Topic 1 - Financial Planning

Learning Objectives:

At the end of the chapter, the learners are expected to:

1. Explain the basic concepts on financial forecasting.
2. Determine the different users of financial forecasting..
3. Differentiate the different approaches of forecasting.
4. Use the different techniques in their forecasting.

Financial Forecasting

Everyone doing business dreams to be somebody in the future such as the lead
distributor of product X for example. However, we cannot just attain the dream without
doing something. One has to exert efforts and should be guided with its VGMO and be
forward looking. . One of the greatest challenges facing owners and managers is how
to improve profitability and generate growth. A crucial business process for meeting
such challenge is financial forecasting.

Financial forecasting is an essential part of business planning that uses past

financial performance and current conditions or trends to predict future company
performance. In short, financial forecasts are tools by which businesses can set and
meet goals. It is the starting point of business planning, making it as one of the most
important functions to be applied in business. Forecasting is the projection of future
sales, revenues, earnings, costs and other possible variables that are helpful in the
firm’s operation. It is the basis for budgeting activities and estimating future financing
needs. Financial forecasts begin with forecasting sales and their related expenses.

Users of Forecast

Forecast can be used by individuals within and outside the company for various
reasons or purposes. Some of the are as follows;

1. Top Management
Forecast is used as a tool for long-range planning. It serves as basis for
making targets and implementing long range strategic decisions and making
capital budgeting decisions.

2. Production Manager
Makes use of forecast to determine the amount of raw materials that will
be needed in the production, the budget, schedule of production activities,
inventory levels to maintain to avoid disruption in the production process, labor
hours, and the schedule of shipments.
 3. Purchasing Manager
Makes use of the forecast to ascertain the volume of materials that should
be purchased for a certain period.

4. Marketing Manager
The forecast is used to estimate how much sales should be made for a
particular period and to plan promotional and advertising activities for the
products.

5. Finance Manager
He makes use of the forecast to anticipate the funding requirements of the
firm. He must establish the firm’s cash inflows and outflow, and indicate the
exact moment when the firm will be needing additional funding.
6. Human resource Manager
He utilizes the forecast to supply the human resources needed in
achieving the firm’s objectives.

7. Colleges and Universities

It utilizes the forecast to identify possible enrollees in a school year. The
figures on hand can help determine the revenues to be obtained from the tuition
fees, the faculty to be hired, planning of room assignments, and building of
facilities.

Approaches in Forecasting

In general, there are two approaches in forecasting namely (1) qualitative and
quantitative. (Shim et. al, 2006)

Qualitative Forecasts

These types of forecasting methods are based on judgments, opinions, intuition,

emotions, or personal experiences and are subjective in nature. They do not rely on any
rigorous mathematical computations. In practice, the combination of both qualitative
and quantitative methods is usually the most effective.

Methods of Qualitative Forecasting

1. Expert opinion
The views of the managers or a group with a high level of expertise, often
in combination with statistical models, are synthesized to generate a consensual
forecast. The forecasting method is simple and easy to implement. The opinion
of the experts become the basis of forecasting, thus no statistical tools being
employed.

2. Delphi Method
 This is similar to the expert opinion, as it is also done by a group of
experts. However, under this method, members are asked individually through a
questionnaire about their forecast of future events.
The participants in this method are the decision-makers, staff assistants,
and respondents where the decision-makers usually consist of experts who make
the actual forecast. Staff assistants aid decision-makers by preparing,
distributing and collecting the questionnaire, and analyzing and summarizing the
survey results. The respondents are people from different places who provide
inputs to the decision-makers before the forecast is made.

3. Sales Force Polling

The sales force is used by companies to arrive at their sales forecast. The
sales people having direct contact with the consumers, envision the condition of
the future market. Under this approach, every sales person estimates the sale in
his region or territory. The forecasts are then reviewed to ensure that the data
are realistic. Then they are combined at the district or national levels to arrive at
a general forecasts.

4. Consumer Market Survey

Firms conduct their own consumer or potential consumer surveys to
accumulate information regarding future purchasing plans. Surveys may be
conducted through telephones, inquiries, questionnaires and interviews. Surveys
can help not only in preparing a forecast but also in improving product design,
planning for new products, and determining consumer behavior.

In summary, a table is presented.

ll. Quantitative Forecasts

 These types of forecasting methods are based on mathematical (quantitative)
models, and are objective in nature. They rely heavily on mathematical computations.
Illustrations:

1. Naïve Method

Compute for the demand forecast for year 6.

