Entrep finance chapter 11 the cash cycle

H a n d o u t f o r E n t r e p r e n e u r s h i p 1 0 1 P a g e | 220

SESSION 11:

MANAGE DAY-TO-DAY OPERATIONS

Overview: The previous sessions gave guidance on setting up the business. In this session, we focus on the day-to-day running of the business. Daily operations may look boring or routine but if they are left unattended, all sorts of problems crop up. These include: damaged reputation, out-of-stock situations, bad debts, and lost opportunities. We show how to avoid such problems in this session. More to the point, we show how to maximize profits by effectively managing the resources used in operations.

Sections: The Operating or Cash Cycle: Investing in the Operating Cycle Cost-Benefit Analysis Payables Inventory Receivables

Learning Objectives At the end of this session, the student should be able to:

1. Define the operating cycle and identify its components 2. Describe the cost-benefit approach to managing the operating cycle

components 3. Describe the role of payment period and discounts for early payment in

managing payables 4. Explain why the focus of inventory management is on costs 5. Identify the different costs in managing inventory and describe the

relationship between the volume ordered and these costs 6. Identify the variables you can manage in relation to receivables and

describe their effects on the costs and benefits of extending credit


STORY FROM REAL LIFE: Dealing with Cold Hard Cash

Roger Laney was an accountant for 30 years and owned his own accounting firm for more than 20 years. He recently came across an intriguing side business: ice houses. Yes, ice. When someone asked him to lease property to a 20-foot-by-40-foot self-serve ice kiosk, Laney's initial response was "What? That's crazy." But 14 months later, he and his partners now run Alamo Ice and own five ice houses in San Antonio, Texas--the closest non-saturated area to their home base of Chipley, Florida. They also sell the machines in 12 counties they have bought licensing rights for. While Laney still works full time at his firm, the icehouse partners take turns traveling to Texas once a month, and Laney has spent many nights and weekends building the business. But he says that once the machines are up and running, it's hands off. "That's the beauty of the ice machine business," says Laney, who adds that two of the biggest headaches small-business owners have are employees and collecting money. The ice machines have neither issue as they're managed and maintained by a contract company in Texas. The partners plan to invest in 80 machines total in Bear County, Texas, and continue selling machines in their 11 other territories. At $130,000 each for full installation, it's a deep investment, but one that Laney says breaks even in 30 months. "I anticipate keeping both businesses for an extended period of time," he says. "Once we get the machines on the ground and operating, there's not a lot to them." Source: http://smallbusiness.aol.com.

Introduction Imagine, for a moment, that you have turned your dream into a reality. You have set up your business by buying machines and delivery trucks-- maybe even built a factory. You have assembled your management team. You are now ready to operate.


The difference between setting up a business and running it has to do with the costs you incurred. In the beginning, the things you bought were one-time costs. They might have been large and expensive, but you will not build a factory every day. Running or operating costs are ―recurring.‖ They happen very frequently in the course of business. You need to focus on these costs because being a good entrepreneur does not mean just having an effective strategy. Your operations need to be efficient too. The one question you need to ask to be efficient is, ―How do I make my investment in the business work hard for me?‖ To know what things to consider in answering the central question, you first need to understand the idea of an operating cycle. We discuss this concept in the next section.

1. The Operating Or Cash Cycle The operating cycle is the set of routine business activities that turn cash … into something … and then back into cash again. For this reason, the operating cycle is also called the cash cycle.

The operating cycle consists of routine business activities

that turn cash into something… and then back into cash again.

Suppose you own a manufacturing firm. Your operating cycle will typically consist of paying cash to buy raw materials, moving the materials into production, storing finished products, selling the items on credit, and finally collecting cash from customers. Let us examine these activities more closely.

Buying and paying for

raw materials

The production

process

Storing finished

products Selling

products on credit /

Accounts Receivable

Collecting

cash from

customers


The operating cycle starts when your firm buys raw materials and supplies. One may think that cash is needed at this point but that is not typically the case. You are likely to be allowed a short period before payment is due. In such cases, you are said to buy on credit. The resulting obligations are called payables. There is no immediate cash out. Cash is needed only when your payables become due.

