IBA, Main Campus

Introduction to
Business finance
Managing Short-Term Assets
Chapter 15

by
M. Yousuf Saudagar
saudagar45@yahoo.com
 significance
• Although Wal-Mart, which is the largest retail store in the world,
generated more than $310 B in sales in 2006, not all of its investors
were pleased. In fact, Wal-Mart’s stock price had declined from a
record high of $69 per share at the beginning of 2000 to less than $50
per share in 2005-2006.
• One explanation for the price decline was that Wal-Mart’s growth
had slowed to less than 3.5% in 2005, which was about 50% of the
growth of its major competitor.
• As a result, in 2006 Wal-Mart announced cuts in its operating costs.
One of the areas that management targeted for cost-cutting actions
was inventory. If Wal-Mart could decrease inventory costs, through
better management of the system it could increase its profit margin,
which management felt would translate into a higher stock price.
• Managers felt that the company needed to become ‘‘lean’’ with
respect to its inventory practices.
2
 significance
• One inventory technique that Wal-Mart planned to use heavily was
just-in-time (JIT) ordering. A firm that follows JIT places orders at the
last possible minute—that is, inventory is ordered so that it arrives
‘‘just in time’’ to be used (sold).
• Analysts also suggested that Wal-Mart should purchase more of its
inventory directly from manufacturers rather than from wholesalers
& other third party organizations.
• Because many of the products it sells are made in China & Wal-Mart
wants to expand its presence in that country from 51 stores to 100
before 2010, it seemed to be a ‘‘natural fit’’ for the company to enter
into business relationships with the Chinese firms that manufacture
the products it sells.
• Following the JIT ordering system more closely will decrease the
amount of inventory Wal-Mart purchases at any point in time.
Businesses that rely heavily on Wal-Mart for sales will be affected.
3
 This chapter
• As you read this chapter, consider just how critical a firm’s inventory
management practices really are.

• Also consider as how important it is to operate as efficiently as

possible while converting short-term assets, such as inventory, into
cash in a timely fashion.

• The lessons to be learned from this chapter apply to the

management of short-term assets, which primarily include:
1. Cash
2. Accounts receivable (Credit Management)
3. Inventory
• Maybe you will be able to take some of the ideas discussed here &
apply them to your personal finances.
4
 This chapter
• As we discovered in the previous chapter, all else equal, the riskiness
of the portfolio of assets held by a firm is based on the combination
of its short- & long-term investments (assets).
• The relative amount invested in short-term assets is a function of
decisions that are made concerning the management of (1)
cash/marketable securities (2) accounts receivable & (3) inventories.
• Of these three assets, we generally consider cash/marketable
securities to be least risky, or most liquid. But the degree of risk can
vary for either accounts receivable or inventories, depending on the
general characteristics of the firm’s working capital policy.
• For example, we generally view receivables as relatively safe assets
because they represent sales the firm expects to collect in the future.
But a firm with an overly aggressive, or relaxed, credit policy might
have many slow payers or bad-debt customers that make its
receivables extremely risky, thus fairly illiquid. 5
 This chapter
• In this chapter, we discuss working capital management policies
with respect to the current (short-term) assets of the firm.
• As you read the chapter, keep in mind that although short-term
assets generally are safer than long-term assets, they earn a lower
rate of return.
• Thus, all else equal, firms that hold greater amounts of short-term
assets are considered less risky than firms that hold greater amounts
of long-term assets; at the same time, firms with more short-term
assets earn lower returns than firms with more long-term assets.
• Consequently, financial managers are faced with a dilemma of
whether to forgo higher returns to attain lower risk or to forgo lower
risk to achieve higher returns.
• In general, however, we will see that some amount of short-term
assets is required to maintain normal operations.
6
Cash Management
 CASH MANAGEMENT
• Managing cash flows is an extremely important task for FM. Part of
this task is determining how much cash a firm should have on hand at
any time to ensure normal business operations without interruption.
• In this section, we discuss (1) some of the factors that affect the
amount of cash firms hold, & (2) we describe some of the cash
management techniques currently used by businesses.
• The term cash refers to the funds a firm holds that can be used for
immediate disbursement. This includes the amount a firm holds in its
checking account as well as the amount of actual currency it holds.
• Cash is a nonearning asset that is required to pay bills. If possible,
should be ‘‘put to work’’ by investing in assets that have returns.
• Thus, the goal of the cash manager is to minimize the amount of cash
the firm must hold for use in conducting its normal business, yet, at
the same time, to have sufficient cash to (1) pay suppliers, (2)
maintain the firm’s credit rating & (3) meet unexpected cash needs.8
 Reasons for holding cash
• Firms generally hold cash for the following reasons:

