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Fundamentals of Financial Management, 12/e

Chapter 10: Accounts Receivable and Inventory Management

After studying Chapter 10,


Chapter 10 you should be able to:
‹ List the key factors that can be varied in a firm's credit policy and
understand the trade-off between profitability and costs

Accounts
Accounts Receivable
Receivable ‹
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
and
and Inventory
Inventory ‹
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 analyze a credit
applicant.
Management
Management ‹ Identify the various types of inventories and discuss the
advantages and disadvantages of increasing/decreasing
inventories.
© Pearson Education Limited 2004 ‹ Describe, explain, and illustrate the key concepts and
Fundamentals of Financial Management, 12/e calculations necessary for effective inventory management and
Created by: Gregory A. Kuhlemeyer, Ph.D. control, including classification, economic order quantity (EOQ),
Carroll College, Waukesha, WI order point, safety stock, and just-in-time (JIT).
10-1 10-2

Accounts Receivable and Credit and Collection


Inventory Management Policies of the Firm
‹ Credit and Collection Quality of Length of
Trade Account
Policies Credit Period
(1) Average
‹ Analyzing the Credit Collection Period
Applicant (2) Bad-debt
Losses
Firm
‹ Inventory Management and Possible Cash Collection
Discount
Control Program

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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Credit Standards Credit Standards


Credit Standards -- The minimum quality Costs arising from relaxing
of credit worthiness of a credit applicant credit standards
that is acceptable to the firm.
‹ A larger credit department
Why lower the firm’ standards?
firm’s credit standards?
‹ Additional clerical work
The financial manager should continually
lower the firm’s credit standards as long as ‹ Servicing additional accounts
profitability from the change exceeds the ‹ Bad-debt losses
extra costs generated by the additional
receivables. ‹ Opportunity costs
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Example of Relaxing Example of Relaxing


Credit Standards Credit Standards
Basket Wonders is not operating at full capacity ‹ Additional annual credit sales of $120,000 and an
and wants to determine if a relaxation of their average collection period for new accounts of 3
credit standards will enhance profitability.
profitability. months is expected.
‹ The before-tax opportunity cost for each dollar of
‹ The firm is currently producing a single funds “tied-up” in additional receivables is 20%.
product with variable costs of $20 and selling
price of $25. Ignoring any additional bad-
bad-debt losses
‹ Relaxing credit standards is not expected to that may arise, should Basket Wonders
affect current customer payment habits. relax their credit standards?

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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Example of Relaxing Credit and Collection


Credit Standards Policies of the Firm
Profitability of ($5 contribution) x (4,800 units) =
additional sales $24,000 Quality of Length of
Trade Account Credit Period
Additional ($120,000 sales) / (4 Turns) =
receivables $30,000 (1) Average
Collection Period
Investment in ($20/$25) x ($30,000) =
add. receivables $24,000 (2) Bad-debt
Losses
Req. pre-tax return (20% opp. cost) x $24,000 = Firm
Possible Cash Collection
on add. investment $4,800 Discount Program
Yes! Profits > Required pre-tax return
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Example of Relaxing
Credit Terms the Credit Period
Credit Terms -- Specify the length of time Basket Wonders is considering changing its
over which credit is extended to a customer credit period from “net 30”
30” (which has resulted
and the discount, if any, given for early in 12 A/R “Turns” per year) to “net 60”
60” (which is
expected to result in 6 A/R “Turns” per year).
payment. For example, “2/10, net 30.”
30.”
‹ The firm is currently producing a single product
Credit Period -- The total length of time over with variable costs of $20 and a selling price of
which credit is extended to a customer to $25.
pay a bill. For example, “net 30”
30” requires
‹ Additionalannual credit sales of $250,000 from
full payment to the firm within 30 days from new customers are forecasted, in addition to the
the invoice date. current $2 million in annual credit sales.
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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Example of Relaxing Example of Relaxing


the Credit Period the Credit Period
‹ The before-tax opportunity cost for each dollar Profitability of ($5 contribution)x(10,000 units) =
of funds “tied-up” in additional receivables is additional sales $50,000
20%. Additional ($250,000 sales) / (6 Turns) =
receivables $41,667
Ignoring any additional bad-
bad-debt losses
Investment in add. ($20/$25) x ($41,667) =
that may arise, should Basket Wonders receivables (new sales) $33,334
relax their credit period?
Previous ($2,000,000 sales) / (12 Turns) =
receivable level $166,667

