Managing inventories

Managing Working Capital Managing accounts receivable

Managing accounts payable
 Overview – managing working capital

Maximisation of
shareholder wealth

o ns
l u ti
Investment Financing So
i ng Dividend decision
decision
e a rn
decision

ex L
r t
Ve
Managing
working
capital

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Syllabus learning outcomes (1)
 The use of relevant techniques in managing inventory, including
the Economic Order Quantity model and Just-in-Time
techniques.
 Discuss, apply and evaluate the use of relevant techniques in
managing accounts receivable, including tions
S olu
 (i) Assessing creditworthiness in g
ar n
 (ii) Managing accounts x L e
receivable
erte
V
 (iii) Collecting amounts owing
 (iv) Offering early settlement discounts
 (v) Using factoring and invoice discounting
 (vi) Managing foreign accounts receivable
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Syllabus learning outcomes (2)
Discuss and apply the use of relevant techniques in managing
accounts payable, including:
 (i) Using trade credit effectively
 (ii) Evaluating the benefits of discounts for early
s
settlement and bulk purchase lution
g S o
 (iii) Managing foreign accountsr n in payable
L e a
rtex
Ve

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Key models and theories
The key models relating to the management of
inventories, accounts receivable, accounts payable and
cash are;

 The economic order quantity model

 Just-in-time (JIT) uti o ns
n g Sol
 Evaluating the use of discounts
L e a rni to management
ex
Vert
receivables and payables
 The use of factors and invoice discounting

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Managing working capital
Working capital management is very important in the F9
exam.

This chapter examines the management of:

 Inventory
ti o ns
 Receivables Sol u
i n g
 Payables rtex L ea r n
Ve

Usually a question will combine several aspects of

working capital management.

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Managing inventories – introduction
Managing inventory deals with two questions:

 The order quantity: how much inventory should be

ordered?
 The reorder level: when should inventory be ordered?
ti o ns
Sol u
rni n g
These amounts are independent:
ex L e a how much you order
Vert when to place the order.
tells you nothing about

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Managing inventories – the order quantity (1)

Inventory has associated costs:

 Cost of procurement (placing order, delivery charges,

processing receipt of the goods and payment)
 Holding costs (such as the cost of finance tied up and
storage) o ns
Sol uti
 Purchase costs (sometimes g
rni after a discount)
n
x L e a
e rte
 Shortage costs (such
V as costs arising from lost sales
and idle workers)

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Managing inventories – the order quantity (2)

Costs relevant to order quantities:

 Cost of procurement, called 'ordering costs'

 Holding costs
 Purchase costs (relevant if there are bulk discounts)
ti o ns
Sol u
rni n g
We start by assuming there
x L e a are no bulk discounts.
Ve rte
Purchase costs are then irrelevant because the purchase
expense over a year will be constant (units bought per
year × cost/unit).

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Managing inventories – the order quantity (3)

Assumption behind the analysis: inventory is used

at a constant rate and supplier lead time is zero or
constant:
Inventory
Maximum inventory

Reorder Average
quantity, ti o ns
Sol u inventory
Q i n g
rtex L ea r n
Ve Time
Delivery received

Maximum inventory = reorder quantity, Q

Average inventory = Q/2
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Lecture example – order quantities
Annual demand = 5,000 units.
Cost of holding 1 unit for 1 year = $5
Ordering cost = $500/order

Prepare a table showing annual holding costs,oordering n s costs and total

olu ti
costs at reorder quantities of: S
r nin g
L e a
r tex
200, 500, 1,000, 1,500 andVe2,500 units

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 Answer to lecture example – order quantities
Annual demand = 5,000 units. Cost of holding 1 unit for 1 year = $5. Ordering cost = $500/order

Order Average Number of Annual Annual Total cost

quantity, Q inventory orders holding cost ordering cost $ ($)
Q/2 (5,000/Q) $ (Orders x $500)
(Q/2 x $5)
on s
200 100 25 o ti
lu500 12,500 13,000
i n g S
500 250 10 ear n 1,250 5,000 6,250
tex L
1,000 500 Ve r 5 2,500 2,500 5,000
1,500 750 3.33 3,750 1,665 5,415
2,500 1,250 2 6,250 1,000 7,250

