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Ch 10 - Accounts Receivable and Inventory Management
 

Ch 10 - Accounts Receivable and Inventory Management

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Financial Management by Van Horne

Financial Management by Van Horne
Ch 10 - Accounts Receivable and Inventory Management

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    Ch 10 - Accounts Receivable and Inventory Management Ch 10 - Accounts Receivable and Inventory Management Presentation Transcript

    • 0-1Chapter 10Chapter 10Accounts ReceivableAccounts Receivableand Inventoryand InventoryManagementManagement© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
    • 0-2Accounts Receivable andAccounts Receivable andInventory ManagementInventory ManagementCredit and CollectionPoliciesAnalyzing the CreditApplicantInventory Management andControl
    • 0-3Credit and CollectionCredit and CollectionPolicies of the FirmPolicies of the Firm(1) AverageCollection Period(2) Bad-debtLossesQuality ofQuality ofTrade AccountTrade AccountLength ofCredit PeriodPossible CashDiscountFirmCollectionProgram
    • 0-4Credit StandardsCredit StandardsThe financial manager should continuallylower the firm’s credit standards as long asprofitability from the change exceeds theextra costs generated by the additionalreceivables.Credit StandardsCredit Standards -- The minimum qualityof credit worthiness of a credit applicantthat is acceptable to the firm.Why lower the firm’s credit standardsWhy lower the firm’s credit standards??
    • 0-5Credit StandardsCredit StandardsA larger credit departmentAdditional clerical workServicing additional accountsBad-debt lossesOpportunity costsCosts arising from relaxingCosts arising from relaxingcredit standardscredit standards
    • 0-6Example of RelaxingExample of RelaxingCredit StandardsCredit StandardsBasket Wonders is not operating at full capacityBasket Wonders is not operating at full capacityand wants to determine if a relaxation of theirand wants to determine if a relaxation of theircredit standards will enhance profitability.credit standards will enhance profitability.The firm is currently producing a singleproduct with variable costs of $20 and sellingprice of $25.Relaxing credit standards is not expected toaffect current customer payment habits.
    • 0-7Example of RelaxingExample of RelaxingCredit StandardsCredit StandardsAdditional annual credit sales of $120,000 and anaverage collection period for new accounts of 3months is expected.The before-tax opportunity cost for each dollar offunds “tied-up” in additional receivables is 20%.Ignoring any additional bad-debt lossesIgnoring any additional bad-debt lossesthat may arise, should Basket Wondersthat may arise, should Basket Wondersrelax their credit standards?relax their credit standards?
    • 0-8Example of RelaxingExample of RelaxingCredit StandardsCredit StandardsProfitability of ($5 contribution) x (4,800 units) =additional sales $24,000$24,000Additional ($120,000 sales) / (4 Turns) =receivables $30,000Investment in ($20/$25) x ($30,000) =add. receivables $24,000Req. pre-tax return (20% opp. cost) x $24,000 =on add. investment $4,800$4,800Yes!Yes! Profits > Required pre-tax return
    • 0-9Credit and CollectionCredit and CollectionPolicies of the FirmPolicies of the Firm(1) AverageCollection Period(2) Bad-debtLossesQuality ofTrade AccountLength ofLength ofCredit PeriodCredit PeriodPossible CashDiscountFirmCollectionProgram
    • 0-10Credit TermsCredit TermsCredit PeriodCredit Period -- The total length of time overwhich credit is extended to a customer topay a bill. For example, “net 30”“net 30” requiresfull payment to the firm within 30 days fromthe invoice date.Credit TermsCredit Terms -- Specify the length of timeover which credit is extended to a customerand the discount, if any, given for earlypayment. For example, “2/10, net 30.”“2/10, net 30.”
    • 0-11Example of RelaxingExample of Relaxingthe Credit Periodthe Credit PeriodBasket WondersBasket Wonders is considering changing itscredit period from “net 30”“net 30” (which has resultedin 12 A/R “Turns” per year) to “net 60”“net 60” (which isexpected to result in 6 A/R “Turns” per year).The firm is currently producing a single productwith variable costs of $20 and a selling price of$25.Additional annual credit sales of $250,000 fromnew customers are forecasted, in addition to thecurrent $2 million in annual credit sales.
    • 0-12Example of RelaxingExample of Relaxingthe Credit Periodthe Credit PeriodThe before-tax opportunity cost for each dollarof funds “tied-up” in additional receivables is20%.Ignoring any additional bad-debt lossesIgnoring any additional bad-debt lossesthat may arise, should Basket Wondersthat may arise, should Basket Wondersrelax their credit period?relax their credit period?