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Example of Relaxing Credit and Collection


the Credit Period Policies of the Firm
New ($2,000,000 sales) / (6 Turns) =
receivable level $333,333 Quality of Length of
Trade Account Credit Period
Investment in $333,333 - $166,667 =
add. receivables $166,666 (1) Average
(original sales) Collection Period

Total investment in $33,334 + $166,666 = (2) Bad-debt


add. receivables $200,000 Losses
Firm
Possible Cash Collection
Req. pre-tax return (20% opp. cost) x $200,000 = Discount
on add. investment $40,000 Program

10-15 Yes! Profits > Required pre-tax return 10-16

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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Example of Introducing
Credit Terms a Cash Discount
Cash Discount Period -- The period of time A competing firm of Basket Wonders is
during which a cash discount can be taken for considering changing the credit period from
early payment. For example, “2/10”
2/10” allows a “net 60”
60” (which has resulted in 6 A/R “Turns”
cash discount in the first 10 days from the per year) to “2/10, net 60.”
60.”
invoice date.
‹ Current
annual credit sales of $5 million are
Cash Discount -- A percent (%) reduction in expected to be maintained.
sales or purchase price allowed for early
‹ The firm expects 30% of its credit customers (in
payment of invoices. For example, “2/10”
2/10” dollar volume) to take the cash discount and
allows the customer to take a 2% cash discount thus increase A/R “Turns” to 8.
during the cash discount period.
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Example of Introducing Example of Using


a Cash Discount the Cash Discount
‹ The before-tax opportunity cost for each dollar Receivable level ($5,000,000 sales) / (6 Turns) =
of funds “tied-up” in additional receivables is (Original) $833,333
20%. Receivable level ($5,000,000 sales) / (9 Turns) =
(New) $555,556
Ignoring any additional bad-
bad-debt losses
Reduction of $833,333 - $555,556 =
that may arise, should the competing firm investment in A/R $277,777
introduce a cash discount?

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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Example of Using the


Cash Discount Seasonal Dating
Pre-tax cost of .02 x .3 x $5,000,000 = Seasonal Dating -- Credit terms that
the cash discount $30,000.
$30,000. encourage the buyer of seasonal products
Pre-tax opp. savings (20% opp. cost) x $277,777 = to take delivery before the peak sales period
on reduction in A/R $55,555.
$55,555. and to defer payment until after the peak
sales period.
Yes! Savings > Costs ‹ Avoids carrying excess inventory and the
associated carrying costs.
The benefits derived from released accounts ‹ Accept dating if warehousing costs plus the
receivable exceed the costs of providing the required return on investment in inventory exceeds
discount to the firm’s customers. the required return on additional receivables.
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Credit and Collection Default Risk and


Policies of the Firm Bad-Debt Losses
Present
Quality of Length of Policy Policy A Policy B
Trade Account Credit Period
Demand $2,400,000 $3,000,000 $3,300,000
(1) Average
Incremental sales $ 600,000 $ 300,000
Collection Period
Default losses
(2) Bad-debt Original sales 2%
Losses Incremental Sales 10% 18%
Firm Avg. Collection Pd.
Possible Cash Collection
Discount Original sales 1 month
Program Incremental Sales 2 months 3 months

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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Default Risk and Collection Policy


Bad-Debt Losses and Procedures
Policy A Policy B
The firm should increase collection
1. Additional sales $600,000 $300,000 Collection expenditures until the marginal
2. Profitability: (20% contribution) x (1) 120,000 60,000 Procedures reduction in bad-
bad-debt losses equals
3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000
4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000 the marginal outlay to collect.
‹ Letters
5. Inv. in add. receivables: (.80) x (4) 80,000 60,000

