Premium Course Notes[Session 5 and 6]

Chapter 9Managing Inventory, Accounts Receivable and Accounts Payable

SYLLABUS
1.Discuss, apply and evaluate the use of relevant techniques in managing inventory, including the EOQ model and JIT techniques.
2.Discuss, apply and evaluate the use of relevant techniques in managing accounts receivable, including:
(a)assessing creditworthiness
(b)managing accounts receivable
(c)collecting amounts owing
(d)offering early settlement discounts
(e)using factoring and invoice discounting
(f)managing foreign accounts receivable
3.Discuss and apply the use of relevant techniques in managing accounts payable, including:
(a)using trade credit effectively
(b)evaluating the benefits of discounts for early settlement and bulk purchase
(c)managing foreign accounts payable

Prepared by Patrick LuiP. 1Copyright @ Kaplan Financial 2015

Premium Course Notes[Session 5 and 6]

Prepared by Patrick LuiP. 1Copyright @ Kaplan Financial 2015

Premium Course Notes[Session 5 and 6]

1.Managing Inventories

1.1Costs of inventories

1.1.1Inventory is a major investment for many companies. Manufacturing companies can easily be carrying inventory equivalent to between 50% and 100% of the revenue of the business. It is therefore essential to reduce the levels of inventory held to the necessary minimum.

1.1.2 / Costs of High Inventory Levels
Keeping inventory levels high is expensive owing to:
(a)purchase costs
(b)holding costs
(i)storage
(ii)stores administration
(iii)risk of theft/damage/obsolescence

1.1.3Carrying inventory involves a major working capital investment and therefore levels need to be very tightly controlled. The cost is not just that of purchasing the goods, but also storing, insuring, and managing them once they are in inventory.

1.1.4Purchase costs: once goods are purchased, capital is tied up in them and until sold on (in their current state or converted into a finished product), the capital earns no return. This lost return is an opportunity cost of holding the inventory.

1.1.5Stores administration: in addition, the goods must be stored. The company must incur the expense of renting out warehouse space, or if using space they own, there is an opportunity cost associated with the alternative uses the space could be put to. There may also be additional requirements such as controlled temperature or light which require extra funds.

1.1.6Other risks: once stored, the goods will need to be insured. Specialist equipment may be needed to transport the inventory to where it is to be used. Staff will be required to manage the warehouse and protect against theft and if inventory levels are high, significant investment may be required in sophisticated inventory control systems.

1.1.7The longer inventory is held, the greater the risk that it will deteriorate or become out of date. This is true of perishable goods, fashion items and high-technology products, for example.

1.1.8 / Costs of Low Inventory Levels
If inventory levels are kept too low, the business faces alternative problems:
(a)stockouts
(i)lost contribution
(ii)production stoppages
(iii)emergency orders
(b)high re-order/setup costs
(c)lost quantity discounts

1.1.9Stockout: if a business runs out of a particular product used in manufacturing it may cause interruptions to the production process – causing idle time, stockpiling of work-in-progress (WIP) or possibly missed orders. Alternatively, running out of goods held for onward sale can result in dissatisfied customers and perhaps future lost orders if custom is switched to alternative suppliers. If a stockout looms, the business may attempt to avoid it by acquiring the goods needed at short notice. This may involve using a more expensive or poorer quality supplier.

1.1.10Re-order/setup costs: each time inventory runs out, new supplies must be acquired. If the goods are bought in, the costs that arise are associated with administration – completion of a purchase requisition, authorisation of the order, placing the order with the supplier, taking and checking the delivery and final settlement of the invoice. If the goods are to be manufactured, the costs of setting up the machinery will be incurred each time a new batch is produced.

1.1.11Lost quantity discounts: purchasing items in bulk will often attract a discount from the supplier. If only small amounts are bought at one time in order to keep inventory levels low, the quantity discounts will not be available.

1.1.12 / The Objectives of Good Inventory Management
The objective of good inventory management is therefore to determine:
(a)the optimum re-order quantity – how many items should be ordered when the order is placedfor all material inventory items.
(b)the optimum re-order level – how many items are left in inventory when the next order is placed, and
In practice, this means striking a balance between holding costs on the one hand and stockout and re-order costs on the other.