Year Actual demand Forecast Note

1 350 - No data to use
2 380 350 Uses last period’s actual
3 400 380 Value as forecast
4 425 400
5 500 425
6 ?
(answer 500)

2. Simple Moving Average Method

 Simple moving average method: The forecast for next period (period t+1)
will be equal to the average of a specified number of the most recent observations,
with each observation receiving the same emphasis (weight).

In this illustration we assume that a 2-year simple moving average is being used. We
will also assume that, in the absence of data at startup, we made a guess for the year 1
forecast (300). Then, after year 1 elapsed, we made a forecast for year 2 using a naïve
method (310). Beyond that point we had sufficient data to let our 2-year simple moving
average forecasts unfold throughout the years.

Year Actual demand Forecast Note/solutions

1 310
2 365
3 395
300 Guess forecast at the beginning
310 Forecast for year 2 – Naïve
Method was used
337.50 From this point forward, these
forecasts were made on a year-
by-year basis using a 2-yr moving
average approach (310 + 365 =
675/2)

4 415 380 395 + 365 = 760/2

5 450 405 415 +395 = 810/2
6 465 432.50 450 + 415 = 865/2
7 457.50 465 + 450 = 915/2

3. Weighted Moving Average Method

Weighted moving average method: The forecast for next period (period
t+1) will be equal to a weighted average of a specified number of the most recent
observations.
In this illustration we assume that a 3-year weighted moving average is
being used. We will also assume that, in the absence of data at startup, we made
a guess for the year 1 forecast (300). Then, after year 1 elapsed, we used a
naïve method to make a forecast for year 2 (310) and year 3 (365). Beyond that
point we had sufficient data to let our 3-year weighted moving average forecasts
unfold throughout the years. The weights that were to be used are as follows:
Most recent year, .5; year prior to that, .3; year prior to that, .2.

Year Actual Forecast Note/solutions

demand
1 310 300 Guess forecast at the beginning
2 365 310 Forecast for year 2 – Naïve Method was
used
3 395 365 This forecast was made using a naïve
 approach.

4 415 369 From this point forward, these forecasts

were made on a year-by-year basis
using a 3-yr weighted. moving average
approach .
(395 x.5 + 365 x.3 + 310 x.2)

5 450 399 (415 x .50 + 395 x .3 + 365 x .2)

6 465 428.50 (450 x .5 + 415 x .3 + 395 x .2)
7 450.50 (465 x .5 + 450 x .3 + 415 x .2)

4. Trend Projections

Trend projection method: This method is a version of the linear

regression technique. It attempts to draw a straight line through the historical
data points in a fashion that comes as close to the points as possible.
(Technically, the approach attempts to reduce the vertical deviations of the points
from the trend line, and does this by minimizing the squared values of the
deviations of the points from the line). Ultimately, the statistical formulas compute
a slope for the trend line (b) and the point where the line crosses the y-axis (a).
This results in the straight line equation
Y = a + bX

Where X represents the values on the horizontal axis (time), and Y represents
the values on the vertical axis (demand).

For the demonstration data, computations for b and a reveal the following
(NOTE: I will not require you to make the statistical calculations for b and
a; these would be given to you. However, you do need to know what to do
with these values when given to you.)

b = 30
a = 295
Y = 295 + 30X

This equation can be used to forecast for any year into the future. For
example:
Year 7: Forecast = 295 + 30(7) = 505
Year 8: Forecast = 295 + 30(8) = 535
Year 9: Forecast = 295 + 30(9) = 565
Year 10: Forecast = 295 + 30(10) = 595
 Self Assessment:

Exercise l

True or False

Instruction: Write the word TRUE if the statement is correct and FALSE if the
statement is incorrect after the last word of each statement.

1. The qualitative forecast rely heavily on mathematical computations.

2. Production managers use the forecast to determine the bulk or volume of materials
that should be purchased for a particular period.

3. The quantitative forecasting methods is more effective than the qualitative methods.

4. Under qualitative forecasting expert opinion is difficult to use.

5. Naïve Method makes use of last year’s actual value as forecast.

6. The trend projection is a technique that uses the least squares method to fit a
Straight line to the data.

8. The top management uses the forecast as a tool for making long-range planning and
capital budgeting decision, implementing long range strategic decisions and as a
basis for performance targets.

9. Consumer market survey makes use of questionnaires, interviews or telephone call

to consumers in generation information from them.

