Topic 9

Inventory and Credit Management

Inventory Management
Credit Management

1
 Inventory Management

• The goal of inventory management is to determine

the reordering quantity to replenish the inventory
in such way as to minimize the total inventory costs
and thereby enhance the profitability of the firm.

2
 Inventory Costs

• Types of inventory costs

– Carrying costs: storage and handling costs,
insurance, property taxes, depreciation, and
obsolescence.
– Ordering costs: cost of placing orders, shipping, and
handling costs.
– Costs of running short: loss of sales or customer
goodwill, and the disruption of production schedules.
• Reducing inventory levels generally reduces
carrying costs, increases ordering costs, and may
increase the costs of running short.

3
 Inventory Costs

• Carrying costs - associated with having inventories

in possession. They generally rise in direct
proportion to the average amount of inventory
held, which in turn depends on the frequency with
which orders are placed.

17-4
 Inventory Costs

• Let
• S = unit sales per year
• Q = order size
• N = number of orders per year
• C = carrying cost as % of average inventory value
• Average inventory = A = Q/2
• A = (sales/no. of orders)/2 = (S/N)/2

17-5
 Inventory Costs

• Example:
• S=120,000, N=4 times/year
• A=Q/2=(S/N)/2=(120,000/4)/2=15,000
• P =purchase price=$2/unit
• Average inventory value = (P)(A) =($2)(15,000) =
$30,000
• Assume C = 21.333%

17-6
 Inventory Costs

• Total carrying costs (TCC) = (C)(P)(A)

• TCC = (0.21333)($2)(15,000) = $6,400

17-7
 Inventory Costs

• Order costs - the cost of placing and receiving an

order. Ordering costs per order are assumed to be
fixed.
• Let F = the fixed costs, N = no. of orders per year =
S/Q
•
• Total ordering costs (TOC) = (F)(S/Q)
• Assume: F= $100, S=120,000, Q=30,000
•
• TOC = $100(120,000/30,000) = $400
17-8
 Inventory Costs

• Total inventory costs (TIC)

• TIC
• = TCC + TOC
• = (C)(P)(Q/2) + F(S/Q)
• = $6,400 + $400 = $6,800

17-9
 Economic Ordering Quantity

• The optimal ordering quantity - the purchase order

size which incurs the minimum total inventory
costs.
• Inventories are necessary, but inventory levels that
are too high or too low are costly to the firm.
• The Economic Ordering Quantity Model minimizes
total inventory cots.

17-10
 Economic Ordering Quantity

• EOQ model assumptions:

• (1) All values are known with certainty and are
constant over time.
• (2) Inventory usage is uniform over time
• (3) Carrying costs vary directly with inventory
level.
• (4) Ordering costs are fixed per order.

17-11
 Economic Ordering Quantity

• Example: Given S = 120,000 per year

• C= 21.333% of inventory value
• P= purchase price = $2
• F= fixed cost per order = $100
•
• EOQ = 7,500

17-12
 Economic Ordering Quantity

• TIC
• = TCC + TOC
• = (C)(P)(Q/2) + F(S/Q)
• = (0.21333)($2)(7,500/2) + $100(120,000/7,500)
• = $1,600 + $1,600 = $3,200

17-13
Economic Ordering Quantity

17-14
 Reorder Point

• Setting the reorder point

• Reorder point - is the predetermined inventory
level at which an order should be placed.
• Reorder point = Lead time x Usage rate
• Lead time - is the period between the placement of
an order and the receipt of the goods ordered.
• Assume: Lead time = 2 days
• Usage rate = S/365 = 120,000/365 = 328.8/day
• Reorder point = 2 x 328.8 = 657.6

17-15
 Safety Stock

• Safety stock - additional units of inventory which

act as a safeguard against stock-outs in the absence
of certainty.
• At the optimal level of safety stock, the probable
cost of running out of inventory is just offset by the
cost of carrying the additional inventory.
• The costs of stock-out include: customer ill-will,
production delays and lost sales.

17-16
 Safety Stock

• The probability of a stock-out is influenced by

fluctuations in usage rate and delivery time.
• Inclusion of safety stock does not affect the EOQ
but it will increase the carrying costs.