Payables are obligations to suppliers when goods are bought on credit.

The raw materials may be kept in a warehouse before they go into the factory and enter the production process. At the factory, the raw materials are combined with other inputs (such as labor, the use of machines, electricity, etc.) to come up with the so-called finished goods--the product your business wants to sell. The finished goods then need to be packed and stored until they are sold. You will eventually have to pay for all of these inputs. But we focus on inventory, as it is the largest item in the process. Accounting has separate records for raw materials, the materials that go into the factory, and finished goods. For our purposes, we will group them together and call these items collectively as inventory. Inventory may be defined as things a business buys or makes in order to sell.

Inventory consists of things you buy or make in order to sell.

Just as suppliers sell to the firm on credit, it is likely that your firm will also sell on credit. Selling on credit creates claims on customers, which we call receivables.

Receivables are claims from customers when goods are sold on credit.

Step back a moment and review the operating cycle thus far. Up until this point, you have paid for all sorts of things without getting any cash back. You have invested a considerable amount of resources. You can only begin to recover your money as your receivables are collected. Investing in the operating cycle. How much is invested in the operating cycle and how significant is it? Let us take receivables as an example to appreciate the amount and nature of funds invested in the operating cycle. The amount you invest in receivables depends on how much you sell, and how long it takes your customers to pay. Let us suppose that you sell Sr10 million a month and that your customers take three months to pay. Then Sr30 million of your resources are tied up in receivables. Put another way, you need to invest


Sr30 million in receivables to carry out a policy of extending three months credit to your customers. You might agree that Sr30 million is a significant amount. But then you might argue that since the Sr30 million is collected in three months, what you really lost is only the opportunity to invest Sr30 million for three months. If you work out the numbers, you might conclude that what you lost is not very much. If you do, you would be mistaken. To understand why, look at the table below which maps out our example. Effect of a 3-month credit policy on receivables

(in Sr millions) Month 1 Month 2 Month 3 Month 4 Month 5

Beginning receivables 0 10 20 30 30 Sales on Credit 10 10 10 10 10 Collections 0 0 0 10 10 Ending Receivables 10 20 30 30 30

Receivables increase as you sell products on credit. They are reduced and turn to cash when you collect from customers.1 In the table above, we begin with zero receivables. You sell Sr10 million in the first month but don’t collect any because customers pay only in 90 days. This pattern is repeated in the second and third month, increasing your uncollected receivables to Sr30 million. In the fourth month, you sell Sr10 million and collect the Sr10 million you sold in the first month. Since receivables are increased and decreased by the same amount, the balance remains unchanged at Sr30 million. The pattern holds for the fifth month and will in fact hold for all months after that. We see then that the Sr30 million in receivables is not a three-month investment. Rather it is a permanent—even perpetual—investment. Clearly, the amount invested is significant as is the opportunity lost because the investment is permanent. And the investment in the operating cycle can only grow as the business grows. It is for these reasons that we look closely at the operating cycle. Recall that the central issue is for your investment in the business to work hard for you. In the case of the operating cycle, the goal is achieved by making the most of the time and/or money invested in the activities of the operating cycle. You make the most of time by speeding up the cash-to-cash cycle. You make

1 Receivables are also reduced when you give up on customers who repeatedly refuse to pay. We

ignore the effect of such customers in this example (In real life, you would worry about collecting.)


the most of resources by putting in only what is needed for the business to exploit its opportunities. Cost-benefit analysis. Exactly how do we make the most of time and money invested in the operating cycle? The approach we will take is cost-benefit analysis. As the name suggests, the process involves weighing the total expected costs against the total expected benefits. The difference is the value created or destroyed for the business by the decision. You should adopt courses of action where the benefits exceed the costs. We will apply cost-benefit analysis to the operating cycle components --- payables, inventory and receivables.

