Chapter 10 Accounts Receivable and Inventory Management 10

Chapter 10 Accounts Receivable and Inventory Management 10. 1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

After Studying Chapter 10, you should be able to: 1. 2. 3. 4. 5. 6. 10. 2 List the key factors that can be varied in a firm's credit policy and understand the trade-off between profitability and costs involved. Understand how the level of investment in accounts receivable is affected by the firm's credit policies. Critically evaluate proposed changes in credit policy, including changes in credit standards, credit period, and cash discount. Describe possible sources of information on credit applicants and how you might use the information to analyse a credit applicant. Identify the various types of inventories and discuss the advantages and disadvantages of increasing/decreasing inventories Describe, explain, and illustrate the key concepts and calculations necessary for effective inventory management and control, including classification, economic order quantity (EOQ), order point, safety stock, and just-in-time (JIT). Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Accounts Receivable and Inventory Management • • • 10. 3 Credit and Collection Policies Analysing the Credit Applicant Inventory Management and Control Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit and Collection Policies of the Firm Quality of Trade Account Length of Credit Period (1) Average Collection Period (2) Bad-debt Losses Possible Cash Discount 10. 4 Firm Collection Program Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Standards – The minimum quality of credit worthiness of a credit applicant that is acceptable to the firm. Why lower the firm’s credit standards? The financial manager should continually lower the firm’s credit standards as long as profitability from the change exceeds the extra costs generated by the additional receivables. 10. 5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Standards Costs arising from relaxing credit standards 10. 6 • A larger credit department • Additional clerical work • Servicing additional accounts • Bad-debt losses • Opportunity costs Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Relaxing Credit Standards Basket Wonders is not operating at full capacity and wants to determine if a relaxation of their credit standards will improve profitability. • The firm is currently producing a single product with variable costs of $20 and selling price of $25. • Relaxing credit standards is not expected to affect current customer payment habits. 10. 7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Relaxing Credit Standards • Additional annual credit sales of $120, 000 and an average collection period for new accounts of 3 months is expected (A/R turnover = 4 times/year). • The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 18%. Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax their credit standards? 10. 8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Relaxing Credit Standards Profitability of additional sales ($5 contribution) x (4, 800 units) = $24, 000 Additional receivables ($120, 000 sales) / (4 Turns) = $30, 000 Investment in add. receivables ($20/$25) x ($30, 000) = $24, 000 Req. pre-tax return on add. investment (18% opp. cost) x $24, 000 = $4, 320 (120, 000/25 = 4, 800 units) (120, 000/(3/12) = 30, 000) (18% of additional investment) Yes! 10. 9 Profits > Required pre-tax return Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit and Collection Policies of the Firm Quality of Trade Account Length of Credit Period (1) Average Collection Period (2) Bad-debt Losses Possible Cash Discount 10. 10 Firm Collection Program Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Average Collection Period The average length of time from a sale on credit until the payment becomes usable funds for the firm. Two parts: Time from the sale until the customer mails the payment Time from when the payment is mailed until the firm has received the cleared funds in its bank account. 10. 11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Average Collection Period Objective is to collect accounts receivable as quickly as possible without losing sales from high pressure collection procedures. This involves three key areas: Credit Selection Credit Terms Credit Monitoring 10. 12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Terms – Specify the length of time over which credit is extended to a customer and the discount, if any, given for early payment. For example, “ 2/10, net 30. ” Credit Period – The total length of time over which credit is extended to a customer to pay a bill. For example, “net 30” requires full payment to the firm within 30 days from the invoice date. 10. 13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Relaxing the Credit Period Basket Wonders is considering changing its credit period from “net 30” (which has resulted in 12 A/R “Turns” per year) to “net 60” (which is expected to result in 6 A/R “Turns” per year). 10. 14 • The firm is currently producing a single product with variable costs of $20 and a selling price of $25. • Additional annual credit sales of $250, 000 from new customers are forecasted, in addition to the current $2 million in annual credit sales. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Relaxing the Credit Period • The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%. Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax their credit period? 10. 