of the cost of
couch 0.25 * 500 = 125) per unit per year. When an order is made, stock will arrives in a
lead time of L=4 weeks.

The stores are under different management where the Bondi junction and CBD store are
managed by Danny Johnson who uses a (R, Q) continuous review policy with cycle
service level of 90% where an order of Q quantities of black leather couch is placed
whenever demand empties the inventory to the quantity R which the value of Q and R has
to satisfy that there is a α =90% probability the store will not run out of stock in a single
ordering cycle.

The Chatswood store on the other hand is managed by Lachlan Buford who uses a (T, S)
periodic review policy to order the product every T=3 weeks and fill up the inventory to
an amount S which will satisfy the aims to have only one stockout a year.

To answer your question, we will firstly analyse the stores individually:

Figure 1.
Inventory
Level
Inventory
Position
R+Q=884
Inventory
on-hand

R=239

ss=38.4

Order Order arrieved Order

Time
Inventory graph for Bondi Junction store

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Bondi Junction store

First of all, assuming the supply chain is running efficiently under the (R, Q) policy, we
have the Economic Order Quantity of the black leather couch:

EOQ = √(2KD/h) = √(2 * 10,000 * 50 * 52 / 125) = 644.98 units

AND

R = DLT + ss

Where DLT is the demand during the lead time between the stock ordered and stock
arrived and ss is the quantity of safety stock that accommodates the variance of the
demand during the lead time.

DLT = L * D = 4 * 50 = 200 units

ss = z * σ LT

Where z is the multiple of the standard deviation above the mean that will accommodate
the probability required to have a stockout in a normal distribution; In this case, the
required service level is 90% so by looking up in the Table of Normal Distribution z =
1.28.

ss = z * √L * σ = 1.28 * 2 * 15 = 38.4

R = 200 + 38.4 = 238.4

So this means under an efficient continuous review policy, the Bondi Junction store
should be ordering 645 units every time when inventory depleted to 239 units. This is
illustrated in Figure 1. The store will have the following characteristic:

An average inventory level of ss + EOQ / 2 = 38.4 + 645 / 2 = 360.9 units

An average holding cost of h * 360.9 = 125 * 360.9 = 45,112.5 per year.

An average number of orders D / Q = 50 * 52 / 645 = 4.031 per year

An average purchasing cost of KD / Q = 10,000 * 4.031 = 40,310 per year

And a total inventory related costs; purchasing cost (include ordering costs and
transportation costs), and holding cost (include storage costs, depreciation costs, damage,
insurance, taxes, and administration costs etc) of:

C = Ch + Cp = 45112.5 + 40310 = $85,422.5 per year

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CBD store

The same as the Bondi Junction store, we assume the supply chain is running efficiently
under the (R, Q) policy, we have the Economic Order Quantity of the black leather
couch:

EOQ = √(2KD/h) = √(2 * 10,000 * 60 * 52 / 125) = 706.54 units

AND

R = DLT + ss

Where DLT is the demand during the lead time between the stock ordered and stock
arrived and ss is the quantity of safety stock that accommodates the variance of the
demand during the lead time.

DLT = L * D = 4 * 60 = 240 units

ss = z * σ LT

Where z is the multiple of the standard deviation above the mean that will accommodate
the probability required to have a stockout in a normal distribution; In this case, the
required service level is 90% so z = 1.28

ss = z * √L * σ = 1.28 * 2 * 15 = 38.4

R = 240 + 38.4 = 278.4

So this means under an efficient continuous review policy, the CBD store should be
ordering 707 units every time when inventory depleted to 279 units. And the store will
have the following characteristic:

An average inventory level of ss + EOQ / 2 = 38.4 + 707 / 2 = 391.9 units

An average holding cost of h * 391.9 = 125 * 391.9 = 48,987.5 per year.

An average number of orders D / Q = 60 * 52 / 707 = 4.413 per year

An average purchasing cost of KD / Q = 10,000 * 4.413 = 44,130 per year

And a total inventory related costs; purchasing cost (include ordering costs and
transportation costs), and holding cost (include storage costs, depreciation costs, damage,
insurance, taxes, and administration costs etc) of:

C = Ch + Cp = 48987.5 + 44130 = $93,117.5 per year

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Chatswood Store

With a periodic review policy of interval T = 3 weeks, the Chatswood store orders the
black leather couch 52 / 3 = 17.33 times a year. During those ordering cycles, we will
expect one stockout under the service level Mr. Buford set.