    • 0-13Example of RelaxingExample of Relaxingthe Credit Periodthe Credit PeriodProfitability of ($5 contribution)x(10,000 units) =additional sales $50,000$50,000Additional ($250,000 sales) / (6 Turns) =receivables $41,667Investment in add. ($20/$25) x ($41,667) =receivables (new sales) $33,334Previous ($2,000,000 sales) / (12 Turns) =receivable level $166,667
    • 0-14Example of RelaxingExample of Relaxingthe Credit Periodthe Credit PeriodNew ($2,000,000 sales) / (6 Turns) =receivable level $333,333Investment in $333,333 - $166,667 =add. receivables $166,666(original sales)Total investment in $33,334 + $166,666 =add. receivables $200,000Req. pre-tax return (20% opp. cost) x $200,000 =on add. investment $40,000$40,000Yes!Yes! Profits > Required pre-tax return
    • 0-15Credit and CollectionCredit and CollectionPolicies of the FirmPolicies of the Firm(1) AverageCollection Period(2) Bad-debtLossesQuality ofTrade AccountLength ofCredit PeriodPossible CashPossible CashDiscountDiscountFirmCollectionProgram
    • 0-16Credit TermsCredit TermsCash DiscountCash Discount -- A percent (%) reduction insales or purchase price allowed for earlypayment of invoices. For example, “2/10”“2/10”allows the customer to take a 2% cash discountduring the cash discount period.Cash Discount PeriodCash Discount Period -- The period of timeduring which a cash discount can be taken forearly payment. For example, “2/10”“2/10” allows acash discount in the first 10 days from theinvoice date.
    • 0-17Example of IntroducingExample of Introducinga Cash Discounta Cash DiscountA competing firm of Basket Wonders isconsidering 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 areexpected to be maintained.The firm expects 30% of its credit customers (indollar volume) to take the cash discount andthus increase A/R “Turns” to 8.
    • 0-18The before-tax opportunity cost for each dollarof funds “tied-up” in additional receivables is20%.Ignoring any additional bad-debt lossesIgnoring any additional bad-debt lossesthat may arise, should the competing firmthat may arise, should the competing firmintroduce a cash discount?introduce a cash discount?Example of IntroducingExample of Introducinga Cash Discounta Cash Discount
    • 0-19Example of UsingExample of Usingthe Cash Discountthe Cash DiscountReceivable level ($5,000,000 sales) / (6 Turns) =(Original) $833,333Receivable level ($5,000,000 sales) / (9 Turns) =(New) $555,556Reduction of $833,333 - $555,556 =investment in A/R $277,777
    • 0-20Pre-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 > CostsThe benefits derived from released accountsreceivable exceed the costs of providing thediscount to the firm’s customers.Example of Using theExample of Using theCash DiscountCash Discount
    • 0-21Seasonal DatingSeasonal DatingAvoids carrying excess inventory and theassociated carrying costs.Accept dating if warehousing costs plus therequired return on investment in inventory exceedsthe required return on additional receivables.Seasonal DatingSeasonal Dating -- Credit terms thatencourage the buyer of seasonal productsto take delivery before the peak sales periodand to defer payment until after the peaksales period.
    • 0-22Credit and CollectionCredit and CollectionPolicies of the FirmPolicies of the Firm(1) AverageCollection Period(2) Bad-debtLossesQuality ofTrade AccountLength ofCredit PeriodPossible CashDiscountFirmFirmCollectionCollectionProgramProgram
    • 0-23Default Risk andDefault Risk andBad-Debt LossesBad-Debt LossesPresentPolicy Policy A Policy BDemand $2,400,000 $3,000,000 $3,300,000Incremental sales $ 600,000 $ 300,000Default lossesOriginal sales 2%Incremental Sales 10% 18%Avg. Collection Pd.Original sales 1 monthIncremental Sales 2 months 3 months
    • 0-24Default Risk andDefault Risk andBad-Debt LossesBad-Debt LossesPolicy A Policy B1. Additional sales $600,000 $300,0002. Profitability: (20% contribution) x (1)2. Profitability: (20% contribution) x (1) 120,000120,000 60,00060,0003. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,0004. Add. receivables: (1) / (New Rec. Turns) 100,000 75,0005. Inv. in add. receivables: (.80) x (4) 80,000 60,0006. Required before-tax return onadditional investment: (5) x (20%) 16,000 12,0007. Additional bad-debt losses +7. Additional bad-debt losses +additional required return: (3) + (6)additional required return: (3) + (6) 76,00076,000 66,00066,0008. Incremental profitability: (2) - (7)8. Incremental profitability: (2) - (7) 44,00044,000 (6,000)(6,000)Adopt Policy A but not Policy B.Adopt Policy A but not Policy B.