1. Transactions balances: Cash balances associated with routine

payments & collections.
2. Compensating balance: Banks often require a firm to maintain a
compensating balance on deposit to help offset the costs of
providing services such as check clearing & cash management
advice.
3. Precautionary balances: Firms generally hold some cash in reserve
for random, unforeseen fluctuations in cash flows. The less
predictable the firm’s cash flows, the larger such balances should
be. However, if the firm has easy access to borrowed funds—that
is, if it can borrow on short notice (for example, via a line of credit
at the bank)—its need for precautionary balances is reduced.
4. Speculative balances Sometimes cash balances are held to enable
the firm to take advantage of bargain purchases that might arise.
9
 Reasons for holding cash
• Although the cash accounts of most firms can be thought of as
consisting of transactions, compensating, precautionary, &
speculative balances, we cannot calculate the amount needed for
each purpose, sum them, & produce a total desired cash balance
because the same money often serves more than one purpose.
• For instance, precautionary & speculative balances can also be used
to satisfy compensating balance requirements. Firms do, however,
consider all four factors when establishing their target cash positions.
• In addition to these four motives, a firm maintains cash balances to
preserve its credit rating by keeping its liquidity position in line with
those of other firms in the industry.
• A strong credit rating enables the firm both to purchase goods from
suppliers on favorable terms & to maintain an ample line of credit
with its bank.
10
 THE CASH BUDGET
• Perhaps the most critical ingredient to proper cash management is
the ability to estimate the cash flows so the firm can make plans to
borrow when cash is deficient or to invest when cash is in excess.
• Cash budget helps management plan investment & borrowing
strategies, & it also is used to provide feedback & control to improve
the efficiency of cash management in the future.
• First, the firm forecasts its operating activities such as expenses &
revenues for the period in question. Then, financing & investment
activities necessary to attain that level of operations is forecasted.
Such forecasts entail the construction of pro forma financial
statements, as discussed in Chapter 17. The information provided
from the pro forma BS & IS is combined with projections about delay
in collecting A/R, A/P & employees, tax payment dates, dividend &
interest payment dates, & so on.
• All of this information is summarized in the cash budget, which shows
11
the firm’s projected cash inflows & outflows over specified period.
 THE CASH BUDGET
• Generally, firms use a monthly cash budget forecasted over the next
year plus a more detailed daily or weekly cash budget for the coming
month. The monthly cash budgets are used for planning purposes &
the daily or weekly budgets are used for actual cash control.
• Cash budget provides much more detailed information concerning a
firm’s future cash flows than do the forecasted financial statements.
• For example, when we develop the forecasted FS for Unilate we
project net sales to be $1,650 M & net income to be $61 M. Based on
the forecasted financial statements, we can determine that Unilate
expects to generate an $80 M cash inflow through normal production
& sales operations. Much of this $80 M will be used for financing &
investment activities. Even after these activities are considered,
Unilate’s cash account is projected to increase by $1.5 M in 2010.
• Does this mean that Unilate will not have to worry about cash
shortages during 2010? To answer this question, we must construct
12
Unilate’s cash budget for 2010.
Step 1. Forecast the Income Statement

