12/04/2011

Instructors: Accounts Receivable and

ANTHONY ESSEL-ANDERSON
&
Inventory Management
EBENEZER SIMPSON

Prepared by A. Essel-Anderson Jan. 11, 2009 1

Accounts Receivable

Accounts receivable refer to amounts owed

to the firm by customers who bought its
goods or enjoyed its services on credit.
Credit Policy and credit
standard It is a component of current assets and as
such a working capital.
Terms of credit

Evaluation of credit applicant It is also referred to as trade debtors or

simply receivables.

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Determinants of Demand Credit Policy

A firm’s credit policy is a

set of decisions that
include the following:
•Credit standards,
•Terms of credit, and
•Collection policy and procedures.

Prepared by A. Essel-Anderson Feb 6, 2010 5 Prepared by A. Essel-Anderson Feb 6, 2010 6

Credit Standards Activity 2

Standards that indicate the minimum quality of  Illustration

creditworthiness of a credit applicant that is acceptable to the Current Situation Value
firm.
Current credit sales level (annual) GH¢200,000

Credit standards are applied to determine which customers Sales price GH¢8 per unit
qualify for the regular credit terms and how much credit to Variable cost GH¢6 per unit
grant.
Average collection period 1 month
A relaxed credit standards is likely to increase
•demand and profit generated on the additional sales.  Assume that the firm would like to embark on a more
•credit cost and opportunity cost of carrying additional accounts receivables. liberal credit policy which will result in an average
collection period of 2 months for new customers.
A more liberal credit standard is worthwhile if the additional  This policy initiative is expected to increase credit sales
profit is greater than the required return on the additional by 30%.
investment in receivables.  Opportunity cost of investment in receivables is 20%.
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Suggested Solution to Activity 2 Terms of Credit

(a) Additional credit sales GH¢200,000 GH¢60,000
X 30% Terms of Credit
(b) Additional contribution (a) * CM ratio GH¢15,000 • The payment conditions offered to credit customers.
GH¢60,000 x 25%
• The terms include the credit period, any cash discount, and any
(c) Additional receivables (a) * Receivables Turnover GH¢10,000 seasonal dating.
GH¢60,000 x (2/12)
Credit Period
(d) Additional investment in (c) * VC ratio
receivables GH¢10,000 x 75% GH¢7,500 • The length of time for which credit is granted.
(e) Cost of additional (d) * Opp. Cost
investment GH¢7,500 x 20% GH¢1,500 Cash Discounts
(d) Excess contribution over (b) – (e)
cost of additional GH¢15,000 - GH¢1,500 GH¢13,500 • A reduction in the invoice value of goods to encourage early payment.
investment
The strategy would Seasonal Dating
result in a net gain
and so would be • Customers are offered goods during before peak and pay after peak
worthwhile. sales period.

Prepared by A. Essel-Anderson Feb 6, 2010 9 Prepared by A. Essel-Anderson Feb 6, 2010 10

Credit Terms Quotes Variations in Credit Terms

“Net 30” The firm may vary its credit policy to speed up sales and receipts
from customers.
• This implies that customers who buy on credit have a
grace period of 30 days to pay for the invoice value.
The firm may:
• No cash discount is offered.
• Extend the credit period (to say 45 days) or
• Increase the percentage cash discount (to say 5%) or

“2/10, net 30” • Extend the cash discount period (to say 15 days) or
• Employ a combination of the above.

• This implies that credit customers can pay within 10

In evaluating a new policy, consider the profitability of additional
days to enjoy 2% cash discount or pay anytime from sales, additional savings/(costs) associated with
the 11th day to the 30th day without cash discount. decrease/(increase) in investments in inventory, and cost of
discount.

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Default Risk Collection Policy

An important risk associated with credit sales is default on the part of

This refers to a set of decisions and related procedures
customers.
followed by a firm to collect its accounts receivable.

In evaluating the profitability of a policy change, consider default risk

(possible increase in bad debt). Collection procedures include:
•Reminders through letters, faxes, telephone calls, and personal visits.
•Arrangements with collection agencies to collect debts.
•Legal actions to collect overdue amounts.
One must use his/her judgement to make a reasonable estimate of possible
increase in bad debt.

