10.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson...

10.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Chapter 10Chapter 10

Accounts Receivable Accounts Receivable and Inventory and Inventory ManagementManagement

Accounts Receivable Accounts Receivable and Inventory and Inventory ManagementManagement


1. List the key factors that can be varied in a firm's credit policy and understand the trade-off between profitability and costs involved.

2. Understand how the level of investment in accounts receivable is affected by the firm's credit policies.

3. Critically evaluate proposed changes in credit policy, including changes in credit standards, credit period, and cash discount.

4. Describe possible sources of information on credit applicants and how you might use the information to analyze a credit applicant.

5. Identify the various types of inventories and discuss the advantages and disadvantages of increasing/decreasing inventories

6. Describe, explain, and illustrate the key concepts and calculations necessary for effective inventory management and control, including classification, economic order quantity (EOQ), order point, safety stock, and just-in-time (JIT).

After Studying Chapter 10, After Studying Chapter 10, you should be able to:you should be able to:


• Credit and Collection Policies

• Analyzing the Credit Applicant

• Inventory Management and Control

Accounts Receivable and Accounts Receivable and Inventory ManagementInventory Management


(1) Average Collection Period

(2) Bad-debtLosses

Quality ofQuality ofTrade AccountTrade Account

Length ofCredit Period

Possible CashDiscount

FirmCollectionProgram

Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm


The financial manager should continually lower the firm’s credit standards as long as profitability from the change exceeds the extra costs generated by the additional

receivables.

Credit StandardsCredit Standards – The minimum quality of credit worthiness of a credit applicant

that is acceptable to the firm.

Why lower the firm’s credit standards?Why lower the firm’s credit standards?

Credit StandardsCredit Standards


• A larger credit department

• Additional clerical work

• Servicing additional accounts

• Bad-debt losses

• Opportunity costs

Costs arising from relaxing Costs arising from relaxing credit standardscredit standards

Credit StandardsCredit Standards


Basket Wonders is not operating at full capacity Basket Wonders is not operating at full capacity and wants to determine if a relaxation of their and wants to determine if a relaxation of their credit standards will enhance profitability. credit standards will enhance profitability.

• The firm is currently producing a single product with variable costs of $20 and selling price of $25.

• Relaxing credit standards is not expected to affect current customer payment habits.

Example of Relaxing Example of Relaxing Credit StandardsCredit Standards


• Additional annual credit sales of $120,000 and an average collection period for new accounts of 3 months is expected.

• The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.

Ignoring any additional bad-debt losses Ignoring any additional bad-debt losses that may arise, should Basket Wonders that may arise, should Basket Wonders

relax their credit standards?relax their credit standards?



Profitability of ($5 contribution) x (4,800 units) =additional sales $24,000$24,000

Additional ($120,000 sales) / (4 Turns) =receivables $30,000

Investment in ($20/$25) x ($30,000) =add. receivables $24,000

Req. pre-tax return (20% opp. cost) x $24,000 =on add. investment $4,800$4,800

Yes!Yes! Profits > Required pre-tax return




(2) Bad-debtLosses

Quality ofTrade Account

Length ofLength ofCredit PeriodCredit Period





Credit PeriodCredit Period – The total length of time over which credit is extended to a customer to

pay a bill. For example, “net 30” “net 30” requires full payment to the firm within 30 days from the

invoice date.

Credit Terms Credit Terms – Specify the length of time over which credit is extended to a customer

and the discount, if any, given for early payment. For example, “2/10, net 30.”“2/10, net 30.”

Credit TermsCredit Terms


Basket Wonders Basket Wonders is considering changing its credit period from “net 30” “net 30” (which has resulted in 12 A/R “Turns” per year) to “net 60” “net 60” (which is expected to result in 6 A/R “Turns” per year).

• The firm is currently producing a single product with variable costs of $20 and a selling price of $25.

• Additional annual credit sales of $250,000 from new customers are forecasted, in addition to the current $2 million in annual credit sales.

Example of Relaxing Example of Relaxing the Credit Periodthe Credit Period



Ignoring any additional bad-debt losses Ignoring any additional bad-debt losses that may arise, should Basket Wonders that may arise, should Basket Wonders

relax their credit period?relax their credit period?