13
 Actual 2009 & Projected 2010 Balance Sheets

(a) 1.10 indicates ‘‘times used for items which grow proportionally with sales.
(b) Indicates a 2009 figure carried over for the initial forecast.
(c)$32.8 M represents the ‘‘addition to retained earnings’’ from the 2010 Proj Inc St .
14
(d)Additional funds needed (AFN)’’ is computed as total liab & eq minus the total assets.
 THE CASH BUDGET
• To simplify the construction of Unilate’s cash budget, we will consider
only the last half of 2010 (July through December). Further, we will
not list every cash flow that is expected to occur but instead will
focus on the operating flows.
• Remember that Unilate’s sales peak is in September & October. All
sales are made on credit with terms 2/10; n 30.
• Some of its customers delay payment for more than 90 days.
• Experience has shown that payment on 20% of sales are discount
sales, made during the month in which the sale is made. On 70% of
sales payment is made during the month immediately following the
month of sale, & payment is made on 10% of sales two months or
more after the initial sales.
• To simplify the cash budget, however, we will assume that the last
10% of sales is collected two months after the sale.
15
 THE CASH BUDGET
• Costs raw materials average 60% of the sales. These purchases are
made one month before the firm expects to sell the goods. Unilate’s
suppliers have agreed for credit of 30 days after the purchase. Thus, if
July sales are forecasted at $150 M, then purchases during June will
amount to $90 M, & this amount actually will be paid in July.
• Other cash expenses such as wages (22% of sales) & rent also are
built into the cash budget, & Unilate must make estimated tax
payments of $16 M on September 15 & $10 M on December 15,
while a $20 M payment for a new plant must be made in October.
• Assuming that Unilate’s target cash balance is $5 M & that it projects
$8 M to be on hand on July 1, 2010, what will the firm’s monthly cash
surpluses/shortfalls be for the period from July through December?
• Unilate’s 2010 cash budget for July - December is presented below.
The approach used to construct this cash budget is termed the
disbursements & receipts method (also called scheduling). 16
17
 THE CASH BUDGET
• The cash surplus or required loan balance is given on the bottom line,
which is a cumulative amount. Thus, Unilate must borrow $9.1 M in
July. Because it has a cash shortfall during August of $24.3 M as
reported on the net cash flow line, Unilate’s total loan requirement at
the end of August is $33.4 M ($9.1 M + $24.3 M), as reported on the
bottom line for August.
• Unilate’s has arranged Running Finance credit line from its bank.
Unilate will use any surplus funds to pay off its loans. If Unilate
actually does have a cash surplus will be invested in short-term,
temporary investments.
• Sales will peak in September, accompanied by increased payments
for purchases, wages, and other items. Receipts from sales will also
go up, but the firm will still be left with a $37 M net cash outflow
during the month. The total loan requirement at the end of
September will hit a peak of $70.4 M, the cumulative cash deficits
plus the target cash balance.
 THE CASH BUDGET
• Sales, purchases, and payments for past purchases will fall sharply in
October, but collections will be the highest of any month because
they will reflect the high September sales.
• As a result, Unilate will generate a healthy $43.7 M net cash gain
during October. This net gain can be used to pay off borrowings, so
loans outstanding will decline by $43.7 M, to $26.7 M.
• Unilate will generate an even larger cash surplus in November, which
will permit the firm to pay off all of its loans.
• In fact, the company is expected to have $29.2 M in surplus cash by
the month’s end, and another cash surplus in Dec will swell the
excess cash to $52.8 M.
• With such a large amount of unneeded funds, Unilate’s treasurer
certainly will want to invest in interest-bearing securities or to put the
funds to use in some other way. Various types of investments into
which Unilate might put its excess funds are available. 19
 additional points
1. For simplicity, our illustrative budget for Unilate omitted many
important cash flows that are anticipated for 2010, such as
dividends, proceeds from stock and bond sales, and investments in
additional fixed assets. The final cash budget should contain all
projected cash inflows and outflows.
2. Our cash budget example does not reflect interest on loans or
income from investing surplus cash. This refinement must added.
3. If cash inflows and outflows are not uniform during the month, we
could seriously understate the firm’s peak financing requirements.
4. The data in Table 15-1 show the situation expected on the last day of
each month, but on any given day during the month it could be quite
different. For example, if all payments had to be made on the fifth of
each month, but collections came in uniformly throughout the
month, the firm would need to borrow much larger amounts than
those shown in the table. In this case, we would have to prepare20a
cash budget identifying requirements on a daily basis.
 additional points
4. Because depreciation is a noncash charge, it does not appear on the
cash budget except for its effect on taxable income, thus taxes paid.
5. Because the cash budget represents a forecast, if actual sales,
purchases, and so on are different from the forecasted levels, then
the projected cash deficits and surpluses will also differ.
6. Computerized spreadsheet programs are well suited for constructing
& analyzing cash budgets, especially with respect to the sensitivity of
cash flows to changes in sales levels, collection periods, and the like.
7. Finally, we should note that the target cash balance will probably be
adjusted over time, rising and falling with seasonal patterns and with
long-term changes in the scale of the firm’s operations. Thus, Unilate
probably will plan to maintain larger cash balances during August
and September than at other times, and, as the company grows, so
will its required cash balance. Also, the firm might even set the
target cash balance at zero. 21
 CASH MANAGEMENT TECHNIQUES
• Cash is the is the most important component of working capital. It
includes, currency, cheques & the balances in its bank accounts.
• Near-cash items are also are included.
• Cash is the basic input required to keep the firm running on a
continuous basis.
• At the same time it is the ultimate output expected to be realized by
selling goods and services.
• A firm should hold sufficient cash, neither more, not less.
• Excessive cash remains idle which simply increases the cost without
contributing anything towards the profitability of the firm.
• In case of too little cash, trading and/ or manufacturing operation will
be disrupted.
22
 CASH MANAGEMENT TECHNIQUES
• Most cash management activities are performed jointly by the firm
and its primary bank.