10. Expert opinion makes use of statistical tools.

Exercise 2 – Multiple Choice

Instruction: Encircle the letter of the correct answer.

1. Which of the following is not a type of qualitative forecasting method?

a. Sales force polling c. PERT-derived forecast

b. Consumer market survey d. simple moving average

2. Its simplest way to forecast is to assume that demand in the next period will be
equal to the demand in the most recent period.

a. Naïve model c. weighted moving average

b. Trend projections d. simple moving average

3. A pattern of data that occurs every several years.

a. Cycle c. seasonality
b. Trend d. random variations

4. Which of the following is not a type of time series method of the quantitative
forecasting?

a. Naïve model c. moving average

b. Weighted moving average regression analysis

5. It is an approach in which each salesperson estimates sales in his region.

a. Expert opinion c. Delphi method

b. Consumer market survey d. sales force polling

6. All of the following are qualitative forecasting approaches except

a. Delphi Method c. Sales force composite

b. Expert Opinion d. Trend projections

7. He makes use of the forecast to estimate how much sales should be made for a
particular period and to plan promotional and advertising activities for the
products.

a. Top Management c. Colleges and Universities

b. Sales Manager d. Production Manager
 Exercise 3 – Application
Instructions: Supply the missing items on the table and show your computations
if needed.

Table 1 – Naïve Method

Year Actual demand Forecast

1 500 ?
2 575 ?
3 625 ?
4 725 ?
5 800 ?
6 ?

Simple Moving Average

Assume that a 3-year simple moving average is being used. We will also assume
that, in the absence of data at startup, we made a guess for the year 1 forecast (300).
Then, after year 1 elapsed, we used a naïve method to make a forecast for year 2 (310)
and year 3 (365). Beyond that point we had sufficient data to let our 3-year simple
moving average forecasts unfold throughout the years.

Table 2 – Simple Moving Average

Year Actual Forecast Note/solutions

demand
1 310
2 365
3 395
4 415
5 450
6 465
7

Topic 4 - Inventory Management

Learning Objectives

At the end of the topic, the students must be able to

1. Explain the importance of having adequate inventories.
2. Identify the objectives of inventory management .
3. Explain the functions of inventory management
4. Compute for EOQ, lead time usage reorder point and safety stock/
5. Apply the techniques learned in inventory management.

Inventory Management Defined

Inventory Management involves the activities in maintaining optimum number or

amount of each inventory item. These inventories include raw materials, goods in
process and finished goods. Effective Inventory management is all about knowing what
is on hand, where it is in use, and how much finished product results. Inventory
management is the process of efficiently overseeing the constant flow of units into and
out of an existing inventory. This process usually involves controlling the transfer in of
units in order to prevent the inventory from becoming too high, or dwindling to levels
that could put the operation of the company into jeopardy.

Objectives of Inventory Management

The following are the objectives of inventory management:
1. Reduce inventories while maintaining customer service levels and quality. The
firm can free needed cash to finance both internal and external growth.
2. To maintain a sufficient amount of inventory to insure the smooth operation of the
firm’s production and the marketing functions .
3. To avoid tying up funds in excessive and slow-moving inventory.

Functions of Inventories
1. Pipeline or transit inventories
These are inventories which are being transferred or moved from one
location to another to fill the supply pipelines between stages of the entire
production-distribution system.
2. Organizational or decoupling inventories
This refers to inventories that are maintained to provide each link in the
production-distribution chain a certain degree of independence from the others.
These will also take care of random fluctuations in demand and/or supply.
3. Seasonal or anticipated stock
This are built up in anticipation of the heavy selling season or in
anticipation of price increase or as part of promotional sales campaign.
4. Batch or lot-size inventories
 Inventories that are maintained whenever the user makes or buys
materials in larger lots than are needed for his immediate purposes.
5. Safety or buffer stock
Inventories are maintained to protect the company from uncertainties such
as unexpected customer demand, delays in delivery of goods ordered, etc.

Cost associated with investment in inventory

1. Carrying costs
 Cost of capital tied up in inventories
 Storage and handling costs
 Insurance
 Property taxes
 Depreciation and obsolescence
 Administrative costs (ex. Accounting costs, etc.)
2. Ordering, shipping and receiving costs
Cost of placing orders including production and setup costs
Shipping and handling costs
3. Cost of running short
Loss of sales
Loss of customer goodwill
Description of production schedules

Inventory Management Techniques

Inventory Planning and Control

This involves the determination of what inventory quality, quantity, timing and
location should be in order to meet future business requirements. The purpose of
inventory planning and control is to determine the optimum level of inventory necessary
to minimize costs.

