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CHAPTER 20

Accounts Receivable and
Inventory Management
CHAPTER ORIENTATION
The investment of funds in accounts receivable inventory involves a trade-off between
profitability and risk. For accounts receivable, this trade off occurs as less creditworthy
customers with a higher probability of bad debts are taken on to increase sales. With respect
to inventory management, a larger investment in inventory leads to more efficient
production and speedier delivery, hence, increased sales. However, additional financing to
support the increase in inventory and increased handling and carrying costs is required. In
addition, the concept of total quality management and single-sourcing have had a major
impact on inventory purchasing.

CHAPTER OUTLINE

I. Accounts receivable
A. Typically, accounts receivable account for just over 20 percent of a firm's
assets.
B. The size of the investment in accounts receivable varies from industry to
industry and is affected by several factors including the percentage of credit
sales to total sales, the level of sales, and the credit and collection policies,
more specifically the terms of sale, the quality of customers, and collection
efforts.
C. Although all these factors affect the size of the investment, only the credit
and collection policies are decision variables under the control of the
financial manager.
D. The terms of sale are generally stated in the form a/b net c, indicating that
the customer can deduct a percentage if the account is paid within b days;
otherwise, the account must be paid within c days.

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Increased collection costs G. what is the annualized opportunity cost of passing up the 2 percent discount and withholding payment until the 60th day? Solution: Substituting the values from the example. Among these are financial statements. 2. the annualized opportunity cost of passing up this a% discount and withholding payment until the cth day is determined as follows: annualized opportunit y a 360 cost of forgoing the = x discount 1 −a c −b Example: Given the trade credit terms of 2/10. One commonly used method for credit evaluation is called credit scoring and involves the numerical evaluation of each applicant in which an applicant receives a score based upon the answers to a simple set of questions. The costs associated with extending credit to lower-quality customers include: a. The score is then evaluated relative to a predetermined standard. 1. Several avenues are open to the firm in considering the credit rating of an applicant.02 30 −10 F. bank references.02 360 36. H. information from other companies. independent credit ratings and reports. One common way of evaluating the current situation is ratio analysis. The major advantage of credit scoring is that it is inexpensive and easy to perform. Increased costs of credit investigation b. ratio of credit sales to receivables (accounts receivable 235 . Analyzing the credit application is a major part of accounts receivable management. A second decision variable in determining the size of the investment in accounts receivable in addition to the trade credit terms is the type of customer.73% = x 1 − 0. If the customer decides to forgo the discount and not pay until the final payment date. we get 0. 1. a.E. examining the average collection period b. its level relative to that standard determining whether or not credit scoring should be extended to the applicant. and past experiences. ratio of receivables to assets c. 1. The key to maintaining control over collection of accounts receivable is the fact that the probability of default increases with the age of the account. Increased probability of customer default c. net 30.

4. This type of inventory uncouples the production function from the purchasing function. while the return aspect of this trade-off results because increased inventory investment costs money. inventory accounts for about four to five percent of a firm's assets. In order to effectively manage the investment in inventory. Inventory A. B. The risk comes from the possibility of running out of inventory if too little inventory is held. turnover ratio) d. aging of accounts receivable schedule I. The order quantity problem involves the determination of the optimal order size for an inventory item given its expected usage. Once delinquent accounts have been identified. The purpose of carrying inventories is to uncouple the operations of the firm. serves to make the payment of bills independent of the collection of accounts due. 3. This type of inventory uncouples the various production operations. already discussed in some detail in preceding chapters. F. This type of inventory uncouples the production and sales function. and ordering costs . Finished goods inventory consists of goods on which the production has been completed but the goods are not yet sold. II. 1. Stock of cash inventory. There are several general types of inventory. Typically. Credit should be extended to the point that marginal profitability on additional sales equals the required rate of return on the additional investment in receivables necessary to generate those sales. As such. Raw materials inventory consists of the basic materials that have been purchased from other firms to be used in the firm's production operations. and this trade-off is always part of making the decision. D. the decision with respect to the size of the investment in inventory involves a basic trade-off between risk and return. two problems must be dealt with: the order quantity problem and the order point problem. Work in process inventory consists of partially finished goods that require additional work before they become finished goods. carrying. G. 236 . J. C. A direct trade-off does exist between collection expenses and lost goodwill on one hand and noncollection of accounts on the other. E. 2. to make each function of the business independent of each other function. amount of bad debts relative to sales over time e. the third and final variable is determined by the firm’s collection policies. that is.

Modification for safety stocks is necessary since the usage rate of inventory is seldom stable over a given timetable. 1. it is a production and management system. The greater the uncertainty associated with forecasted demand or order time. 1. Inflation can also have an impact on the level of inventory carried. O. The cost of carrying goods may increase. The costs associated with running out of inventory will also determine the safety stock levels. How much safety stock does the management desire? K. Under this system. and the time and physical distance between the various production operations is also minimized. L. The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs. Goods may be purchased in large quantities in anticipation of price rises. 2. 1. the optional order quantity. The order point problem attempts to answer the following question: How low should inventory be depleted before it is reordered? J. inventory is cut down to a minimum. The just-in-time inventory control system is more than just an inventory control system. The EOQ is given as Q* = where C = carrying costs per unit O = ordering costs per order S = total demand in units over the planning period Q* = the optimal order quantity in units I. 237 .H. This safety stock is used to safeguard the firm against changes in order time and receipt of shipped goods. N. A point is reached where it is too costly to carry a larger safety stock given the associated risk. the larger the safety stock. What is the usual procurement or delivery time and how much stock is needed to accommodate this time period? 2. M. causing a decline in Q*. 2. In answering this question two factors become important: 1.

2. B. 3. TQM and Inventory Purchasing management. A. Actually the just-in-time inventory control system is just a new approach to the EOQ model which tries to produce the lowest average level of inventory possible. In many cases firms that only a few years ago placed an upper limit of 10 or 20 percent on the purchases of any part from a single supplier now rely on a single supplier using the single-sourcing relationship. D. The concept of total quality management has led to strong customer-supplier relationships in an effort to increase quality. III. C. Financially. Single sourcing ties the interests of the supplier to the firm to which it supplies and allows the supplier to provide input on production techniques that might improve quality. 238 . the TQM view argues that higher quality will result in increased sales and market share and as a result the traditional economic analysis of inventory management is flawed. Average inventory is reduced by locating inventory supplies in convenient locations and setting up restocking strategies that cut time and thereby reduce the needed level of safety stock.