• However, the financial manager is ultimately responsible for the

effectiveness of the cash management program.

• Effective cash management encompasses proper management of

both the cash inflows and the cash outflows of a firm

• This entails consideration of the factors discussed next.

23
 Cash Flow Synchronization
• It would be ideal if the receipt of a cash payment occurred at exactly
the same time a bill needs to be paid; that portion paid out would
never be idle and any excess could be invested quickly to reduce the
time it is idle.
• Recognizing this point, companies try to arrange it so that cash
inflows and cash outflows are matched as closely as possible—
customers are billed so their billing cycles coordinate with when the
firm pays its own bills.
• Having synchronized cash flows enables a firm to reduce its cash
balances, decrease its bank loans, lower interest expenses & boost
profits.
• The more predictable the timing of the cash flows, the greater the
synchronization that can be attained.
• Utilities and credit card companies generally have a high degree of
cash flow synchronization. 24
 Check-Clearing Process
• When a customer writes & mails a check, this does not mean that the
funds are immediately available. When we deposit check in our
account, bank must first make sure that it is good & the funds are
received from customer’s bank before it will give us cash.
• Quite a bit of time could be required for a firm to process incoming
checks & obtain the use of the money.
• A paper check must first be delivered through the mail & then be
cleared through the banking system. Checks received from customers
in distant cities are delayed more because of mail time & also
because more parties are involved in the check-clearing process. For
example, assume that you receive a check and deposit it in your
bank. Your bank must send the check to the bank on which it was
drawn. Only when this latter bank transfers funds to your bank are
the funds available
• If a check is deposited in the same bank on which it was drawn, that
bank merely transfers funds by bookkeeping entries. 25
 Using Float
• Float is defined as the difference between the balance shown in a
firm’s (or individual’s) checkbook and the balance on the bank’s
records.
• Suppose a firm writes, on average, checks in the amount of $5,000
each day, and it normally takes five days from the time the check is
mailed until it is cleared and deducted from the firm’s bank account.
This will cause the firm’s own checkbook to show a balance equal to
$25,000 ($5,000 x 5 days) smaller than the balance on the bank’s
records; this difference is called disbursement float.
• Now suppose the firm also receives checks in the amount of $5,000
daily, but it loses three days while they are being deposited and
cleared. This will result in $15,000 of collections float.
• In total, the firm’s net float will be $10,000, which means the balance
the bank shows in the firm’s checking account is $10,000 greater than
the balance the firm shows in its own checkbook. 26
 Delays that cause float
• Delays that cause float arise because it takes time for checks to:

1. Travel through the mail (mail delay)

2. Be processed by the receiving firm (processing delay), and
3. Clear through the banking system (clearing, or availability, delay).
• The size of a firm’s net float is a function of its ability to speed up
collections on checks received and to slow down collections on
checks written.
• Efficient firms go to great lengths to speed up the processing of
incoming checks, thus putting the funds to work faster, and they try
to delay their own payments as long as possible.