Number of stockout per year NP = (1 - α ) * 1 / T = 17.33 – 17.33α = 1

Cycle service level α = 16.33 / 17.33 = 0.9423 = 94.23%

Look up from the α value in the Normal Distribution Table we can find z = 1.58

The interval between the time an order is placed to the time when the next order arrives is
T + L, this is called the protection interval which the manager has to ensure stockout is
not going to occur during this period base on the cycle service level.

The demand during the protection interval:

DPI = (T + L) * D = (3 + 4) * 80 = 560 units

The standard deviation of the demand during the protection interval:

σ PI = √(T + L) * σ = √(3 + 4) * 15 = 39.68

The safety tock ss = z * σ PI = 1.58 * 39.68 = 62.7

And the stock level we will refill up to every time we order:

S = DPI + ss = 560 + 62.7 = 623

The average level of stock, including the cycle stock, is given by the safety stock plus
half the average order quantity. The average order quantity is the same as the average
demand during the interval T. This gives us:

The average total stock level ss + T * D / 2 = 62.7 + 3 * 80 / 2 = 182.7 units

The average holding cost Ch = h * 182.7 = 125 * 182.7 = $22,837.5 per year

The average purchasing cost Cp = 17.33 * 10,000 = $173,300 per year

The total inventory related cost C = Ch + Cp = 196,137.5 per year

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However, if we change the periodic review policy to a continuous policy for the
Chatsweood store, we would have:

EOQ = 815.84

R = 367.4

So this means under an efficient continuous review policy, the Chatswood store should be
ordering 816 units every time when inventory depleted to 368 units. And the store will
have the following characteristic

An average inventory level of 455.4 units

An average holding cost of $56,925 per year

An average number of orders 5.1 per year

An average purchasing cost of $51,000 per year

And Total inventory related cost of $107,925 per year

Compare to the current $ 196,137.5 per year, there is a saving of $88, 212.5 or a 50%
saving per year.

From the number presented, a three stage recommendation is presented.

Stage 1:

The continuous review policy is more cost efficient due to the fast turnover of the black
leather couch and the large fixed purchase cost. The different costs for the same product
are due to the different review policy which base heavily on the holding cost and
purchasing cost of the product. The different service level is due to the different
inventory size to have a different possible stockout rate.

In the Chatswood store, Mr. Buford has reduce the holding cost of this particular product
but since it’s a level A product which contribute to a large percentage of total sales, it
incur a larger amount of purchasing cost which overwrites any benefit received in the
reduced holding cost. Assuming the company is not going to change the strategy of
selling the leather couch and the market demand is not going to change in a short period
of time, as well as the financial situation can accommodate a continuous review which
orders 816 units, then a continuous review policy should be enforced immediately.

Stage 2:

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Because the black leather couch is not a product that a customer can walk out the store
with it, the inventory does not need to be physically in the store. And in cases of stockout,
the order can be fulfilled by one of the other store. That is why there is no need for three
separate inventories. By locating a central location in a cheaper area close to the stores,
the warehousing cost can be reduced dramatically, considering the equipments, labor
cost, rent, etc. By consolidating the warehouses, we then can also consolidate the
purchases provided that the demands from each store are independent to each other:

Total demand of three stores: DT = 50 + 60 + 80 = 190 units per week

Total standard deviation σ T = √(152 + 152 + 152) = 25.98 units per week

Under a consolidated purchase, the EOQ = 1257.3 units

R = 190 * 4 + 1.28 *2 * 26 = 826.56 using a service level of 90 %

An average inventory level of 629 units

An average holding cost of $78,625 per year

An average number of orders 7.8 per year

An average purchasing cost of $78,000 per year

And Total inventory related cost of $156,625 per year

We will have a further saving around 45% in the purchase cost after Stage 1 has been
completed. The reason we set the service level at 90% is because the product like
mentioned before, is not an item that can be taken by the customer when they do their
regular shopping. Most of time a delivery is needed. So a short time delay in delivering
the product in the case of stockout will not have a major effect the demand of the product.

