More sophisticated models are needed in practice Source Wisner Leong and Tan

# More sophisticated models are needed in practice

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More sophisticated models are needed in practice (Source: Wisner, Leong and Tan, 2005). Consider a hypothetical situation in which a company has the option to make or buy a component part. Its annual requirement is 15,000 units. A supplier is able to supply it at \$7 per unit. The firm estimates that it costs \$500 to prepare the contract with the supplier.
Logistics Training Course for the Public Sector Freight Planners. Do not Distribute without Permission. National Center for Freight and Infrastructure Research and Education ( C FIRE) University of Wisconsin – Madison. Instructor: Bruce X. Wang and Ernie Wittwer. - 35 - To make the part in house, the firm must invest \$25,000 in equipment and it estimates a unit cost of \$5 to manufacture. Costs make option buy option ------------------- -- ------------------ -------------------------- Fixed cost \$25000 \$500 Variable cost 5 7 (per unit) -------------------------------------------------------------------------------------------------- Annual requirement = 15,000 units. Solution The break-even quantity, Q*, is found by setting the two options equal to each other and solving for Q* (see in figure below). If the quantity Q>Q*, the make option is more desirable. Otherwise, the buy option gives a lower cost. Figure 2.11 Cost curve of a product component Total cost to make = total cost to buy \$25000+\$5Q* = \$500+\$7Q* Æ Break-even quantity Q* = 12,250 units Total cost at break even point TC BE =\$25000+\$5x12250=\$86,250 As to the actual demand quantity, we compare the two options below. Total cost for make option TC M = \$25000+\$5x15000=\$87250 Total cost for buy option TC B = \$500+\$7x15000=\$105,500 Buy option Make option Total cost Q<Q* Buy Q>Q* Make 15,000 Q*=12,250 Quantity
Logistics Training Course for the Public Sector Freight Planners. Do not Distribute without Permission. National Center for Freight and Infrastructure Research and Education ( C FIRE) University of Wisconsin – Madison. Instructor: Bruce X. Wang and Ernie Wittwer. - 36 - The conclusion is to make the part in-house. This example is a highly simplified case. In reality, a firm needs to consider whether the in-house production option is within the firm’s core competency. To maintain its market competitiveness, the firm would prefer to develop in areas within its own core competency and to outsource functions in other areas. Remarks Procurement and outsourcing are expedited with the development of regionalization and globalization. For example, the North American Trade Agreement significantly enhances the business relationship between Canada, US and Mexico. Many manufacturing functions are outsourced or shifted to border areas with Mexico. Significant cross-border traffic is seen at crossings with Canada that go to the greater Detroit and New York areas. Procurement and outsourcing is largely driven by the complementarities of businesses, resources and technology. It would not be surprising to see increasing traffic between regions and countries in the years to come. Great pressure will continue to build on the major freight terminals, harbors and ports. Therefore, it is safe to say that procurement is one of the drivers of logistic activities that impact the transportation system. For example, Wal-Mart heavily relies on its global purchasing. A large volume of low cost products are purchased from

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