A B C D E F G H I

1 4/11/2010
2
3 Chapter 28. Tool Kit for Advanced Issues in Cash Management and Inventory Control
4
5
In Chapters 16 and 27, we addressed the topic of working capital management and short-term financing. In this
6 chapter, we extend those analyses to several more advanced issues, including: (1) the target cash balance, (2)
accounting for inventory, (3) the EOQ model for inventory, and (4) monitoring the receivables position.
7
8 SETTING THE TARGET CASH BALANCE (Section 28.2)
9
10 THE BAUMOL MODEL
11 The Baumol Model is used for determining optimal cash balances.
12
13 Weekly cash expenditure $1,000,000
14 Weekly cash inflows $900,000
15 Net weekly cash outflows $100,000
16
17 C = amount of cash raised by selling marketable securities or by borrowing = $400,000
18 C/2 = average cash balance $200,000 Frequency of transfer (weeks 4
19
20 Data for Table 28-1
Cash B alances

21 are on the Worksheet Tab Data 28-1

22
23
24 Figure 28-1 Cash Balances
$450,000
25
26 $400,000
27 $350,000
28 $300,000
29 $250,000
30
$200,000
31
32 $150,000
33 $100,000
34 $50,000
35 $0
36 0 3 6 9 12
37
38 Weeks
39
40 Costs
41 F = fixed costs of selling securites or obtaining loan = $150
42 T = total amount of net new cash needed during a year = $5,200,000
43 r = opportunity cost of holding cash = 15%
44 # of transactions per year = 13.00
45
46
47 Holding costs Average cash balance * r = $30,000
48 Transactions costs = # of transactions * Cost per transaction $1,950
49 Total cost = Holding costs + Transactions costs = $31,950
50
51 Optimal cash transfer = (2*F*T/r).5 = $101,980
C osts of Hold in g C ash ($)

52
53 Costs as a function of Cash Transfer Size
54 Transfer a
55
56 $20,000
Figure 28-2
57 Total Costs of Holding Cash $40,000
58 $45,000 $60,000
59 $40,000 $80,000
60 $35,000 $100,000
61 $30,000 Opportunity Cost
$120,000
62 $25,000 $140,000
63 $20,000 $160,000
Transactions Cost
64 $15,000 $180,000
65 $10,000 $200,000
66 $5,000 $220,000
67 $0 $240,000
68 $260,000
69 $280,000
70 Cash Transferred ($) $300,000
71 $320,000
72 $340,000
 A B C D E F G H I
73 $360,000
74 $380,000
75 ACCOUNTING FOR INVENTORY (Section 28.4) $400,000
76 $420,000
77 Specific Identification $440,000
78 Each unit of inventory has a specific cost. When a particular unit it sold, the value of inventory is $460,000
79 reduced by the specific amount of the unit sold. COGS reflects cost of the particular inventory used. $480,000
80
81 First-In, First-Out (FIFO)
82 The units sold in a period are assumed to be the first units that were placed in the inventory. The
83 remaining inventory reflects costs of newest inventory. COGS reflects cost of oldest inventory.
84
85 Last-In, First-Out (LIFO)
86 The units sold in a period are assumed to be the last units that were placed in the inventory. The
87 remaining inventory reflects costs of oldest inventory. COGS reflects cost of newest inventory.
88
89 Weighted Average
90 Each item in inventory is assigned the weighted average cost of all items.
91
92 COMPARISON OF INVENTORY VALUATION METHODS
93
94 Custom Furniture purchased five tables during the year at the following costs:
95 Table # 1 2 3 4 5 Total
96 Cost $10,000 $12,000 $14,000 $16,000 $18,000 $70,000
97
98 Custom Furniture had no inventory in stock at the beginning of the year. It sold Tables 1, 3, and 5
99 for a total of $80,000. How much is its profit and ending inventory for each of the four methods?
100
101 Ending
Method Sales COGS Profit Inventory
102 Specific ID $80,000 $42,000 $38,000 $28,000
103 FIFO $80,000 $36,000 $44,000 $34,000
104 LIFO $80,000 $48,000 $32,000 $22,000
105 Average $80,000 $42,000 $38,000 $28,000
106
107
108 THE ECONOMIC ORDERING QUANTITY (EOQ) MODEL (Section 28.5)
109 Data for Cotton Tops, Inc.
110 S = annual units sold = 26,000
111 N = number of orders per year = 4
112 # units per order = S/N = 6,500
113 A = average inventory = # units per order / 2 = (S/N)/2 = 3,250
114 C = percentage carrying cost = 25%
115 P = purchase price per shirt = $4.92
116 F = fixed costs per order = $1,000
117 Total carrying costs (TCC) = (C)(P)(A) = $3,998
118 Total ordering costs (TOC) = (F)(N) = $4,000
119 Total inventory cost (TIC) = TCC + TOC = $7,998
120
121 Economic order quantity (EOQ) = optimal quantity to be ordered
2 ( F )( S )
122 EOQ = [ (2*F*S) / (C*P) ].5 = 6,502 EOQ 
123 ( C )( P )
124
125
126
Figure 28-4
Units (in thousands)

