SOUTHERN LUZON STATE UNIVERSITY

College of Engineering
Industrial Engineering Department
Lucban, Quezon

CASE STUDY NO. 4

BUY OR MAKE ANALYSIS

Submitted by:
Fitz Alwyn Lester R. Ambrocio
Anghelo A. De Asis
Garry L. Famorca Jr.
Kristine Anne Inal
Luz Claire G. Orbita
Leechel Ella M. Recalde
BS Industrial Engineering V-GK

Submitted to:
Engr. Maria Rossana D. De Veluz
Systems Engineering
 INVENTORY MODELS
Independent Demand Vs. Dependent Demand
Inventory control models assume that demand for an item is either independent
of or dependent on the demand for other items.
Holding, Ordering, and Setup Costs
Holding cost - The cost to keep or carry inventory in stock. Holding costs also
include obsolescence and costs related to storage, such as insurance, extra staffing, and
interest payments.
Ordering cost is the cost of the ordering process. Ordering cost includes costs of
supplies, forms, order processing, purchasing, clerical support, and so forth.
Setup cost is the cost to prepare a machine or process for production. This includes
time and labor to clean and change tools or holders
Setup time is the time required to prepare a machine or process for production. In
manufacturing environments, setup cost is highly correlated with setup time.
INVENTORY MODELS FOR INDEPENDENT DEMAND
In this section, we introduce three inventory models that address two important
questions: when to order and how much to order. These independent demand models
are:
1. Basic economic order quantity (EOQ) model
2. Production order quantity model
3. Quantity discount model
The Basic Economic Order Quantity (EOQ) Model
The economic order quantity (EOQ) model is one of the most commonly used
inventory-control techniques. This model is an inventory-control technique that minimizes
the total of ordering and holding costs. This technique is relatively easy to use but is based
on several assumptions:
1. Demand for an item is known, reasonably constant, and independent of decisions
for other items.
2. Lead time—that is, the time between placement and receipt of the order—is
known and consistent.
3. Receipt of inventory is instantaneous and complete. In other words, the inventory
from an order arrives in one batch at one time.
4. Quantity discounts are not possible.
5. The only variable costs are the cost of setting up or placing an order (setup or
ordering cost) and the cost of holding or storing inventory over time (holding or
carrying cost).
6. Stock-outs (shortages) can be completely avoided if orders are placed at the
right time.
MINIMIZING COSTS
The objective of most inventory models is to minimize total costs. With the assumptions
just given, significant costs are setup (or ordering) cost and holding (or carrying) cost. All
other costs, such as the cost of the inventory itself, are constant. Thus, if we minimize the
sum of setup and holding costs, we will also be minimizing total costs.
Using the following variables, we can determine setup and holding costs and solve
for Q*:
Q = Number of units per order
Q * = Optimum number of units per order (EOQ)
D = Annual demand in units for the inventory item
S = Setup or ordering cost for each order
H = Holding or carrying cost per unit per year

1. Annual setup cost = (Number of orders placed per year) x (Setup or order cost per
order)
𝑫
= 𝑺
𝑸
2. Annual holding cost = (Average inventory level) x (Holding cost per unit per year)
𝑸
= 𝑯
𝟐
3. Optimal order quantity is found when annual setup (order) cost equals annual
holding cost, namely:
𝑫 𝑸
𝑺= 𝑯
𝑸 𝟐
4. To solve for Q *, simply cross-multiply terms and isolate Q on the left of the equal
sign:
2𝐷𝑆 = 𝑄 2 𝐻
2𝐷𝑆
𝑄2 =
𝐻

