Ch 10 - Accounts Receivable and Inventory Management

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Chapter 10Chapter 10

Accounts Receivable Accounts Receivable and Inventory and Inventory ManagementManagement

Accounts Receivable Accounts Receivable and Inventory and Inventory ManagementManagement

© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/e

Created by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI

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Accounts Receivable and Accounts Receivable and Inventory ManagementInventory Management

Credit and Collection Policies

Analyzing the Credit Applicant

Inventory Management and Control

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

(1) Average Collection Period

(2) Bad-debtLosses

Quality ofQuality ofTrade AccountTrade Account

Length ofCredit Period

Possible CashDiscount

FirmCollectionProgram

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Credit StandardsCredit Standards

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 standardsWhy lower the firm’s credit standards??

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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

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Example of Relaxing Example of Relaxing 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.

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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?

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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

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(2) Bad-debtLosses

Quality ofTrade Account

Length ofLength ofCredit PeriodCredit Period



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Credit TermsCredit Terms

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 TermsCredit 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.”

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Example of Relaxing Example of Relaxing the Credit Periodthe Credit Period

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.

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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?

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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

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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

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(2) Bad-debtLosses



Possible CashPossible CashDiscountDiscount


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Credit TermsCredit Terms

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.

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Example of Introducing Example of Introducing a Cash Discounta Cash Discount

A competing firm of Basket Wonders is considering changing the credit period from “net 60” “net 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.

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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

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Example of Using Example of Using the Cash Discountthe Cash Discount

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

Receivable level ($5,000,000 sales) / (9 Turns) =(New) $555,556

Reduction of $833,333 - $555,556 =investment in A/R $277,777

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Pre-tax cost of .02 x .3 x $5,000,000 =the cash discount $30,000$30,000..

Pre-tax opp. savings (20% opp. cost) x $277,777 =on reduction in A/R $55,555$55,555..

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

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Seasonal DatingSeasonal Dating

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.

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(2) Bad-debtLosses




FirmFirmCollectionCollectionProgramProgram

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

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

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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.

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Collection Policy Collection Policy and Proceduresand Procedures

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

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Analyzing the Analyzing the Credit ApplicantCredit Applicant

Obtaining information on the credit applicant

Analyzing this information to determine the applicant’s creditworthiness

Making the credit decision

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Sources of InformationSources of Information

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.

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Credit AnalysisCredit Analysis

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::

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Sequential Sequential Investigation ProcessInvestigation Process

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 10-30 through 10-32.

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

* 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

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

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”?

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

** 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

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Other Credit Other Credit Decision IssuesDecision Issues

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.

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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.

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Inventory Inventory Management and ControlManagement and Control

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 typesInventory types::

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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:

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Appropriate Appropriate Level of InventoriesLevel of Inventories

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?

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ABC Method of ABC Method of Inventory ControlInventory Control

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

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How Much to Order?How Much to Order?

Forecast usage

Ordering cost

Carrying costOrdering 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:

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Total Inventory CostsTotal Inventory Costs

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

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(in

un

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(in

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its)

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Economic Order QuantityEconomic Order Quantity

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

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Example of the Example of the 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?

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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

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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

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When to Order?When to Order?

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.

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Example of When to OrderExample of 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

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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*)

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Safety StockSafety Stock

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.

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Order Point Order Point with Safety Stockwith Safety Stock

0 18 20 380 18 20 38

400400

20002000

OrderOrderPointPoint

UN

ITS

UN

ITS

DAYSDAYS

22002200

Safety StockSafety Stock200200

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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

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How Much Safety Stock?How Much 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::

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Just-in-TimeJust-in-Time

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::

Economy & Finance

Ch 10 - Accounts Receivable and Inventory Management