127 Maximum Inventory =

Slope = Sales Rate
128 6,500 = EOQ
= 500 Shirts per Week
129 7.0
130
131 6.0
132
5.0
133
134 4.0
135
136 3.0
137 2.0
138
139 1.0
140
0.0
141
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28
142
143 Weeks
144 Data for Table 28-3
 A B C D E F G H I
145 Inventory Costs Costs as a function of Units ordered
146 Units order Carrying co
147 $3,998
148 1,000
149
Figure 28-3 2,000
150 3,000
151 $30,000 4,000
152 5,000
Costs ($)

$25,000
153 Total Inventory Costs (TIC)
6,000
154 $20,000 7,000
155 8,000
156 $15,000 9,000
157 10,000
$10,000
158 Total Carrying Costs (TCC) 11,000
159 $5,000 12,000
Total Ordering Costs (TOC)
160 13,000
161 $0 14,000
162 0 0 0 0 15,000
00 00 00 00 00 00 00 00 00
163 3, 6, 9, ,0 ,0 ,0 ,0 ,0 ,0 16,000
12 15 18 21 24 27
164 Order Size (Units) 17,000
165 18,000
166 19,000
167 20,000
168 21,000
169 EOQ MODEL EXTENSIONS (Section 28.6) 22,000
170 23,000
171 SAFETY STOCK ANALYSIS 24,000
172

