Talbot Industries is evaluating its service level policy for a product that is c

Question

Talbot Industries is evaluating its service level policy for a product that is considered critical to customers. Demand for the item averages 220 units per day and the lead time from the supplier of the item averages 4 days. An analysis of demand and lead time patterns has shown that the standard deviation of demand during lead time is 230 units. The existing service level policy allows for a stockout probability of 15 percent during the replenishment cycle. Marketing managers claim that the item is so critical that the firm should carry two standard deviations of safety stock. Use Table 7-2.

If the item cost is $110 and Talbot’s inventory carrying cost is 20 percent, what is the incremental inventory carrying cost of the suggestion by marketing managers? (Round your intermediate calculations and final answer to the nearest whole number.)

Explanation / Answer

Current Policy:

The existing service level = 1 – stockout probability = 1 – 0.15 = 0.85

For service level of 85%, z value is 1.0364, requires safety stock equal to 1.0364 times the standard deviation in the demand during lead time.

Safety stock (85%) = 1.0364 x 230 units = 238.4 or approximately 239 units

Safety stock inventory carrying cost = holding charge x unit cost x safety stock

Safety stock inventory carrying cost of current policy = (0.20)($110)(239) = $5,258

The suggested policy requires two standard deviation of safety stock

Safety stock = 2 x 230 = 460 units

Safety stock inventory carrying cost = (0.20)($110)(460) = $10,120

The incremental cost is $10,120 - $5,258 = $4,862.

incremental inventory carrying cost = $4,862

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