Chapter 10 -- Accounts Receivable and Inventory Management

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Chapter 10
Accounts Receivable and Inventory Management
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After Studying Chapter 10, you should be able to

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 analyse 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).

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Accounts Receivable and Inventory Management

• Credit and Collection Policies
• Analysing the Credit Applicant
• Inventory Management and Control

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Credit and Collection Policies of the Firm
Quality of Trade Account
Length of Credit Period
(1) Average Collection Period
(2) Bad-debt Losses
Firm Collection Program
Possible Cash Discount
5
Credit Standards
Credit Standards The minimum quality of credit
worthiness of a credit applicant that is
acceptable to the firm. Why lower the firms
credit standards?
The financial manager should continually lower
the firms credit standards as long as
profitability from the change exceeds the extra
costs generated by the additional receivables.
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Credit Standards
Costs arising from relaxing credit standards

• A larger credit department
• Additional clerical work
• Servicing additional accounts
• Bad-debt losses
• Opportunity costs

7
Example of Relaxing Credit Standards

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

8
Example of Relaxing Credit Standards

• Additional annual credit sales of 120,000 and an
  average collection period for new accounts of 3
  months is expected (A/R turnover 4 times/year).
• The before-tax opportunity cost for each dollar
  of funds tied-up in additional receivables is
  18.
• Ignoring any additional bad-debt losses that
  may arise, should Basket Wonders relax their
  credit standards?

9
Example of Relaxing Credit Standards
Profitability of (5 contribution) x (4,800
units) additional sales 24,000 (120,000/25
4,800 units) Additional (120,000 sales) / (4
Turns) receivables 30,000 (120,000/(3/12)
30,000) Investment in (20/25) x (30,000)
add. receivables 24,000 Req. pre-tax return
(18 opp. cost) x 24,000 on add.
investment 4,320 (18 of additional
investment) Yes! Profits gt Required
pre-tax return
10
Credit and Collection Policies of the Firm
Quality of Trade Account
Length of Credit Period
(1) Average Collection Period
(2) Bad-debt Losses
Firm Collection Program
Possible Cash Discount
11
Average Collection Period

• The average length of time from a sale on credit
  until the payment becomes usable funds for the
  firm.
• Two parts
• Time from the sale until the customer mails the
  payment
• Time from when the payment is mailed until the
  firm has received the cleared funds in its bank
  account.

12
Average Collection Period

• Objective is to collect accounts receivable as
  quickly as possible without losing sales from
  high pressure collection procedures. This
  involves three key areas
• Credit Selection
• Credit Terms
• Credit Monitoring

13
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.
Credit Period The total length of time over
which credit is extended to a customer to pay a
bill. For example, net 30 requires full payment
to the firm within 30 days from the invoice date.
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Example of Relaxing the Credit Period

• Basket Wonders is considering changing its credit
  period from net 30 (which has resulted in 12
  A/R Turns per year) to 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.

15
Example of Relaxing the Credit Period

• The before-tax opportunity cost for each dollar
  of funds tied-up in additional receivables is
  20.
• Ignoring any additional bad-debt losses that may
  arise, should Basket Wonders relax their credit
  period?

16
Example of Relaxing the Credit Period
Profitability of (5 contribution)x(10,000
units) additional sales 50,000 (250,000/25
10,000) 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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Example of Relaxing the Credit Period
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 Yes! Profits gt
Required pre-tax return
18
Changing credit standards

• Li Hong Company is currently selling a product
  for 10 per unit. Sales (all on credit) for last
  year were 60,000 units. The variable cost per
  unit is 6. The firms total fixed costs are
  120,000.
• The firm is considering a relaxation of credit
  standards that is expected to result in the
  following a 5 increase in unit sales to 63,000
  units an increase in the average collection
  period from 30 days (its current level) to 45
  days an increase in bad-debt expenses from 1 of
  sales (the current level) to 2. The firms
  required return on equal-risk investments, which
  is the opportunity cost of tying up funds in
  accounts receivable, is 15.