17-17
 Effect of Quantity Discount

• Effects of quantity discount on TIC

• Discount = 1% when Q = 10,000
• Pd = (0.99)($2) = $1.98
•
• TICd = (0.21333)($1.98)(10,000/2) + ($100)
(120,000/10,000)
• = $2,112 + $1,200 = $3,312

17-18
 Effect of Quantity Discount

• Savings from discount: (0.01)(120,000)($2) = $2,400

• Costs of taking discount; $3,312 - $3,200 = $112

• Net effect in favour of taking discount

• = $2,400 - $112 = $2,288
•

17-19
 Quick Check 

The Bertin Breads Company buys and then sells (as bread) 2.6
milliom bushels of wheat annually. The wheat must be
purchased in multiples of 2,000 bushels. Ordering costs, which
include grain elevator removal charges of $3,500, are $5,000
per order. Annual carrying costs are 2 percent of the purchase
price per bushels of $5. The company maintains a safety stock
of 200,000 bushels.
 Quick Check 

What is the EOQ?

a. 508,000
b. 510,000
c. 512,000
d. 514,000
e. 516,000
 Quick Check 

What are the total inventory cost?

a. $40,990.20
b. $50,990.20
c. $60,990.20
d. $70,990.20
e. $80,990.20
 Credit Management and Policy

• Granting credit is making an investment in a

customer – an investment tied to the sale of a
product or service. Whenever credit is granted, an
account receivable is created.
• Accounts receivable = Daily credit sales x DSO (Days
sales outstanding)

23
 Credit Management and Policy

• Granting credit may stimulate sales, however, there

are costs associated with granting credit, such as
the possibility of bad debt, the costs of carrying the
receivables.
• The credit policy decision thus involved a trade-off
between the benefits of increased sales and the
costs of granting credit.

24
 Receivables Management

• Receivables must be actively managed to ensure

that the firm's receivables policy is effective. There
are two commonly used methods to monitor a
firm's receivables.
• The DSO measures the average length of time it
takes a firm's customers to pay off their credit
purchases.
• An aging schedule breaks down a firm's receivables
by the ages of the accounts.

25
 Elements of Credit Policy

1. Credit Period: How long to pay? Shorter period

reduces DSO and average A/R, but it may
discourage sales.
2. Cash Discounts: Lowers price. Attracts new
customers and reduces DSO.
3. Credit Standards: Restrictive standards tend to
reduce sales, but reduce bad debt expense. Fewer
bad debts reduce DSO.
4. Collection Policy: How tough? Restrictive policy
will reduce DSO but may damage customer
relationships.

26
 Analyzing changes in credit policy

• Illustration: Easing the credit terms from 1/10, net

30 to 2/10, net 40
•
• Present Proposed
• $m $m
• Sales 400 530
• Collection exp. 5 2

17-27
 Analyzing changes in credit policy

• Present Proposed
• Collection Pattern: Day
• 10 - 50% 10 - 60%
• 30 - 40% 40 - 20%
• 40 - 10% 50 - 20%
• Bad debt (% of sales) 2.5 6.0

17-28
 Analyzing changes in credit policy

• Other information: Tax rate = 20%

• Pre-tax cost of fund = 20%
• Variable cost ratio = 70%

17-29
 Solutions

• Bad debt losses:

• Present = 0.025($400m) = $10m
• Proposed = 0.06($530m) = $31.8m
•
• Days sales outstanding:
• Present=.5(10)+.4(30)+.1(40)=21
• Proposed=.6(10)+.2(40)+.2(50)=24

17-30
 Solutions

• Discounts taken:
• Present=.01($400m)(.5) = $2.00m
• Proposed=.02($530m)(.6) = $6.36m
•
• Cost of carrying receivables:
• Present=$400m(21/365)(0.7)(0.2)= $3.22m
• Proposed=$530m(24/365)(0.7)(0.2)=$4.88m

17-31
 Solutions

Present Proposed
Gross sales 400.00 530.00
Less : Discounts 2.00 6.36
Net sales 398.00 523.64
Production costs 280.00 371.00
Profit before credit costs and
taxes 118.00 152.64
Cost of carrying receivables
3.22 4.88
Bad debt losses 10.00 31.80
Collection expense 5.00 2.00
Profit before taxes 99.78 113.96
Taxes (20%) 19.96 22.79
Net income 79.82 91.17

17-32
 Quick Check 

Which of the following statements is CORRECT?

a. In managing a firm's accounts receivable, it is possible to
increase credit sales per day yet still keep accounts receivable fairly
steady, provided the firm can shorten the length of its collection
period (its DSO) sufficiently.
b. Because of the costs of granting credit, it is not possible for
credit sales to be more profitable than cash sales.
c. Since receivables and payables both result from sales
transactions, a firm with a high receivables-to-sales ratio must also
have a high payables-to-sales ratio.
d. Other things held constant, if a firm can shorten its DSO, this
will lead to a higher current ratio.