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 injection-
molded 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.
By contrast, 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. Sales had
required only a few days to provide Chang with the new projected one-year estimates for the 75
products. After adjusting these figures by scrap, testing, and pilferage loss percentages supplied
by Industrial Engineering, 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.

The next step in the analysis had been to determine the order quantities (lot sizes) currently used
for each product. These quantities had been determined judgmentally by the supervisors of the
departments. Although the order quantities for certain items had varied a great deal from year to
year, the variation during the previous four months had been relatively small for most products.
Chang therefore took the average order size over this four-month period as the lot size currently
in use.

Having spent nearly two months gathering all of these data, Chang had proceeded to calculate
the EOQ for each product. The results of these calculations convinced Chang that the great
amount of data-gathering time had been well spent. For almost every product, the order quantity
indicated by the EOQ calculation was significantly lower than the lot size currently used. A
quick analysis of the results suggested that Plastico could reduce its average inventory of these
items by about 25 percent.

Before sharing these results with Lynn Rosen, however, Chang had decided it would be a good
idea first to get the reactions of some department supervisors. To facilitate these discussions,
Chang separated the products by department. Exhibit 1 is an example showing the current and
EOQ lot sizes for eight items produced in Injection Molding Department 1. This department
operated on a three-shift basis, five days a week, giving it 6,000 annual machine-hours capacity.

These products are facing an expanding demand. It is estimated that any money tied down by
them can earn a before-tax return of 12%. The cost parameters used in the EOQ calculation
(Exhibit 1) are calculated as follows.

Setup cost: Since the company has been monitoring setup hours per order for each of its products,
it is easy for Chang to obtain the existing data and apply them. Setup cost per order is calculated
as setup cost per hour multiplied by setup hours per order. For setup cost per hour, Chang bases
his calculations on the payment to those working on the line. One of the three workers is a full-
time employee, with an annual salary equivalent to $9.00 per hour, based on the standard 8 hours
a day and 300 days a year. The other two are paid an hourly rate of $5.00. Chang understands
that orders require processing by the administrative staff, whose salaries are sunk cost and, thus,
not included in the setup cost. Consequently, the setup cost per hour is $5*2+$9=$19.

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. Exhibit 3 is a breakdown of the
full unit cost for the eight products in Department No.1. Chang deducts state tax, inspection cost,
variable overhead, and fixed overhead allocation from the full unit cost and uses the resulting
figure as unit cost in the EOQ formula. State tax is excluded because the tax liability is not
incurred until the sale of the finished products, and inspection costs are omitted because Plastico
passes per item inspection cost directly to customers at the time of sale. Overhead costs are left
out because they are not production but administrative costs.

Holding cost percentage: Holding cost is the sum of the cost of capital, shrinkage and
obsolescence cost, insurance, and year-end inventory tax. The cost of capital is assumed to be
12%, which is the prevailing interest rate for debt available to Plastico. The other costs sum up to
10%. Chang concludes that 12%+10%=22% is the appropriate holding cost percentage for the
EOQ model.

With a sense of great self confidence, two days ago Chang had shown the data in Exhibit 1 to Pat
Garcia, the Department 1 supervisor. Garcia had listened patiently to Chang’s explanation of
how the new order quantities had been calculated, 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. When Chang had finished presenting the information, Garcia asked to make a
copy of the results in order to study them further. There was something about Garcia’s reaction
and body language that was bothersome, so Chang decided not to show similar results to other
supervisors until hearing back from Garcia.

This morning, Garcia had come into Chang’s office carrying several pages of calculations in
addition to the ones Chang had done. “Jamie,” Garcia said, “I’ve been doing some work with
these numbers you showed me. I don’t understand all of the EOQ math, but I do know that I
can’t operate with these new lot sizes of yours, no matter how you calculated them. Because
most of them are smaller than the quantities I’m now running, I’d have to make a lot more
production runs to make the same total number of units. That would be okay with me if it
weren’t for the increase in total setup time that would be required.” Handing Chang a copy of the
numbers shown in Exhibit 2, Garcia continued, “As you can see, I now need only about 540
hours of setup time per year, whereas your EOQ numbers would result in more than 750 hours of
setup time per year; 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, show me how I can cut inventory without increasing my setup
costs. If you can’t do that, then these EOQ numbers don’t mean a thing to me.” With that, Garcia
had left the room.

