A Materials and Inventory Management Case
Production and Operations Management: An Applied Modern Approach
This case is intended to be the basis for a business analysis and
class discussion rather than to illustrate either effective or
ineffective handling of a business situation. Companies and
characters are fictitious and are not intended to represent actual
companies or people.
Copyright 1997 by Joseph Martinich. All rights reserved. No part
of this publication may be reproduced, stored in a retrieval system,
or transmitted in any form or by any means without the permission of
Joseph Martinich or the distributor, John Wiley & Sons, 605 Third
Ave., New York, NY 10158. Printed in the U.S.A.
Copyright 1997 by Joseph Martinich. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without the permission of Joseph Martinich or the distributor, John Wiley & Sons, 605 Third Ave., New York, NY 10158. Printed in the U.S.A.
ThermalCare Ltd. is a manufacturer of home and small commercial furnaces. The company manufactures many of its own components and buys the rest from suppliers. It then assembles these into modules (which can be easily installed at the end-customer's site) and packages the furnaces for shipment to its customers (independent furnace installers).
ThermalCare was one of the first companies to develop high efficiency furnace technologies. This technological advantage helped to propel ThermalCare from being a local producer that sold almost exclusively to its home market in Ontario, Canada, to a rapidly growing international company. Encouraged by initial success in expanding its sales throughout eastern Canada, in 1994 ThermalCare began selling furnaces throughout Michigan, Indiana, Ohio, and New York. This international expansion raised ThermalCare's annual sales from $7 million to nearly $12 in only two years, with nearly half of the sales coming from the United States. Sales growth was projected to slow to approximately 20-25% annually for the foreseeable future.
Although profits increased with sales, the profit margin was slowly, but steadily, decreasing (see Table 1). These developments greatly troubled Delbert Price, President of ThermalCare. In early 1996 Delbert had a daylong meeting with his vice-presidents of marketing, finance, and operations, and their chief advisors. During the meeting the company's pricing policies, market competition, and business operations were scrutinized in detail. Everyone agreed that under the prevailing competitive conditions, ThermalCare's pricing and supply policies were effective, its sales staff was performing well, and the overall product quality was good. Even the vice-president of operations, Michael Nelson, agreed that the problem appeared to be in operations - per unit costs were increasing, rather than decreasing as one would expect with the increased production volume.
There appeared to be three main problem areas. First, the surge in demand forced ThermalCare to utilize overtime production to a large extent. (This was especially true during the Autumn and Winter, when demand was often 2-3 times the average rate.) Because ThermalCare's production process is relatively labor-intensive, the high overtime pay (sometimes as much as twice the regular time rate) increased the labor cost per furnace system. To solve this problem, and to prepare for future sales growth, ThermalCare had added another production shift and was expanding its facilities and was adding more production work cells. These changes were expected eventually to reduce per furnace labor costs, but until the new workers gained experience and the normal start-up problems in the new production cells were resolved, labor costs would remain abnormally high. Michael assigned a special task force to monitor the expansion of production capacity, but he was confident that these savings would begin to appear within the next 6 months.
The third problem area was in materials management and purchasing. ThermalCare had expected to achieve at least some per unit cost savings in materials as it expanded production due to greater purchasing strength, normal quantity discounts, and the typical efficiencies of spreading fixed procurement and set-up costs over larger volumes of items being purchased and produced. These savings had not materialized. Neither the causes of these material problems, nor the solutions were obvious to Michael, so he brought together his primary subordinates: the managers of production, purchasing & materials management, plant accounting, and quality assurance, and the plant industrial engineer.
Michael asked Emma Roth, the production manager, to describe any major problems she was encountering that might be contributing to the increasing costs, especially those problems that might be related to materials. Emma was quite proud of how efficiently the manufacturing plant had been performing, especially in light of the plant expansion, overtime, and addition of a second production shift. There were a few problems, however, that Emma had noticed.