𝟐𝑫𝑺
𝑸∗ = √
𝑯

We can also determine the expected number of orders placed during the year
(N) and the expected time between orders ( T ), as follows:
𝐷𝑒𝑚𝑎𝑛𝑑 𝐷
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑒𝑟𝑠 = 𝑁 = = ∗
𝑂𝑟𝑑𝑒𝑟 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑄
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑡𝑖𝑚𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑜𝑟𝑑𝑒𝑟𝑠 = 𝑇 =
𝑁
The Total Annual Variable Inventory Cost is the sum of setup and holding costs:
Total annual cost = Setup (order) cost + Holding cost
 In terms of the variables in the model, we can express the total cost TC as:
𝑫 𝑸
𝑻𝑪 = 𝑺+ 𝑯
𝑸 𝟐
Reorder Points

Now that we have decided how much to order, we will look at the second
inventory question, when to order. Simple inventory models assume that receipt of an
order is instantaneous. In other words, they assume (1) that a firm will place an order when
the inventory level for that particular item reaches zero and (2) that it will receive the
ordered items immediately. However, the time between placement and receipt of an
order, called lead time, or delivery time, can be as short as a few hours or as long as
months. Thus, the when-to- order decision is usually expressed in terms of a reorder point
(ROP).

Lead Time - In purchasing systems, the time between placing an order and
receiving it; in production systems, the wait, move, queue, setup, and run times for each

Reorder point (ROP) - The inventory level (point) at which action is taken to
replenish the stocked item. The reorder point (ROP) is given as:

ROP = Demand per day * Lead time for a new order in days = d * L
This equation for ROP assumes that demand during lead time and lead time itself
are constant. When this is not the case, extra stock, often called safety stock (ss), should
be added. The reorder point with safety stock then becomes:

ROP = Expected demand during lead time + Safety stock

The demand per day, d, is found by dividing the annual demand, D, by the
number of working days in a year:
𝐷
𝑑=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟

Production Order Quantity Model

An economic order quantity technique applied to production orders.

This model is applicable under two situations: (1) when inventory continuously flows
or builds up over a period of time after an order has been placed or (2) when units are
produced and sold simultaneously. Under these circumstances, we take into account
daily production (or inventory-flow) rate and daily demand rate.

It is useful when inventory continuously builds up over time, and traditional

economic order quantity assumptions are valid. We derive this model by setting ordering
or setup costs equal to holding costs and solving for optimal order size, Q *.
Using the following symbols, we can determine the expression for annual inventory
holding cost for the production order quantity model:
 Q = Number of units per order
H = Holding cost per unit per year
p = Daily production rate
d = Daily demand rate, or usage rate
t = Length of the production run in days
1. Annual Inventory Holding Cost = (Average inventory level) x (Holding cost per unit
per year)
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐿𝑒𝑣𝑒𝑙
2. Average Inventory Level =
2
3. Maximum Inventory Level = (Total Production during the production run) - (Total
used during the production run)
= pt - dt
However, Q = total produced = pt, and thus t = Q/p. Therefore:
𝑑
Maximum inventory level = 𝑞(1 − 𝑝)

4. Annual inventory holding cost (or simply holding cost) =

Maximum inventory level 𝑄 𝑑

2
(𝐻) = 2
[1 − (𝑝)](𝐻)

Using this expression for holding cost and the expression for setup cost developed
in the basic EOQ model, we solve for the optimal number of pieces per order by equating
setup cost and holding cost:
𝟏
Setup cost = (D/Q)S Holding cost = HQ[1 – (d/p)]
𝟐

Set ordering cost equal to holding cost to obtain Qṕ :

D 1 𝑑
𝑆 = 𝐻𝑄[1 − ( )]
𝑄 2 𝑝

2𝐷𝑆
𝑄2 =
𝑑
𝐻[1 − (𝑝)]