27
 Acceleration of Receipts & Disbursement Control
• Pages 605 & 606

28
 CREDIT
MANAGEMENT
(Accounts receivables)
 CREDIT MANAGEMENT
• Ideally, firms prefer to sell for cash only. So why do firms sell for
credit?

• The primary reason most firms offer credit sales is because their
competitors offer credit.

• Buying firms prefer to delay their payments, especially if there are no

additional costs associated.

• Effective credit management is critical because too much credit is

costly in terms of the investment & maintenance of accounts
receivable, whereas too little credit could result in the loss of sales.

• Carrying receivables has both direct and indirect costs, but it also has
an important benefit—granting credit should increase profits.

30
 CREDIT MANAGEMENT
• Thus, to maximize shareholders’ wealth, a financial manager needs to
understand how to effectively manage the firm’s credit activities.
• In this section, we discuss:

1. The factors considered important when determining the

appropriate credit policy
2. Procedures for monitoring the credit policy to ensure it is being
administered properly, and
3. How to evaluate whether credit policy changes will be beneficial
to the firm.

31
 Credit policy
• The major controllable variables that affect demand for a company’s
products are:

a) Sales prices

b) Product quality

c) Advertising, and

d) The firm’s credit policy.

• The firm’s credit policy, in turn, includes the factors

we discuss next.

32
 1. Credit Standards
• Credit Standards indicate the minimum financial strength a customer
must have to be granted credit.

• The major factors that are considered when setting credit standards
relate to the likelihood that a given customer will pay slowly or
perhaps even end up as a bad debt loss.

• Determining the credit quality or creditworthiness, of a customer

probably is the most difficult part of credit management.

• But credit evaluation is a well established practice, and a good credit

manager can make reasonably accurate judgments of the probability
of default exhibited by different classes of customers by examining a
firm’s current financial position and evaluating factors that might
affect the financial position in the future.

33
 2. Terms of credit
• The payment conditions offered to credit customers; which include
the length of the credit period and any cash discounts offered.
• Credit period is the length of time for which credit is granted; after
that time, the credit account is considered delinquent. Cash discount
is a reduction in the invoice price of goods offered by the seller to
encourage early payment.
• Firms need to determine when the credit period begins, how long the
customer has to pay for credit purchases before the account is
considered delinquent, and whether a cash discount for early
payment should be offered.
• Credit terms range from cash before delivery (CBD) and cash on
delivery (COD) to offering cash discounts for early payment. For
example, a firm that offers terms of 2/10, net 30.
• Due to competition, most financial managers follow the industry
norm in which they operate when setting credit terms. 34
 3. Collection policy
• The procedures followed by a firm to collect its accounts receivable.
• The firm needs to determine when and how notification of the credit
sale will be conveyed to the buyer.
• Quicker a customer receives an invoice, the sooner the bill is paid. In
today’s world, firms have turned more to send electronic invoices to
customers.
• One of the most important collection policy decisions is how the
past-due accounts should be handled. For example:
a) Notification might be sent to customers when bill is 10 days past
due;
b) A more severe notice, followed by a telephone call, might be used
if payment is not received within 30 days; and
c) The account might be turned over to a collection agency after 90
35
days.
 Receivables Monitoring
• Once a firm sets its credit policy, it wants to operate within the
policy’s limits.

• Thus, it is important that a firm examines its receivables periodically

to determine whether customers’ payment patterns have changed
such that credit operations are outside the credit policy limits.

• For instance, if the balance in receivables increases either because

the amount of ‘‘bad,’’ or uncollectible, sales increases or because the
average time it takes to collect existing credit sales increases, the firm
should consider making changes in its credit policy.

• Receivables monitoring refers to the process of evaluating the credit

policy to determine whether a shift in the customers’ payment
patterns has occurred.