Profitability of ($5 contribution)x(10,000 units) =additional sales $50,000$50,000

Additional ($250,000 sales) / (6 Turns) =receivables $41,667

Investment in add. ($20/$25) x ($41,667) =receivables (new sales) $33,334

Previous ($2,000,000 sales) / (12 Turns) =receivable level $166,667



New ($2,000,000 sales) / (6 Turns) =receivable level $333,333

Investment in $333,333 - $166,667 =add. receivables $166,666 (original sales)

Total investment in $33,334 + $166,666 =add. receivables $200,000

Req. pre-tax return (20% opp. cost) x $200,000 =on add. investment $40,000$40,000

Yes! Yes! Profits > Required pre-tax return




(2) Bad-debtLosses



Possible CashPossible CashDiscountDiscount




Cash DiscountCash Discount – A percent (%) reduction in sales or purchase price allowed for early payment of invoices. For example, “2/10” “2/10”

allows the customer to take a 2% cash discount during the cash discount period.

Cash Discount PeriodCash Discount Period – The period of time during which a cash discount can be taken for

early payment. For example, “2/10”“2/10” allows a cash discount in the first 10 days from the

invoice date.

Credit TermsCredit Terms


A competing firm of Basket Wonders is considering changing the credit period from “net “net

60” 60” (which has resulted in 6 A/R “Turns” per year) to “2/10, net 60.”“2/10, net 60.”

• Current annual credit sales of $5 million are expected to be maintained.

• The firm expects 30% of its credit customers (in dollar volume) to take the cash discount and thus increase A/R “Turns” to 8.

• (30% x 10 days + 70% x 60 days = 3 + 42 days = 45 days

• 360 days per year / 45 days = 8 turns per year

Example of Introducing Example of Introducing a Cash Discounta Cash Discount



Ignoring any additional bad-debt losses Ignoring any additional bad-debt losses that may arise, should the competing firm that may arise, should the competing firm

introduce a cash discount?introduce a cash discount?

Example of Introducing Example of Introducing a Cash Discounta Cash Discount


Receivable level ($5,000,000 sales) / (6 Turns) =(Original) $833,333

Receivable level ($5,000,000 sales) / (8 Turns) =(New) $625,000

Reduction of $833,333 - $625,000 =investment in A/R $208,333

Example of Using Example of Using the Cash Discountthe Cash Discount


Pre-tax cost of 0.02 x 0.3 x $5,000,000 =the cash discount $30,000$30,000..

Pre-tax opp. savings (20% opp. cost) x $208,333 =on reduction in A/R $41,667$41,667..

Yes! Yes! Savings > Costs

The benefits derived from released accounts receivable exceed the costs of providing the

discount to the firm’s customers.

Example of Using the Example of Using the Cash DiscountCash Discount


• Avoids carrying excess inventory and the associated carrying costs.

• Accept dating if warehousing costs plus the required return on investment in inventory exceeds the required return on additional receivables.

Seasonal DatingSeasonal Dating – Credit terms that encourage the buyer of seasonal products

to take delivery before the peak sales period and to defer payment until after the peak

sales period.

Seasonal DatingSeasonal Dating



(2) Bad-debtLosses




FirmFirmCollectionCollectionProgramProgram



PresentPolicy Policy A Policy B

Demand $2,400,000 $3,000,000 $3,300,000 Incremental sales $ 600,000 $ 300,000 Default losses Original sales 2% Incremental Sales 10% 18% Avg. Collection Pd. Original sales 1 month Incremental Sales 2 months 3 months

Default Risk and Default Risk and Bad-Debt LossesBad-Debt Losses


Policy A Policy B

1. Additional sales $600,000 $300,000 2. Profitability: (20% contribution) x (1)2. Profitability: (20% contribution) x (1) 120,000 120,000 60,000 60,000 3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000 4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000 5. Inv. in add. receivables: (.80) x (4) 80,000 60,000 6. Required before-tax return on

additional investment: (5) x (20%) 16,000 12,000 7. Additional bad-debt losses +7. Additional bad-debt losses +

additional required return: (3) + (6)additional required return: (3) + (6) 76,000 76,000 66,000 66,000

8. Incremental profitability: (2) - (7)8. Incremental profitability: (2) - (7) 44,000 44,000 (6,000) (6,000)

Adopt Policy A but not Policy B.Adopt Policy A but not Policy B.

Default Risk and Default Risk and Bad-Debt LossesBad-Debt Losses


The firm should increase collection collection expenditures expenditures until the marginal

reduction in bad-debt losses bad-debt losses equals the marginal outlay to collect.

Collection Collection Procedures Procedures

• Letters

• Phone calls

• Personal visits

• Legal action

SaturationSaturationPointPoint

Collection ExpendituresCollection Expenditures

Bad

-Deb

t L

oss

esB

ad-D

ebt

Lo

sses

Collection Policy Collection Policy and Proceduresand Procedures


• Obtaining information on the credit applicant

• Analyzing this information to determine the applicant’s creditworthiness

• Making the credit decision

Analyzing the Analyzing the Credit ApplicantCredit Applicant


• Financial statements• Credit ratings and reports• Bank checking• Trade checking• Company’s own experience

The company must weigh the amount amount of information of information needed versus the time time

and expense requiredand expense required.