Ask yourself Are there people who owe me money? Did I manage to collect from them? Can I apply cost-benefit analysis to other aspects of my life? Sports, gadgets, etc.

2. Payables Payables arise when your business buys on credit. You and other buyers are most likely to prefer buying on credit than paying cash up front. You get the goods without having to pay for them, at least for a time. There seems to be no interest charged; it looks like free financing. Sellers extend credit because it is a way to increase sales. They are generally more willing to extend credit than are banks, so small businesses like yours rely on them for financing. In fact, it is the largest source of short-term funds for business firms. It would seem, then, that your interests as a buyer and the interests of a seller are aligned in credit transactions. You both want to do it. You may even conclude that you should maximize payables by buying all things on credit and paying as late as possible. By financing operations this way, you minimize the need for funds from investors. This view is at best only partially correct.


Payables are free financing up to a point. You should delay payment up to that point. Beyond this cut-off, further delays in payables can be very costly. To understand why, let’s look closely at the terms that come with buying on credit. Credit terms define when payment is due. They may include an incentive for early payment. Credit terms are included in the terms of sale, which are specified by the seller. They can be seen in the invoice that the seller sends to the buyer. Credit terms are written with a kind of short-cut language. For example, the terms ―net 60‖ means that you must pay the full amount within 60 days. The terms ―2/10, net 30‖ means that you get a 2 percent discount if you pay within 10 days; otherwise, you must pay the full amount within 30 days. Let’s take the first example --- net 60. When should you pay? Since you will pay the same amount whether you pay on day 1 or day 60, you should pay on day 60. There is no cost to the use of credit. You should take advantage of this benefit by paying as late as possible. Now let’s take the second example --- 2/10, net 30. When should you pay? If you bought Sr100, you could pay that amount on the 30th day. Or you could avail of the 2% discount and pay only Sr98 on the 10th day. The other days within the period don’t really matter since you would pay the same amount (Sr98 or Sr 100) earlier and not take advantage of free credit. Is the 2% discount worth taking? You may think 2% is small but remember that the discount is over a 20-day period (the time from the 10th to the 30th day). Since there are about eighteen 20-day periods in a year (360/20 = 18), 2% every 20 days roughly converts to 36% per year! It turns out that paying beyond the 10th day is very costly. If the return required by banks or by investors is less than 36% a year, it would be better for the business to obtain funds from them to pay suppliers early. This is opposite to the conclusion we reached earlier. Is it possible to go beyond the payment period? It is and it happens often. Sellers may themselves stretch the payment period during the low season to encourage sales. Buyers also use all sorts of tactics to pay as late as possible to enjoy free financing for longer than the seller intended. But do not abuse the privilege. If your business pays too late too often, its reputation gets damaged. Suppliers may impose stricter terms, increase their prices, or not deal with your business at all. Bankers may raise their fees in view of the increased risk. Bankers might even refuse to lend.


To summarize, payables represent a ready form of financing to your firm. Payables come automatically in the course of business. They are normally free of restrictions such as a strict payment schedule or collateral. But payables are not costless. There is an opportunity loss if discounts are not taken. Stretching payables beyond an acceptable period damages the reputation of your business. You will have to balance the costs and benefits to come up with a wise policy on payables.

Ask yourself Do I have any items that I have to pay for, but I have not yet fully paid for them? Have I ever taken advantage of a discount for cash payments?

3. Inventory STORY FROM REAL LIFE Using technology to manage inventory A large telecoms firm was challenged by the management of its inventory parts. Incorrect forecasts led to production bottlenecks and expensive delays. To address the problem, the firm hired an outside team to build a computer-based inventory planning system. The benefits were significant. In one facility, parts inventory was reduced by 40 percent for an $11 million cost savings in that year. Order backlogs were cut by