The judgement may be influenced by : An important decision variable is the amount of money
•past experience spent on collection procedures.
•average bad debts in the industry
•economic conditions

Prepared by A. Essel-Anderson Feb 6, 2010 13 Prepared by A. Essel-Anderson Feb 6, 2010 14

Receivables Monitoring Analysing Credit Applicant

The process of evaluating the credit

policy to determine any variance in the
customer’s payment pattern.

Common methods used to monitor the

time credit remain outstanding are:
• Average collection period
• Aging schedule

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Analysing Credit Applicant Credit Evaluation and Approval

The information about the credit applicant is analysed to

determine the applicants creditworthiness in terms of:
•Character,
•Capacity,
•Capital,
•Conditions and
•Collateral.

The analysis is be done using methods such as:

•Sequential investigation process and
•Credit-scoring system.

Prepared by A. Essel-Anderson Feb 6, 2010 17 Prepared by A. Essel-Anderson Feb 6, 2010 18

Credit Scoring Index of Credit Worthiness

Applying Fair Isaacs Method
• How promptly the applicant has paid in the past (35% of
score)
• How much debt of each type is outstanding (30% of score)
• The length of the applicant’s credit history (15% of score)
Using return on asset and current ratio as indicators
of credit worthiness, we could devise a scoring system
thus:
Z-score = return on asset + 10(current ratio)

• The number of credit cards and recently opened credit

accounts that the applicant has (10% of score)
• The mix of regular credit cards, store card, and margin
account (10% of score)
Rule of thumb:
•If applicant’s z-score is over 15 then he could pay so grant credit
•If applicant’s z-score is below 15, then he will not be able to pay.

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Types of Inventories

Raw Materials and Components

• Materials and supplies that are consumed in

production.
Goal of inventory management

Inventory costs Work-in-process

The EOQ model • Assets held in the production process for sale in the
ordinary course of business.
ABC classification & control of
inventory
Finished Goods
The JIT system
• Assets held for sale in the ordinary course of business

Prepared by A. Essel-Anderson Feb 6, 2010 21 Prepared by A. Essel-Anderson Feb 6, 2010 22

Advantages of Holding Disadvantages for Holding

Inventories
Inventories
Inventories in transit allow efficient production scheduling and utilisation of
resources.
If too much inventories are held the firm may
incur inventory costs such as:
Raw materials inventory allow the firm to be flexible in its purchasing.

•Obsolescence.
Finished goods inventory allow the firm to be flexible in its production and
marketing.
•Storage costs including warehousing rent.
•Insurance premium.
Large inventories allow the firm to meet its customers’ demand efficiently. •Opportunity costs in the form of returns that
could have been earned on investment in
Stock-out costs such as high cost of rush purchases, production stoppages
and idle time, and lost sales and customer confidence are avoided or reduced.
inventories.

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The Goal of Inventory

Optimal Inventory Level
Management

The goal of inventory management is

Steps involved in determining the
to provide an optimal level of inventory
to sustain operations at least cost.
optimal inventory level

• Indentifying the costs involved in

Inventory management involves:
purchasing and maintaining inventory.
• Establishing and maintaining proper inventory
level. • Determining the point at which those
• Establishing and maintaining inventory control
costs are minimised.
systems.

Prepared by A. Essel-Anderson Feb 6, 2010 25 Prepared by A. Essel-Anderson Feb 6, 2010 26

Inventory Costs The EOQ Model

EOQ Model
Carrying costs
• A calculus based model used to determine the point at
• Costs associated with holding inventory – storage which total inventory cost is minimised.
costs, insurance, costs of tying up funds etc. • The Economic Order Quantity (EOQ) is the optimum units to
order so as to minimise total inventory cost.
Ordering costs
Assumptions
• Costs associated with placing and receiving an order
for new inventory. • Inventory usage is evenly distributed throughout the period
under review and can be forecasted precisely.
• Orders are received when expected.
Stock-out costs
• The purchase price of each item is the same regardless of
• Costs associated with running out of inventory. the quantity ordered.