15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Relaxing the Credit Period Profitability of additional sales ($5 contribution)x(10, 000 units) = $50, 000 (250, 000/25 = 10, 000) Additional receivables ($250, 000 sales) / (6 Turns) = $41, 667 Investment in add. ($20/$25) x ($41, 667) = receivables (new sales) $33, 334 Previous receivable level 10. 16 ($2, 000 sales) / (12 Turns) = $166, 667 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Relaxing the Credit Period New receivable level ($2, 000 sales) / (6 Turns) = $333, 333 Investment in add. receivables (original sales) $333, 333 - $166, 667 = $166, 666 Total investment in add. receivables $33, 334 + $166, 666 = $200, 000 Req. pre-tax return on add. investment (20% opp. cost) x $200, 000 = $40, 000 Yes! 10. 17 Profits > Required pre-tax return Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changing credit standards 10. 18 Li Hong Company is currently selling a product for $10 per unit. Sales (all on credit) for last year were 60, 000 units. The variable cost per unit is $6. The firm’s total fixed costs are $120, 000. The firm is considering a relaxation of credit standards that is expected to result in the following: a 5% increase in unit sales to 63, 000 units; an increase in the average collection period from 30 days (its current level) to 45 days; an increase in bad-debt expenses from 1% of sales (the current level) to 2%. The firm’s required return on equal-risk investments, which is the opportunity cost of tying up funds in accounts receivable, is 15%. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changing credit standards 10. 19 Need to calculate the effect on the firm’s additional profit contribution from sales, the cost of the marginal investment in accounts receivable and the cost of marginal bad debts. Additional profit contribution from sales Fixed costs are ‘sunk’ and thereby unaffected by a change in the sales level. Variable cost is the only cost relevant to a change in sales. Sales are expected to increase by 5%, or 3, 000 units. The profit contribution per unit equals the difference between the sale price per unit ($10) and the variable cost per unit ($6) and so the profit contribution per unit will be $4. Thus, the total additional profit contribution from sales will be $12, 000 (3, 000 units × $4 per unit). Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changing credit standards 10. 20 Cost of the marginal investment in accounts receivable To determine the cost of the marginal investment in accounts receivable, Li Hong must find the difference between the cost of carrying receivables before and after the introduction of the new credit standards. We are only concerned about the out-ofpocket costs so the relevant cost in this analysis is the variable cost. The average investment in accounts receivable can be calculated using the following formula: Average investment in accounts receivable = total variable cost of annual sales/ turnover of accounts receivable where Turnover of accounts receivable = 365/average collection period Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changing credit standards 10. 21 The total variable cost of annual sales, using the variable cost per unit of $6 are, Total variable cost of annual sales: Under present plan: ($6 × 60, 000 units) = $360, 000 Under proposed plan: ($6 × 63, 000 units) = $378, 000 The proposed plan increases total variable cost of sales by $18, 000. The turnover of accounts receivable shows the number of times each year that accounts receivable are turned into cash. It is found by dividing the average collection period into 365. Turnover of accounts receivable (rounded): Under present plan: 365/30 = 12. 2 Under proposed plan: 365/45 = 8. 1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changing credit standards 10. 22 Substitute the cost and turnover data just calculated to get the following average investments in accounts receivable: Average investment in accounts receivable: Under present plan: $360, 000/12. 2 = $29, 508 Under proposed plan: $378, 000/8. 1 = $46, 667 The marginal investment in accounts receivable, and its cost, are calculated as follows: Cost of marginal investment in accounts receivable (A/R): Average investment under proposed plan $46, 667 – Average investment under present plan 29, 508 Marginal investment in accounts receivable $17, 159 × Required return on investment 0. 15 Cost of marginal investment in A/R $2, 574 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changing credit standards 10. 23 The value of $2, 574 is a cost because it represents the maximum amount that could have been earned on the $17, 159 had it been placed in the best equal-risk investment alternative available at the firm’s required return on investment of 15%. Cost of marginal bad debts The cost of marginal bad debts is the difference between the level of bad debts before and the level of bad debts after the change in credit standards: Cost of marginal bad debts: Under proposed plan: 0. 02 × $10 × 63, 000 units = 12, 600 Under present plan: 0. 01 × $10 × 60, 000 units = 6, 000 Cost of marginal bad debts $6, 600 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changing credit standards 10. 24 Bad debts costs are calculated by using the sale price per unit ($10) to identify not just the true loss of variable (or out-of-pocket) cost ($6) that results when a customer fails to pay its account, but also the profit contribution per unit—in this case, $4 ($10 sales prices – $6 variable cost)—that is included in the ‘additional profit contribution from sales’. Thus, the resulting cost of marginal bad debts is $6, 600. To decide whether the firm should relax its credit standards, the additional profit contribution from sales must be compared with the sum of the cost of the marginal investment in accounts receivable and the cost of marginal bad debts. If the additional profit contribution is greater than marginal costs, credit standards should be relaxed. Additional profit $12, 000 Less Marginal investment in Accounts receivable (2, 574) Less marginal cost of bad debts (6, 600) Net profit (loss) from change in credit terms $2, 826 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Changing credit standards 10. 