Accounts ReceivableAccounts Receivableand Inventoryand Inventory

May 4, 2009

Learning ObjectivesLearning Objectives

How and why firms manage accounts receivable and inventory.

Computation of optimum levels of accounts receivable and inventory.

Alternative inventory management approaches.

How firms make and evaluate credit policy decisions

Why do firms accumulate accounts Why do firms accumulate accounts receivable and inventory?receivable and inventory? Given that accounts receivable and inventory are

assets that do not provide an explicit rate of return, it is important to understand why firms might still want to have these investments.

Granting credit, resulting in Accounts Receivable, is often an essential business practice and can enhance sales. (But also will increase costs.)

Holding adequate inventory is necessary to avoid loss of sales due to stock-outs and have an efficient manufacturing process.

Finding the Optimum Level of Finding the Optimum Level of Accounts ReceivableAccounts Receivable

Accounts Receivable represent your money sitting in someone else’s bank account. It earns you nothing!

So, if the firm does grant credit, how do we minimize the impact on cash flow

Firm’s managers must review the firm’s credit policies and evaluate the impact of any proposed changes in policies based on the NPV of incremental cash flows due to the proposed changes

Accounts Receivable - TermsAccounts Receivable - Terms The terms of sale are generally stated in the

form X / Y, n ZX / Y, n Z This means that the customer can deduct XX

percentage if the account is paid within YY days; otherwise, the full amount must be paid within ZZ days.

Example:Example: 2/10 n 30– The company offers a 2% discount if the

invoice is paid in 10 days. Otherwise,– Balance due in 30 days.

Average Collection Period (ACP)Average Collection Period (ACP) Old Policy; 2/10, n30

– 35% of customers pay in 10 days– 62% of customers pay in 30 days– 3% of customers pay in 100 days– ACP=(.35x10)+(.62x30)+(.03x100)=25.1 days

New Policy; 2/10, n40– 35%of customers pay in 10 days– 60% of customers pay in 40 days– 5% of customers pay in 100 days– ACP=(.35x10)+(.60x40)+(.05x100)=32.5 days(If sales are $1M per day, this will cost $7.4M!)

Analysis of Accts. Receivable Analysis of Accts. Receivable Changes to Credit PolicyChanges to Credit Policy Develop pro formapro forma financial statements for

each policy under consideration. Use the pro formas to estimate incremental estimate incremental

cashcash flowsflows by comparing forecasts to current policy cash flows.

Use the incremental cash flows to estimate estimate the NPVthe NPV of each policy change.

Choose the policy change that maximizes the value of the firm (highest NPV).

Example:Example:ABC Corporation is considering a credit policy change from offering no credit to offering 30 days credit with no discount

Why might they do this?-Increase sales-Increase market share

What costs will the firm incur as a result?-Cost of carrying accounts receivable-Potential increase in bad debts-Credit analysis and collection costs

Analysis of Accts. Receivable ChangesAnalysis of Accts. Receivable Changes

Analysis of Accts. Receivable ChangesAnalysis of Accts. Receivable Changes Assume the Net Incremental Cash Flows associated

with ABC’s new credit policy are as follows: (They lose one month of cash flow which they will have to borrow)

External financing (Init. Investment) = $28,000 t=0– Increase in sales = $30,000 – Increase in COGS = $15,000 – Increase in Bad Debts = $3,000– increase in Other Expenses = $5,000– Increase in Interest Expense = $500– Increase in Taxes = $2,600– Total Incr. Operating Cash Flow = $3,900/yr.

Analysis of Accts. Receivable ChangesAnalysis of Accts. Receivable Changes Calculate the NPV of the change (k = 12%): PV of the expected inflows of $3,900 per year

from t = 0 to infinity (perpetuity)= $3,900/.12 = $32,500$32,500

NPV = PV of inflows - initial investment= $32,500 - $28,000 = $4,500$4,500

Since NPV > 0, ABC should undertake the credit policy change

Note: If they keep the $28,000, cash flow at 12% = $3,360

Methods of CollectionMethods of Collection

Send reminder letters. Make telephone calls. Send in big Gene Hire collection agencies. Sue the customer. Settle for a reduced amount. Write off the bill as a loss. Sell accounts receivable to factors.

Most Most firmsfirms use some of the following: use some of the following:

Inventory ManagementInventory Management Typically, inventory accounts for about four to five

percent of a firm's assets. In manufacturing firms, this could be 20 to 25% of the firm’s assets.