1.2Economic Order Quantity (EOQ)

(Dec 07, Jun 08, Dec 10, Dec 13)

1.2.1For businesses that do not use JIT (discussed in more detail below), there is an optimum order quantity for inventory items, known as the EOQ.

1.2.2The EOQ model is based on a cost function for holding stock which has two terms: holding costs and ordering costs.

1.2.3The aim of the EOQ model is to minimise the total cost of holding and ordering inventory.

1.2.4 / EOQ Formula
EOQ =
C0 = Cost of placing one order
CH = Holding cost per unit of inventory for one period
D = Annual demand

1.2.5 / Example 1
The demand for a commodity is 40,000 units a year, at a steady rate. It costs $20 to place an order, and 40 cents to hold a unit for a year. Find the order size to minimize inventory costs, the number of orders placed each year, the length of the inventory cycle and the total costs of holding inventory for the year.
Solution:
EOQ = = 2,000 units
This means that there will be = 20 orders placed each year.
The inventory cycle is therefore = 2.6 weeks
Total costs will be (20 × $20) + = $800 a year.

1.2.6Limitations of EOQ

(a)Only based on two types of costs: holding costs and ordering costs.

(b)Demand for stock, holding cost per unit per year and order cost are assumed to be certain and constant. In practice, demand is likely to be variable or irregular and costs will not remain constant.

(c)Ignore the cost of running out of stock (stockouts). This has caused some to suggest that the EOQ model has little to recommend it as a practical model for the management of stock.

(d)Developed on the basis of zero lead time and no buffer stock. However, these are not difficulties that prevent the practical application of the EOQ model. The EOQ model can be used in circumstances where buffer stock exists and provided that lead time is known with certainty.