Economic Oder Quantity

The basic inventory problem facing a firm is one of minimizing the total cost of
the inventories. To solve this problem, the firm has to avoid the possibility of any stock-
outs, which would result in customer loss and dissatisfaction. Minimizing total inventory
costs can be dealt with the use of the Economic Order Quantity Model.
The economic order quantity is the order size of the appropriate number of units
that should be ordered.

Formulas

1. Economic Oder Quantity = √ 2 x Annual Demand∈Units x Cost per Order

Carrying costs per Unit

a. Total inventory costs = total Ordering Costs + total carrying costs

b. Total Ordering costs = Annual demand in Units x Ordering costs per order
EOQ or order size

c. Total carrying costs = Average Inventory x Carrying costs per unit

d. Average Inventory = EOQ or Order size/2

2. Reorder Point = Lead time Usage + Safety stock

Reorder point – the time when to place the order for the order quantity (size)
Safety stock - this represent the inventories carried over and above the quantity
determined by the EOQ formula to meet unanticipated demand.

Problem:

ABC Company sells 1,000 units of its products annually at a price of P15. The
wholesale price that the store pays per unit is P10.50. Costs of carrying a unit of the
product are estimated at 1.25 per year while ordering costs are estimated at P11.

Required:
1. Determine the economic order quantity.
2. Determine the total carrying costs
3. Determine the total ordering costs
4. Determine the total annual inventory costs

Solutions:
1. EOQ = √ 2 x 1,000 x 11 = 133.66 or 134 units
1.25

2. Total carrying costs = Average Inventory x Carrying costs per unit

= 134/2 x 1.25 = P87.75

3. Total Ordering costs = Annual demand in Units x Ordering costs per order
EOQ or order size
= 1,000 x P11 = P82.09
134
4. Total inventory costs = total Ordering Costs + total carrying costs
 = P82.09 + P87.75 = P169.84

Problem 2

The following inventory information and relationships for Bea Company are
available:

1. Annual unit usage is 200,000. (assume a 50-week year in your calculations)

2. The carrying cost is 25% of the purchase price of the goods.
3. The purchase price is P15 per unit.
4. The ordering cost is P60 per order
5. The desired safety stock is 1,200.
6. Delivery time is 3 weeks.

Required:
1. What is the economic order quantity?
2. How many orders will be placed annually?
3. At what inventory level should a reorder be made?

Solution:
1. EOQ = √ 2 x 200,000 xP 60 = 2,530 units
15 x .25
2. Number of Orders = 200,000/2,530 = 79

3. Reorder point = 200,000/50 x 2 + 1,200 = 17,200 units

Level Monitoring and Inventory control Systems

Inventory control is the regulation of inventory within predetermined limits.
Effective inventory management should provide adequate stocks to meet the
requirements of the business, while at the same time keeping the required investment to
the minimum.

Inventory control systems

1. Fixed Order Quantity system

Each time the inventory goes down to a predetermined level known as the
reorder point, an order for a fixed quantity is placed. This system required the
use of a perpetual inventory records or the continuous monitoring of the inventory
 level. An example of this application is the two-bin system under which reorder is
placed when the contents of the first bin are used up.

2. Fixed Reorder cycle System (Periodic Review or Replacement System)

Orders are made after a review of inventory levels had been done at
regular intervals. An order is placed if at the time of the review the inventory
level had gone down since the preceding review. The quantity ordered under
this system is variable depending on usage or demand during the review period.

Replenishment level is computed by the following formula:

M = B + D(R + L)
Where M = Replenishment level in un its
B = Buffer stocks in units
D = Average demand per day
R = Time intervals in days, between
reviews
L = Lead time in days

3. Optional Replenishment system

It represents a combination of the important control mechanisms of the
other two systems . Replenishment level is computed by the use of the equation.

P = B + D(L + R/2)
Where P = Reorder points in units
B = Buffer stocks in units
D = Average daily demand in units
L = Lead time in days
R = time between review in days

3. ABC Classification system

The segregation of materials for selective control is made under this system.
Inventories are classified into “A” or high-value items, “B” or medium cost items and “C”
or low cost items. Control may be exercised on the items as follows:

1. A items – highest possible controls, including most complete, accurate

records, regular review by top supervisor, blanket orders with frequent
deliveries from vendor, close follow-up through the factory to reduce lead
time, etc. If possible accurate careful determination of order quantities and
order point with frequent review to reduce.
 2. B items – normal controls involving good records and regular attention; good
analysis for EOQ and order point but reviewed quarterly only or when major
changes occur.
3. C items – simplest possible controls such as periodic review of physical
inventory with no records or only the simplest notations that replenishment
stocks have been ordered; no EOQ or order point calculation.