36
 Receivables Monitoring
• Traditionally, firms have monitored accounts receivable by using
methods that measure the amount of time credit remains
outstanding. Two such methods are the
1. Days sales outstanding (DSO), which is sometimes called the
average collection period, represents the average time it takes to
collect credit accounts. DSO is computed by dividing annual credit
sales by daily credit sales.
2. Aging schedule is a breakdown of A/R by age of account.

37
 ANALYZING PROPOSED CHANGES IN CREDIT POLICY
• The key question: How will the firm’s value be affected? Changes in
credit policy might bring in additional costs.

• Unless the added benefits exceed the added costs on a present value
basis, the policy change should not be made.

• Let’s examine what would happen if Unilate makes changes to reduce

its average collection period 43.2 days to 35.6 days.

• Unilate’s FM has proposed that this task be accomplished next year

by:

1. Billing customers sooner and exerting more pressure on

delinquent customers to pay their bills on time and

2. Examining the accounts of existing credit customers and

suspending the credit of customers who are considered
‘‘habitually delinquent.’’ 38
 ANALYZING PROPOSED CHANGES IN CREDIT POLICY
• These actions will result in a direct increase in the costs associated
with Unilate’s credit policy (1.0M).
• Also, it is expected that some sales will be lost to competitors (2.0M).
• But because the credit policy changes will have little or no effect on
the good credit customers, the financial manager does not expect
there to be a change in the payments of the customers who take
advantage of the cash discount.
• If the proposed credit policy changes are approved, the financial
manager believes the average collection period, or DSO, for
receivables can be reduced from 43.2 days to 35.6 days, which is
more in line with the credit terms offered by Unilate (2/10, net 30)
and is closer to the industry average of 32.1 days.
• Also, if the average collection period is reduced, the amount
‘‘carried’’ in accounts receivable is reduced, which means less funds
are ‘‘tied up’’ in receivables. 39
40
 ANALYZING PROPOSED CHANGES IN CREDIT POLICY
• Whether Unilate should adopt the financial manager’s proposal? We
need to evaluate the effect the proposed changes on the value of the
firm. Thus, we must compare the NPVs of the two credit policies.

41
 INVENTORY
MANAGEMENT
 INVENTORY MANAGEMENT
• If it could, a firm would prefer to have no inventory at all because
while products are in inventory they do not generate returns and
they must be financed.
• However, most firms find it necessary to maintain inventory in some
form because demand cannot be predicted with certainty and it takes
time to transform a product into a form that is ready for sale.
• And although excessive inventories are costly to the firm, so are
insufficient inventories because customers might purchase from
competitors if products are not available when demanded, and thus
future business could be lost.
• Understanding basics of inventory management is important because
proper management requires coordination among the sales,
purchasing, production & finance departments. Lack of coordination,
poor sales forecasts or both can lead to financial ruin.
• In this section, we describe concepts of inventory management. 43
 Types of Inventory
• Inventory item can be grouped into one of the following categories:

1. Raw materials include new inventory items purchased from

suppliers; it is the material a firm purchases to transform into
finished products for sale. As long as the firm has an inventory of
raw materials, delays in ordering and delivery from suppliers do not
affect the production process.
2. Work-in-process refers to inventory items that are at various stages
in the production process. If a firm has WIP at every stage of the
production process, then it will not have to completely shut down
production if a problem arises at one of the earlier stages.
3. Finished goods inventory represents products that are ready for
sale. Firms carry FG to ensure that orders can be filled when they
are received. If there are no FGs, the firm has to wait for the
completion of the production process before inventory can be sold;
thus, demand might not be satisfied when it arrives and the firm44
might lose the demand to competitors, perhaps permanently.
 Optimal Inventory Level
• The goal of inventory management is to provide the inventories
required to sustain operations at the lowest possible cost.
• Thus, the first step in determining the optimal inventory level is to
identify the costs involved in purchasing and maintaining inventory.
• Then we need to determine at what point those costs are minimized.