25 The effect of Li Hong’s credit relaxation policy: Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Exercise Now try to do problems 14 -24 and 14 -27 from Gitman Ch 14 handout 10. 26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit and Collection Policies of the Firm Quality of Trade Account Length of Credit Period (1) Average Collection Period (2) Bad-debt Losses Possible Cash Discount 10. 27 Firm Collection Program Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Terms Cash Discount Period – The period of time during which a cash discount can be taken for early payment. For example, “ 2/10” allows a cash discount in the first 10 days from the invoice date. Cash Discount – A percent (%) reduction in sales or purchase price allowed for early payment of invoices. For example, “ 2/10” allows the customer to take a 2% cash discount during the cash discount period (10 days). 10. 28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Terms 10. 29 The terms of sale for customers who have been extended credit by the firm. E. g. ‘net 30’ means the customer has 30 days from the beginning of the credit period to pay the full invoice amount. Some firms offer cash discounts as percentage discounts from the purchase price for full payment within a specified time. E. g. ‘ 2/10 net 30’ means the customer can take a 2% discount from the amount payable if payment is made within the first 10 days of the credit period, or pay the full amount payable within 30 days of the beginning of the credit period. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Terms 10. 30 Any discounts for early payment should only be offered after a cost benefit analysis. Are reflective of the type of business the firm operates. E. g. seasonal, perishable goods etc Should be reflective of industry standards at a firm level, but reflective of customer riskiness at an individual customer level. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Terms 10. 31 Li Hong Company has an average collection period of 40 days (turnover = 365/40 = 9. 1). The firm’s credit terms are net 30. Li Hong is considering changing its credit terms from net 30 to 2/10 net 30. This change is expected to reduce the average collection period to 25 days (turnover = 365/25 = 14. 6). As shown in the EOQ example (slide 66), Li Hong has a raw material with current annual usage of 1, 100 units. Each finished product produced requires one unit of this raw material at a variable cost of $1, 500 per unit, incurs another $800 of variable cost in the production process and sells for $3, 000 on terms of net 30. Li Hong estimates that 80% of its customers will take the 2% discount and that offering the discount will increase sales of the finished product by 50 units (from 1, 100 to 1, 150 units) per year but will not alter its bad-debt percentage. Li Hong’s opportunity cost of funds invested in accounts receivable is 14%. Should Li Hong offer the proposed cash discount? Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Terms 10. 32 Analysis of initiating a cash discount for Li Hong Company Li Hong’s opportunity cost of funds is 14% Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Introducing a Cash Discount A competitor of Basket Wonders is considering changing the credit period from “net 60” (which has resulted in 6 A/R “Turns” per year) to “ 2/10, net 60. ” 10. 33 • Current annual credit sales of $5 million are expected to be maintained. • The firm expects 30% of its credit customers (in dollar volume) to take the cash discount and thus increase A/R “Turns” to 8. • (30% x 10 days + 70% x 60 days = 3 + 42 days = 45 days • 360 days per year / 45 days = 8 turns per year Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Introducing a Cash Discount • The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%. Ignoring any additional bad-debt losses that may arise, should the competing firm introduce a cash discount? 10. 34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Using the Cash Discount Receivable level (Original) ($5, 000 sales) / (6 Turns) = $833, 333 Receivable level (New) ($5, 000 sales) / (8 Turns) = $625, 000 Reduction of investment in A/R $833, 333 - $625, 000 = $208, 333 10. 35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of Using the Cash Discount Pre-tax cost of the cash discount 0. 02 x 0. 3 x $5, 000 = $30, 000. Pre-tax opp. savings on reduction in A/R (20% opp. cost) x $208, 333 = $41, 667. Yes! Savings > Costs The benefits derived from reducing accounts receivable exceed the costs of providing the discount to the firm’s customers. 10. 36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit and Collection Policies of the Firm Quality of Trade Account Length of Credit Period (1) Average Collection Period (2) Bad-debt Losses Possible Cash Discount 10. 37 Firm Collection Program Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Default Risk and Bad. Debt Losses (see p. 251 for details) Present Policy A Policy B Demand $2, 400, 000 $3, 300, 000 Incremental sales $ 600, 000 $ 300, 000 Default losses Original sales 2% Incremental Sales 10% 18% Avg. Collection Pd. Original sales 1 month Incremental Sales 12 times 2 months 3 months per year 6 times 4 times 10. 