INVENTORY AND CURRENT LIABILITY MANAGEMENT

GENERAL DISPOSITION TOWARD INVENTORY EOQ assumes that the relevant costs of inventory
LEVELS can be divided into ordering costs and carrying
costs.

 Ordering costs
 the fixed clerical costs of placing and
receiving an inventory order
 Carrying costs
 the variable costs per unit of holding an
INVENTORY MANAGEMENT item in inventory for a specific period of
time
The ABC inventory system is an inventory
management technique that divides inventory into The EOQ model analyzes the tradeoff between
three groups: order costs and carrying costs to determine the
order quantity that minimizes the total inventory
 The A group includes those items with the
cost.
largest investment. Typically, this group consists
of 20 percent of the firm's inventory items but PROBLEM 1
80 percent of its investment in inventory.
Barter Corporation had been buying Product A in
 The B group consists of items that account for
lots of 1,200 units which represents average supply
the next largest investment in inventory.
for four months. The cost per unit is P100; the order
 The C group consists of a large number of
cost is P200 per order; and the annual inventory
items that require a relatively small investment.
carrying cost for one unit is P25. The lead time is 5
A just-in-time (JIT) system - materials days. (Use 360-day year)
arrive at exactly the time they are needed for
Requirements:
production.
1. What is the economic order quantity?
 Because its objective is to minimize inventory
2. Frequency of order
investment, a JIT system uses no (or very little)
3. Total inventory cost
safety stock.
4. Reorder point
 Extensive coordination among the firm's
5. Safety stock if the maximum daily usage is 14
employees, its suppliers, and shipping
units
companies must exist to ensure that material
inputs arrive on time. Failure of materials to
arrive on time results in a shutdown of the
production line until the materials arrive.
 Likewise, a JIT system requires high-quality
parts from suppliers.

The Economic Order Quantity (EOQ) Model

is an inventory management technique for
determining an item's optimal order size, which is
the size that minimizes the total of its order costs
and carrying costs.
 The EOQ model is an appropriate model for the
management of A and B group items.
PROBLEM 2

Neggie Corp has a secret ingredient in its

production. This ingredient costs the company P60
each from the supplier and requires a 6-day lead
time. The demand every quarter is 13,680 units.
The ordering cost is P12.50 per order. (EOQ is
1200 units)

Requirements:

1. The carrying cost per unit is PROBLEM 4

2. The total inventory cost amounts to The ReignLyn Tags Company produces a luggage
3. The desired safety stock if the maximum daily and bag tag product, and has the following
usage is 175 units is information available concerning its inventory items:

Annual demand 50,000 units per year

Purchase price P35 per package
Ordering costs P250 per purchase order
Carrying costs 10% of purchase price plus
P4.50

Requirements:

1. What is the economic order quantity?

2. What are the total relevant costs at the
economic order quantity?
3. What are the total relevant costs if the quantity
ordered equals 1,000 units?

PROBLEM 3

The General Chemical Company uses 150,000

gallons of hydrochloric acid per month. The cost of
carrying the chemical in inventory is 50 cents per
gallon per year, and the cost of ordering the
chemical is P150 per order. The firm uses the
chemical at a constant rate throughout the year. It
takes 18 days to receive an order once it is placed.

Requirements:

1. The chemical's economic order quantity is PROBLEM 5

2. The reorder point is Yana Corp's monthly material requirement used in
3. Safety stock if the maximum usage is 162,000 production is 4,050 units. This material costs P180
gallons per month per unit for a supplier and it requires 5 days lead
time from the date of order to date of delivery. The
ordering cost is P120 per order and the carrying
cost is 8% of inventory investment per unit. (Use
360 days).
Requirements:

1. EOQ
2. Frequency of order
3. Total inventory cost
4. Reorder point PROBLEM 7
5. Reorder point if maximum daily usage is 150 Viray Company makes bicycles. It produces 800
units bicycles a month. It buys the tires for bicycles from
6. Safety stock a supplier at a cost of P20 per tire. The company's
inventory carrying cost is estimated to be 15% of
cost and the ordering is P50 per order.

Requirements:

1. Calculate the EOQ.

2. What is the number of orders per year?
3. Compute the average inventory.

PROBLEM 6
RCR Company has a secret ingredient in its
production. This ingredient costs the company P60
each from the supplier and requires 5-day lead
time. The ordering cost is P25 per order and the
carrying cost per unit is 10% of purchase price.
(EOQ is 2,400 units). PROBLEM 8
The Polly Company wishes to determine the
Requirements: amount of safety stock that it should maintain for
Product D that will result in the lowest cost. The
1. Annual demand
following information is available:
2. Frequency of order
3. Total inventory cost Stock-out cost per occurrence P80
4. Reorder point Carrying cost per unit of safety stock P4
5. Reorder point if maximum daily usage is 2,000 Number of purchase orders per year P5
units
6. Safety stock With the below available options open to Polly,
determine the number of units of safety stock that
will result in the lowest cost.

