Question

The Thomas Lee Baking Co. orders flour using a continuous review inventory model. Lee's ordering cost is $45, its inventory carrying percentage is 20% (i.e. i=0.2), the flour costs 45 cents per pound, the annual demand for flour is 100,000 pounds. Consequently, Lee's economic order quantity is10,000 pounds. Suppose Lee is about to place an order and learns that the supplier, Tommy Flour Company, has an excess inventory that it wants to get rid of. The supplier offers Lee the following options:

(1) A ONE-TIME DEAL of 50,000 pounds at 43 cents per pound now and 50,000 pounds at 44 cents 6 months later.

(2) A ONE-TIME DEAL of 25,000 pounds at 40 cents per pound now and 75,000 pounds at 44 cents 3 months later.

Assuming demand occurs at a known constant rate, what should Lee do? Justify your answer.

Answer 1

To determine the most cost-effective option, Lee needs to compare the carrying cost and ordering cost of the original quantity with the costs and savings of each option. The carrying cost is calculated by multiplying the carrying percentage by the cost of flour per pound. Option 1 offers a lower carrying cost and savings on ordering costs due to reduced prices, while Option 2 has a lower carrying cost but higher ordering costs. By analyzing these costs and benefits, Lee can make an informed decision.

Step-by-step explanation:

To determine what Lee should do, we need to compare the costs and benefits of the two options offered by the supplier. Option 1 offers 50,000 pounds of flour at 43 cents per pound now and an additional 50,000 pounds at 44 cents per pound 6 months later. Option 2 offers 25,000 pounds at 40 cents per pound now and 75,000 pounds at 44 cents per pound 3 months later.

To make a decision, we need to consider the carrying cost, the ordering cost, and any potential savings from the one-time deals. Carrying cost is calculated by multiplying the carrying percentage (i) by the cost of the flour per pound. Order cost is the fixed cost of placing an order. By comparing the carrying cost and ordering cost of the original quantity of 10,000 pounds with the carrying cost, ordering cost, and savings of each option, we can determine the most cost-effective option for Lee.

In Option 1, Lee is ordering a total of 100,000 pounds of flour over a year, which is the same as the original quantity. However, the carrying cost will be lower because the flour is purchased at a reduced price. To calculate the carrying cost, multiply the carrying percentage by the sum of the cost per pound of the flour for the first and second purchase. Additionally, Lee will save on ordering costs since fewer orders need to be placed. By comparing the carrying cost and ordering cost for Option 1, we can determine if this option is more cost-effective than the original quantity.

In Option 2, Lee is also ordering a total of 100,000 pounds of flour over a year. The carrying cost will be lower due to the lower price of the first purchase. However, more orders need to be placed compared to Option 1, which incurs additional ordering costs. By comparing the carrying cost and ordering cost for Option 2, we can determine if this option is more cost-effective than the original quantity or Option 1.

By analyzing the costs and benefits of each option, Lee can make an informed decision about which one-time deal to accept based on their impact on the carrying cost and ordering cost.