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 Managing inventories – the order quantity (4)

The table showed that, of the reorder quantities tried, 1,000 was the
most economical.
A precise result can be quickly obtained using a formula:
Economic order quantity =
Ch
√ 2Co D

ti o ns
Sol u
r ni n g
Where: Co = cost of placing an e a
x order
L
e rte
D = annual demandV
Ch = cost of holding one unit for one year

(The formula is provided in the exam, but you are not told what the
symbols mean!)
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 Managing inventories – the order quantity (5)

Economic order quantity =

Ch
√ 2Co D

Using the lecture example data (annual demand = 5,000 units, cost of
holding 1 unit for 1 year = $5, ordering cost = $500/order).
s
√ n g Sol uti
i 500 × 5,000
Economic order quantity = ex Lea2rn×
o n

Vert
5
= 1,000 units

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Question to consider
A company sells 1,000 units/month and each item costs $400 to
buy. Placing an order costs $640. The company's cost of capital
is 6% pa. What is the economic order quantity?

Economic order quantity = √ 2Co D utions

Sol
Ch
r nin g
L e a
r tex
Ve
Where: Co = cost of placing an order
D = annual demand
Ch = cost of holding one unit for one year
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 Answer
Economic order quantity =
Ch
√2C D o

Co = 640; D = 12 × 1,000 = 12,000 [annual demand]

ti ons
Ch = 400 × 6% = 24 [cost of holding one unit for g So lu year]
one
ni n
ar
Economic order quantity =
√
V e r tex L e
2 × 640 × 12,000
24
= 800 units

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Question to consider
A company sells 1,000 units/month and each item costs $400 to
buy. Placing an order costs $640. The company's cost of capital
is 6% pa. Economic order quantity = 800 units.

What is the total annual cost of ordering, purchasing and

holding inventory? n s
lu ti o
A $9,600 g So
rni n
B $4,809,000 L e a
e x
Vert
C $4,819,200
D $4,828,800

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 Answer
A company sells 1,000 units/month and each item costs $400 to buy. Placing an order
costs $640. The company's cost of capital is 6% pa. Economic order quantity = 800
units.
C

Cost element ti ons $

Solu
Ordering: 1,000 × 12/800 × $640 arning 9,600
x L e
e
Vert
Purchasing: 1,000 × 12 × $400 4,800,000
Holding: 6% × 800/2 × $400 9,600
Total cost 4,819,200

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The order quantity with bulk discounts
The purchase price of goods is relevant if a
discount is given for orders of a minimum quantity
as it might be worth increasing the order size to get
the discount.

Technique:
ti o ns
1. Work out the EOQ as normal. g Sol u
a rni n
2. Work out the total L e
inventory-related
ex price at the
V e rt
EOQ (ordering, purchasing and holding
inventory).
3. Work out the total inventory-related price where
the discount is first available (ordering,
purchasing and holding inventory).
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Question – Order quantity with discounts
A company sells 1,000 units/month and each item costs $400 to buy.
Placing an order costs $640. The company's cost of capital is 6% pa.
The supplier offers a 1% discount for purchases of at least 6,000 units.

Should the reorder quantity be moved from its current 800 units to
6,000 units? on s
olu ti
n g S
rni
e a
Lcost of ordering, purchasing and
rtex
Note: at EOQ of 800 units, etotal
holding = $4,819,200 V

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 Answer – Order quantity with discounts
If the order quantity is moved to 6,000 units, the costs are:

Cost element $ Previously

Ordering: (1,000 × 12)/6,000 × $640 1,280

s 9,600
ti on
lu
Purchasing: 1,000 × 12 × $400 × 99% ing So4,752,000 4,800,000
L e a rn
Holding: 6% × 6,000 × 99% × $400/2
r tex 71,280 9,600
Ve
Total cost 4,824,560 4,819,200