Inventory Costs
We generally classify inventory costs into three categories:
1. Those associated with running short of inventory. Stock-out Occurs
when a firm runs out of inventory and customers arrive to
purchase the product.
2. Those associated with carrying inventory
3. Those associated with ordering/receiving inventory (Ordering cost)
• First, We’ll look at the two costs that are directly observable— 45
carrying costs and ordering costs.
 Optimal Inventory Level
Carrying costs include any expenses associated with having inventory,
such as rent paid for the warehouse where inventory is stored &
insurance on the inventory. They generally increase in direct
proportion to the average amount of inventory carried.
Ordering costs are expenses associated with placing & receiving an
order for new inventory, which include:
– Costs of generating memos, fax transmissions, etc.
– Cost to prepare a purchase requisition & purchase order
– Cost of the labor required to inspect goods when on arrival
– Cost to put away goods once they have been received
– Cost to process the supplier invoice related to an order
– Cost to prepare and issue a payment to the supplier
• For the most part, the costs associated with each order are fixed
regardless of the order size. 46
 Optimal Inventory Level
• If we assume that the firm knows how much total inventory it needs
and sales are distributed evenly during each period, then we can
combine the total carrying costs (TCC) and the total ordering costs
(TOC) to find total inventory costs (TIC) as follows:

C = Carrying costs as a % of the purchase price of each inventory

item
PP = Purchase price, or cost, per unit
Q = Number of units purchased with each order
T = Total demand, or number of units sold, per period 47
• According to Equation 15–1, the average investment in inventory
depends on how frequently orders are placed & size of each order. If
we order daily, the average inventory will be much smaller and
inventory carrying costs will be low, but the number of orders will be
large & inventory ordering costs will be high. We can reduce ordering
costs by ordering greater amounts less often, but then average
inventory, thus the total carrying cost, will be high.
• This trade-off between carrying costs & ordering costs is a point at
which the total inventory cost (TIC) is minimized is called the
economic (optimum) ordering quantity (EOQ).

48
 The Economic Ordering Quantity (EOQ) Model
• The EOQ is determined by using calculus to find the point at which
the slope of the TIC curve in Figure 15-3 is perfectly horizontal; thus,
it equals zero. The result is the following equation:

• The primary assumptions of the EOQ model given by Equation 15–2

are that:
1. Sales are evenly distributed throughout the period examined and
can be forecasted precisely
2. Orders are received when expected, and
3. The purchase price (PP) of each item in inventory is the same
regardless of the quantity ordered.
49
 The Economic Ordering Quantity (EOQ) Model
• To illustrate the EOQ model, consider the following data supplied by
Cotton Tops Inc., a distributor of custom-designed T-shirts that
supplies concessionaires at Daisy World:
• T (# of units sold) = 78,000 shirts per year.
• C (Carrying costs as a % of PP) = 25% of inventory value.
• PP (Purchase price) = $3.84 per shirt. (The shirts sell for $9, but this is
irrelevant for our purposes here.)
• O (Fixed costs per order ) = $260 per order.
• Substituting these data into Equation 15–2, we find an EOQ equal to
6,500 units:

50
 The Economic Ordering Quantity (EOQ) Model
• If Cotton Tops orders 6,500 shirts each time it needs inventory, it will
place 78,000/6,500 = 12 orders per year and carry an average
inventory of 6,500/2 = 3,250 shirts. Thus, at the EOQ quantity, Cotton
Tops’ total inventory costs would equal $6,240:

• Note these two points:

1. Because we assume the purchase price of each inventory item does
not depend on the amount ordered, TIC does not include the
$299,520 ($78,000 x $3.84) annual cost of purchasing the inventory
itself.
2. As we see both in Figure 15-3 and in the numbers here, at the EOQ,
total carrying cost (TCC) equals total ordering cost (TOC). This
property is not unique to our Cotton Tops illustration; it always
holds. 51
 The Economic Ordering Quantity (EOQ) Model
• Table 15-5 contains the total inventory costs that Cotton Tops would
incur at various order quantities, including the EOQ level. Note that
(1) as the amount ordered increases, the total carrying costs increase
but the total ordering costs decrease, and vice versa; (2) if less than
the EOQ amount is ordered, then the higher ordering costs more
than offset the lower carrying costs; and (3) if greater than the EOQ
amount is ordered, the higher carrying costs more than offset the
lower ordering costs.