Stage 3:

Assuming this black leather couch is a standard product with a low demand uncertainty
and a stable supply which is shown from the standard deviation 15 units per week of the
50 – 80 units sold every week in each store, we should focus on producing the highest
cost efficiencies in the supply chain.

This means develop a lean operation with the supplier and within the store. Such
improvement include: production line improvement to reduce cost and increase
efficiency,
Communication between the stores and the supplier in regards to the product. Structure
and improve the logistic system to efficiently move the products from the supplier to the
customers. e.g. Stock ordered in the stores will be deliver to the customer direct from the
warehouse, specially designed shipping container to increase shipping efficiency. And

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most importantly, share the information in regards to of the product. So ideas can be
created by different level of service personal to work towards a lean operation.

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Question 2,

a) With the Basic Model use piston compressors, The critical ratio

Rc = Cu / (Cu + Co), where Co = 100, and Cu = 550-350 = 200

Rc = 0.6666

Refer to the Normal Distribution Table, z = 0.43

Optimal stock Quantity Qpiston* = D + z * σ = 800 + 0.43 * 300 = 929

With the Elite Model use scroll compressors, The critical ratio

Rc = Cu / (Cu + Co), where Co = 120, and Cu = 700 – 520 = 180

Rc = 0.6

z = 0.26

Optimal stock Quantity Qscroll* = D + z * σ = 1200 + 0.26 * 400 = 1304

b) If the optimal order sizes are ordered,

Profit of piston compressor is 100-50 = $50 per unit

929 units are ordered

Total profit of piston compressor are 929 * 50 = $46450

Profit of scroll compressor is 120 – 50 = $70 per unit

1204 units are ordered

Total profit of piston compressor are 1304 * 70 = $91280

Total profit of the supplier are $91280 + $46450 = $137730.

c) By using the scroll compressor to both model of air conditioner models, the cost
structure of the Basic model is changed. Now, Super Cool has to combine the
demand and order for the compressor,

Combine demand Dcombine = 1200 + 800 = 2000

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σ combine = √(4002 + 3002) = 500

Cost of the base model

Co = 120

Cu = 550 – 370 = 180

z is now the same as the Elite model = 0.26

The optimal stock for the combine demand of the scroll compressor Q* = 2000 +
0.26 * 500 = 2130 units.

From the supplier’s point of view, the total number of units ordered is reduced
due to the risk pooling effect on the compressor by Super Cool. The profit is
reduced. The supplier is worse off after the redesign.

However, Super Cool on the other hand after the redesign, High demands that
happen by chance on one model can be compensated for by lower demands from
the other model. Therefore reduce the discarded compressors at the end of the
season. If we don’t consider the cost of the redesign, the product cost of the Basic
model is $20 extra, but the risk pooling effect saves $100 on each piston
compressor discarded at the end of the season. So Super Cool is better off after
the redesign.

d) After the alliance, if we consider the two supply chain parts as one then we will
have:

Cu = 700 – (150 + 50 + 200 + 50) = 250 for Elite model

Cu = 550 – (150 + 50 + 50 + 50) = 250 for Basic model
Co = 50 supplier’s cost of the compressor
Rc = 250 / (250 + 50) = 0.8333
Zz = 0.97
Optimal Ordering Quantity for scroll compressor Q* = 2000 + 0.97 * 500
= 2485 units

This differs from the order quantity in part c) where the Super Cool has to wear
the risk of overstock. Therefore to maximum their profit, Super Cool will not
order the optimal ordering quantity for the entire supply chain. Unless a risk
sharing agreement is in place.

e) If a buyback contract is in place, the supplier and Super Cool share the risk of
overstock For Super Cool, the cost of overstock is reduced and it makes sense to
order more to reduce the chances of understock and profit from the reduced risk.
And for the supplier a larger quantity is ordered from Super Cool produces more

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profit. So the buyback contract helps in reaching the optimal supply chain
ordering policy.
Assuming the compressor wholesale price remains the same, to reach the supply
chain optimum we need a critical ration Rc = 0.8333 calculated in part d)

Cu / (Cu + Co - b) = 0.8333, where b is the buyback price

180 / (180 + 120 – b) = 0.8333

0.8333b = 0.8333 * 300 -180

b = 84

So if the supply chain will have a optimum output when the supplier set a
buyback price of $84.

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