Lecture 12 - Accounts Receivable and Inventory Management.pdf

12/04/2011

1

Instructors:

ANTHONY ESSEL-ANDERSON&

EBENEZER SIMPSON

Jan. 11, 2009 1Prepared by A. Essel-Anderson

Accounts Receivable and Inventory Management

Credit Policy and credit standard

Terms of credit

Evaluation of credit applicant

Feb 6, 2010Prepared by A. Essel-Anderson 3

Accounts receivable refer to amounts owed

to the firm by customers who bought its

goods or enjoyed its services on credit.

It is a component of current assets and as

such a working capital.

It is also referred to as trade debtors or

simply receivables.


Accounts Receivable

12/04/2011

2


Determinants of Demand

A firm’s credit policy is a

set of decisions that

include the following:

•Credit standards,

•Terms of credit, and

•Collection policy and procedures.


Credit Policy

Standards that indicate the minimum quality of

creditworthiness of a credit applicant that is acceptable to the

firm.

Credit standards are applied to determine which customers

qualify for the regular credit terms and how much credit to

grant.

A relaxed credit standards is likely to increase

•demand and profit generated on the additional sales.

•credit cost and opportunity cost of carrying additional accounts receivables.

A more liberal credit standard is worthwhile if the additional

profit is greater than the required return on the additional

investment in receivables.


Credit Standards

Illustration

Assume that the firm would like to embark on a more liberal credit policy which will result in an average collection period of 2 months for new customers.

This policy initiative is expected to increase credit sales by 30%.

Opportunity cost of investment in receivables is 20%.


Activity 2

Current Situation Value

Current credit sales level (annual) GH¢200,000

Sales price GH¢8 per unit

Variable cost GH¢6 per unit

Average collection period 1 month

12/04/2011

3

(a) Additional credit sales GH¢200,000X 30%

GH¢60,000

(b) Additional contribution (a) * CM ratioGH¢60,000 x 25%

GH¢15,000

(c) Additional receivables (a) * Receivables TurnoverGH¢60,000 x (2/12)

GH¢10,000

(d) Additional investment in receivables

(c) * VC ratio GH¢10,000 x 75% GH¢7,500

(e) Cost of additional investment

(d) * Opp. Cost GH¢7,500 x 20% GH¢1,500

(d) Excess contribution over cost of additional investment

(b) – (e)GH¢15,000 - GH¢1,500 GH¢13,500

The strategy would result in a net gain and so would be worthwhile.


Suggested Solution to Activity 2

• The payment conditions offered to credit customers.

• The terms include the credit period, any cash discount, and any

seasonal dating.

Terms of Credit

• The length of time for which credit is granted.

Credit Period

• A reduction in the invoice value of goods to encourage early payment.

Cash Discounts

• Customers are offered goods during before peak and pay after peak

sales period.

Seasonal Dating


Terms of Credit

• This implies that customers who buy on credit have a

grace period of 30 days to pay for the invoice value.

• No cash discount is offered.

“Net 30”

• This implies that credit customers can pay within 10

days to enjoy 2% cash discount or pay anytime from

the 11th day to the 30th day without cash discount.

“2/10, net 30”


Credit Terms Quotes

The firm may vary its credit policy to speed up sales and receipts

from customers.

The firm may:

•Extend the credit period (to say 45 days) or

• Increase the percentage cash discount (to say 5%) or

•Extend the cash discount period (to say 15 days) or

•Employ a combination of the above.

In evaluating a new policy, consider the profitability of additional

sales, additional savings/(costs) associated with

decrease/(increase) in investments in inventory, and cost of

discount.


Variations in Credit Terms

12/04/2011

4

An important risk associated with credit sales is default on the part of

customers.

In evaluating the profitability of a policy change, consider default risk

(possible increase in bad debt).

One must use his/her judgement to make a reasonable estimate of possible

increase in bad debt.

The judgement may be influenced by :

•past experience

•average bad debts in the industry

•economic conditions


Default Risk

This refers to a set of decisions and related procedures

followed by a firm to collect its accounts receivable.