    • 0-25Collection PolicyCollection Policyand Proceduresand ProceduresThe firm should increase collectioncollectionexpendituresexpenditures until the marginalreduction in bad-debt lossesbad-debt losses equalsthe marginal outlay to collect.CollectionCollectionProceduresProceduresLettersPhone callsPersonal visitsLegal actionSaturationSaturationPointPointCollection ExpendituresCollection ExpendituresBad-DebtLossesBad-DebtLosses
    • 0-26Analyzing theAnalyzing theCredit ApplicantCredit ApplicantObtaining information on thecredit applicantAnalyzing this information todetermine the applicant’screditworthinessMaking the credit decision
    • 0-27Sources of InformationSources of InformationFinancial statementsCredit ratings and reportsBank checkingTrade checkingCompany’s own experienceThe company must weigh the amountamountof informationof information needed versus the timetimeand expense requiredand expense required.
    • 0-28Credit AnalysisCredit Analysisthe financial statements of the firm(ratio analysis)the character of the companythe character of managementthe financial strength of the firmother individual issues specific tothe firmA credit analyst is likely to utilizeA credit analyst is likely to utilizeinformation regardinginformation regarding::
    • 0-29SequentialSequentialInvestigation ProcessInvestigation ProcessThe cost of investigation (determiningthe type and amount of informationcollected) is balanced against theexpected profit from an order.An example is provided in the followingthree slides 10-30 through 10-32.
    • 0-30Sample InvestigationSample InvestigationProcess Flow Chart (Part A)Process Flow Chart (Part A)* For previous customers only a Dun & Bradstreet reference book check.Pending OrderBadpast creditexperienceDun & Bradstreetreport analysis*RejectYesNoStage 1$5 CostStage 2$5 - $15CostNo prior experience whatsoever
    • 0-31Sample InvestigationSample InvestigationProcess Flow Chart (Part B)Process Flow Chart (Part B)AcceptYesNoCredit rating“limited” and/or otherdamaging informationunearthed?NoYesRejectCredit rating“fair” and/or otherclose to maximum“line of credit”?
    • 0-32Sample InvestigationSample InvestigationProcess 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 analysisAccept RejectAccept, only upondomestic irrevocableletter of credit (L/C)**Fair PoorGoodStage 3$30 Cost
    • 0-33Other CreditOther CreditDecision IssuesDecision IssuesLine of CreditLine of Credit -- A limit to the amount of creditextended to an account. Purchaser can buy oncredit up to that limit.Streamlines the procedure for shippinggoods.Credit-scoring SystemCredit-scoring System -- A system used todecide whether to grant credit by assigningnumerical scores to various characteristicsrelated to creditworthiness.
    • 0-34Other CreditOther CreditDecision IssuesDecision IssuesCredit decisions are madeLedger accounts maintainedPayments processedCollections initiatedDecision based on the corecompetencies of the firm.Outsourcing Credit and CollectionsOutsourcing Credit and CollectionsThe entire credit and/or collection function(s)are outsourced to a third-party company.
    • 0-35InventoryInventoryManagement and ControlManagement and ControlRaw-materials inventoryWork-in-process inventoryIn-transit inventoryFinished-goods inventoryInventories form a link betweenproduction and sale of a product.Inventory typesInventory types::
    • 0-36InventoryInventoryManagement and ControlManagement and ControlPurchasingProduction schedulingEfficient servicing of customerdemandsInventories provide flexibilityInventories provide flexibilityfor the firm in:for the firm in:
    • 0-37AppropriateAppropriateLevel of InventoriesLevel of InventoriesEmploy a cost-benefit analysisEmploy a cost-benefit analysisCompare the benefits of economies ofproduction, purchasing, and productmarketing against the cost of theadditional investment in inventories.How does a firm determineHow does a firm determinethe appropriate level ofthe appropriate level ofinventories?inventories?