Michael asked Elizabeth Wells, the manager of purchasing & materials management, to shed some light on the possible causes of these problems. Elizabeth expressed some surprise by the first problem because she stated that by following a policy of buying only from the lowest bidder she had kept component prices steady during the past two years. This resulted in changing suppliers for several of the components. She was especially proud of the fact that she had been able to reduce per unit transport costs during the past two years.
Because ThermalCare paid for the cost of shipping components, Elizabeth had studied these costs carefully. All the components were shipped by truck, and she determined that anytime ThermalCare purchased at least 1/4 of a truckload of components, it was less expensive to simply contract an entire truck to make the delivery than to pay a freight service, which charged by the pound. She estimated that on average it cost $400 for a truckload delivery regardless of how much was actually carried on the truck. With such a large fixed cost per delivery, Elizabeth decided to only order components in full truckload quantities. (The number of units of each major purchased component that can be carried in a truck is listed in Table 2.) Elizabeth estimated that this strategy cut the number of shipments by 25% and saved the company almost $5000 in shipping costs during 1995, compared to using the previous order quantities. She noted that as a side benefit the number of purchase orders placed was also reduced, which she estimated to be worth $20 per order in administrative costs. The larger order quantities also allowed her to obtain quantity discounts on limit and safety switches and igniters. (The prices offered by each of the major suppliers are listed in Table 3.)
Elizabeth conceded that there were some problems with the reliability of deliveries from the new suppliers of the motors (Davis Co.) and gas manifolds (Sentry). The lead-time is supposed to be one week for these items, but frequently the time is much longer (see Table 4). With regard to the quality problem, Elizabeth said that she had not heard about any quality problems, but she would only be notified if the defect rate was above that of the contracted level, which was between 0.25% and 0.50% for most purchased components.
Michael commended Elizabeth on her efforts to reduce costs. Her explanation made Michael even more puzzled about why costs were increasing. He asked the others for any insights they might have. The manager of accounting, Silvio Madeo, jumped in with a few observations. First, he confirmed that transport costs per furnace had decreased markedly. But, he noted, the inventory turnover had decreased, meaning the average inventory per furnace had increased during the past 2-3 years. At an estimated carrying cost rate of 15% per year (which he considered to be very conservative) this could affect profits significantly. He thought that the larger order quantities were the main cause. Finally, he observed that the number of defective switches and blower motors that were returned to the suppliers because of quality problems had increased considerably since changing suppliers.
Richard Lake, manager of quality assurance, followed up on these points with his own observations. From his records the defect rate for switches had increased from 0.07% to 0.48% after changing from Electrolux to Smithson as the supplier, and the defect rate on motors increased from 0.14% to 0.38% after changing from Atlas to Davis as the supplier. Jack Springer, the plant industrial engineer, pointed out that even though the suppliers replaced the defective components free of charge, extra labor was being spent on inspection because of the higher defect rates and the production process was being disrupted. He thought that using higher cost suppliers that made higher quality components might be cost effective. Jack added that he spent most of his time in the plant studying various operations for improvement. His studies suggested that the increase in inventories was definitely slowing production as material handlers had trouble maneuvering around the plant, and components were being buried behind other items, which made them hard to find and required extra time to move them where they were needed. He suggested that reducing the order quantities would help alleviate this problem.
ThermalCare's Sales and Profits
Normal daily Production volume
* This is also the current order quantity for each component.
Average Std. Deviation
1. Suppose ThermalCare remained with the same suppliers it is currently using. What, if any, revisions in the order quantities should be made for the six components listed in Table 2 (note that one of each of component is contained in each furnace)? How much money would be saved each year from these changes? What effect would this have on shipping costs?
2. What other benefit(s) might be obtained by ThermalCare using the order quantities suggested by your answers to question 1 (as compared to Elizabeth's order quantities)?
3. Currently the six components are being supplied by five different suppliers. Using your answer for question 1 and any other analysis necessary, would there be any advantage to combining orders and buying the six components from only two or three suppliers, even though the suppliers may not be the lowest-price suppliers for each component? Explain why or why not, and if such actions should be taken, state which companies should supply each component and what savings would occur.
Copyright 1997, John Wiley & Sons, Inc.