Multiple Choice Questions
1.Gogo plc is a retailer of large storage boxes. The company has anannual demand of 120,000 units. The costs incurred each time an orderis placed are $200. The carrying cost per unit of the item each month isestimated at $3. The purchase price of each unit is $4.
When using this formula to find the optimal quantity to beordered, which of the following amounts are not included in thecalculation?
ACost per order ($200)
BCarrying cost per unit ($3)
CPurchase price per unit ($4)
DEstimated usage of the inventory item over a particular period(120,000 units per annum)
2.The Economic Order Quantity (EOQ):
Ais a formula that calculates a realistic purchase price for an item
Bdetermines the lowest order quantity by balancing the cost ofordering against the cost of holding inventory
Cis used to calculate how much safety inventory should be carried
Dshould be calculated once a year
3.Which of the following are assumptions used when calculating the economic order quantity for inventory?
(i)Lead time is constant
(ii)Demand is constant
(iii)Purchase costs are constant
AAll of the above
B(i) and (ii) only
C(i) and (iii) only
D(ii) and (iii) only
4.According to a colleague, the basic economic order quantity (EOQ) inventory model is based on a number of limitingassumptions, which include the following:
1.lead times are constant or zero
2.selling prices remain constant
3.demand is constant
4.the purchase price of inventory items remains constant
Which TWO of the above assumptions are correct?
A1 and 2
B1 and 3
C2 and 4
D3 and 4
5.A retailer sells 25,000 units of a particular product each year and the demand for the product is even throughout theyear. The purchase price of the product is $4 per unit. The cost of placing each order for the product is $10, the costof holding one unit in stock for one year is $2 and the economic order quantity is 500 units.
What is the total annual cost of trading in this particular product?
A$100,500
B$101,000
C$101,500
D$102,500
6.A business keeps an item in stock for which demand is 30,000 units per year. The cost of placing an order for theitem is $40 and the cost of holding one unit of the item is $0·60 per year. The business uses the economic orderquantity (EOQ) approach to derive the optimal order quantity for the item. Demand for the item is even throughoutthe year.
What is the combined annual cost of stock holding and stock ordering for the item?
A$1,200
B$1,800
C$40,600
D$41,200
7.A retailer sells 80,000 units of a particular product each year and demand for the product is even throughout theyear. The cost of placing each order for the product is $12, the cost of holding one unit in stock for one year is $6 and the retailer orders in batches of 1,600 units. A buffer stock of 10,000 units is held throughout the year.
What is the combined annual cost of ordering and holding this particular product?
A$5,400
B$10,200
C$65,400
D$70,200
8.Lechtal Co sells a particular product for which it pays $6 per unit. Annual sales are 60,000 units and demand accruesevenly throughout the year. The cost of ordering the product is $15 per order and the inventory cost of holding oneunit of the product for one year is $3. It is Lechtal Co’s policy to have an order quantity of 1,200.
What is the total annual cost to the business of trading in this product?
A$360,750
B$361,800
C$362,550
D$364,550
9.ABC Co has calculated the following in relation to its inventories.
Buffer inventory level / 50 units
Reorder size / 250 items
Fixed order costs / $50 per order
Cost of holding onto one item pa / $1.25 pa
Annual demand / 10,000 items
Purchase price / $2 per item
What are the total inventory related costs for a year (to the nearest whole $)?
A$2,219
B$22,219
C$20,894
D$20,219
10.To aid financial planning, Elburz Co has adopted the following target financial ratios for the forthcoming financial year:
Return on equity 10% (using year-end equity figure)
Non-current liabilities: Equity 2:1
Total assets less current liabilities: Current assets 3:1
Current ratio 1:1
Acid test ratio 0·8:1
The net profit after tax for the forthcoming year is forecast to be $500,000.
What will be the forecast level of inventory at the end of the year?
A$0·5m
B$1·0m
C$4·0m
D$9·0m
Question 1– EOQ, early settlement discount and JIT
TNG Co expects annual demand for product X to be 255,380 units. Product X has a selling price of £19 per unit and is purchased for £11 per unit from a supplier, MKR Co. TNG places an order for 50,000 units of product X at regular intervals throughout the year. Because the demand for product X is to some degree uncertain, TNG maintains a safety (buffer) stock of product X which is sufficient to meet demand for 28 working days. The cost of placing an order is £25 and the storage cost for Product X is 10 pence per unit per year.
TNG normally pays trade suppliers after 60 days but MKR has offered a discount of 1% for cash settlement within 20 days.
TNG Co has a short-term cost of debt of 8% and uses a working year consisting of 365 days.
Required:
(a)Calculate the annual cost of the current ordering policy. Ignore financing costs in this part of the question. (4 marks)
(b)Calculate the annual saving if the economic order quantity model is used to determine an optimal ordering policy. Ignore financing costs in this part of the question.
(5 marks)
(c)Determine whether the discount offered by the supplier is financially acceptable to TNG Co. (4 marks)
(d)Critically discuss the limitations of the economic order quantity model as a way of managing stock. (4 marks)
(e)Discuss the advantages and disadvantages of using just-in-time stock management methods. (8 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control June 2005 Q5)
Question 2 – Objectives of working capital management, EOQ, AR management
PKA Co is a European company that sells goods solely within Europe. The recently-appointed financial manager of PKA Co has been investigating the working capital management of the company and has gathered the following information:
Inventory management
The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production requirements during the next year is 625,000 units. The cost of placing and processing an order is €250, while the cost of holding a unit in stores is €0•50 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year.
Accounts receivable management
Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show that the average accounts receivable period in the last financial year was 75 days. The financial manager also noted that bad debts as a percentage of sales, which are all on credit, increased in the last financial year from 5% to 8%.
Required:
(a)Identify the objectives of working capital management and discuss the conflict that may arise between them. (3 marks)
(b)Calculate the cost of the current ordering policy and determine the saving that could be made by using theeconomic order quantity model. (7 marks)
(c)Discuss ways in which PKA Co could improve the management of domestic accounts receivable. (7 marks)
(ACCA F9 Financial Management December 2007 Q4(a), (b) & (c))

1.3Quantity discount (bulk purchase discount)

(Jun 11, Dec 12)

1.3.1Discounts may be offered for ordering in large quantities. If the EOQ is smaller than the order size needed for a discount, should the order size be increased above the EOQ?

