Define commercial paper. Explain its pros and cons.

.5 Commercial paper (CP) is a form of unsecured promissory note issued by firms to raise short
term funds. The CP are issued by companies having net worth of Rs. 10 crore or more, and are
financially sound and highest rated companies. In addition to this, companies should have maximum
permissible bank finance of not less than Rs. 25 crore, and are listed on stock exchange. The RBI
provided that size of issue should be at least Rs. 1 crore and the size of the each CP should not be
less than Rs. 25 lakh. In India, the maturity of CP

Runs between 91 to 180 days. It is expected that CP is used for short term financing only, as an
alternative to bank credit and other short term sources. The interest rate of CP will be determined
by market.

Advantages: 1) The CP is an alternative source of raising short term finance.

2) It is cheaper source of finance in comparison to bank credit.

Disadvantages or limitations:

1) As it is impersonal method, so it may not be possible to get the maturity of CP extended.

2) It cannot be redeemed until maturity, and will have to incur interest costs.

3)A firm facing temporary liquidity problems may not be able to raise funds by issuing new CP etc.

1.
2. Ordering Cost
Cost of procurement and inbound logistics costs form a part of Ordering Cost.
Ordering Cost is dependant and varies based on two factors - The cost of ordering
excess and the Cost of ordering too less.

Both these factors move in opposite directions to each other. Ordering excess quantity will
result in carrying cost of inventory. Whereas ordering less will result in increase of
replenishment cost and ordering costs.

These two above costs together are called Total Stocking Cost. If you plot the order
quantity vs the TSC, you will see the graph declining gradually until a certain point after which
with every increase in quantity the TSC will proportionately show an increase.

This functional analysis and cost implications form the basis of determining the Inventory
Procurement decision by answering the two basic fundamental questions - How Much to
Order and When to Order.

How much to order is determined by arriving at the Economic Order Quantity or EOQ.

3. Carrying Cost
Inventory storage and maintenance involves various types of costs namely:

 Inventory Storage Cost

 Cost of Capital
 Inventory carrying involves Inventory storage and management either using in house facilities
or external warehouses owned and managed by third party vendors. In both cases, inventory
management and process involves extensive use of Building, Material Handling Equipment’s,
IT Software applications and Hardware Equipment’s coupled managed by Operations and
Management Staff resources.

SAFETY STOCK
A safety stock refers to inventories held by a company as a buffer/reserve
against any increase is demand during the work-order lead time and/or delay in
receipt/production of inventories.

A safety stock is a rainy-day stock held by a company to guard against stock-out

costs. Stock out costs are costs that result from non-availability of raw materials
and/or finished goods. Availability of adequate raw materials is important for
production to continue smoothly. If there is any disruption in supply of raw materials,
the production process would stop, and the company must incur significant setup
costs to restart it. Similarly, availability of sufficient finished goods inventory is also
critical because if there is no finished goods inventory on hand, the company will
lose sales and it would hurt its reputation.

Formula
Estimation of appropriate level of safety stock depends on the nature and extent of
stock-out costs and carrying costs. A company should select its safety stock such that
the sum of its stock-out costs and carrying costs is minimized.

If the stock-out costs are very high, maintaining maximum safety stock might make
sense. The maximum safety stock level can be worked out using the following
formula:

Maximum Safety Stock

= (Maximum Weekly Demand – Average Weekly Demand) × Maximum Lead Time (in
Weeks)

But this approach is not optimal in all cases. It is because when safety stock is high,
carrying costs are high too. In practice, companies identify their optimal safety cost
by conducting a scenario analysis based on the probability of different demand
levels. Identifying the safety stock under this method involves the following steps:

STEP 1: Find out carrying cost per unit, stock-out cost per unit, economic order
quantity (EOQ) and reorder level.

STEP 2: Using historical data, assign different probabilities to occurrence of

difference demand levels.
STEP 3: Select a safety stock level and find out expected stock out costs and carrying
costs using the following formulas:

Expected Stock Out Costs = Σ (SO × P × O × SOC)

Where SO is the shortage of unit i.e. the volume of stock-out, P is the associated
probability the stock-out, O stands for number of orders and SOC is the stock-out
cost per unit.

Expected Carrying Costs = S × CC

Where S is the safety stock level and CC is the carrying cost per unit per annum.

STEP 4: Select another safety stock level and calculate expected stock-out costs and
carrying costs.

STEP 5: Identify the safety stock level which minimizes the sum of stock-out costs
and carrying costs.

What Is Economic Order Quantity (EOQ)?

Economic order quantity (EOQ) is the ideal order quantity a company
should purchase to minimize inventory costs such as holding costs,
shortage costs, and order costs. This production-scheduling model was
developed in 1913 by Ford W. Harris and has been refined over time. The
formula assumes that demand, ordering, and holding costs all remain constant

KEY TAKEAWAYS

 The EOQ is a company's optimal order quantity that minimizes its

total costs related to ordering, receiving, and holding inventory.
 The EOQ formula is best applied in situations where demand,
ordering, and holding costs remain constant over time.