𝟐𝑫𝑺
Qṕ = √ 𝒅
𝑯[𝟏−( )]
𝒑

Each order may require a change in the way a machine or process is set up.
Reducing setup time usually means a reduction in setup cost, and reductions in setup
costs make smaller batches (lots) economical to produce. Increasingly, setup (and
operation) is performed by computer-controlled machines, such as this one, operating
from previously written programs.
QUANTITY DISCOUNT MODELS
Quantity discount is the reduced price for items purchased in large quantities.
Total annual cost = Annual setup (ordering) cost + Annual holding cost + Annual product
cost,
𝐷 𝑄
Or 𝑇𝐶 = 𝑆 + 𝐼𝑃 + 𝑃𝐷
𝑄 2

Where Q = Quantity ordered

D = Annual demand in units
S = Setup or ordering cost per order
P = Price per unit
I = Holding cost per unit per year expressed as a percent of price P
The EOQ formula is modified for the quantity discount problem as follows:

𝟐𝑫𝑺
Q* = √ 𝑰𝑷

PROBABILISTIC MODELS AND SAFETY STOCK

Probabilistic model - A statistical model applicable when product demand or any other
variable is not known but can be specified by means of a probability distribution.
Service level - The probability that demand will not be greater than supply during lead
time. It is the complement of the probability of a stockout
Reorder point = ROP = d X L
Where, d = Daily demand
L = Order lead time, or number of working days it takes to deliver an order.
The inclusion of safety stock (ss) changed the expression to:
ROP = d X L + ss
The amount of safety stock maintained depends on the cost of incurring a
stockout and the cost of holding the extra inventory. Annual stockout cost is computed
as follows:
Annual stockout costs = The sum of the units short for each demand level X The
probability of that demand level X The stockout cost/unit X The number of orders per year
Safety Stock with Probabilistic Demand
ROP = Expected demand during lead time + zdLT
Where z = Number of standard deviations
Dlt = Standard deviation of demand during lead time
OTHER PROBABILISTIC MODELS
The aforementioned equations assume that both an estimate of expected
demand during lead times and its standard deviations are available. When data on lead
time demand are not available, the preceding formulas cannot be applied. However,
three other models are available. We need to determine which model to use for three
situations:
1. Demand is variable and lead time is constant. When only the demand is
variable, then:
ROP = (Average daily demand x Lead time in days) + zdLT
where dLT = Standard deviation of demand during lead time
= d √Lead time and;
d = Standard deviation of demand per day

2. Lead time is variable and demand is constant. When the demand is constant
and only the lead time is variable, then:
ROP = (Daily demand * Average lead time in days) + Z * Daily demand * LT
where LT Standard deviation of lead time in days
3. Both demand and lead time are variable. When both the demand and lead
time are variable, the formula for reorder point becomes more complex:

ROP = (Average daily demand * Average lead time in days) + zdLT

where d = Standard deviation of demand per day

LT = Standard deviation of lead time in days

and dLT = √(𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑒𝑎𝑑 𝑡𝑖𝑚𝑒 𝑥 𝜎2𝑑 ) + (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑑𝑒𝑚𝑎𝑛𝑑)2 𝜎𝐿𝑇
2