1.3.2 / Example 2
The annual demand for an item of inventory is 125 units. The item costs $200 a unit to purchase, the holding cost for one unit for one year is 15% of the unit cost and ordering costs are $300 an order. The supplier offers a 3% discount for order of 60 units or more, and a discount of 5% for orders of 90 units or more. What is the cost minimizing order size?
Solution:
(a)The EOQ ignoring discount is:
= 50 units
$
Purchases (no discount) 125 × $200 / 25,000
Holding costs (50/2) 25 units × $30 (15% x $200) / 750
Ordering costs 2.5 orders × $300 / 750
Total annual costs / 26,500
(b)With a discount of 3% and an order quantity of 60 units costs are as follows.
$
Purchases $25,000 × 97% / 24,250
Holding costs 30 (= 60/2) units ×(15% × 97% ×$200) / 873
Ordering costs 2.08 (= 125/60) orders × $300 / 625
Total annual costs / 25,748
(c)With a discount of 5% and an order quantity of 90 units costs are as follows.
$
Purchases $25,000 × 95% / 23,750
Holding costs 45 (=90/2) units ×(15% ×95% ×$200) / 1,282.5
Ordering costs 1.39 (= 125/90) orders × $300 / 416.7
Total annual costs / 25,449.2
The cheapest option is to order 90 units at a time.
Question 3
A company uses an item of inventory as follows.
Purchase price: / $96 per unit
Annual demand: / 4,000 units
Ordering cost: / $300
Annual holding cost: / 10% of purchase price
Economic order quantity: / 500 units
Should the company order 1,000 units at a time in order to secure an 8% discount?
Question 4– Changes in receivables policy, bulk purchase discount, reasons for holding cash and factors in formulating receivables management policy
KXP Co is an e-business which trades solely over the internet. In the last year the company had sales of $15 million.All sales were on 30 days’ credit to commercial customers.
Extracts from the company’s most recent statement of financial position relating to working capital are as follows:
$000
Trade receivables / 2,466
Trade payables / 2,220
Overdraft / 3,000
In order to encourage customers to pay on time, KXP Co proposes introducing an early settlement discount of 1% forpayment within 30 days, while increasing its normal credit period to 45 days. It is expected that, on average, 50%of customers will take the discount and pay within 30 days, 30% of customers will pay after 45 days, and 20% ofcustomers will not change their current paying behaviour.
KXP Co currently orders 15,000 units per month of Product Z, demand for which is constant. There is only onesupplier of Product Z and the cost of Product Z purchases over the last year was $540,000. The supplier has offereda 2% discount for orders of Product Z of 30,000 units or more. Each order costs KXP Co $150 to place and theholding cost is 24 cents per unit per year.
KXP Co has an overdraft facility charging interest of 6% per year.
Required:
(a)Calculate the net benefit or cost of the proposed changes in trade receivables policy and comment on yourfindings. (6 marks)
(b)Calculate whether the bulk purchase discount offered by the supplier is financially acceptable and commenton the assumptions made by your calculation. (6 marks)
(c)Identify and discuss the factors to be considered in determining the optimum level of cash to be held by acompany. (5 marks)
(d)Discuss the factors to be considered in formulating a trade receivables management policy. (8 marks)
(25 marks)
(ACCA F9 Financial Management December 2012 Q2)

1.4Re-order level (ROL)

1.4.1Having decided how much inventory to re-order, the next problem is when to re-order. The firm needs to identify a level of inventory which can be reached before an order needs to be placed.

1.4.2When lead time and demand are known with certainty, ROL = demand during lead time. Where there is uncertainty, an optimum level of buffer inventory must be found.

1.4.3If an order is placed too late, the organization may run out of inventory, a stock-out, resulting in a loss of sales and/or a loss of production.

1.4.4If an order is placed too soon, the organization will hold too much inventory, and inventory holding costs will be excessive.

1.4.5 / Re-order Level Formula
Re-order level = maximum usage × maximum lead time
Lead time – the lag between when an order is placed and the item is delivered.
Use of a re-order level builds in a measure of safety inventory and minimizes the risk of the organization running out of inventory. This is particularly important when the volume of demand or the supply lead time are uncertain.

Multiple Choice Questions
11.Which of the following statements is true?
Statement 1:The reorderlevel is the measure of inventory at which areplenishment order should be made.
Statement 2:Use of a reorderlevel builds in a measure of safetyinventory and minimises the risk of the organizationrunning out of inventory.
Statement 1 / Statement 2
A / True / True
B / True / False
C / False / True
D / False / False

1.5Maximum and minimum inventory levels