Units of Probability of Running out of

Safety Stock Safety stock
23 50%
30 40%
40 25%
50 10%
60 5%
 GGEM Industries, operator of a small chain of
video stores, purchased P1,000 worth of
merchandise on February 27 from a supplier
extending terms of 2/10 net 30 EOM.

If the firm takes the cash discount, it must pay P980

by March 10, thereby saving P20.

Solution: [P1,000 - (0.02 x P1,000)]

A. 1. Cost ff Giving Up a Cash Discount

 the implied rate of interest paid to delay

payment of an account payable for an
CURRENT LIABILITIES MANAGEMENT additional number of days

A. Spontaneous Liabilities Payment Options – Cost of Giving Up a Cash

Discount
 financing that arises from the normal course of
business; the two major short-term sources of
such liabilities are accounts payable and
accruals.

B. Unsecured short-term financing

 short-term financing obtained without pledging

specific assets as collateral.
 The firm should take advantage of these
"interest-free" sources of unsecured short-term
financing whenever possible.

Accounts Payable Management

 Accounts payable is the major source of

unsecured short-term financing for business Where:
firms.
CD = stated cash discount in percentage terms
 They result from transactions in which
merchandise is purchased but no formal note is N = number of days that payment can be delayed
signed to show the purchaser's liability to the by giving up the cash
seller.
 The average payment period has TWO PARTS:
1. the time from the purchase of raw materials
until the firm mails the payment
2. payment float time (the time it takes after
the firm mails its payment until the supplier
has withdrawn spendable funds from the
firm's account).
 The credit terms that a firm is offered by its
suppliers enable it to delay payments for its
purchases.

EXAMPLE:
A. 2. Stretching Accounts Payable

 paying bills as late as possible without

damaging the firm's credit rating
 GGEM Industries was extended credit terms of
2/10 net 30 EOM.
Approx. cost of giving up the cash discount =
36.5%  [2% x (365 / 20)]
 Stretch account payable to 70 days without A.4. Accruals Management
damaging its credit ring
Approx. cost of giving up the cash discount = Accruals
12.2%  [2% x (365 (60)]  liabilities for services received for which
Reduces the implicit cost of giving up a cash payment has yet to be made
discount. EXAMPLE: Wages and taxes.
A. 3. Accounts Payable Management  Because taxes are payments to the
Carmen, Inc., a large building-supply company, has government, their accrual cannot be
four possible suppliers, each offering different credit manipulated by the firm.
terms. Otherwise, their products and services are  However, the accrual of wages can be
identical. manipulated to some extent by delaying
payment of wages, thereby receiving an
interest-free loan from employees who are paid
sometime after they have performed the work.

PROBLEM

Buefano Company, a large janitorial service

company, currently pays its employees at the end
of each work week. The weekly payroll totals
If the firm needs short-term funds , which it can P400,000. Buefano could earn 10% annually on
borrow from its bank at an interest rate of 13% and invested funds.
if each of the suppliers is viewed separately, which
(if any) of the suppliers’ cash discounts will the firm This strategy would be worth P40,000 per year
given up. (0.10) P400,000).

PROBLEM 1 Unsecured Sources of Short-Term Loans: Bank

Loans
What is the effective annualized cost of foregoing
the trade dicsount on terms 2/10 net 80? short-term, self-liquidating loan

 an unsecured short-term loan in which the use

to which the borrowed money is put provides
the mechanism through which the loan is repaid

Banks lend unsecured, short-term funds in three

basic ways:

1. single-payment notes
2. lines of credit
PROBLEM 2 3. revolving credit agreements
What is the effective annualized cost of foregoing
the trade dicsount on terms 2/15 net 70?
Effective (True) Annual Rate
Once the nominal (or stated) annual rate is fixed-rate loan
established, the method of computing interest is
 a loan with a rate of interest that is determined
determined.
at a set increment above the prime rate and
Interest can be paid either remains unvarying until maturity

1. When a loan matures floating-rate loan

2. in advance
 a loan with a rate of interest initially set at an
increment above the prime rate and allowed to
If interest is paid at maturity, the effective (or
"float," or vary, above prime as the prime rate
true) annual rate-the actual rate of interest paid-for
varies until maturity
an assumed 1-year period is equal to:
SINGLE PAYMENT NOTE
Interest
Amount borrowed Gordon Manufacturing, a producer of rotary mower
blades, recently borrowed P100,000 from each of
two banks-bank A and bank B. The loans were
When interest is paid in advance  incurred on the same day, when the prime rate of
discount loans, the effective annual rate for a interest was 6%. Each loan involved a 90-day note
discount loan, assuming a 1-year period, is with interest to be paid at the end of 90 days. (Use
calculated as: 360 days)
Interest Additional information:
Amount borrowed - Interest
1. Bank A - interest rate was set at 1.5% above
PROBLEM 1 the prime rate
2. Bank B - set interest rate at 1% above the
Rosal Company, a manufacturer of athletic apparel,
prime rate on floating rate note
wants to borrow P10,000 at a stated annual rate of
a. initially at 6%
10% interest for 1 year. Interest is paid at maturity.
b. after 30 days, rate will be 6.5%
The effective annual rate is therefore: c. after 30 days, rate drops to 6.25%