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... The EOQ Model ... The EOQ Model

 The EOQ is the quantity that will minimise the

If the right amount of inventories are kept stock-out costs total inventory costs.
can be avoided.
 Applying the rules of minimisation:
1. The first derivative of the TIC function must be equal
Thus, total inventory cost (TIC) can be expressed as follows: to zero (i.e. = 0) and

• TIC = Total Carrying Cost (TCC) + Total Ordering Costs (TOC) 2. The second derivative must be positive (i.e. )
• and:
• TCC = (carrying cost per unit) x (average inventory) = C (Q/2)
• TOC = (cost per order) x (number of orders) = O(Total Usage/Q)
 Solve for Q in the resulting equation in point 1
Thus, TIC = C (Q/2) + O (U/Q) to get the optimum quantity (Q* or EOQ).

Prepared by A. Essel-Anderson Feb 6, 2010 29 Prepared by A. Essel-Anderson Feb 6, 2010 30

The EOQ Formula Activity 1

 The following data relates to DML Ltd a

The EOQ formula is as follows: distributor of an antitoxic rubber.
◦ Total demand = 7,800 packs per year.
◦ Carrying cost = 20% of purchase price.
◦ Purchase price = GH¢4 per pack.
◦ Selling price = GH¢8 per pack.
◦ Ordering cost = GH¢100 per order
Where:  Required:
◦ Compute the optimal order quantity.
• Q* = the optimal order quantity (in units)
◦ Determine the number of times orders should be
• O = cost per order placed
• U = total usage ◦ Compute the total cost when the optimal order size is
• C = carrying cost per unit purchased.

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Suggested Solution to Activity 1 Key Inventory Levels

Safety Stock
 The optimal order quantity is given by:
• Additional inventory held in reserve as guard against
uncertain demand/usage or production/delivery delays.
• Safety stock increases with (1) uncertainty of demand
forecast; (2) stock-out costs; (3) possibility of delays in
 The number of orders to place is the total delivery of new orders.
demand divided by the optimal order quantity
◦ 7,800/1396 = approximately 6 times. Re-order Level

• This is the inventory level at which order for new inventory

 Total cost when the optimal order size is should be placed to replenish inventory.
purchased is: • Re-order Level = Lead Time x Daily Usage
◦ TIC = (0.2* GH¢4)(1396/2) + (GH¢100)(6) = • Re-order Level = (Avge. Lead Time x Avge. Daily Usage) +
GH¢1,158.4 Safety Stock
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Inventory Control Systems Just-In-Time

Red-line Method  Successful implementation of a JIT inventory

management system requires:
• An inventory control procedure where a red line is drawn around the inside ◦ Accurate production with few or no defective products.
of a stock bin to indicate the re-order level. ◦ Highly efficient purchasing.
Computerised Inventory Control System ◦ Very reliable suppliers.
◦ Accurate inventory information system.
• Computer applications are used to determine re-order points and to adjust ◦ Efficient inventory handling system.
inventory balances.

Just-In-Time System  The objective of JIT system is to reduce inventory

costs by:
• Raw materials and components are ordered and received just as they are
◦ Ordering in small lots to meet production demands to
needed in the production process. reduce carrying costs.
Outsourcing ◦ Requiring suppliers to supply materials and components
“with no defect” thus reducing inspection costs
• Components are purchased instead of producing in-house and storing in the ◦ Improving on plant layout, product features, and
production process. production processes to reduce setup time and costs.
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The ABC Method of Inventory

The Role of the Finance Manager
Classification & Control

 Inventory control activities are usually carried out

Under the ABC system inventories are classified into 3:
by account staff.
• A – About 15% of items of inventory which account for  However, investment of funds in inventory is an
important aspect of financial management.
70% of total inventory value (more valuable items).
 Thus, the finance manager must be familiar with
• B – About 30% of items of inventory which account for systems of inventory control to ensure efficient
20% of total inventory value (valuable items). capital allocation and appropriate investment in
• C – About 55% of items of inventory which account for inventories.
10% of total inventory value (less valuable).  The finance manager should work hand-in-hand
with the heads of production, marketing,
purchasing and account departments in the
Under the ABC system more valuable items of inventory are closely monitored management and control of inventories.
than less valuable items.

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