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Changing credit standards

• Need to calculate the effect on the firms
  additional profit contribution from sales, the
  cost of the marginal investment in accounts
  receivable and the cost of marginal bad debts.
• Additional profit contribution from sales
• Fixed costs are sunk and thereby unaffected by
  a change in the sales level.
• Variable cost is the only cost relevant to a
  change in sales. Sales are expected to increase
  by 5, or 3,000 units. The profit contribution
  per unit equals the difference between the sale
  price per unit (10) and the variable cost per
  unit (6) and so the profit contribution per unit
  will be 4.
• Thus, the total additional profit contribution
  from sales will be 12,000 (3,000 units 4 per
  unit).

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Changing credit standards

• Cost of the marginal investment in accounts
  receivable
• To determine the cost of the marginal investment
  in accounts receivable, Li Hong must find the
  difference between the cost of carrying
  receivables before and after the introduction of
  the new credit standards. We are only concerned
  about the out-of-pocket costs so the relevant
  cost in this analysis is the variable cost.
• The average investment in accounts receivable can
  be calculated using the following formula
• Average investment in accounts receivable total
  variable cost of annual sales/ turnover of
  accounts receivable
• where
• Turnover of accounts receivable 365/average
  collection period

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Changing credit standards

• The total variable cost of annual sales, using
  the variable cost per unit of 6 are,
• Total variable cost of annual sales
• Under present plan (6 60,000 units)
  360,000
• Under proposed plan (6 63,000 units)
  378,000
• The proposed plan increases total variable cost
  of sales by 18,000.
• The turnover of accounts receivable shows the
  number of times each year that accounts
  receivable are turned into cash. It is found by
  dividing the average collection period into 365.
• Turnover of accounts receivable (rounded)
• Under present plan 365/30 12.2
• Under proposed plan 365/45 8.1

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Changing credit standards

• Substitute the cost and turnover data just
  calculated to get the following average
  investments in accounts receivable
• Average investment in accounts receivable
• Under present plan 360,000/12.2 29,508
• Under proposed plan 378,000/8.1 46,667
• The marginal investment in accounts receivable,
  and its cost, are calculated as follows
• Cost of marginal investment in accounts
  receivable (A/R)
• Average investment under proposed plan 46,667
• Average investment under present plan
  29,508
• Marginal investment in accounts receivable
  17,159
• Required return on investment 0.15
• Cost of marginal investment in A/R 2,574

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Changing credit standards

• The value of 2,574 is a cost because it
  represents the maximum amount that could have
  been earned on the 17,159 had it been placed in
  the best equal-risk investment alternative
  available at the firms required return on
  investment of 15.
• Cost of marginal bad debts
• The cost of marginal bad debts is the difference
  between the level of bad debts before and the
  level of bad debts after the change in credit
  standards
• Cost of marginal bad debts
• Under proposed plan 0.02 10 63,000 units
  12,600
• Under present plan 0.01 10 60,000 units
  6,000
• Cost of marginal bad debts 6,600

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Changing credit standards

• Bad debts costs are calculated by using the sale
  price per unit (10) to identify not just the
  true loss of variable (or out-of-pocket) cost
  (6) that results when a customer fails to pay
  its account, but also the profit contribution per
  unitin this case, 4 (10 sales prices 6
  variable cost)that is included in the
  additional profit contribution from sales.
  Thus, the resulting cost of marginal bad debts is
  6,600.
• To decide whether the firm should relax its
  credit standards, the additional profit
  contribution from sales must be compared with the
  sum of the cost of the marginal investment in
  accounts receivable and the cost of marginal bad
  debts. If the additional profit contribution is
  greater than marginal costs, credit standards
  should be relaxed.
• Additional profit 12,000
• Less Marginal investment in Accounts receivable
  (2,574)
• Less marginal cost of bad debts
  (6,600)
• Net profit (loss) from change in credit terms
  2,826