If the reorder quantity were kept at 800 units, total annual costs =
$4,819,200, so the discount offer is not worthwhile
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 Q3 June 2008
FLG Co wishes to minimise its inventory costs. Annual demand for a
raw material costing $12 per unit is 60,000 units per year. Inventory
management costs for this raw material are as follows:
Ordering cost: $6 per order; Holding cost: $0.5 per unit per year
The supplier of this raw material has offered a bulks purchase
discount of 1% for orders of 10,000 units or lu ti
more.on If bulk purchase
i ng So
orders are made regularly, it is expected
L e arn that annual holding cost for
r
this raw material will increase t x $2 per unit per year.
eto
Ve
Required:
(i) Calculate the total cost of inventory for the raw material when
using the economic order quantity. (4 marks)
(ii) Determine whether accepting the discount offered by the
supplier will minimise the total cost of inventory for the raw
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material. (3 marks)
Q3 June 2008 (1)
(i) Economic order quantity = (2 × 6 × 60,000/0.5)0.5 = 1,200
units
Number of orders = 60,000/1,200 = 50 order per year
Annual ordering cost = 50 × 6 = $300 per year
Average inventory = 1,200/2 = 600 units tions
S o lu
ni ng
Annual holding cost = 600 ×x 0.5
L e r
a = $300 per year
Verte
Inventory cost = 60,000 × 12 = $720,000
Total cost of inventory with EOQ policy = 720,000 + 300 +
300 = $720,600 per year

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Q3 June 2008 (2)
(ii) Order size for bulk discounts = 10,000 units
Number of orders = 60,000/10,000 = 6 orders per year
Annual ordering cost = 6 × 6 = $36 per year
Average inventory = 10,000/2 =5,000 units
tions
Annual holding cost = 5,000 × 2 = $10,000 S o lu per year
ni ng
L e r
a 0.99 = $11.88 per unit
Discounted material cost e=12
x ×
Vert
Inventory cost = 60,000 × 11·88 = $712,800
Total cost of inventory with discount = 712,800 + 36 + 10,000 =
$722,836 per year
The EOQ approach results in a slightly lower total inventory cost

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Managing inventories – the reorder level (ROL) (1)

The ROL = when to order inventory. To what level should

inventory fall before placing an order?

Aim: not to have an inventory shortage as this is

expensive:
 Idle workers o ns
Sol uti
 Unused machinery rni n g
x L e a
e rte
 Lost sales V
 Disappointed customers
 Opportunities for competitors

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Managing inventories – the reorder level (ROL) (2)

ROL depends on:

 Lead time: how long between placing an order and

receiving delivery
 Quantity demanded in the lead time
ti o ns
Sol u
rni n g
If lead time and quantityex Ldemanded
e a in lead time are
Vert
constant, ROL is relatively straightforward, but generally
there is some uncertainty about both.

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Question – simple ROL
A company's supplier always delivers inventory five days after an
order is placed. The company always uses 300 units per day.

What is the reorder level?

on s
olu ti
r ni ng S
Le a
r tex
Ve

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 Answer – simple ROL
If a company's supplier always delivers inventory five days after an
order is placed and the company always uses 300 units per day:

ROL = 5 × 300 = 1,500

ti ons
Solu
Place the order when inventory = a1,500 ni n g and just as the last item is
L e r
r tex
used, a delivery should be ereceived.
V

Note: 1,500 tells you nothing about how much to order: that is
determined by the economic order quantity.

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Managing inventories–the reorder level (ROL) (3)

Generally both lead time and usage per day vary.

To avoid having stock-outs (ie demand but no
inventory), the reorder level is set higher and a
buffer or safety inventory is maintained:

Inventory
level
ti o ns x = order
Sol u placed
i n g
x
r
x
tex Lex arn x x
Ve x

Safety inventory

Time
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Managing inventories – the reorder level (ROL) (4)

Generally both lead time and usage per day vary. To

avoid having stock-outs (ie demand but no inventory)

ROL = maximum lead time × maximum daily usage

This will mean that inventory willorarely ti o ns fall to zero and

S l u
there will be buffer or safety g
rninventory:
i n
x L e a
V e rte

Buffer inv = ROL – (average lead time × average usage)

Average inventory = buffer inventory + reorder
quantity/2
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Question – buffer inventory
A company has set its reorder level at 5,000 units.
Average lead time = four days and average daily usage = 1,000.