SINGLE-PERIOD MODEL
A single-period inventory model is a system for ordering items that have little or no
value at the end of a sales period (perishables). To determine the optimal stocking policy,
the following should be considered:
𝐶𝑠 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠ℎ𝑜𝑟𝑡𝑎𝑔𝑒 (𝑤𝑒 𝑢𝑛𝑑𝑒𝑟𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑) = 𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 − 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝐶𝑠 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑜𝑣𝑒𝑟𝑎𝑔𝑒 (𝑤𝑒 𝑜𝑣𝑒𝑟𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑) = 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
The service level or the probability of not stocking out is set at:
𝐶𝑠
𝑆𝑒𝑟𝑣𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙 =
𝐶𝑠 + 𝐶𝑜
Therefore, considering an increase in the order quantity until the service level is
equal or more than the ratio of [Cs/(Cs + Co)].
FIXED-PERIOD (P) SYSTEMS
The inventory models considered on the previous discussion are fixed quantity or
Q systems. A Fixed-quantity (Q) system is an ordering system with the same amount of
order amount each time. In here, orders are triggered by events. When inventory
decreases to the reorder point (ROP), a new order for Q units is placed.
To use this model, inventory must be continuously monitored. This requires a
perpetual inventory system. This is a system that keeps track of each withdrawal or
addition to inventory continuously, so that records are always current. In a fixed-period
system (also coined as periodic review or P system), is ordered at the end of a given
period. Then, and only then, is on-hand inventory counted. Only the amount necessary
to bring total inventory up to a prespecified target level (T) is ordered.
Assumptions for P system:
• The only relevant costs are the ordering and holding costs.
• Lead times are known and constant.
• Items are independent of one another.
The advantage of the fixed-period system is that there is no physical count of
inventory items after an item is withdrawn—this occurs only when the time for the next
review comes up. This procedure is also convenient administratively.
A fixed-period (P) system is appropriate when vendors make routine (i.e., at fixed-
time interval) visits to customers to take fresh orders or when purchasers want to
combine orders to save ordering
 I. SUMMARY OF THE CASE
Wagner Fabricating Company is reviewing the economic feasibility of
manufacturing the part that is currently purchased from a supplier. A one-week lead time
was required to obtain part from the supplier. Each part costs $18. An analysis of demand
shows that lead time demand is approximately normally distributed with a mean of 64
units and standard deviation of 10 units. A one-time stock out per year is acceptable
base on the policy.
If the product will be manufacture, it will need a two-weeks lead time but schedule
can be arranged to produce a part whenever needed. The demand for two-weeks lead
time was approximately normally distributed with a mean of 128 units and standard
deviation of 10 units. Production cost is expected to be $17 per unit. However, set-up cost
will be a consideration. And the labor cost which is $50 per hour and operates 8 hours
per day.
II. PROBLEM IDENTIFIED
1. What is the annual holding cost?
2. How much is the ordering cost? How much does it cost per order?
3. How much is the set-up cost for production operation?
4. What is the acceptable inventory policy including all the parameters if:
5. Ordering a fixed quantity Q from a supplier
6. Ordering a fixed quantity Q from in-plant production
7. Should the company purchase or manufacture the part?
8. How much will the company save?

III. ANALYSIS
These are the current status of the Wagner Fabricating Company given the following
information:

Annual demand = 3200 units

Operating days = 250 days per year
Annual Costs:
• Cost of capital = 14%
• Average investment on inventory = $600 000
• Cost of taxes and insurance on inventory= $24 000
• Shrinkage and pilferage costs= $9 000
• Warehouse overhead costs = $15 000

These are the analysis of the current purchasing operation of the WFC.

Purchase time per part ordered = 2 hours

Purchasing Salaries= $28 per hour
Other Ordering expense = $2375 for 125 orders = $19 per order
Lead time = 1 week
Lead time demand = 64 units with std. deviation of 10 units
Price = $18 per unit
The information below shows the analysis of the possible production operation of the WFC
if they proceed on producing the said part.

Production capacity= 1000 units per month

Available time for production= 5 months
Lead time = 2 weeks
Demand during lead time = 128 units with std. deviation of 10 units
Production cost = $17 per part
Setup cost = $50 per hour
Setup time = 8 hours

The information below discuss the annual holding cost rate of Wagner Fabricating
Company incomes to percentage of the 600,000 annual investment for the company’s
inventory.