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Changing credit standards

• The effect of Li Hongs credit relaxation policy

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Exercise

• Now try to do problems 14-24 and 14-27 from
  Gitman Ch 14 handout

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Credit and Collection Policies of the Firm
Quality of Trade Account
Length of Credit Period
(1) Average Collection Period
(2) Bad-debt Losses
Firm Collection Program
Possible Cash Discount
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Credit Terms
Cash Discount Period The period of time during
which a cash discount can be taken for early
payment. For example, 2/10 allows a cash
discount in the first 10 days from the invoice
date.
Cash Discount A percent () reduction in sales
or purchase price allowed for early payment of
invoices. For example, 2/10 allows the customer
to take a 2 cash discount during the cash
discount period (10 days).
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Credit Terms

• The terms of sale for customers who have been
  extended credit by the firm.
• E.g. net 30 means the customer has 30 days from
  the beginning of the credit period to pay the
  full invoice amount.
• Some firms offer cash discounts as percentage
  discounts from the purchase price for full
  payment within a specified time.
• E.g. 2/10 net 30 means the customer can take a
  2 discount from the amount payable if payment is
  made within the first 10 days of the credit
  period, or pay the full amount payable within 30
  days of the beginning of the credit period.

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Credit Terms

• Any discounts for early payment should only be
  offered after a cost benefit analysis.
• Are reflective of the type of business the firm
  operates. E.g. seasonal, perishable goods etc
• Should be reflective of industry standards at a
  firm level, but reflective of customer riskiness
  at an individual customer level.

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Credit Terms

• Li Hong Company has an average collection period
  of 40 days (turnover 365/40 9.1). The firms
  credit terms are net 30. Li Hong is considering
  changing its credit terms from net 30 to 2/10 net
  30. This change is expected to reduce the average
  collection period to 25 days (turnover 365/25
  14.6).
• As shown in the EOQ example (slide 66), Li Hong
  has a raw material with current annual usage of
  1,100 units. Each finished product produced
  requires one unit of this raw material at a
  variable cost of 1,500 per unit, incurs another
  800 of variable cost in the production process
  and sells for 3,000 on terms of net 30. Li Hong
  estimates that 80 of its customers will take the
  2 discount and that offering the discount will
  increase sales of the finished product by 50
  units (from 1,100 to 1,150 units) per year but
  will not alter its bad-debt percentage. Li Hongs
  opportunity cost of funds invested in accounts
  receivable is 14. Should Li Hong offer the
  proposed cash discount?

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Credit Terms

• Analysis of initiating a cash discount for Li
  Hong Company
• Li Hongs opportunity cost of funds is 14

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Example of Introducing a Cash Discount

• A competitor of Basket Wonders is considering
  changing the credit period from net 60 (which
  has resulted in 6 A/R Turns per year) to 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

34
Example of Introducing a Cash Discount

• The before-tax opportunity cost for each dollar
  of funds tied-up in additional receivables is
  20.
• Ignoring any additional bad-debt losses that may
  arise, should the competing firm introduce a cash
  discount?

35
Example of Using the 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
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Example of Using the Cash Discount
Pre-tax cost of 0.02 x 0.3 x 5,000,000 the
cash discount 30,000. Pre-tax opp.
savings (20 opp. cost) x 208,333 on reduction
in A/R 41,667. Yes! Savings gt Costs The
benefits derived from reducing accounts
receivable exceed the costs of providing the
discount to the firms customers.
37
Credit and Collection Policies of the Firm
Quality of Trade Account
Length of Credit Period
(1) Average Collection Period
(2) Bad-debt Losses
Firm Collection Program
Possible Cash Discount
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Default Risk and Bad-Debt Losses (see p. 251 for
details)
Present Policy 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 12 times 2 months 3
months per year 6 times 4 times
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Default Risk and Bad-Debt Losses
Policy A Policy B 1. Additional
sales 600,000 300,000 2. Profitability
(20 contribution) x (1) 120,000 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.
Invest in add. receivables (0.80) 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 additional required return (3) (6)
76,000 66,000 8. Incremental
profitability (2) - (7) 44,000
(6,000) Adopt Policy A but not Policy B.
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Collection Policy and Procedures
The firm should increase collection expenditures
until the marginal reduction in bad-debt losses
equals the marginal outlay to collect. As an
account becomes more overdue, the collection
effort becomes more personal and more intense,
until a resolution achieved.

