Management of

1
Chapter 18

• Management of
• Accounts Receivable
• and Inventory

2
Accounts Receivable (A/R)

• Large investment for most companies
• Essentially an investment decision
• Extend credit whenever the marginal returns from
  extending credit exceed the marginal costs
• Liberal credit policy provides returns in the
  form of increased sales and gross profit
• Costs
• Opportunity cost of funds (Interest)
• Cost of credit checks
• Increase in bad debt

3
Credit Policy

• Credit Standards
• Criteria used to screen credit applications
• Determines the quality of accounts receivable
• Credit Terms
• Conditions under which credit extended must be
  repaid
• Collection efforts
• Methods employed in an attempt to collect payment
  on past due accounts

4
Credit Standards

• Company must gather information and undertake
  credit checks
• Financial Statements, Credit Reports, Customer
  History
• Five Cs of credit
• Character
• Capacity
• Capital
• Collateral
• Conditions

5
Credit Standards

• What Determines Quality of A/R
• Time a customer takes to repay
• Probability a customer will fail to repay
• Default risk
• Quantitative Measures of Quality
• Average collection period
• Bad-debt ratio

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Bad Debt
7
Credit Terms

• Credit Period
• Time allowed for payment
• Cash Discount
• Payment made within a specific period of time
• Specified as of the invoiced amount (2/10, net
  30)
• Granted to speed up collection of A/R
• Seasonal Dating
• Offered to retailers on seasonal merchandise
• Accept delivery well ahead of peak season
• Pay shortly after peak sales

8
Collection Efforts

• Balance between leniency and alienating customers
• Calling, Late Notices, Visiting, Collection
  Agency, Litigation
• Monitoring status Aging of A/R
• Classifying accounts into categories according to
  the number of days they are past due
• Changes in the age composition of accounts may
  reveal changes in the quality of A/R

9
Changes in Credit Policy

• Increase in the credit period
• Increase in sales pretax profit contribution
• Increased Accounts Receivable balance
• Lower Cash balance
• Liberalization of cash discount
• Increase in sales pretax profit contribution
• Reduction in Accounts Receivable balance
• Additional income from alternative investments
• Decrease in cost of funds
• Discount reduces gross margin

10
Changes in Credit Policy (Contd)

• Increase in collection effort
• Reduced sales and pretax profit contribution
• Increased collection expenses
• Reduced bad-debt losses
• Shortening the credit period, lowering cash
  discounts, and reducing collection efforts have
  the opposite effect.

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Financial Statement Impact

• Income Statement
• Impact on Sales and Gross Profit
• Impact on Bad Debt expense
• Impact on Net Income
• Balance Sheet
• Impact on Cash, Accounts Receivable, and
  Inventory balances
• What are offsetting asset/liability/equity
  accounts

12
Inventory

• Buffer in the procurement-production-sales cycle
• Should provide flexibility
• Timing the purchase of raw materials
• Scheduling production facilities employees
• Meeting fluctuating uncertain demand
• Too much inventory is expensive, wasteful, and
  could result in obsolescence
• Not enough inventory can result in lost sales and
  customer dissatisfaction

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Types of Inventory

• Raw Materials Inventory - basic materials to be
  used in the firms production operations.
• Work-in-Process Inventory - partially finished
  goods requiring additional work before becoming
  finished goods.
• Finished Goods Inventory - completed products
  that are not yet sold.

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Costs Associated with an Inventory Policy

• Ordering costs
• Costs of placing and receiving an order of goods
• Carrying costs
• Costs of holding inventory for a given period of
  time
• Expressed as cost per unit per period
• Stockout costs
• Incurred when a firm is unable to fill an order
• Lost sales
• Rescheduling production
• Placing and expediting special orders

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Inventory Control Models

• ABC Inventory Classification
• Divides Inventory into three groups
• A) Larger dollar value, smaller of items
• B) Items between category A and C
• C) Smaller dollar value, larger of items
• Basic Economic Order Quantity (EOQ) Model
• Assumes that demand is constant and known with
  certainty
• Cant be applied to seasonal businesses
• Assumes orders to replenish inventory are
  received instantaneously
• No lead time, and thus, no need to have a safety
  stock to protect against stockouts

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Inventory Control Models

• Extensions of Basic EOQ Model
• Nonzero lead time
• Provides for lead time between ordering and
  delivery
• Probabilistic inventory control methods
• Allows for fluctuations in demand
• Need for safety stock
• Just-in-time inventory systems
• Inventory items supplied to production process at
  exactly the right time and quantities.

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Just-In-Time Inventory Management System

• Reduces operating cycle and costs
• Inventory supplied
• At exactly the right time
• In exactly the right quantities
• Requires close coordination between
• Company
• Suppliers

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18
Economic Order Quantity

• EOQ formula (Q)
• Q 2SD
• C
• where,
• Q Economic Order Quantity, in units
• D Annual demand, in units
• S Cost of placing and receiving an order
  (setup cost)
• C Annual cost of carrying one unit in
  inventory

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Economic Order Quantity

• Total Costs Formula (TC)
• TC Ordering Costs Carrying Costs
• TC (D/Q ? S) (Q/2 ? C)
• Optimal length of one inventory cycle
• T Q or 365 x Q
• D/365 D

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EOQ Example

• SportsMart sells 360,000 baseballs annually. The
  baseballs cost SportsMart 15 per dozen (1.25
  each). Annual inventory carrying costs are 20 of
  inventory value and the cost of placing and
  receiving an order are 72. Determine the
• A) Economic Order Quantity
• B) Total annual inventory costs of this policy
• C) Optimal ordering frequency

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EOQ Example

• Economic Order Quantity
• D Demand 360,000 baseballs
• S Setup cost 72
• C Carrying cost 20 x 1.25 0.25 per
  baseball
• Q 2SD 2(72)(360,000)
• C 0.25
• Q 14,400 baseballs (1,200 dozen)

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EOQ Example

• Total Annual Inventory Costs (TC)
• D Demand 360,000 baseballs
• S Setup cost 72
• C Carrying cost 0.25 per baseball
• Q EOQ 14,400 baseballs
• TC (D/Q ? S) (Q/2
  ? C)
• TC (360,000/14,400?72) (14,400/2 ?0.25)
• TC 3,600

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EOQ Example

• Optimal Ordering Frequency (T)
• D Demand 360,000 baseballs
• Q EOQ 14,400 baseballs
• T 365 x Q 365 x 14,400
• D 360,000
• T 14.6 days