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 EOQ Model Extensions
• Its obvious that some of the assumptions necessary in the basic EOQ
to hold are unrealistic. To make the model more useful, we can apply
some simple extensions.
• First, if there is a delay between the time inventory is ordered &
when it is received, the firm must reorder before it runs out of
inventory.
• For example, if it normally takes two weeks to receive orders, then
Cotton Tops should reorder when two weeks of inventory are left.
Cotton Tops sells 78,000/52 = 1,500 shirts per week, so its reorder
point is when inventory drops to 3,000 shirts.
• Even if Cotton Tops orders additional inventory at the appropriate
reorder point, unexpected demand might cause it to run out of
inventory before the new inventory is delivered.
• To avoid this, the firm could carry safety stocks, which represent
additional inventory that helps guard against stockouts. 53
 EOQ Model Extensions
• The amount of safety stock a firm holds generally increases with:

a) The uncertainty of demand forecasts

b) The costs (in terms of lost sales and lost goodwill) that result
from stockouts, and
c) The chances that delays will occur in receiving shipments.
• The amount of safety stock decreases as the cost of carrying this
additional inventory increases.

54
 EOQ Model Extensions
• Another factor a firm might need to consider when determining
appropriate inventory levels is whether its suppliers offer discounts to
purchase large quantities.
• For example, if Cotton Tops’ supplier offered a 1% discount for
purchases equal to 13,000 units or more, the total reduction in the
annual cost of purchasing inventory would be [0.01($3.84)] x 78,000
= $2,995.20.
• In Table 15-5 we see that the total inventory cost (excluding purchase
price) at 13,000 units is $7,800, which is $1,560 ($7,800 - $6,240)
greater than the cost at the EOQ level of 6,500 units. But the net
benefit of taking advantage of the quantity discount is $1,435.20
($2,995.20 - $1,560.00).
• Therefore, under these conditions, each time Cotton Tops orders
inventory it will be more beneficial to order 13,000 units rather than
the 6,500 units prescribed by the basic EOQ model. 55
 EOQ Model Extensions
• In cases in which it is unrealistic to assume that the demand for the
inventory is uniform throughout the year, the EOQ should not be
applied on an annual basis.
• Rather, it would be more appropriate to divide the year into the
seasons within which sales are relatively constant, say, the summer,
the spring and fall, and the winter; then the EOQ model can be
applied separately to each period.
• Although we did not explicitly incorporate the extensions we
mentioned here into the basic EOQ, our discussion should give you
an idea of how the EOQ amount should be adjusted to determine the
optimal inventory level if any of the conditions exist.

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 Inventory Control Systems – red line method
• The EOQ model can be used to help establish the proper inventory
level, but inventory management also involves the establishment of
an inventory control system.
• Inventory control systems run the gamut from very simple to
extremely complex, depending on the size of the firm and the nature
of its inventories.
• For example, one simple control procedure is the red-line method:
Inventory items are stocked in a bin, a red line is drawn around the
inside of the bin at the level of the reorder point, and the inventory
clerk places an order when the red line shows.
• This procedure works well for parts such as bolts in a manufacturing
process or for many items in retail businesses.

57
 Inventory Control Systems – Computerized system
• Most firms employ some type of computerized inventory control
system.
• Large companies often have fully integrated computerized inventory
control systems in which the computer adjusts inventory levels as:
a) Sales are made
b) Orders inventory when the reorder point is reached, and
c) Records the receipt of an order.
• The computer records also can be used to determine whether the
usage rates of inventory items change, and thus adjustments to
reorder amounts can be made.

58
 Inventory Control Systems –JIT/Outsourcing
• Another approach to inventory control that requires a coordinated
effort between the supplier and the buyer is called the just-in-time
system, which was refined by Japanese firms many years ago.
• With this system, materials are delivered to the company at about
the same time they are needed, perhaps a few hours before they are
used.
• Still another important development related to inventories is
outsourcing, which is the practice of purchasing components rather
than making them in-house.
• Outsourcing often is combined with just-in-time systems to reduce
inventory levels.

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