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Question:

Mary Rhodes, operations manager at Kansas Furniture, has received the following estimates of demand
requirements:

July Aug Sep Oct Nov Dec

1,000 1,200 1,400 1,800 1,800 1,600

Assuming stock out costs for lost sales of $100 per unit, inventory carrying costs of $25 per unit per
month, and zero beginning and ending inventory, evaluate these two plans on an incremental cost basis:

Plan A - Produce at a steady rate (equal to minimum requirement) of 1,000 units per month and
subcontract additional units at a $60 per unit premium cost.

Plan B - Vary the workforce, which performs at a current production level of 1,300 units per month. The
cost of hiring additional workers is $3,000 per 100 units produced. The cost of layoffs is $6,000 per 100
units cut back.

Solution: Computation of the following

Plan A:

Only incremental cost is cost of sub-contracting. Since there is no limit on subcontracting, going stock
out should not be used as stock out cost of $100 is higher than that for sub-contracting. Similarly, since
there is not limit on sub-contracting, no point in keeping the units in inventory and incurring inventory
carrying cost. Order subcontracting the period when required

Plan A

Month July Aug Sep Oct Nov Dec Total

Demand 1,000 1,200 1,400 1,800 1,800 1,600 8,800

Production Capacity 1000 1000 1000 1000 1000 1000 6,000

Subcontracting 0 200 400 800 800 600 2,800

Subcontracting Cost 0 12000 24000 48000 48000 36000 168,000

Incremental cost of this plan is $168,000


Plan A:

We start with a capacity of 1300. The hiring cost is $3000 per 100 units (i.e. $30 per unit) and firing cost
is $6000 per 100 units (i.e. $60 per unit). So hiring in same month and firing at the end of the month will
cost $90 per unit, therefore again under plan B going stock out should not be used as stock out cost of
$100 is higher than that for Hiring/Firing combination. The objective should be to hire only and avoid
firing as firing cost is high. Inventory carrying cost is $25, thus we should opt for hire /fire only if we are
carrying inventory for more than 3 months, and else inventory build-up is a better strategy.

Plan B

Month July Aug Sep Oct Nov Dec Total

Demand 1,000 1,200 1,400 1,800 1,800 1,600 8,800

Production Capacity

Beginning 1300 1300 1300 1400 1600 1600

Added 0 0 100 200 0 0

Reduced 0 0 0 0 0 0

Total for the month 1300 1300 1400 1600 1600 1600 8,800

Hiring cost 0 0 3,000 6,000 0 0 9,000

Firing cost 0 0 0 0 0 0 0

Ending inventory 300 400 400 200 0 0

Inventory carrying cost 7500 10000 10000 5000 0 0 32,500

Stock out cost 0 0 0 0 0 0 0

Total incremental cost 41,500

Note: Assumed that if capacity at the end of the planning phase is kept at last month demand of 1600
and if it is more than 1600 than firing cost is added to reduce it to 1600 level.

The incremental cost under plan B is $41.500. Hence, plan B is recommended.