    • 0-38ABC Method ofABC Method ofInventory ControlInventory ControlMethod which controlsexpensive inventoryitems more closely thanless expensive items.Review “A” itemsmost frequentlyReview “B” and “C”items less rigorouslyand/or less frequently.ABC method ofABC method ofinventory controlinventory control0 15 45 1000 15 45 100Cumulative PercentageCumulative Percentageof Items in Inventoryof Items in Inventory70709090100100CumulativePercentageCumulativePercentageofInventoryValueofInventoryValueAABBCC
    • 0-39How Much to Order?How Much to Order?Forecast usageOrdering costCarrying costOrdering can mean either the purchase orOrdering can mean either the purchase orproduction of the item.production of the item.The optimal quantity to orderThe optimal quantity to orderdepends on:depends on:
    • 0-40Total Inventory CostsTotal Inventory CostsCC: Carrying costs per unit per periodOO: Ordering costs per orderSS: Total usage during the periodTotal inventory costs (T) =Total inventory costs (T) =CC ((Q / 2Q / 2) +) + OO ((SS // QQ))TIMETIMEQ / 2Q / 2QQAverageAverageInventoryInventoryINVENTORYINVENTORY(inunits)(inunits)
    • 0-41Economic Order QuantityEconomic Order QuantityThe EOQ oroptimalquantity(Q*) is:The quantity of an inventory item to orderso that total inventory costs are minimizedover the firm’s planning period.Q*Q* ==2 (2 (O) () (SS))CC
    • 0-42Example of theExample of theEconomic Order QuantityEconomic Order QuantityBasket WondersBasket Wonders is attempting to determine theeconomic order quantity for fabric used in theproduction of baskets.10,000 yards of fabric were used at a constantrate last period.Each order represents an ordering cost of $200.Carrying costs are $1 per yard over the 100-dayplanning period.What is the economic order quantity?What is the economic order quantity?
    • 0-43Economic Order QuantityEconomic Order QuantityWe will solve for the economic order quantitygiven 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$1Q*Q* == 2,000 Units2,000 Units
    • 0-44Total Inventory CostsTotal Inventory CostsEOQ (Q*) represents the minimumEOQ (Q*) represents the minimumpoint in total inventory costs.point in total inventory costs.Total Inventory CostsTotal Inventory CostsTotal Carrying CostsTotal Carrying CostsTotal Ordering CostsTotal Ordering CostsQ*Q* Order Size (Q)Order Size (Q)CostsCosts
    • 0-45When to Order?When to Order?Order PointOrder Point -- The quantity to which inventorymust fall in order to signal that an order mustbe placed to replenish an item.Order PointOrder Point (OPOP) = Lead timeLead time X Daily usageIssues to considerIssues to consider::Lead TimeLead Time -- The length of time between theplacement of an order for an inventory item andwhen the item is received in inventory.
    • 0-46Example of When to OrderExample of When to OrderJulie Miller of Basket WondersBasket Wonders has determinedthat it takes only 2 days to receive the order offabric after the placement of the order.When should Julie order more fabric?When should Julie order more fabric?Lead timeLead time == 2 days2 daysDaily usageDaily usage = 10,000 yards / 100 days= 10,000 yards / 100 days== 100 yards per day100 yards per dayOrder PointOrder Point == 2 days2 days xx 100 yards per day100 yards per day== 200 yards200 yards
    • 0-47Example of When to OrderExample of When to Order00 18 20 38 4018 20 38 40LeadLeadTimeTime20020020002000OrderOrderPointPointUNITSUNITSDAYSDAYSEconomic Order Quantity (Q*)Economic Order Quantity (Q*)
    • 0-48Safety StockSafety StockOur previous example assumed certain demandand lead time. When demand and/or lead time areuncertain, then the order point is:Order PointOrder Point =(Avg. lead time x Avg. daily usage) + Safety stockSafety stockSafety StockSafety Stock -- Inventory stock held in reserveas a cushion against uncertain demand (orusage) and replenishment lead time.
    • 0-49Order PointOrder Pointwith Safety Stockwith Safety Stock0 18 20 380 18 20 3840040020002000OrderOrderPointPointUNITSUNITSDAYSDAYS22002200Safety StockSafety Stock200200
    • 0-50Order PointOrder Pointwith Safety Stockwith Safety StockUNITSUNITSDAYSDAYSSafety StockSafety StockActual leadActual leadtime is 3 days!time is 3 days!(at day 21)(at day 21)2200220020002000OrderOrderPointPoint4004002002000 18 210 18 21The firm “dips”The firm “dips”into the safety stockinto the safety stock
    • 0-51How Much Safety Stock?How Much Safety Stock?Amount of uncertainty in inventory demandAmount of uncertainty in the lead timeCost of running out of inventoryCost of carrying inventoryWhat is the proper amount ofWhat is the proper amount ofsafety stock?safety stock?Depends on theDepends on the::
    • 0-52Just-in-TimeJust-in-TimeA very accurate production andinventory information systemHighly efficient purchasingReliable suppliersEfficient inventory-handling systemJust-in-TimeJust-in-Time -- An approach to inventorymanagement and control in which inventoriesare acquired and inserted in production at theexact times they are needed.Requirements of applying this approachRequirements of applying this approach::