PROBLEM 2

If the money is borrowed at the same stated annual

rate for 1 year but interest is paid in advance, the
effective annual rate in this case is:

prime rate of interest (prime rate)

 the lowest rate of interest charged by leading

banks on business loans to their most important
business borrowers
LINE OF CREDIT This is to ensure that money lent under a line-
of-credit agreement is actually being used to
 an agreement between a commercial bank and
finance seasonal needs.
a business specifying the amount of unsecured
short-term borrowing the bank will make Revolving Credit Agreement
available to the firm over a given period of time
 a line of credit guaranteed to a borrower by a
 Line-of-credit agreement
commercial bank regardless of the scarcity of
 Interest rate on a line of credit
money
 Operating-change restrictions
 Compensating balance commitment fee
PROBLEM 1  the fee that is normally charged on a revolving
credit agreement; it often applies to the average
Busy Sign, a graphic design firm, has borrowed P1
unused portion of the borrower's credit line
million under a line-of-credit agreement. It must pay
a stated interest rate of 10% and maintain, in its PROBLEM
checking account, a compensating balance equal
to 20% of the amount borrowed, or P200,000 MAS Company has a P2 million revolving credit
agreement with its bank. Its average borrowing
under the agreement for the past year was (P1.5
million. The bank charges a commitment fee of
0.5% on the average unused balance. The term
calls for a 7.5% interest rate.

PROBLEM 2

Busy Sign, a graphic design firm, has borrowed P1

million under a line-of-credit agreement. It must pay
a stated interest rate of 10% and maintain, in its
checking account, a compensating balance equal
to 20% of the amount borrowed, or P200,000. The
firm normally maintains & P100,000 balance in its
checking account.

COMMERCIAL PAPER

 a form of financing consisting of short-term,

unsecured promissory notes issued by firms
with a high credit standing
 Generally, only large firms of
questionable financial sondness are able
to issue commercial paper.
Annual Cleanup  Most commercial paper issues have
maturities ranging from 3 to 270 days.
 the requirement that for a certain number of
days during the year borrowers under a line of
credit carry a zero loan balance (that is, owe
the bank nothing)
PROBLEM  Holding collateral can reduce losses if the
borrower defaults, but the presence of
Wu Corporation, a large shipbuilder, has just issued
collateral has no impact on the risk of
P1 million worth of commercial paper that has a 90-
default.
day maturity and sells for P990,000.
security agreement

 the agreement between the borrower and the

lender that specifies the collateral held against
a secured loan
 terms of the loan against which the
security is held
 a copy is filed in a public office within the
state

Secured Sources of Short-Term Loans:

Characteristics
INTERNATIONAL LOANS 1. percentage advance
The important difference between  the percentage of the book value of the
international and domestic transactions is that collateral that constitutes the principal of a
payments are often made or received in a foreign secured loan
currency.
2. commercial finance companies
 Exposed to exchange rate risk.
 Typical international transactions are large  lending institutions that make only secured
in size and have long maturity dates. loans-both short-term and long-term-to
businesses

Secured Sources of Short-Term Loans: Use of

Letter of Credit ACCOUNTS RECEIVABLE as Collateral
 a letter written by a company's bank to the Two commonly used means of obtaining short-term
company's foreign supplier, stating that the financing with accounts receivable:
bank guarantees payment of an invoiced
amount if all the underlying agreements are met 1. Pledge
 The letter of credit essentially substitutes  the use of a firm's accounts receivable as
the bank's reputation and security, or collateral, to obtain a short-term
creditworthiness for that of its commercial loan
customer. 2. Factoring accounts receivable
 An exporter is more willing to sell goods to a  the outright sale of accounts receivable at a
foreign buyer if the transaction is covered by discount to a factor or other financial
a letter of credit issued by a well-known institution
bank in the buyer's home country. Pledges of accounts receivable are typically made
Secured Sources of Short-Term Loans on

secured short-term financing 1. Non-notification basis, which is the basis on

which a borrower, having pledged an account
 short-term financing (loan) that has specific receivable, continues to collect the account
assets pledged as collateral payments without notifying the account
 The collateral commonly takes the form of customer.
an asset, such as accounts receivable or 2. Notification basis, is the basis on which an
inventory. account customer whose account has been
 pledged (or factored) is notified to remit
payment directly to the lender

Factoring is normally done on:

1. notification basis
2. nonrecourse basis

Secured Sources of Short-Term Loans: Use of

INVENTORY as Collateral

Inventory is generally second to accounts

receivable in desirability as short-term loan
collateral.

 Marketability.
 A warehouse of perishable items, such as
fresh fruits, may be quite marketable, but if
the cost of storing and selling the fruits is
high, they may not be desirable collateral.
 Specialized items, such as moon-roving
vehicles, are not desirable collateral either,
because finding a buyer for them could be
difficult.