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10-1
Chapter 10Chapter 10Accounts 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
10-2
Accounts Receivable and Accounts Receivable and Inventory ManagementInventory Management
Credit and Collection Policies
Analyzing the Credit Applicant
Inventory Management and Control
10-3
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
10-4
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??
10-5
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
10-6
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.
10-7
Example of Relaxing Example of Relaxing Credit StandardsCredit Standards
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?
10-8
Example of Relaxing Example of Relaxing Credit StandardsCredit Standards
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
10-9
Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm
(1) Average Collection Period
(2) Bad-debtLosses
Quality ofTrade Account
Length ofLength ofCredit PeriodCredit Period
Possible CashDiscount
FirmCollectionProgram
10-10
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.”
10-11
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.
10-12
Example of Relaxing Example of Relaxing the Credit Periodthe 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 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?
10-13
Example of Relaxing Example of Relaxing the Credit Periodthe Credit Period
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
10-14
Example of Relaxing Example of Relaxing the Credit Periodthe 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$40,000
Yes! Yes! Profits > Required pre-tax return
10-15
Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm
(1) Average Collection Period
(2) Bad-debtLosses
Quality ofTrade Account
Length ofCredit Period
Possible CashPossible CashDiscountDiscount
FirmCollectionProgram
10-16
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.
10-17
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.
10-18
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 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
10-19
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
10-20
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
10-21
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.
10-22
Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm
(1) Average Collection Period
(2) Bad-debtLosses
Quality ofTrade Account
Length ofCredit Period
Possible CashDiscount
FirmFirmCollectionCollectionProgramProgram
10-23
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
10-24
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.
10-25
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 Los
ses
Bad
-Deb
t Los
ses
10-26
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
10-27
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.
10-28
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::
10-29
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.
10-30
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
10-31
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”?
10-32
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
10-33
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.
10-34
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.
10-35
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::
10-36
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:
10-37
Appropriate Appropriate Level of InventoriesLevel of Inventories
Employ a cost-benefit analysisEmploy a cost-benefit analysisCompare 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?
10-38
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 100Cumulative Percentage Cumulative Percentage
of Items in Inventoryof Items in Inventory
7070
9090100100
Cum
ulat
ive
Perc
enta
ge
Cum
ulat
ive
Perc
enta
ge
of In
vent
ory
Valu
eof
Inve
ntor
y Va
lue
AA
BBCC
10-39
How Much to Order?How Much to Order?
Forecast usage Ordering cost Carrying cost
Ordering 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:
10-40
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
INVE
NTO
RY
INVE
NTO
RY
(in u
nits
)(in
uni
ts)
10-41
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
10-42
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?
10-43
Economic Order QuantityEconomic Order QuantityWe 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
10-44
Total Inventory CostsTotal Inventory CostsEOQ (Q*) represents the minimum EOQ (Q*) represents the minimum
point in total inventory costs.point in total inventory costs.
Total Inventory CostsTotal Inventory Costs
Total Carrying CostsTotal Carrying Costs
Total Ordering CostsTotal Ordering Costs
Q*Q* Order Size (Q)Order Size (Q)
Cos
tsC
osts
10-45
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.
10-46
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 daysDaily usage Daily usage = 10,000 yards / 100 days = 10,000 yards / 100 days = = 100 100 yards per dayyards per dayOrder PointOrder Point = = 2 days 2 days xx 100 yards per day100 yards per day== 200 yards200 yards
10-47
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*)
10-48
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.
10-49
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
10-50
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
10-51
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::
10-52
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::
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