68 percent. In a fiber optics plant, materials became available 98 percent of the time leading to a 20 percent increase in service levels. Inventory is what your business buys or makes in order to sell. It consists of raw materials, the materials in the factory, and unsold products. Very often, inventory is the single largest investment of a business. It pays to give it your attention. Manage it effectively. The focus in managing inventories is not on benefits but on costs. This is because the benefit derived from inventories – the profit made from sales --- is either already known or determined elsewhere. The profit from every sale depends on the price, which is determined in your marketing plan. The number of units sold depends largely on demand, which is estimated by your sales people. Once the price and demand have been determined or estimated, the manager responsible for inventory has little choice in the matter. He must buy the inventory that will at least meet demand. Since sales and the resulting profit is something beyond his control, he cannot manage the benefits of inventory. Instead the manager focuses on lowering the costs in buying and keeping inventory. But which costs? This may surprise you: one cost you cannot manage is the cost of the inventory itself! This is rather odd since you should bargain hard when buying inventory. But you will negotiate for the lowest cost in any case, however way you buy the inventory. So we may assume that the cost at which you buy inventory is already the lowest possible. And since you must buy inventory to meet demand, you will spend the same amount regardless of how you buy it. The amount may be very significant but if it cannot be changed, then like the benefits of inventory, it cannot be managed. The costs you can manage are the other costs surrounding the inventory process and may be grouped into:

1. Ordering costs 2. Holding or carrying costs 3. The lost opportunity to sell when you are out of stock.

As the name suggests, ordering costs are costs related to the purchase or ordering of inventory. They include costs related to processing the order, inspecting the goods, and paying the bills. They are generally fixed in nature. That is, the cost remains about the same per order regardless of the volume ordered.


Costs related to the purchase or ordering

of inventory are called ordering costs. STORY FROM REAL LIFE Using technology to manage inventory An entrepreneur facing problems with purchase order delays decided to use software to address this challenge. As a result, purchasing tasks now take him a fraction of the time it took before. Forecasting is tied up to vendor information and the most cost effective shipping methods. Tracking of shipments is also done by the system. The state-of-the-art solution has allowed the company to double revenue without adding personnel. When the inventory arrives, you will want to sell it as soon as possible. But until the sale happens, you will need to store and keep the inventory in good condition. The costs relating to these activities are called holding or carrying costs. They include rent, insurance, spoilage, theft, salaries of warehouse staff, and the cost of the funds invested in inventory. These costs are generally variable in nature. The greater the volume per order, the greater the holding costs.

Costs needed to store and keep inventory

are called holding or carrying costs.

Finally, there will be instances where you will run out of stock when demand is temporarily greater than supply. The immediate cost is the profit not earned from the lost sale. When you are out-of-stock often enough, customers become unhappy and begin to turn away. In this case, you not only miss the profit from a lost sale, you may lose all future profits! Effectively managing inventories is not just a matter of reducing the costs just discussed. The costs relate to and offset each other. The trade-off among the costs has to do with the quantity or number of units bought per order. If you order plenty of units each time, you will place fewer orders, and lessen the total ordering costs. But then your carrying costs will be high.


If you order a small quantity each time, you end up with more orders, and you increase total ordering costs. However, a smaller inventory level means lower carrying costs. This kind of situation is called ―a trade-off.‖ The diagram below illustrates the relationships between carrying costs, ordering costs, and order quantity.

Costs as Functions of Order Quantity

Annual

Cost

PG 6.12

Order QuantityIdeal Quantity

Total Cost s

Carrying Costs

Ordering Costs

Minimum

Cost

Out-of-stock situations are handled by maintaining some ―buffer stock‖ or ―safety stock‖. Here, too, there is a trade-off. If you have substantial safety stock, you lessen the chance of running out of stock. But you trap more funds in inventory. If you maintain little or no safety stock, you free up funds for other uses but risk a greater chance of running out of stock. Managing the costs of inventory involves a balancing act. It is not any one cost that needs to be lowered but the total of ordering, holding, and stock-out costs.


Ask yourself Do I use technology to manage my data, papers, items in storage? Do I know where to find all the files and data that I have stored? Have I ever tried to buy something from a store or restaurant, an item which was out of stock? Was it a total disappointment? Did I learn something valuable from the experience?