Safety
Stock
173 Sales During Shortage Cost Expected Carrying Expected
Two-Week (Lost Profits) Shortage Cost: Total Cost
Safety Stock Delivery Probability $2.04x(4) = Cost: (3) x (5) $0.308 x (1) (6) + (7) =
(1) Period (2) (3) Shortage (4) (5) = (6) = (7) (8)
174 0 0 10% 0 $0 $0
175 500 20% 0 $0 $0
176 1,000 40% 0 $0 $0
177 1,500 20% 500 $1,020 $204
178 2,000 10% 1,000 $2,040 $204
179 100% Expected shortage cost = $408 $0 $408
180
181 500 0 10% 0 $0 $0
182 500 20% 0 $0 $0
183 1,000 40% 0 $0 $0
184 1,500 20% 0 $0 $0
185 2,000 10% 500 $1,020 $102
186 100% Expected shortage cost = $102 $154 $256
187
188 1,000 0 10% 0 $0 $0
189 500 20% 0 $0 $0
190 1,000 40% 0 $0 $0
191 1,500 20% 0 $0 $0
192 2,000 10% 0 $0 $0
193 100% Expected shortage cost = $0 $308 $308
194
195
196 EOQ SENSITIVITY ANALYSIS
197
198 TIC at EOQ = $7,998
199
Total Percentage
200 Ordering Inventory Deviation
Quantity Costs from Optimal
201 $7,998
202 3,000 31.4%
203 4,000 #VALUE!
204 5,000 #VALUE!
205 6,000 #VALUE!
206 6,500 #VALUE!
207 7,000 #VALUE!
208 8,000 #VALUE!
209 9,000 #VALUE!
210 10,000 #VALUE!
Data for Table 28-1
Data for Table 28-1
Week
Cycle number 1 2 3 4 5 6 7
Starts 0 4 8 12 16 20 24
Ends 4 8 12 16 20 24 28
Length 4 4 4 4 4 4 4
0 $400,000 $0 $0 $0 $0 $0 $0
0.999999 $300,000 $0 $0 $0 $0 $0 $0
1 $300,000 $0 $0 $0 $0 $0 $0
1.000001 $300,000 $0 $0 $0 $0 $0 $0
1.999999 $200,000 $0 $0 $0 $0 $0 $0
2 $200,000 $0 $0 $0 $0 $0 $0
2.000001 $200,000 $0 $0 $0 $0 $0 $0
2.999999 $100,000 $0 $0 $0 $0 $0 $0
3 $100,000 $0 $0 $0 $0 $0 $0
3.000001 $100,000 $0 $0 $0 $0 $0 $0
3.999999 $0 $0 $0 $0 $0 $0 $0
4 $0 $400,000 $0 $0 $0 $0 $0
4.000001 $0 $400,000 $0 $0 $0 $0 $0
4.999999 $0 $300,000 $0 $0 $0 $0 $0
5 $0 $300,000 $0 $0 $0 $0 $0
5.000001 $0 $300,000 $0 $0 $0 $0 $0
5.999999 $0 $200,000 $0 $0 $0 $0 $0
6 $0 $200,000 $0 $0 $0 $0 $0
6.000001 $0 $200,000 $0 $0 $0 $0 $0
6.999999 $0 $100,000 $0 $0 $0 $0 $0
7 $0 $100,000 $0 $0 $0 $0 $0
7.000001 $0 $100,000 $0 $0 $0 $0 $0
7.999999 $0 $0 $0 $0 $0 $0 $0
8 $0 $0 $400,000 $0 $0 $0 $0
8.000001 $0 $0 $400,000 $0 $0 $0 $0
8.999999 $0 $0 $300,000 $0 $0 $0 $0
9 $0 $0 $300,000 $0 $0 $0 $0
9.000001 $0 $0 $300,000 $0 $0 $0 $0
9.999999 $0 $0 $200,000 $0 $0 $0 $0
10 $0 $0 $200,000 $0 $0 $0 $0
10.000001 $0 $0 $200,000 $0 $0 $0 $0
10.999999 $0 $0 $100,000 $0 $0 $0 $0
11 $0 $0 $100,000 $0 $0 $0 $0
11.000001 $0 $0 $100,000 $0 $0 $0 $0
11.999999 $0 $0 $0 $0 $0 $0 $0
12 $0 $0 $0 $400,000 $0 $0 $0
12.000001 $0 $0 $0 $400,000 $0 $0 $0
12.999999 $0 $0 $0 $300,000 $0 $0 $0
13 $0 $0 $0 $300,000 $0 $0 $0
 8 9 10 11 12
28 32 36 40 44
32 36 40 44 48
4 4 4 4 4
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
$0 $0 $0 $0 $0
Data for Figure 28-4
Data for Figure 28-4
Week First Second
0 6.5
1 6.0
2 5.5
3 5.0
4 4.5
5 4.0
6 3.5
7 3.0
8 2.5
9 2.0
10 1.5
11 1.0
12 0.5
13 0.0 6.5
14 6.0
15 5.5
16 5.0
17 4.5
18 4.0
19 3.5
20 3.0
21 2.5
22 2.0
23 1.5
24 1.0
25 0.5
26 0.0