38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Default Risk and Bad -Debt Losses Policy A Policy B 1. Additional sales $600, 000 $300, 000 2. Profitability: (20% contribution) x (1) 120, 000 60, 000 3. Add. bad-debt losses: (1) x (bad-debt %) 60, 000 54, 000 4. Add. receivables: (1) / (New Rec. Turns) 100, 000 75, 000 5. Invest in add. receivables: (0. 80) x (4) 80, 000 6. Required before-tax return on additional investment: (5) x (20%) 16, 000 12, 000 7. Additional bad-debt losses + additional required return: (3) + (6) 76, 000 66, 000 8. Incremental profitability: (2) - (7) 44, 000 (6, 000) Adopt Policy A but not Policy B. 10. 39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Collection Policy and Procedures • Letters • Phone calls • Personal visits • Legal action As an account becomes more overdue, the collection effort becomes more personal and more intense, until a resolution achieved. Bad-Debt Losses Collection Procedures The firm should increase collection expenditures until the marginal reduction in baddebt losses equals the marginal outlay to collect. Saturation Point Collection Expenditures 10. 40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Sources of Information The company must weigh the amount of information needed versus the time and expense required • • • 10. 41 Financial statements Credit ratings and reports Bank checking Trade checking Company’s own experience Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Credit Analysis A credit analyst is likely to use the following information: • • • 10. 42 the financial statements of the firm (ratio analysis) the character of the company the character of management the financial strength of the firm other individual issues specific to the firm Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Inventory Management and Control Inventories form a link between production and sale of a product. Inventory types: • • 10. 43 Raw-materials inventory Work-in-process inventory In-transit inventory Finished-goods inventory Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Inventory Management Differing views of inventory management. For example: Financial Manager: Keep stock as low as possible. Marketing Manager: Keep stock of finished goods high. Manufacturing Manager: Keep raw materials supplies high, and have large production runs. Purchasing Manager: Keep raw materials supplies high. 10. 44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Inventory Management and Control Inventories provide flexibility for the firm in: • • • 10. 45 Purchasing Production scheduling Efficient servicing of customer demands Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Appropriate Level of Inventories How does a firm determine the appropriate level of inventories? Employ a cost-benefit analysis Compare the benefits of economies of production, purchasing, and product marketing against the cost of the additional investment in inventories. 10. 46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

ABC Method of Inventory Control Method which controls expensive inventory items more closely than less expensive items. • Review “A” items most frequently • Review “B” and “C” items less rigorously and/or less frequently. 10. 47 100 Cumulative Percentage of Inventory Value ABC method of inventory control 90 C 70 B A 0 15 45 100 Cumulative Percentage of Items in Inventory Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

ABC Method of Inventory Control ABC System: Divides inventory into three categories A, B, & C in descending order of importance and level of inventory, based on the dollar investment in each. A – The group requiring the largest dollar investment, generally 20% of the firm’s inventory items which account for 80% of the firm’s dollar investment in inventory. Monitored intensively and tracked using a perpetual inventory system to allow for daily verification of stock levels. 10. 48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

ABC Method of Inventory Control B – The middle group. Inventory levels are monitored through periodic checks. C – The group of large numbers of inventory items, accounting for a relatively small amount of the investment in inventory. 10. 49 Generally monitored using unsophisticated techniques such as the two bin method. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Economic Order Quantity Determines an inventory item’s optimal order quantity that will reduce total inventory costs. Achieved by minimising both the total of its order costs and carrying costs. Order Costs: The costs attributable to placing and receiving an order. Carrying Costs: The cost per unit of holding an item of inventory for a specific period of time. 10. 50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Economic Order Quantity 10. 51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

