Comparative Analysis Based on Annual Cost and Inventory Costs

Introduction:

In the following assignment, a comparative analysis based on annual cost and inventory costs will enable us to understand how firms choose and measure their supplier performance. Supplier performance analysis, alongside benchmarking, is a critical stage of the supply chain that can assist or wane a firm's effort in acquiring supply chain surplus.

The sourcing / procurement department is responsible for this stage and it's activities, beside the selection, the design of supplier contracts and products, procurement of required materials, should include the evaluation of supplier performance (Chopra, S. & Meindl, P. 2010: p.393). Methods of supplier performance include calculations of price and cost on lead-time, safety inventory, and material costs. Nevertheless, the sourcing department can also utilise benchmarking against the supplier's competitors to ensure that the lowest prices and most optimal configuration is being offered.

Clean Car Solutions Supplier Performance:

This is currently the situation at Clean Car Solutions (CCS), a manufacturer of car and two-wheeler engines. The sourcing department is currently purchasing one thousand bearing per week from a local supplier. This local supplier charges $1 per bearing, has an average lead-time of two weeks and delivers the bearing in batches of two thousand. Additionally, the local supplier has an average lead time of 2 weeks and has agreed to deliver the bearings in batches of 2000. Based on past on-time performance, the CEO estimates that the lead time has a standard deviation of one week.

With the following information we are able to calculate the following:

Annual material cost= 1,000 x 52 x 1 = $52,000

The annual material cost is made up of the weekly demand of 1000 multiplied by one year (52 weeks = 1 year) and the local cost of $1 per bearing.

Average cycle inventory= 2,000/2 = 1,000

The average cycle inventory is acquired by multiplying the local supplier average lead-time and the number of batches, in this case two thousand.

Annual cost of holding cycle inventory = 1,000 x 1 x 0.30 = $300

Once the average cycle inventory is known, we can now calculate the annual cost of holding cycle inventory, which is equal to the average cycle inventory times the price per bearing (1$) and the holding cost of CSS of 30% or 0.30. The holding cost represents a fixed cost (such as rent warehousing, staff salary or utility bills that are required to hold inventory), which can be represented by a linear function based on average inventory. Other supplier characteristics, such as reliability, quality and design capability will have a direct impact on the total cost of CSS using selected suppliers.

We the current indications of the CSS CEO we are able to further evaluate the performance of the local supplier based, not on fixed replenishment time, but add the factor of uncertainty and how might this impact the annual cost of holding safety inventory. Previously firms were content using EOQ for supplier performance. However, EOQ's number of assumptions proved to be too unrealistic for today's highly dynamic and uncertain market. The EOQ therefore remained mainly to offer managers a valuable insight when transportation decisions had to be made empirically rather than based on personal intuition (Langley, C., 1976: p.91). Nowadays a different assumption is made, instead of a unchanged constant, replenishment is now normally distributed. This is represents the current reality in CSS, where it uses a continuous review policy for managing inventory and aims for a cycle service level of 95 percent.

Therefore, we can now calculate the standard deviation of demanded during lead-time using the following formula (Chopra, S. & Meindl, P. 2010:p. 301):

DL=DL σL=√(Lσ2D+ D2s2L)

Where:

D: Average demand per period

σD: Standard deviation of demand per period

L: Average lead-time for replenishment

sL: Standard deviation of lead time

With CSS local supplier performance we calculate the following:

Standard deviation of demanded during lead time = √(2 x 3002 + 1,0002 x 12) = 1,086.28

With the distribution of customer demand during lead-time we can now obtain the required safety inventory with the excel function of NORMSINV. The excel function NORMSINV (numerical value of the cycle service level) returns the value, with probability of service level so a standard normal bell-shape curve variable takes on a value which is less than or equal to the value calculated.

Safety inventory required with current supplier = NORMSINV(0.95) x 1086.28 = 1, 787

Therefore CSS must carry a safety inventory of 1,787 bearings, which is equivalent to about two days of demand for bearings. With the normally deviated amount of safety inventory we can calculate the annual cost of holding safety inventory, which is equally to the amount of safety inventory times the price per bearing times the holding cost of thirty percent.

Annual cost of holding safety inventory = 1, 787 x 1 x 0.30 = $536.10

CSS annual cost of holding safety inventory using the local supplier is $536.10. Note that this amount is almost double of the annual cost of holding cycle inventory. With all this calculated data the CSS CEO can now compare the current local supplier based on the impact on total annual cost, which is equal to the annual material cost plus the annual cost of holding inventory plus the annual cost of holding safety inventory.

Annual cost of using current supplier = 52,000 + 300 + 536.10= $52,836.10

CSS current local supplier has an annual cost of $52,836.10.

After a business trip to the world bearing expo trade exhibition, the CEO of CCS has identified another potential source willing to supply the bearings to CSS with a price of $0.95 per bearing. Additionally the new supplier, located in another county,