4. Receivables Receivables are the opposite of payables. Just as suppliers extend credit when you buy from them, you are likely to extend credit when customers buy from you. Your reason for extending credit to customers is the same reason suppliers extend credit to you—to increase sales. More correctly, the benefit of receivables is the profit from the increase in sales as a result of extending credit. As you may now have come to expect, the benefits of receivables do not come without a cost. The first cost is the cost of money. Had you sold in cash, you would now have the money to invest or enjoy. But you did not and so forego the reward of investing or enjoying the funds. The second cost is related to risk, that the customer may not pay. We call this cost bad debts. Of the two costs, bad debts is more significant. The cost of money depends largely on the alternative. Had you sold in cash and invested the funds in a government Treasury bill that earns 5 percent per year, then that reward is what you sacrificed by putting the money in receivables instead. If you sold on credit and the customer does not pay, you lose the entire thing! Why would you be willing to accept these costs? It must be because the benefit of increased profits from extending credit exceeds the cost of money and bad debts. The excess benefit is the value added to your business.


Benefit 1. More profit from

more sales

Receivables

Policy Cost 1. Cost of money

2. Bad debts

Think about the last sentence and the diagram a bit more. When you first extend credit, you are likely to do so to your most preferred customers. The cost of money and bad debts are both low so benefits clearly exceed costs. As you extend credit to less preferred customers, the profit per sale remains the same but the costs, especially bad debts, will start to creep up. Benefits may still exceed costs but do so at smaller amounts. Eventually, you will come to a point where benefits equal the costs. The value of an effective policy in receivables is maximized at that point. Beyond that, the costs will exceed the benefits. When that happens, it will no longer be worth selling on credit. As with payables, we now come to understand that your business benefits by extending credit but that this benefit has a limit. You should keep on extending credit only until the benefits of doing so exceeds its costs. Having presented the framework for extending credit, we now go into the details of how receivables are managed. As before, you can only manage the things you can control or change. The variables you can manipulate in managing receivables are:

Quality of customers—Are your customers both willing and able to pay? The higher the quality of your customers, the lower the bad debts. But limiting credit to high-quality customers also limits sales.

Payment period—Longer payment periods encourage more profits as it allows customers who may be tight on cash to buy your products. But the longer time frame increases both the cost of money and bad debts.


Discounts for early payment—Giving customers an incentive for paying early lowers the cost of money as you receive the funds earlier. It also lowers bad debts. But as the price is effectively lowered by the discount, your profits are likewise lower.

The mathematics of managing receivables can be found in specialized books on financial management. What is important is for you to know that the variables above are within your control. You can change any variable or a combination. Once again, your decision will involve a balancing act. The benefits and costs offset each other and it is not always clear what the overall effect will be. So long as you keep the cost-benefit framework in mind, you are likely to be in the right direction. STORY FROM REAL LIFE Managing receivables An urgent-care medical clinic lacked the people to handle its receivables from several insurance firms. This led to delays in billings and a decrease in collections. Instead of hiring more staff, it decided to outsource collections to an agency. By handing the function over to experts in collection, it now takes just 23 days to collect, down from the usual 34. Cash flow has improved. The experts in collection relieved the medical clinic of a support function, and allowed it to concentrate on patient care.


Ask yourself Did I ever sell goods to people, and did I collect the payment?

Conclusion We have just covered the tasks necessary for the day-to-day running of the business. Daily operations may look boring or routine, but if they are left unattended, all sorts of problems crop up. These include: damaged reputation, out-of-stock situations, bad debts, and lost opportunities. We show how to avoid such problems in this session. More to the point, we show how to maximize profits by effectively managing the resources used in operations.

Points To Remember

The operating cycle is the set of routine business activities that turn cash into something and then back into cash again. For this reason, the operating cycle is also called the cash cycle.

A typical operating cycle consists of paying cash to buy raw materials,

moving the materials into production, storing finished products, selling the items on credit, and finally collecting cash from customers.

Managing day-to-day operations involves managing the components of the operating cycle--payables, inventory, and receivables. The investment your business makes in the operating cycle is significant and permanent which motivates us to examine it closely and manage it effectively.

