The problem is to find an order quantity Q that maximizes Machey’s annual profit.There are several components of the annual profit. First, each time Machey’s places anorder, it incurs a fixed ordering cost, labeled K. For this example, K$125. Because DQorders are placed per year, the annual ordering cost isAnnual ordering cost KDQ (13.2)On top of this, Machey’s pays a variable cost, labeled c, for each camera it purchases.Here, c$100. Because the annual demand is D1200 and all demand must be met, theannual variable cost is cD $120,000. Note that this cost does not depend on Q. Similarly,the company’s revenue from each camera, labeled r, is r$130, so its annual revenue isrD. This is also unaffected by the order quantity Q.Now we consider the annual holding cost. There is no cost for physically storing thecameras, but Machey’s loses money from potential investments by having excess cash tiedup in inventory. If we let i be Machey’s annual cost of capital, where i0.08 (8%), then itcan be shown from a net present value argument that the relevant annual holding cost is imultiplied by the average monetary value of inventory, where this average is over the entire year. Because the inventory decreases linearly from Q to 0 between orders, the averagelevel of inventory at a typical point in time is (Q0)2 Q2, which implies that the average monetary value of inventory is cQ2. Therefore, the annual holding cost from moneytied up in inventory isAnnual financial holding cost icQ2 (13.3)[In general, if there is also a storage cost of s dollars per unit held in storage per year, thenthe total annual holding cost is (sic)Q2. In the inventory literature, the combined unitholding cost,(sic), is usually labeled h.]We can now develop a spreadsheet to optimize Machey’s annual profit.
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