The holding cost = $6 per unit per year.

on s
What is the cost of holding the buffer inventory?olu ti
n g S
rni
A $1,000 L e a
tex
B $6,000 Ver
C $24,000
D $26,000

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 Answer – buffer inventory
A company has set its reorder level at 5,000 units. Average lead time = 4 days and average
daily usage = 1,000.
The holding cost = $6 per unit per year
B
Buffer inventory = ROL – (average lead time × average usage):
ti ons
Solu
ni n g
= 5,000 – (4 × 1,000) L e a=r 1,000 units
e r tex
V
Annual buffer inventory holding cost = $6 × 1,000 = $6,000

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Reasons for holding inventory
 To deal with unexpected demand
 To deal with unexpected delays in delivery
 To make use of bulk discounts
 To buy when prices are low
 Seasonal production (eg fruit picked when ripe)
ti o ns
 Technical reasons (eg whiskygmaturingSol u for 12 years)
a rni n
ex L e
Ve rt

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Just in time (JIT) procurement (1)
JIT = obtaining inventory at the last possible moment.

Advantages:

• No holding costs
ti o ns
• Less chance of obsolescence g Sor
ol damage
u
a rni n
• Flexible production e e
–x can tailor output to meet the
L
V e rt
exact needs of customers as the product is made to
order

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Just in time (JIT) procurement (2)
JIT = obtaining inventory at the last possible moment

Requirements:
• Very good production planning systems
• Suppliers who can respond quickly
ti o ns
• Short physical delivery times g S(eg
ol close suppliers)
u
a rni n
• Guaranteed quality ex L e
Ve rt

However, there are serious consequences if delivery is

disrupted as there is no inventory to maintain
operations.
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Question to consider
Which of the following do you think might be Suitable/not
suitable
suitable for a JIT approach to inventory
management?

A company makes computers to buyers'

specifications. All parts are received from
suppliers within one hour of being ordered.lutions
g So
r nin
An earth moving equipment manufacturer
L e a
rtex
makes products to buyersV' especifications. Parts
come by ship from overseas.
A health department is responsible for giving
vaccines for certain epidemics. Making a batch
of vaccines takes one month.
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 Answer
A company makes computers to Provided quality is
buyers' specifications. All parts are reliable, this is
received from suppliers within one suitable for JIT
hour of being ordered.
An earth moving equipment Overseas shipment
manufacturer makes products to ons delays so
willlucause
ti
buyers' specifications. Parts come by g So
makes this unsuitable
ni n
ship from overseas. L e ar for JIT
tex
V er
A health department is responsible Manufacturing is too
for giving vaccines for certain slow to allow JIT.
epidemics. Making a batch of
vaccines takes one month.

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 Recent exam questions

Nature of question Exam details

Bulk discounts on inventory Q2 (b) December 2012
purchases
Early settlement discount/bulk Q4 (b) Junes 2011
purchase discount lu ti on
i ng So
Inventory – ordering quantity; L e arn Q3 (a) (b) December 2010
JIT
e r tex
V

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Managing receivables (1)
Finding the least costly balance between enticing
customers, whose use of credit entails considerable
costs, and refusing opportunities for profitable
sales.

Costs include: s
uti o n
 Initial credit checks n g Sol
L e a rni
 Administering the e rtex
receivables ledger
V
 Extending credit (postponing receipt of cash)
 Bad debts

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Managing receivables (2)
Assuming that credit is going to be offered in
principle, a trade receivables policy then has three
parts:

 Credit analysis
 Credit control o ns
Sol uti
 Receivables collection earni n g
rtex L
Ve
In more detail…

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Managing receivables (3)
Credit analysis:
Assess creditworthiness of new customers and establish a
credit limit for each.

Information that can be useful includes:

ti o ns
Sol u
i n g
rnstatements
 Last three years' financial
x L e a
e rte
 Credit references V
 Trade references

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Managing receivables (4)
Credit control:
Ensure that the terms under which credit was granted are
followed.

Methods include:
 Preventing orders that would exceed o ns
So l uti credit limit
a r ni ng
 Aged receivable analysis
rtex Le
Ve
 Regular statements
 Follow up with slow payers
 Offer early settlement discounts

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Managing receivables (5)
Receivables collection:
Cash received needs to be banked quickly if payment is
not made electronically by credit transfer.