The approach we use to guide us in managing the operating cycle is the cost-benefit approach. In this approach, total expected costs are compared against total expected benefits. The investment is made when benefits exceed the costs.

We applied the cost-benefit approach to the components of the operating cycle and the particulars are shown in the table below:


Operating cycle component

Benefits Costs Management variables

Payables Readily available financing Free and flexible financing

Cost of money Damaged reputation

Payment period Discounts for early payment

Inventory Profits from sales (but this cannot be managed)

Cost of inventory (but this cannot be managed) Ordering costs Holding costs Lost profits when out-of-stock

Order quantity (number of units per order Safety stock

Receivables Profits from increased sales

Cost of money Bad debts

Quality of customers Payment period Discounts for early payment

You change the level of investment in the operating cycle components by

managing the variables within your control. You will manage these variables such that benefits always exceed the costs.

Credit terms define when payment is due and may include an incentive for early payment.

Sellers may themselves stretch the payment period during the low season

to encourage sales. Buyers also use all sorts of tactics to pay as late as possible.

There is an opportunity loss if discounts are not taken. Payables may be stretched but doing so beyond an acceptable period damages the reputation of your business.

Inventory management: The focus in managing inventories is not on benefits but on costs. This is because the benefit derived from inventories – the profit made from sales --- is either already known or determined


elsewhere. The manager focuses on lowering the costs in buying and keeping inventory.

The costs you can manage are the other costs surrounding the inventory process and may be grouped into:

o Ordering costs o Holding or carrying costs o The lost opportunity to sell, when you are out of stock.

The variables you can manipulate in managing receivables are: Quality of customers --- Are your customers both willing and able to pay? The higher the quality of your customers, the lower the bad debts. But limiting credit to high-quality customers also limits sales. Payment period --- Longer payment periods encourage more profits as it allows customers who may be tight on cash to buy your products. But the longer time frame increases both the cost of money and bad debts. Discounts for early payment --- Giving customers an incentive for paying early lowers the cost of money as you receive the funds earlier. It also lowers bad debts. But as the price is effectively lowered by the discount, your profits are likewise lower.

Learning From The Internet 1. To know more about the operating cycle: http://www.newyorkfed.org/education/addpub/credit.html 2. To know more about inventory management: http://www.edwardlowe.org/index.elf?page=sserc&storyid=0103&function=story 3. To know more about managing receivables: http://www.rbcbankusa.sbresources.com/SBR_template.cfm?DocNumber=PL10_0830.htm

Review Questions

1. What is an operating cycle? What would be the activities in an operating cycle of a manufacturing company?

http://www.newyorkfed.org/education/addpub/credit.html

http://www.edwardlowe.org/index.elf?page=sserc&storyid=0103&function=story

http://www.rbcbankusa.sbresources.com/SBR_template.cfm?DocNumber=PL10_0830.htm

http://www.rbcbankusa.sbresources.com/SBR_template.cfm?DocNumber=PL10_0830.htm


2. Why is it important to look into what the business invests in the operating cycle?

3. Briefly describe the cost-benefit approach to managing the operating cycle components.

4. What is the trade-off between the payment period and the discount for

early payment in managing payables?

5. Why should the focus on inventory management be on costs?

6. What are the costs that need to be managed in managing inventories?

7. What is the relationship between ordering costs, holding costs, and the volume ordered?

8. What variables (things you as owner/manager can control or change) can you manage in relation to receivables?

9. What are the effects on receivables of managing quality of customers, payment period, and discounts for early payment?

Discussion Questions

1. The authors have tried to make the case that in inventory management, the benefit and the cost of inventory is not something you can manage. But are you convinced? Discuss this concept with your peers and try to come up with a consensus answer.

2. In inventory and receivables, the outcome from managing the variables under your control is unclear because the costs and benefits offset each other. One way to estimate the outcome is to work through the numbers as detailed in specialized books in finance. Another is to just change the variables by trial and error and see the effects on your business (You can always undo the change should the effect be negative). What do you think of the trial and error approach?