Sources of InformationSources of Information


• the financial statements of the firm (ratio analysis)

• the character of the company• the character of management• the financial strength of the firm• other individual issues specific to

the firm

A credit analyst is likely to utilize A credit analyst is likely to utilize information regardinginformation regarding::

Credit AnalysisCredit Analysis


The cost of investigation (determining the type and amount of information collected) is balanced against the

expected profit from an order.

An example is provided in the following three slides 10-31 through 10-33.

Sequential Sequential Investigation ProcessInvestigation Process


* For previous customers only a Dun & Bradstreet reference book check.

Pending Order

Badpast creditexperience

Dun & Bradstreetreport analysis*

RejectYesNoStage 1$5 Cost

Stage 2$5 - $15

Cost

No prior experience whatsoever

Sample Investigation Sample Investigation Process Flow Chart (Part A)Process Flow Chart (Part A)


Accept

Yes

No

Credit rating“limited” and/or otherdamaging information

unearthed?

No

Yes

Reject

Credit rating“fair” and/or otherclose to maximum

“line of credit”?

Sample Investigation Sample Investigation Process Flow Chart (Part B)Process Flow Chart (Part B)


** That is, the credit of a bank is substituted for customer’s credit.

Bank, creditor, and financialstatement analysis

Accept RejectAccept, only upon

domestic irrevocableletter of credit (L/C)**

Fair PoorGood

Stage 3$30 Cost

Sample Investigation Sample Investigation Process Flow Chart (Part C)Process Flow Chart (Part C)


Line of CreditLine of Credit – A limit to the amount of credit extended to an account. Purchaser can buy on

credit up to that limit.

• Streamlines the procedure for shipping goods.

Credit-scoring SystemCredit-scoring System – A system used to decide whether to grant credit by assigning numerical scores to various characteristics

related to creditworthiness.

Other Credit Other Credit Decision IssuesDecision Issues


• Credit decisions are made• Ledger accounts maintained• Payments processed• Collections initiated

Decision based on the core competencies of the firm.

Outsourcing Credit and CollectionsOutsourcing Credit and Collections

The entire credit and/or collection function(s) are outsourced to a third-party company.

Other Credit Other Credit Decision IssuesDecision Issues


• Raw-materials inventory• Work-in-process inventory• In-transit inventory• Finished-goods inventory

Inventories form a link between production and sale of a product.

Inventory types:Inventory types:

Inventory Inventory Management and ControlManagement and Control


• Purchasing• Production scheduling• Efficient servicing of customer

demands

Inventories provide flexibility Inventories provide flexibility for the firm in:for the firm in:

Inventory Inventory Management and ControlManagement and Control


Employ a cost-benefit analysisEmploy a cost-benefit analysis

Compare the benefits of economies of production, purchasing, and product

marketing against the cost of the additional investment in inventories.

How does a firm determine How does a firm determine the appropriate level of the appropriate level of

inventories?inventories?

Appropriate Appropriate Level of InventoriesLevel of Inventories


Method which controls expensive inventory

items more closely than less expensive items.

• Review “A” items most frequently

• Review “B” and “C” items less rigorously and/or less frequently.

ABC method of ABC method of inventory controlinventory control

0 15 45 1000 15 45 100

Cumulative Percentage Cumulative Percentage of Items in Inventoryof Items in Inventory

7070

9090

100100

Cu

mu

lati

ve P

erce

nta

ge

Cu

mu

lati

ve P

erce

nta

ge

of

Inve

nto

ry V

alu

eo

f In

ven

tory

Val

ue

AA

BBCC

ABC Method of ABC Method of Inventory ControlInventory Control


Forecast usage Ordering cost Carrying cost

Ordering can mean either the purchase or Ordering can mean either the purchase or production of the item.production of the item.

The optimal quantity to order The optimal quantity to order depends on:depends on:

How Much to Order?How Much to Order?


CC: Carrying costs per unit per periodOO: Ordering costs per orderSS: Total usage during the period

Total inventory costs (T) =Total inventory costs (T) =CC ( (Q / 2Q / 2) + ) + OO ( (SS / / QQ))

TIMETIME

Q / 2Q / 2

QQAverageAverage

InventoryInventory

INV

EN

TO

RY

IN

VE

NT

OR

Y

(in

un

its)

(in

un

its)

Total Inventory CostsTotal Inventory Costs


The EOQ or optimal quantity (Q*) is:

The quantity of an inventory item to order so that total inventory costs are minimized

over the firm’s planning period.