Collection procedures include:

•Reminders through letters, faxes, telephone calls, and personal visits.

•Arrangements with collection agencies to collect debts.

•Legal actions to collect overdue amounts.

An important decision variable is the amount of money

spent on collection procedures.


Collection Policy

The process of evaluating the credit

policy to determine any variance in the

customer’s payment pattern.

Common methods used to monitor the

time credit remain outstanding are:

• Average collection period

• Aging schedule


Receivables Monitoring


Analysing Credit Applicant

12/04/2011

5

The information about the credit applicant is analysed to

determine the applicants creditworthiness in terms of:

•Character,

•Capacity,

•Capital,

•Conditions and

•Collateral.

The analysis is be done using methods such as:

•Sequential investigation process and

•Credit-scoring system.


Analysing Credit Applicant


Credit Evaluation and Approval

Applying Fair Isaacs Method

• How promptly the applicant has paid in the past (35% of

score)

• How much debt of each type is outstanding (30% of score)

• The length of the applicant’s credit history (15% of score)

• The number of credit cards and recently opened credit

accounts that the applicant has (10% of score)

• The mix of regular credit cards, store card, and margin

account (10% of score)


Credit Scoring

Using return on asset and current ratio as indicators

of credit worthiness, we could devise a scoring system

thus:

Z-score = return on asset + 10(current ratio)

Rule of thumb:

•If applicant’s z-score is over 15 then he could pay so grant credit

•If applicant’s z-score is below 15, then he will not be able to pay.


Index of Credit Worthiness

12/04/2011

6

Goal of inventory management

Inventory costs

The EOQ model

ABC classification & control of inventory

The JIT system


• Materials and supplies that are consumed in

production.

Raw Materials and Components

• Assets held in the production process for sale in the

ordinary course of business.

Work-in-process

• Assets held for sale in the ordinary course of business

Finished Goods


Types of Inventories

Inventories in transit allow efficient production scheduling and utilisation of

resources.

Raw materials inventory allow the firm to be flexible in its purchasing.

Finished goods inventory allow the firm to be flexible in its production and

marketing.

Large inventories allow the firm to meet its customers’ demand efficiently.

Stock-out costs such as high cost of rush purchases, production stoppages

and idle time, and lost sales and customer confidence are avoided or reduced.


Advantages of Holding

Inventories

If too much inventories are held the firm may

incur inventory costs such as:

•Obsolescence.

•Storage costs including warehousing rent.

•Insurance premium.

•Opportunity costs in the form of returns that

could have been earned on investment in

inventories.


Disadvantages for Holding

Inventories

12/04/2011

7

The goal of inventory management is

to provide an optimal level of inventory

to sustain operations at least cost.

Inventory management involves:

• Establishing and maintaining proper inventory

level.

• Establishing and maintaining inventory control

systems.


The Goal of Inventory

Management

Steps involved in determining the

optimal inventory level

• Indentifying the costs involved in

purchasing and maintaining inventory.

•Determining the point at which those

costs are minimised.


Optimal Inventory Level

• Costs associated with holding inventory – storage

costs, insurance, costs of tying up funds etc.

Carrying costs

• Costs associated with placing and receiving an order

for new inventory.

Ordering costs

• Costs associated with running out of inventory.

Stock-out costs


Inventory Costs

•A calculus based model used to determine the point at

which total inventory cost is minimised.

•The Economic Order Quantity (EOQ) is the optimum units to

order so as to minimise total inventory cost.

EOQ Model

• Inventory usage is evenly distributed throughout the period

under review and can be forecasted precisely.

•Orders are received when expected.

•The purchase price of each item is the same regardless of

the quantity ordered.

Assumptions


The EOQ Model

12/04/2011

8

If the right amount of inventories are kept stock-out costs

can be avoided.