• Collection Procedures
• Letters
• Phone calls
• Personal visits
• Legal action

Saturation Point
Bad-Debt Losses
Collection Expenditures
41
Sources of Information
The company must weigh the amount of information
needed versus the time and expense required.

• Financial statements
• Credit ratings and reports
• Bank checking
• Trade checking
• Companys own experience

42
Credit Analysis
A credit analyst is likely to use the following
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

43
Inventory Management and Control
Inventories form a link between production and
sale of a product. Inventory types

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

44
Inventory Management

• Differing views of inventory management. For
  example
• Financial Manager Keep stock as low as possible.
• Marketing Manager Keep stock of finished goods
  high.
• Manufacturing Manager Keep raw materials
  supplies high, and have large production runs.
• Purchasing Manager Keep raw materials supplies
  high.

45
Inventory Management and Control
Inventories provide flexibility for the firm in

• Purchasing
• Production scheduling
• Efficient servicing of customer demands

46
Appropriate Level of Inventories
How does a firm determine the appropriate level
of inventories?
Employ a cost-benefit analysis Compare the
benefits of economies of production, purchasing,
and product marketing against the cost of the
additional investment in inventories.
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ABC Method of Inventory Control
ABC method of inventory control
100
90

• 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.

C
B
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Cumulative Percentage of Inventory Value
A
0 15 45 100
Cumulative Percentage of Items in Inventory
48
ABC Method of Inventory Control

• ABC System
• Divides inventory into three categories A, B, C
  in descending order of importance and level of
  inventory, based on the dollar investment in
  each.
• A The group requiring the largest dollar
  investment, generally 20 of the firms inventory
  items which account for 80 of the firms dollar
  investment in inventory.
• Monitored intensively and tracked using a
  perpetual inventory system to allow for daily
  verification of stock levels.

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ABC Method of Inventory Control

• B The middle group. Inventory levels are
  monitored through periodic checks.
• C The group of large numbers of inventory
  items, accounting for a relatively small amount
  of the investment in inventory.
• Generally monitored using unsophisticated
  techniques such as the two bin method.

50
Economic Order Quantity

• Determines an inventory items optimal order
  quantity that will reduce total inventory costs.
• Achieved by minimising both the total of its
  order costs and carrying costs.
• Order Costs The costs attributable to placing
  and receiving an order.
• Carrying Costs The cost per unit of holding an
  item of inventory for a specific period of time.

51
Economic Order Quantity
52
How Much to Order?
The optimal quantity to order depends on
Forecast usage Ordering cost Carrying
cost Ordering can mean either the purchase or
production of the item.
53
Total Inventory Costs
Total inventory costs (T) C (Q / 2) O (S / Q)
Q
Average Inventory
INVENTORY (in units)
Q / 2
TIME
C Carrying costs per unit per period O
Ordering costs per order S Total usage during
the period Q Order quantity in units
54
Economic Order Quantity
The quantity of an inventory item to order so
that total inventory costs are minimised over the
firms planning period.
The EOQ or optimal quantity (Q) is
2 (O) (S)
Q
C
55
Example of the Economic Order Quantity

• 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?