Methods include:
 Encourage electronic payments o ns
So land
uti direct debits
a r ni ng
 Consider what action rtex Letake about slow payers and
to
Ve
bad debts
 Prompt invoicing
 Try to settle disputes that might be preventing
payment
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Question to consider: effective cost of a discount

Customers take three months' credit. We are considering offering a

discount of 3% for payment within one month.
Sales are $12,000,000 pa
We are paying overdraft interest of 20% pa

on s
u ti
Calculate the effective % cost pa of the discount?
ol
n g S
i
Should we offer the discount? Learn
r tex
Ve

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 Answer: effective cost of a discount

Consider an invoice for $100: with no discount the company

receives $100 after three months. With the discount, $97 is
received after one month.

Effective cost of cash raised = 3/97 over two ons

months
ti
Solu
Cost over 12 months is approximately ni n g × 12/2 = 18.6%
3/97
L e ar
e r tex
V
If the overdraft rate is 20%, then it is worth offering the
discount as that is the cheaper way to increase cash.
In fact, working out the effective cost is not usually the best
approach…
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 Question to consider: discount for prompt payment

A company has annual credit sales of $9,000,000 and, on average,

customers pay after two months. The company is considering offering
a 5% discount for payments made within one month of the invoice
being sent. It is estimated that 70% of customers will take the
discount. The company pays 8% on its overdraft.

on s
olu ti
Is the change in credit policy worthwhile?
n g S
rni
L e a
ex
Vert
Note: assume that the volume of sales will be unaffected by the
discount.

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 Answer: discount for prompt payment
Annual sales = $9m; average payment after two months. Consider 5% discount for
payments made within one month. 70% take the discount. Overdraft rate = 8%
$

Current receivables balance: 9,000,000 × 2/12 1,500,000

New receivables balance: 9,000,000 × 70% × 1/12 +utions 975,000

9,000,000 × 30% × 2/12 g Sol
in a rn
L e
Decrease in receivables = decrease
e r teinx overdraft 525,000
V
Annual cost of discount = 9,000,000 × 70% × 5% 315,000
Cost of overdraft is 8% * 525,000 42,000

Giving discount is not advised.

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Managing receivables (6)
Sometimes, offering different credit terms might affect:

 Sales (eg longer credit would attract customers)

 Bad debts (usually longer credit increases bad debts)

ti o ns
Calculations can then become gaSlittle ol u more complex. But
the principle is the same: rni
compare
a n the actual cost of the
ex L e
change in cash flows t
Verwith the cost of finance.

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Question to consider: change in credit terms

A company has annual credit sales of $12,000,000. Current credit terms

= one month, and bad debts are 2% of sales.

Proposed credit terms = two months and this should increase sales by
25%. Bad debts would then be 3% of sales.
on s
olu ti
n g S
Contribution to sales ratio = 30% arni
x L e
Cost of finance = 15% Verte

Is the change in credit terms worthwhile?

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 Answer: change in credit terms
$
Increase in sales = $12,000,000 × 25% 3,000,000
Increase in contribution = $3,000,000 × 30% 900,000
Increase in bad debts expense: (15,000,000 × 3%) –
(12,000,000 × 2%) 210,000
Net annual increase in profit ons
lu ti 690,000
Proposed receivables: $15,000,000 × 2/12 g So 2,500,000
i n
L e a rn
e r tex × 1/12
Current receivables: $12,000,000
Increase in receivables
V 1,000,000
1,500,000
Annual cost of funding the increase in receivables =
$1,500,000 × 15%
225,000

The proposal is worthwhile as $690,000>$225,000

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Factoring and invoice discounting
Factoring: an arrangement to have debts collected by a factor
company, which advances a proportion of the money it is due to
collect.

Invoice discounting: the purchase of individual trade debts at a

discount to raise working capital. s
uti o n
n g Sol
L e a rni
rt
Note: factors often administer
e extheir client's receivables ledger; invoice
V
discounters do not.