Bad--Debt Losses
6. Required before-tax return on ‹ Phone calls
additional investment: (5) x (20%) 16,000 12,000
7. Additional bad-
bad-debt losses + ‹ Personal visits Saturation
additional required return: (3) + (6) 76,000 66,000
Point
‹ Legal action
8. Incremental profitability: (2) - (7) 44,000 (6,000)

Bad
10-25 Adopt Policy A but not Policy B. 10-26
Collection Expenditures

Analyzing the
Credit Applicant Sources of Information
The company must weigh the amount
‹ Obtaining information on the of information needed versus the time
credit applicant and expense required.
required
‹ Analyzing this information to ‹ Financial statements
determine the applicant’s ‹ Credit ratings and reports

creditworthiness ‹ Bank checking


‹ Trade checking
‹ Making the credit decision
‹ Company’s own experience
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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Sequential
Credit Analysis Investigation Process
A credit analyst is likely to utilize The cost of investigation (determining
information regarding:
regarding: the type and amount of information
collected) is balanced against the
‹ the financial statements of the firm
expected profit from an order.
(ratio analysis)
‹ the character of the company
‹ the character of management An example is provided in the following
‹ the financial strength of the firm three slides 10-31 through 10-33.
‹ other individual issues specific to
the firm
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Sample Investigation Sample Investigation


Process Flow Chart (Part A) Process Flow Chart (Part B)
Pending Order
Credit rating
“limited” and/or other Yes
Bad damaging information
Reject
Stage 1 No Yes unearthed?
$5 Cost
past credit Reject
experience
No

No prior experience whatsoever


Stage 2 Credit rating
$5 - $15
Dun & Bradstreet No “fair” and/or other
Cost report analysis* Accept close to maximum
“line of credit”?

* For previous customers only a Dun & Bradstreet reference book check.
Yes
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Van Horne & Wachowicz, by Gregory A. Kuhlemeyer, Ph.D.,


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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Sample Investigation Other Credit


Process Flow Chart (Part C) Decision Issues
Credit-
Credit-scoring System -- A system used to
Bank, creditor, and financial
Stage 3 decide whether to grant credit by assigning
statement analysis
$30 Cost numerical scores to various characteristics
Good Fair Poor related to creditworthiness.

Accept Reject Line of Credit -- A limit to the amount of credit


Accept, only upon extended to an account. Purchaser can buy on
domestic irrevocable credit up to that limit.
letter of credit (L/C)** ‹ Streamlines the procedure for shipping
** That is, the credit of a bank is substituted for customer’s credit. goods.
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Other Credit Inventory


Decision Issues Management and Control
Outsourcing Credit and Collections Inventories form a link between
The entire credit and/or collection function(s) production and sale of a product.
are outsourced to a third-party company.

‹ Credit decisions are made Inventory types:


‹ Ledger accounts maintained ‹ Raw-materials inventory
‹ Payments processed
‹ Collections initiated ‹ Work-in-process inventory
Decision based on the core ‹ In-transit inventory
competencies of the firm. ‹ Finished-goods inventory
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Van Horne & Wachowicz, by Gregory A. Kuhlemeyer, Ph.D.,


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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Inventory Appropriate
Management and Control Level of Inventories
How does a firm determine
Inventories provide flexibility
the appropriate level of
for the firm in: inventories?
‹ Purchasing Employ a cost-benefit analysis
‹ Production scheduling Compare the benefits of economies of
production, purchasing, and product
‹ Efficientservicing of customer marketing against the cost of the
demands additional investment in inventories.
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ABC Method of
Inventory Control How Much to Order?
ABC method of 100
The optimal quantity to order
inventory control
depends on:
Cumulative Percentage

90
of Inventory Value

Method which controls


expensive inventory C
items more closely than
70
B Forecast usage
less expensive items.
Ordering cost
‹ Review “A” items
most frequently A Carrying cost
‹ Review “B” and “C” 0 15 45 100
Ordering can mean either the purchase or
items less rigorously Cumulative Percentage
and/or less frequently. of Items in Inventory
production of the item.
item.
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Van Horne & Wachowicz, by Gregory A. Kuhlemeyer, Ph.D.,