56
Economic 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).
2 (200) (10,000)
Q
1
Q 2,000 Units
57
Total Inventory Costs
EOQ (Q) represents the minimum point in total
inventory costs.
Total Inventory Costs
Total Carrying Costs
Costs
Total Ordering Costs
Q
Order Size (Q)
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When to Order?
Issues to consider Lead Time The length of
time between the placement of an order for an
inventory item and when the item is received in
inventory.
Order Point The quantity to which inventory
must fall in order to signal that an order must
be placed to replenish an item. Order Point (OP)
Lead time X Daily usage
59
Example of When to Order
Julie Miller of 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? Lead time 2
days Daily usage 10,000 yards / 100 days
100 yards per day Order Point 2 days x 100
yards per day 200 yards
60
Example of When to Order
Economic Order Quantity (Q)
2000
UNITS
Order Point
200
0 18 20 38
40
Lead Time
DAYS
61
Safety Stock
Safety Stock Inventory stock held in reserve as
a cushion against uncertain demand (or usage) and
replenishment lead time.
Our previous example assumed certain demand and
lead time. When demand and/or lead time are
uncertain, then the order point is Order Point
(Avg. lead time x Avg. daily usage) Safety
stock
62
Order Point with Safety Stock
2200
2000
Order Point
UNITS
400
200
Safety Stock
0 18 20
38
DAYS
63
Order Point with Safety Stock
2200
2000
Actual lead time is 3 days! (at day 21)
The firm dips into the safety stock
Order Point
UNITS
400
200
Safety Stock
0 18 21
DAYS
64
How Much Safety Stock?
What is the proper amount of safety
stock? Depends on the

• Amount of uncertainty in inventory demand
• Amount of uncertainty in the lead time
• Cost of running out of inventory
• Cost of carrying inventory

65
Just-in-Time

• An inventory management system used to minimise
  inventory investment by having materials inputs
  arrive at exactly the time they are needed for
  production.
• Carries little or no safety stocks.
• Relies on exceptional coordination between firm,
  suppliers and logistics.
• Runs the risk of stalling production if inventory
  fails to arrive when planned for.

66
Just-in-Time

• Requirements of applying this approach
• A very accurate production and inventory
  information system
• Highly efficient purchasing
• Reliable suppliers
• Efficient inventory-handling system

67
EOQ and JIT example

• Li Hong Company has an A group inventory item
  that is vital to the production process. This
  item costs 1,500, and Li Hong uses 1,100 units
  of the item per year. Li Hong wants to determine
  its optimal order strategy for the item. To
  calculate the EOQ, we need the following inputs
• Order cost per order 150
• Carrying cost per unit per year 200
• Substituting into EOQ Equation, we get
• EOQ v(2 1,100 150)/200
• 41 units

68
EOQ and JIT example

• The reorder point depends on the number of days
  Li Hong operates per year. Assuming that he
  operates 250 days per year and uses 1,100 units
  of this item, its daily usage is 4.4 units (1,100
  / 250).
• If its lead time is two days and Li Hong wants to
  maintain a safety stock of four units, the
  reorder point for this item is 12.8 units ((2
  4.4) 4). However, orders are made only in whole
  units, so the order is placed when the inventory
  falls to 13 units.

69
EOQ and JIT example

• Now assume the same information as before, but
  assume that the marginal cost of placing an order
  is (1) 11 or (2) 2.
• 1 Order cost of 11
• EOQ v(2 1,100 11)/200
• v121 11 units
• 2 Order cost of 2
• EOQ v(2 1,100 2)/200
• v22 5 units

70
EOQ and JIT example

• As the order cost falls, the EOQ model now tells
  Li Hong to order fewer units per order, more
  often.
• Applying a marginal order cost, the EOQ model
  moves towards a JIT system, where inventory
  arrives when it is needed, with an order cost
  based on the cost of a phone call to the supplier
  or a predetermined delivery schedule.
• A pure JIT system assumes that suppliers will
  deliver on time, every time. Without such
  assurances, pure JIT systems can cause headaches
  for manufacturers

71
Exercise

• ? Now try to do problem 14-18 from Gitman Ch 14
  handout