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Benefits of factoring
 Receivables ledger can be administered by a
specialist company so:
 Greater efficiency
 Release of management time
 Lowered admin costs
 Better cash flows as cash from sales is advanced
by the factor. ti o ns
Sol u
n g
rni (at a cost): non-
 Credit protection is available
x L e a
e rte
recourse factoringV means that the factor bears
any bad debts.
 Business growth can be financed through sales.

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 HSBC website – advantages of factoring
Maintain working capital
Access the vital working capital tied up in invoices and concentrate on
growing your business.
Take advantage of professional sales ledger management
A dedicated Invoice Finance Manager and a Credit Controller can run
your sales ledger for you.
Save time and keep in touch uti ons
g S ol
Keep up-to-date with your accountaby r n n
iusing our online Internet
Invoice Finance service. ertex L
e
V
Guard against late payment and bad debts
Use our Credit Protection facility to guard against late or non-
payment of invoices.
Benefit from our overseas service
Factoring can be used for both your domestic and international sales.
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Question to consider: factoring
Annual sales = $12,000,000 and customers currently pay as follows:
20% after one month, 40% after two months, 40% after three
months.
A factor would pay 100% after one month and charge 3% of
turnover. Savings in credit control costs = $50,000 per year.
The company's bank overdraft rate is 9% pa.tions
Solu
r nin g
L e a
Should the company employ r te x factor?
the
Ve

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 Answer: factoring
Sales = $12,000,000 p.a. Customers currently pay: 20% after one month, 40% after two months,
40% after three months. A factor would pay 100% after 1 month and charge 3% of turnover.
Savings in credit control costs = $50,000 per year. Overdraft rate is 9% p.a.

$
Current receivables = (12,000,000 × 20% × 1/12) + 2,200,000
(12,000,000 × 40% × 2/12) + (12,000,000 × 40% × 3/12 )
ti ons
Solu
Receivables using factor = 12,000,000/12ni n g
L e ar 1,000,000
r tex in cash
Decrease in receivables/increase
e 1,200,000
V
Saving in finance cost 1,200,000 × 9% 108,000
Cost of factor 3% × 12,000,000 (360,000)
Add: savings in administration costs 50,000
Net cost (202,000)
Therefore, factoring should not be chosen
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Foreign accounts receivable (1)
Additional problems arise from:

 Time taken to transport goods – so payment delayed

 Administration delays (eg customs)
 Customers are less familiar, so it can be difficult to
assess credit worthiness ti o ns
Sol u
rni n g
 Foreign jurisdictions inevitably
x L e a make it more difficult
erte
and expensive to Vresolve disputes and pursue bad
debts
 Exchange rate risk (see Chapter 19)

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Foreign accounts receivable (2)
Techniques used:

 Export credit insurance (expensive)

 Discounting bills of exchange (similar to invoice
discounting)
 Export factoring (specialist factors) ti o ns
Sol u
n g
 Documentary credits x(buyer's
L e arni bank issues a letter of
e rte
credit to the seller)
V

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Managing accounts payable
The management of trade accounts payable involves:
 Obtaining satisfactory credit from suppliers
 Attempting to extend credit during periods of cash
shortage
 Maintaining good relations with important suppliers
ti o ns
Sol u
n g
rni a supplier settlement
 Deciding whether to accept
x L e a
e rte
discount is a mirror
V image of deciding whether to offer
a discount to customers.
 Note: the cost of forgoing a settlement discount is
usually very high...

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Question to consider: supplier discounts
A supplier gives a 2% discount if invoices are paid within 15 days'
of receipt. Currently we take 40 days to pay invoices and so do
not receive the discount.
What is the annual % effective cost of forgoing the discount?

on s
olu ti
r ni ng S
Le a
r tex
Ve

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 Answer: supplier discounts
A supplier gives a 2% discount if invoices are paid within 15 days'
of receipt. Currently we take 40 days to pay invoices and so do
not receive the discount.

Consider an invoice of $100. ons

olu ti
Currently we pay $100 after 40 days. i n g S
e ar n
L
rtex
We could pay $98 after 15Vedays.

Effective cost = 2/98 over 25 days (40 – 15)

Effective annual cost = 2/98 × 365/25 = 29.8%

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