Thus, total inventory cost (TIC) can be expressed as follows:

• TIC = Total Carrying Cost (TCC) + Total Ordering Costs (TOC)

• and:

• TCC = (carrying cost per unit) x (average inventory) = C (Q/2)

• TOC = (cost per order) x (number of orders) = O(Total Usage/Q)

Thus, TIC = C (Q/2) + O (U/Q)


... The EOQ Model

The EOQ is the quantity that will minimise the total inventory costs.

Applying the rules of minimisation:1. The first derivative of the TIC function must be equal

to zero (i.e. = 0) and

2. The second derivative must be positive (i.e. )

Solve for Q in the resulting equation in point 1 to get the optimum quantity (Q* or EOQ).


... The EOQ Model

The EOQ formula is as follows:

Where:

•Q* = the optimal order quantity (in units)

•O = cost per order

•U = total usage

•C = carrying cost per unit


The EOQ Formula

The following data relates to DML Ltd a distributor of an antitoxic rubber.◦ Total demand = 7,800 packs per year.◦ Carrying cost = 20% of purchase price.

◦ Purchase price = GH¢4 per pack.◦ Selling price = GH¢8 per pack.◦ Ordering cost = GH¢100 per order

Required:◦ Compute the optimal order quantity. ◦ Determine the number of times orders should be

placed◦ Compute the total cost when the optimal order size is

purchased.


Activity 1

12/04/2011

9

The optimal order quantity is given by:

The number of orders to place is the total demand divided by the optimal order quantity◦ 7,800/1396 = approximately 6 times.

Total cost when the optimal order size is purchased is:◦ TIC = (0.2* GH¢4)(1396/2) + (GH¢100)(6) =

GH¢1,158.4


Suggested Solution to Activity 1

•Additional inventory held in reserve as guard against

uncertain demand/usage or production/delivery delays.

•Safety stock increases with (1) uncertainty of demand

forecast; (2) stock-out costs; (3) possibility of delays in

delivery of new orders.

Safety Stock

•This is the inventory level at which order for new inventory

should be placed to replenish inventory.

•Re-order Level = Lead Time x Daily Usage

•Re-order Level = (Avge. Lead Time x Avge. Daily Usage) +

Safety Stock

Re-order Level


Key Inventory Levels

Red-line Method

• An inventory control procedure where a red line is drawn around the inside

of a stock bin to indicate the re-order level.

Computerised Inventory Control System

• Computer applications are used to determine re-order points and to adjust

inventory balances.

Just-In-Time System

• Raw materials and components are ordered and received just as they are

needed in the production process.

Outsourcing

• Components are purchased instead of producing in-house and storing in the

production process.


Inventory Control Systems

Successful implementation of a JIT inventory management system requires:◦ Accurate production with few or no defective products.◦ Highly efficient purchasing.◦ Very reliable suppliers.◦ Accurate inventory information system.◦ Efficient inventory handling system.

The objective of JIT system is to reduce inventory costs by:◦ Ordering in small lots to meet production demands to

reduce carrying costs. ◦ Requiring suppliers to supply materials and components

“with no defect” thus reducing inspection costs◦ Improving on plant layout, product features, and

production processes to reduce setup time and costs.


Just-In-Time

12/04/2011

10

Under the ABC system inventories are classified into 3:

• A – About 15% of items of inventory which account for

70% of total inventory value (more valuable items).

• B – About 30% of items of inventory which account for

20% of total inventory value (valuable items).

• C – About 55% of items of inventory which account for

10% of total inventory value (less valuable).

Under the ABC system more valuable items of inventory are closely monitored

than less valuable items.


The ABC Method of Inventory

Classification & Control

Inventory control activities are usually carried outby account staff.

However, investment of funds in inventory is animportant aspect of financial management.

Thus, the finance manager must be familiar withsystems of inventory control to ensure efficientcapital allocation and appropriate investment ininventories.

The finance manager should work hand-in-handwith the heads of production, marketing,purchasing and account departments in themanagement and control of inventories.


The Role of the Finance Manager

Lecture 12 - Accounts Receivable and Inventory Management.pdf

Documents

Transcript of Lecture 12 - Accounts Receivable and Inventory Management.pdf