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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Total Inventory Costs Economic Order Quantity


Total inventory costs (T) = The quantity of an inventory item to order
C (Q / 2) + O (S / Q) so that total inventory costs are minimized
Q over the firm’s planning period.
Average
INVENTORY
(in units)

Inventory
Q/2
The EOQ or
optimal 2 (O
( ) (S)
TIME
quantity Q* = C
C: Carrying costs per unit per period
(Q*) is:
O: Ordering costs per order
10-41
S: Total usage during the period 10-42

Example of the
Economic Order Quantity Economic Order Quantity
Basket Wonders is attempting to determine the We will solve for the economic order quantity
economic order quantity for fabric used in the given that ordering costs are $200 per order,
production of baskets. total usage over the period was 10,000 units,
and carrying costs are $1 per yard (unit).
‹ 10,000 yards of fabric were used at a constant
rate last period.
‹ Each order represents an ordering cost of $200.
2 ($200
( ) (10,000)
‹ Carrying costs are $1 per yard over the 100-day Q* =
planning period. $1

10-43
What is the economic order quantity?
10-44
Q* = 2,000 Units

Van Horne & Wachowicz, by Gregory A. Kuhlemeyer, Ph.D.,


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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Total Inventory Costs When to Order?


EOQ (Q*) represents the minimum Issues to consider:
point in total inventory costs.
Lead Time -- The length of time between the
placement of an order for an inventory item and
Total Inventory Costs
when the item is received in inventory.
Costs

Total Carrying Costs Order Point -- The quantity to which inventory


must fall in order to signal that an order must
Total Ordering Costs
be placed to replenish an item.
Order Point (OP
OP) = Lead time X Daily usage
Q* Order Size (Q)
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Example of When to Order Example of When to Order


Economic Order Quantity (Q*)
Julie Miller of Basket Wonders has determined
that it takes only 2 days to receive the order of 2000
fabric after the placement of the order.
When should Julie order more fabric?

UNITS
Order
Lead time = 2 days Point
Daily usage = 10,000 yards / 100 days 200
= 100 yards per day
Order Point = 2 days x 100 yards per day 0 18 20 38 40
= 200 yards Lead

10-47 10-48
Time DAYS

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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Order Point
Safety Stock with Safety Stock
Safety Stock -- Inventory stock held in reserve 2200

as a cushion against uncertain demand (or 2000


usage) and replenishment lead time.

UNITS
Our previous example assumed certain demand Order
and lead time. When demand and/or lead time are Point

uncertain, then the order point is: 400

200
Order Point = Safety Stock
(Avg. lead time x Avg. daily usage) + Safety stock 0 18 20 38

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DAYS

Order Point
with Safety Stock How Much Safety Stock?
2200
What is the proper amount of
2000
Actual lead
safety stock?
time is 3 days!
(at day 21)
Depends on the:
the:
UNITS

Order The firm “dips”


dips”
Point into the safety stock
‹ Amount of uncertainty in inventory demand
400
‹ Amount of uncertainty in the lead time
200
Safety Stock ‹ Cost of running out of inventory
0 18 21
‹ Cost of carrying inventory
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DAYS 10-52

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© Pearson Education Limited 2004 Carroll College, Waukesha, WI
Fundamentals of Financial Management, 12/e
Chapter 10: Accounts Receivable and Inventory Management

Just-in-Time Supply Chain Management


Just-
Just-in-
in-Time -- An approach to inventory Supply Chain Management (SCM) – Managing
management and control in which inventories the process of moving goods, services, and
are acquired and inserted in production at the information from suppliers to end customers.
exact times they are needed.
Requirements of applying this approach:
approach: ‹ JIT inventory control is one link in SCM.
‹ The internet has enhanced SCM and
‹ A very accurate production and allows for many business-to-business
inventory information system (B2B) transactions
‹ Highly efficient purchasing ‹ Competition through B2B auctions helps
‹ Reliable suppliers reduce firm costs – especially
‹ Efficient inventory-handling system standardized items
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© Pearson Education Limited 2004 Carroll College, Waukesha, WI