Holding Cost

Cost of Capital = 14%

Taxes Insurance = ($24000/$600000) 4.0%
Shrinkage = ($9000/$600000) 1.5%
Overhead Costs = ($15000/$600000) 2.5%
Annual holding cost rate = 14% + 4% + 1.5% + 2.5% = 22%

The computation for the ordering cost per order of the part:

Ordering Cost (S) = purchasing salaries + other ordering expense

= ($28 * 2hrs) + $19 = $75 per order

If the company chooses to produce the part, the setup cost would be:

Set-up Cost = (labor cost) x (set up time)

= ($50 per hour) x (8hours) = $400 per setup

CONDITION 1: ANALYSIS IF WAGNER FABRICATING COMPANY REMAINS IN ORDERING THE

PART

Ordering a fixed Quantity (Q) from a supplier

Using the EOQ model:

Annual cost of holding one unit in inventory (H) = 0.22($18) = $3.96 per unit

2𝐷𝑆 2(3200)($75)
Q*= √ 𝐻
=√ $3.96
= 348.16 units or 348 units

Number of orders = 3200 units/348 units = 9.19 orders per year

348 𝑢𝑛𝑖𝑡𝑠
Cycle time = 3200𝑢𝑛𝑖𝑡𝑠 = 27.19 days
( )
250𝑑𝑎𝑦𝑠
 Reorder Point:

P (stockout) = 1/9.19 = 0.10875

Z-value = 1.23

ROP = expected demand during lead time + (z-value) (std. deviation of demand
during lead time)

= 64units + 1.23 (10) = 76.3 units or 76 units

Safety stock= (1.23) (10) = 12.3 units or 12 units

Maximum Inventory = Q* + safety stock = 348 units + 12 units = 360 units
Average inventory = (Q*/2) + safety stock = 348/2 units + 12 units = 186 units
Annual Holding Costs = (H) (average inventory)
= ($3.96 per unit) (186 units) = $736.56
𝐷𝑆 (3200 𝑢𝑛𝑖𝑡𝑠)($75)
Annual Ordering Costs = = = $689.66
𝑄 348 𝑢𝑛𝑖𝑡𝑠
Purchase Cost= (3200 units) ($18 per unit) = $57,600
Total Annual Cost = $736.56 + $689.66 + $57600 = $59,026.22

CONDITION 2: IF THE WAGNER FABRICATING COMPANY ARE TO PRODUCE THE PRODUCT,

THE PARTICULAR COSTS WOULD BE:

Using the EOQ model:

Annual cost of holding one unit in inventory (H) = 0.22($17) = $3.74 per unit
Annual Production = (1000 units per month) (12 months) = 12000 units
2𝐷𝑆 2(3200)($400)
Q*= √ 𝐷 =√ 3200 = 966.13 units or 966 units
𝐻(1− ) ($3.74)(1− )
𝑃 12000

Number of production runs = 3200 units/966 units = 3.31 production runs per year
966 𝑢𝑛𝑖𝑡𝑠
Cycle time = 3200𝑢𝑛𝑖𝑡𝑠 = 75.47 days
( )
250𝑑𝑎𝑦𝑠

Reorder Point:
P(stockout) = 1/3.31 = 0.301825
Z-value = 0.52
ROP = expected demand during lead time + (z-value) (std. deviation of demand
during lead time)
= 128 units + (0.52) (10) = 133.2 units or 133 units
Safety stock= (0.52) (10) = 5.2 units or 5 units
𝐷 3200
Maximum Inventory = 𝑄(1 − 𝑃 )= 966(1 − 12000) = 713 units
𝑄𝐻 𝐷 (966)($3.74) 3200
Annual Holding Costs = 2
(1 − 𝑃 )= 2
(1 − 12000)= $1363.79
Production Cost= (3200 units) ($17 per unit) = $54400
𝑫 𝟑𝟐𝟎𝟎
Annual Setup Cost = (𝑸) (𝑺)= ( 𝟗𝟔𝟔 ) ($𝟒𝟎𝟎)= $1325.75
Total Annual Cost = $1363.79 + $1325.75 + $54400 = $57089.54
IV. CONCLUSION AND RECOMMENDATION

After doing the analysis, the conclusion was to manufacture the part that will only
cost $57,087.79 annually, this will give the company a savings of $1940.02. The most
economical recommendation for the company was to manufacture the part they
needed.