Q* Q* ==2 (2 (O) () (SS))

CC

Economic Order QuantityEconomic Order Quantity


Basket Wonders Basket Wonders is attempting to determine the economic order quantity for fabric used in the

production of baskets. • 10,000 yards of fabric were used at a constant

rate last period.• Each order represents an ordering cost of $200.• Carrying costs are $1 per yard over the 100-day

planning period.

What is the economic order quantity?What is the economic order quantity?

Example of the Example of the Economic Order QuantityEconomic Order Quantity


We will solve for the economic order quantity given that ordering costs are $200 per order, total usage over the period was 10,000 units,

and carrying costs are $1 per yard (unit).

Q* Q* ==2 (2 ($200) () (10,00010,000))

$1$1

Q* Q* = = 2,000 Units2,000 Units

Economic Order QuantityEconomic Order Quantity


EOQ (Q*) represents the minimum EOQ (Q*) represents the minimum point in total inventory costs.point in total inventory costs.


Total Carrying CostsTotal Carrying Costs

Total Ordering CostsTotal Ordering Costs

Q*Q* Order Size (Q)Order Size (Q)

Co

sts

Co

sts



Order PointOrder Point – The quantity to which inventory must fall in order to signal that an order must

be placed to replenish an item.

Order Point Order Point (OPOP) = Lead time Lead time X Daily usage

Issues to considerIssues to consider::Lead TimeLead Time – The length of time between the

placement of an order for an inventory item and when the item is received in inventory.

When to Order?When to Order?


Julie Miller of Basket Wonders Basket Wonders has determined that it takes only 2 days to receive the order of

fabric after the placement of the order.

When should Julie order more fabric?When should Julie order more fabric?

Lead time Lead time = = 2 days2 days

Daily usage Daily usage = 10,000 yards / 100 days = 10,000 yards / 100 days = = 100 yards per day100 yards per day

Order PointOrder Point = = 2 days 2 days xx 100 yards per day100 yards per day== 200 yards200 yards

Example of When to OrderExample of When to Order


0 0 18 20 38 40 18 20 38 40LeadLeadTimeTime

200200

20002000

OrderOrderPointPointU

NIT

SU

NIT

S

DAYSDAYS

Economic Order Quantity (Q*)Economic Order Quantity (Q*)

Example of When to OrderExample of When to Order


Our previous example assumed certain demand and lead time. When demand and/or lead time are

uncertain, then the order point is:

Order PointOrder Point =

(Avg. lead time x Avg. daily usage) + Safety stockSafety stock

Safety StockSafety Stock – Inventory stock held in reserve as a cushion against uncertain demand (or

usage) and replenishment lead time.

Safety StockSafety Stock


0 18 20 380 18 20 38

400400

20002000

OrderOrderPointPoint

UN

ITS

UN

ITS

DAYSDAYS

22002200

Safety StockSafety Stock200200

Order Point Order Point with Safety Stockwith Safety Stock


UN

ITS

UN

ITS

DAYSDAYS

Safety StockSafety Stock

Actual leadActual leadtime is 3 days!time is 3 days!

(at day 21)(at day 21)

22002200

20002000

OrderOrderPointPoint

400400

200200

0 18 210 18 21

The firm “dips”The firm “dips”into the safety stockinto the safety stock

Order Point Order Point with Safety Stockwith Safety Stock


• Amount of uncertainty in inventory demand

• Amount of uncertainty in the lead time

• Cost of running out of inventory

• Cost of carrying inventory

What is the proper amount of What is the proper amount of safety stock?safety stock?

Depends on theDepends on the::

How Much Safety Stock?How Much Safety Stock?


• A very accurate production and inventory information system

• Highly efficient purchasing• Reliable suppliers• Efficient inventory-handling system

Just-in-TimeJust-in-Time – An approach to inventory management and control in which inventories are acquired and inserted in production at the

exact times they are needed.

Requirements of applying this approachRequirements of applying this approach::

Just-in-TimeJust-in-Time


• JIT inventory control is one link in SCM.• The internet has enhanced SCM and

allows for many business-to-business (B2B) transactions

• Competition through B2B auctions helps reduce firm costs – especially standardized items

Supply Chain Management (SCM)Supply Chain Management (SCM) – Managing the process of moving goods, services, and

information from suppliers to end customers.

Supply Chain ManagementSupply Chain Management

10.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson...

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