Self Assessment

Exercise 1 - Multiple choice

Instruction: Encircle the letter that corresponds to your answer.

1. It is the optimum amount of goods to be ordered so that the total inventory costs
are maintained.
a. Order cost c. economic order quantity
b. Carrying cost d. total cost
2. It is the process of determining appropriate level of inventory
a. Economic order quantity c. inventory management
b. Economic order point d. inventory planning
3. It is the cost of placing an order and receiving the merchandise. It includes the
freight charges and clerical costs.
a. Ordering cost c. total inventory cost
b. Carrying cost d. safety stock
4. The number of units of units of stock sold between an order placed and the time
it arrives.
a. Lead time c. reorder point
b. Lead time demand d. safety stock level
5. Which of the following is not an advantage of quantity discount buying?
a. Lower stock turnover c. lower ordering costs
b. Lower unit prices d. fewer stockouts
6. Which of the following is not an assumption of the EOQ model?
a. Demand is known and is nearly constant.
b. The new inventory arrives when the level of old inventory hits zero
c. All cost information is known and constant
d. Back orders and lost sales are known and are nonzero
7. A stockout might occur when
a. It takes longer than expected to receive a new order
b. Unusually high demand is observed before the reorder point is reached.
c. The new order is received in an unexpected short time
d. Answers a and b
8. Inventory carrying costs may include all except one of the following
a. Placing goods into inventory
b. Obsolescence of inventory items
c. Inventory storage costs
 d. All of the above
9. The cost of maintaining an inventory. It includes the rent of warehouse,
insurance premium on inventories, property taxes and spoilage.
a. Order costs
b. Economic order quantity
c. Carrying costs
d. Total cost

Exercise 2 – Matching Type - Problems

Instruction: Encircle the letter that corresponds to your answer. Show all your computations.

1. The Zyra Company requires 40,000 units of product A for the year. The units
will be required evenly throughout the year. It costs P60 to place an order. It
costs P10 to carry a unit in inventory for the year. What is the economic order
quantity?

a. 400 c. 600
b. 490 d. 693

2. The following information relates to the cordillera Company:

Units required per year 30,000
Cost of placing an order P 400
Unit carrying cost per year P 600

Assuming that the units will be required evenly throughout the year, what is the
economic order quantity?

a. 200 c. 400
b. 300 d. 500
c.
3. The following information is available for Gabelle Company’s material Y:
Annual usage in units 10,000
Working days per year 250
Normal lead time in working days 30
Maximum lead time in working days 70
Assuming that the units of material Y will be required evenly throughout the year,
the order point would be

a. 1,200 c. 2,000
b. 1,600 d. 2,800
 4. ABC Company manufactures bookcases. Set up costs are P2.00. ABC
manufactures 4,000 bookcases evenly throughout the year. Using the economic
order quantity approach, the optimal production run would be 200 when the cost
of carrying on bookcase in inventory for one year is

a. P0.05 c. P0.20
b. 0.10 d. 0.40

5. The Hot Corporation purchases 60,000 headbands per year. The average
purchase lead time is 20 working days. Maximum lead time is 27 working days.
The corporation works 240 days per year.
Hot Corporation should carry safety stock of (in units)
a. 5,000 c. 1,750
b. 6,750 d. 5,250

Exercise 3 – Problem Solving

Problem 1

The Lax Company buys 500 boxes of item A every two months. Order costs are
P380 per order, carrying costs are P1 per unit, and vary directly with inventory
investment. Currently the company purchases the item for P5 each.

Required:
1. Determine the ordering and carrying costs under current policy.
2. Determine the economic order quantity and the related ordering and carrying
costs.
3. What is the order size decision Lax Company should make, of the supplier
gives a 5% discount for order sizes of 3,000 units.

Problem 2

Melon Company has obtained the following costs and other information pertaining to one
of the materials:

Working days per year 250 Lead time (in days) 5

Normal usage per day (units) 500 Cost of placing one order P36
Maximum use per day (units) 600 carrying cost per unit/year 4

Required:
1. Calculate the economic order quantity
2. Determine the safety stock.
3. Compute the order quantity