How Much to Order? The optimal quantity to order depends on: Forecast usage Ordering cost Carrying cost Ordering can mean either the purchase or production of the item. 10. 52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Inventory Costs INVENTORY (in units) Total inventory costs (T) = C (Q / 2 ) + O (S / Q) Average Inventory Q Q/2 TIME 10. 53 C: O: S: Q: Carrying costs per unit period Ordering costs per order Total usage during the period Order quantity in units Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Economic Order Quantity The quantity of an inventory item to order so that total inventory costs are minimised over the firm’s planning period. The EOQ or optimal quantity (Q*) is: 10. 54 Q* = 2 (O ( ) (S) C Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of the Economic Order Quantity Basket Wonders is attempting to determine the economic order quantity for fabric used in the production of baskets. • • • 10, 000 yards of fabric were used at a constant rate last period. Each order represents an ordering cost of $200. Carrying costs are $1 per yard over the 100 -day planning period. What is the economic order quantity? 10. 55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Economic Order Quantity We will solve for the economic order quantity given that ordering costs are $200 per order, total usage over the period was 10, 000 units, and carrying costs are $1 per yard (unit). Q* = 2 ($200 ) (10, 000) ( $1 Q* = 2, 000 Units 10. 56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Inventory Costs EOQ (Q*) represents the minimum point in total inventory costs. Costs Total Inventory Costs Total Carrying Costs Total Ordering Costs Q* 10. 57 Order Size (Q) Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

When to Order? Issues to consider: Lead Time – The length of time between the placement of an order for an inventory item and when the item is received in inventory. Order Point – The quantity to which inventory must fall in order to signal that an order must be placed to replenish an item. Order Point (OP) OP = Lead time X Daily usage 10. 58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of When to Order Julie Miller of Basket Wonders has determined that it takes only 2 days to receive the order of fabric after the placement of the order. When should Julie order more fabric? Lead time = 2 days Daily usage = 10, 000 yards / 100 days = 100 yards per day Order Point = 2 days x 100 yards per day = 200 yards 10. 59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Example of When to Order Economic Order Quantity (Q*) UNITS 2000 Order Point 200 0 10. 60 Lead Time 18 20 38 40 DAYS Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Safety Stock – Inventory stock held in reserve as a cushion against uncertain demand (or usage) and replenishment lead time. Our previous example assumed certain demand lead time. When demand and/or lead time are uncertain, then the order point is: Order Point = (Avg. lead time x Avg. daily usage) + Safety stock 10. 61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Order Point with Safety Stock 2200 UNITS 2000 Order Point 400 200 Safety Stock 0 18 20 38 DAYS 10. 62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Order Point with Safety Stock 2200 UNITS 2000 Actual lead time is 3 days! (at day 21) The firm “dips” into the safety stock Order Point 400 200 Safety Stock 0 18 21 DAYS 10. 63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

How Much Safety Stock? What is the proper amount of safety stock? Depends on the: • Amount of uncertainty in inventory demand • Amount of uncertainty in the lead time • Cost of running out of inventory • Cost of carrying inventory 10. 64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Just-in-Time An inventory management system used to minimise inventory investment by having materials inputs arrive at exactly the time they are needed for production. Carries little or no safety stocks. Relies on exceptional coordination between firm, suppliers and logistics. Runs the risk of stalling production if inventory fails to arrive when planned for. 10. 65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Just-in-Time Requirements of applying this approach: • • 10. 66 A very accurate production and inventory information system Highly efficient purchasing Reliable suppliers Efficient inventory-handling system Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EOQ and JIT example 10. 67 Li Hong Company has an A group inventory item that is vital to the production process. This item costs $1, 500, and Li Hong uses 1, 100 units of the item per year. Li Hong wants to determine its optimal order strategy for the item. To calculate the EOQ, we need the following inputs: Order cost per order = $150 Carrying cost per unit per year = $200 Substituting into EOQ Equation, we get EOQ =√(2 × 1, 100 × $150)/200 ≈ 41 units Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EOQ and JIT example The reorder point depends on the number of days Li Hong operates per year. Assuming that he operates 250 days per year and uses 1, 100 units of this item, its daily usage is 4. 4 units (1, 100 / 250). If its lead time is two days and Li Hong wants to maintain a safety stock of four units, the reorder point for this item is 12. 8 units ((2 × 4. 4) + 4). However, orders are made only in whole units, so the order is placed when the inventory falls to 13 units. 10. 68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EOQ and JIT example 10. 69 Now assume the same information as before, but assume that the marginal cost of placing an order is (1) $11 or (2) $2. 1 Order cost of $11 EOQ = √(2 × 1, 100 × $11)/200 = √ 121 = 11 units 2 Order cost of $2 EOQ = √(2 × 1, 100 × $2)/200 = √ 22 = 5 units Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EOQ and JIT example As the order cost falls, the EOQ model now tells Li Hong to order fewer units per order, more often. Applying a marginal order cost, the EOQ model moves towards a JIT system, where inventory arrives when it is needed, with an order cost based on the cost of a phone call to the supplier or a predetermined delivery schedule. A pure JIT system assumes that suppliers will deliver on time, every time. Without such assurances, pure JIT systems can cause headaches for manufacturers 10. 70 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Exercise Now try to do problem 14 -18 from Gitman Ch 14 handout 10. 71 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.