Inventory sitting on your shelf earns nothing! In fact, it costs you 20 to 30% of the value of the

inventory just to keep and maintain it. Therefore, the objective is to minimize the investment

in inventory without sacrificing production requirements

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Inventory MangementInventory Mangement

In order to effectively manage the investment in inventory, two problems must be dealt with: how much to order and how often to order.

The economic order quantity (EOQ) modeleconomic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs.

Inventory ManagementInventory Management Determining Optimal Inventory (where total

costs are minimized)

TotalInventory

Costs=

TotalCarrying

Costs

TotalOrdering

Costs+

Note: We are not talking about the cost of the Inventory itself, but costs of holding and maintaining the inventory

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Inventory CostsInventory Costs Carrying Costs

Warehouse rent, insurance, security costs,utility costs, maintenance costs, property taxes,move and re-arrange, obsolescence, and opportunity cost, i.e., using cash for profitable projects rather than being tied up in inventory.

Ordering costsClerical expense, telephone, Material Resource Planning (MRP) system, management time, receiving costs, etc.

TimeTime

OrderQuantity

Q

InventoryInventoryLevelLevel

(units)(units)

The EOQ Model assumes the firm orders a The EOQ Model assumes the firm orders a fixed amount (Q) at equal intervals.fixed amount (Q) at equal intervals.

TimeTime

OrderQuantity

Q

InventoryInventoryLevelLevel

(units)(units)

The EOQ ModelThe EOQ Model

Average inventory = Order Quantity

2

=Total

InventoryCosts

( ) CC + ( ) OCOQ2

S OQ

Where:Where:OQ = Order Size (order quantity)S = Annual Sales VolumeCC = Carrying Cost per UnitOC = Ordering Cost per Order

TotalInventory

Costs=

TotalCarrying

Costs

TotalOrdering

Costs+

Order Size Order Size (units)(units)

CostCost($)($)

Ordering Costs, Ordering Costs, per unitper unit

= ( )OC S OQ

Ordering Costs

Ordering costs per unit go down as order size increases. Assumes orderingcosts are relatively fixed.

Carrying CostsCarrying Costs

Order Size (units)Order Size (units)

CostCost($)($)

Carrying Costs = ( ) CC OQ 2

= ( )OC S OQ

Ordering Costs

Carrying costs increaseas the size of the inventory increases.

Total Costs = Carrying Costs + Order CostsTotal Costs = Carrying Costs + Order CostsTotal Cost = Total Cost = OQOQ x CC + x CC + SS x OC x OC

22 OQ OQ

Order Size (units)Order Size (units)

CostCost($)($)

Carrying Costs = ( ) CC OQ 2

= ( )OC S OQ

Ordering Costs

X

Y The economic order quantity is the intersection of the X and Y points where total inventory cost is minimized

Inventory ManagementInventory Management

– The ordering quantity that minimizes the total costs of inventory.

Determining Optimal Inventory

OQ =2 x S x OC

CC

Inventory ManagementInventory Management

– Economic Order Quantity (EOQ)

Example:Example:Awesome Autos expects to sell 1,560 new automobiles in the next year. It currently costs $40 per order placed with the manufacturer. Carrying costs amount to $50 per auto. How many autos should they order each time they place an order?

=

= 49.96 50 cars

2(1560)4050

Determining Optimal Inventory

OQ =2 x S x OC

CC

Inventory ManagementInventory Management Determining Optimal Inventory

– Economic Order Quantity (EOQ)

OQ autos in each order

Place 1,560/ 50 = 31.2 orders each yearOrder cost = 31.2 x $40 = $1,248

Example:Example:Awesome Autos expects to sell 1,560 new automobiles in the next year. It currently costs $40 per order placed with the manufacturer. Carrying costs amount to $50 per auto. How many autos should they order each time they place an order? How many orders per year?

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Inventory Reorder PointInventory Reorder Point

If total demand is 1560 and 52 weeks in year, then 1,560 / 52 or 30 cars sold per week.

If it takes one week to get a shipment of cars from the manufacturer, then 1 x 30 or when you get down to 30 cars, they would reorder

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Safety StockSafety Stock Assume Awesome autos does not want to risk

running out of cars and lose sales They determine that to offset variations in the

delivery cycle, they need a safety stock of 20 autos

The amount of safety stock is added to the inventory reorder point

So the new inventory reorder point would be 30 plus 20 or 50 autos

Inventory Management with Safety Inventory Management with Safety Stock- Order before inventory is at zero.Stock- Order before inventory is at zero.

EOQ

Depleted StockDuring Delivery

Inventory Order PointInventory Order Point

Actual Delivery Time

SafetyStock

TimeTime

InventoryInventoryLevelLevel

(units)(units)

20

50

70