3. The operating cycle discussed in this session is for a manufacturing business. What would be the components for the operating cycle of a supermarket? Of a law firm?

4. From experience, provide examples of tactics buyers use to pay as late as possible. Are these tactics right or wrong? Would you employ some of the tactics yourself?


Case Study: McDonald’s It used to be that McDonald’s would pre-cook batches of burgers and let them sit under heat lamps until ordered by a customer. The hamburgers were kept as long as possible. Those unsold after a certain time had to be discarded. To get a fresh hamburger then, one had to make a special order. Now, it has employed Just-in-time (JIT) inventory so that McDonald’s does not begin to cook (or more probably reheat or assemble) until a customer has placed an order. For it to achieve JIT, McDonald’s had to invest in methods and technology including a record-breaking bun toaster. The effect of these efforts is that McDonald’s made burgers much faster, resulting in the tasty and delicious burgers than every patron now enjoys.

Case Analysis

1. What do you think are the benefits to McDonald's in employing just-in-time inventory?

2. Do you think it is worth investing in technology to achieve the benefits of JIT?

3. Because McDonald’s does not cook until an order is placed, there is the danger of having a large number of customers come in at one time and having to wait longer. How do you think McDonald’s handles situations like these?

Glossary Operating cycle: The set of everyday business activities that convert cash back into cash again. Thus, it is also called the cash cycle. The activities may include paying cash for raw materials, moving materials into production, storing finished products, selling the products, and collecting from customers. Payables: Obligations that arise when purchases are made on credit; that is, the buyer is allowed a short period after goods are delivered before payment is due. Inventory: Things a business buys or makes with the intention of selling them to customers.


Receivables : Claims on customers that arise when sales are made on credit; that is, when a seller allows a short period before collecting payment. Ordering costs: Costs related to the purchase or ordering of inventory. They are generally fixed in nature. Holding or carrying costs: Costs related to storing, keeping, controlling the inventory after delivery. They are generally variable in nature. Trade-Off A trade-off between quantities occurs when an improvement in one quantity means a worsening in the other quantity. In such cases there is usually an ideal value for each quantity.

EXERCISES FOR SESSION 11:

MANAGING DAY-TO-DAY OPERATIONS

Review Questions

1. What is an operating cycle? What would be the activities in an operating cycle of a manufacturing company? ______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

2. Why is it important to look into what the business invests in the operating cycle? _____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

3. Briefly describe the cost-benefit approach to managing the operating cycle components.


______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

4. What is the trade-off between the payment period and the discount for

early payment in managing payables? ______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

5. Why should the focus on inventory management be on costs?

______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

6. What are the costs that need to be managed in managing inventories?

______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

7. What is the relationship between ordering costs, holding costs, and the

volume ordered? ______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________


________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

8. What variables (things you as owner/manager can control or change)

can you manage in relation to receivables? ______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

9. What are the effects on receivables of managing quality of customers,

payment period, and discounts for early payment? ______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Exercises and Activities 1. Interview an entrepreneur and find out what his raw materials are, what his production process is, how long it takes to sell his goods, and how long it takes to collect from customers. 2. Make a drawing of the cash cycle of the entrepreneur you interviewed. The operating cycle diagram is shown below as a guide but be more specific. Exactly what are his raw materials? What are his finished goods?


3 Visit a factory. Take note of the various kinds of inventory that they have in the stockroom. 4. Interview a manufacturing manager. Ask him for his policies in managing his

inventory. What are the typical problems he encounters? What have been the solutions they implemented?

5. Speak with a grocery store owner. Ask him how much his receivables are. Ask how many of those receivables are more than 30 days old? How many are more than 90 days old? What does he do to collect the older receivables?

The production

process

Storing finished products

Selling products on credit

crecredAccounts Receivable

Collecting cash from

customers

Buying and paying for raw

materials

Entrep finance chapter 11 the cash cycle

Business

Transcript of Entrep finance chapter 11 the cash cycle