After Garcia’s exit, Chang had carefully studied Garcia’s calculations. There was no doubt that
Garcia’s statement about a 40-percent increase in total setup time was correct. Chang was
unhappy not to have noticed this before giving Garcia the figures. Trying several hours to find a
way around the problem proved fruitless. Chang realized that some way was needed to
demonstrate the relationship of total lot-size inventory holding cost to total setup cost. Then, to
make matters worse, Lynn Rosen had stopped in this afternoon. “I hear you’ve gotten some
results on your inventory study, Jamie,” the manufacturing vice president had said with a slight
note of mirth. “Mind if I have a look at them?” Showing Rosen a portion of the results, Chang
suspected that Rosen already had heard from Garcia the implications of the EOQ calculations,
although Rosen did not mention it. Chang was careful to point out that the calculations were
“rough and tentative” and needed further analysis before they could be used.
Rosen had then stood up and said, apparently with a little impatience, “These EOQ calculations
are okay, Jamie. You’ve put a lot of time into developing them, and I’m sure you’ll be able to
make the appropriate adjustments so that they can be used. But your EOQ numbers don’t help
me much with some of the other inventory questions I’ve been concerned about. For example, I
want to know how much unnecessary investment in inventory we’re making now at our present
customer-service levels. And I’d like to know how much it will cost us to improve our service, as
that’s becoming more important for us to maintain our competitiveness. What I’d really like to
see is some sort of graph that would show the relationship between customer-service level and
inventory investment.” Turning to walk out the door, Rosen had concluded, “The real trouble
with this EOQ approach is that it seems to keep you thinking about inventory on a product-by-
product basis, and you end up missing the big picture. I hope you’ll give some thought to that.”
Reflecting on the events of the day while driving home, Chang’s mood varied from
discouragement to anger. The focus on EOQ was a natural one because of remembering that
topic from the required MBA operations management course. In fact, Chang mused, it was hard
to remember having learned anything about inventory control other than how to do EOQ
calculations for a particular item. Garcia’s concern about total setup time seemed obvious in
retrospect, but it was not something that Chang could remember having been discussed in
business school.

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, 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. Chang also realized that some different approach would be necessary to address
Rosen’s concerns, but Chang was not sure where to begin. Pulling into the driveway at home,
Chang had a sudden change of heart: “I’ve had enough of this inventory stuff for today; 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.”
 EXHIBIT 1

8 Products from Department no. 1

Product Yearly Present Order Quantity Setup Product EOQ**

Demand Hrs. per Unit
(Units) Order Cost*

A 3,200,000 140,000 6.0 $0.655 71,156

B 2,000,000 80,000 5.0 0.047 191,704
C 5,600,000 300,000 6.5 0.065 311,010
D 1,200,000 100,000 4.5 0.205 67,453
E 400,000 60,000 4.0 0.501 23,487
F 960,000 160,000 2.5 0.085 69,836
G 320,000 40,000 4.5 0.275 30,074
H 1,440,000 180,000 3.0 0.338 46,986
1,060,000 811,705

*Figured on basis of direct labor and material costs

**Calculated using the standard EOQ formula with:

Setup cost per hour = $18.00 (same rate for all items in this department).

Inventory holding cost = 20% of product unit cost for all items in this department.

2 × 3,200,000 × 6.0 × 19
For example, for product A the EOQ =
0.22 × .655

= 72,638 units
 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 Setup Hrs. Product Setup Hrs. Req'd

Req'd
A 137.1 A 269.8
B 125.0 B 52.2
C 121.3 C 117.0
D 54.0 D 80.1
E 26.7 E 68.1
F 15.0 F 34.4
G 36.0 G 47.9
H 24.0 H 91.9

539.1 761.4

Yearly demand
Note: Yearly setup hours = x Setup hrs. per order
Order quantity
3,200,000 × 6.0
For example, item A setup hours =
140,000
= 137.1 hours
 EXHIBIT 3

Product A B C D E F G H
Material $ 0.625 $ 0.017 $ 0.035 $ 0.175 $ 0.471 $ 0.055 $ 0.245 $ 0.308
Direct labor $ 0.030 $ 0.030 $ 0.030 $ 0.030 $ 0.030 $ 0.030 $ 0.030 $ 0.030
State tax $ 2.050 $ 2.050 $ 2.050 $ 2.050 $ 2.050 $ 2.050 $ 2.050 $ 2.050
Inspection cost $ 0.040 $ 0.040 $ 0.040 $ 0.040 $ 0.040 $ 0.040 $ 0.040 $ 0.040
Variable $ 0.500 $ 0.500 $ 0.500 $ 0.500 $ 0.500 $ 0.500 $ 0.500 $ 0.500
overhead
Fixed overhead $ 1.150 $ 1.150 $ 1.150 $ 1.150 $ 1.150 $ 1.150 $ 1.150 $ 1.150
allocation
Full unit cost $ 4.395 $ 3.787 $ 3.805 $ 3.945 $ 4.241 $ 3.825 $ 4.015 $ 4.078
EOQ unit cost $ 0.655 $ 0.047 $ 0.065 $ 0.205 $ 0.501 $ 0.085 $ 0.275 $ 0.338

Questions:
1. Are the EOQ calculations correct?
2. What did Jaime Change overlook in the EOQ study shown to Garcia?
3. 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).
4. What factors determine the “right” amount of inventory?