2. Table of Content BBA 302 Module -VI
Inventory management....................................................................................................2
Economic order quantity (EOQ).........................................................................................3
Assumption of the EOQ model ..........................................................................................3
ABC analysis.....................................................................................................................4
Cash management............................................................................................................4
Definition .......................................................................................................................................................5
Purpose ...................................................................................................................................5
Cash planning...........................................................................................................................5
Cash flow management....................................................................................................6
Optimal Cash Models........................................................................................................6
William Baume Model..............................................................................................................6
Miller-Orr Model ..............................................................................................................7
Ogle’s Model....................................................................................................................8
Inventory management
Inventory management is a science primarily about specifying the shape and percentage of
stocked goods. It is required at different locations within a facility or within many locations
of a supply network to precede the regular and planned course of production and stock of
materials. The scope of inventory management concerns the fine lines between replenishment
lead time, carrying costs of inventory, asset management, inventory forecasting, inventory
valuation, inventory visibility, future inventory price forecasting, physical inventory,
available physical space for inventory, quality management, replenishment, returns and
defective goods, and demand forecasting. Balancing these competing requirements leads to
optimal inventory levels, which is an on-going process as the business needs shift and react to
the wider environment. Inventory management involves a retailer seeking to acquire and
maintain a proper merchandise assortment while ordering, shipping, handling, and related
costs are kept in check. It also involves systems and processes that identify inventory
requirements, set targets, provide replenishment techniques, report actual and projected
inventory status and handle all functions related to the tracking and management of material.
This would include the monitoring of material moved into and out of stockroom locations and
the reconciling of the inventory balances. It also may include ABC analysis, lot tracking,
cycle counting support, etc. Management of the inventories, with the primary objective of
determining/controlling stock levels within the physical distribution system, functions to
3. balance the need for product availability against the need for minimizing stock holding and
handling costs.
Economic order quantity (EOQ)
The economic order quantity (EOQ) is a model that is used to calculate the optimal quantity
that can be purchased or produced to minimize the cost of both the carrying inventory and the
processing of purchase orders or production set-ups.
Formula
Following is the formula for the economic order quantity (EOQ) model:
Where Q = optimal order quantity
D = units of annual demand
S = cost incurred to place a single order or setup
H = carrying cost per unit
This formula is derived from the following cost function:
Total cost = purchase cost + ordering cost + holding cost
Limitations of the economic order quantity model:
It is necessary for the application of EOQ order that the demands remain constant throughout
the year. It is also necessary that the inventory be delivered in full when the inventory levels
reach zero.
Assumption of the EOQ model
Following are the underlying assumptions for the EOQ model. Without these assumptions,
the EOQ model cannot work to its optimal potential.
• The cost of the ordering remains constant.
• The demand rate for the year is known and evenly spread throughout the year.
• The lead time is not fluctuating (lead time is the latency time it takes a process to initiate
and complete).
• No cash or settlement discounts are available, and the purchase price is constant for
every item.
• The optimal plan is calculated for only one product.
• There is no delay in the replenishment of the stock, and the order is delivered in the
quantity that was demanded, i.e. in whole batch.
4. ABC analysis
The ABC analysis is a business term used to define an inventory categorization technique
often used in materials management. It is also known as Selective Inventory Control. Policies
based on ABC analysis:
• A ITEMS: very tight control and accurate records
• B ITEMS: less tightly controlled and good records
• C ITEMS: simplest controls possible and minimal records
The ABC analysis provides a mechanism for identifying items that will have a significant
impact on overall inventory cost,[1]
while also providing a mechanism for identifying
different categories of stock that will require different management and controls.
The ABC analysis suggests that inventories of an organization are not of equal
value. [2]
Thus, the inventory is grouped into three categories (A, B, and C) in order of their
estimated importance.
'a' items are very important for an organization. Because of the high value of these ‘a’ items,
frequent value analysis is required. In addition to that, an organization needs to choose an
appropriate order pattern (e.g. ‘Just- in- time’) to avoid excess capacity.
'B' items are important, but of course less important, than ‘A’ items and more important than
‘C’ items. Therefore ‘B’ items are intergroup items.
'C' items are marginally important.
Cash management
Cash management is a broad term that covers a number of functions that help individuals and
businesses process receipts and payments in an organized and efficient manner.
Administering cash assets today often makes use of a number of automated support services
offered by banks and other financial institutions. Services range from simple check book
balancing to investing and using software that allows easy, automated cash collection. Proper
management of company funds requires those in the finance department to be extremely
literate regarding the different strategies and tools available. Technology is drastically
changing how businesses manage their funds, streamlining processes.
5. Definition
Cash management is a set of strategies or techniques a company uses to collect, track and
invest money. Although cash by definition refers only to paper or coin money, in cash
management, companies usually also work with cash equivalents such as checks. This is
becoming increasingly common as the money system becomes more abstract, using
electronic methods.
Purpose
In general, small businesses do not always have the ability to obtain the credit they might
need. They have to rely more on their own money to meet expenses. Even in a large business,
costs might come up that are not expected. Being unable to handle these situations puts a
company at risk for loss of revenue or, in the worst case scenario, going out of business.Cash
management lets companies process and use their money in such a way that they have
adequate funds available for regular costs like paying employees. It ensures that the company
has some money for the things they did not plan on, such as a higher-than-expected increase
in the cost of materials. The business also uses these techniques to check that people are
paying as they should and that the funds are used for their original intent—that is, it prevents
payment loss and heightens financial and overall operational accountability. These strategies
influence cash flow, as well, making it more likely that the business will have the funds it
needs at the right time.
Cash planning
The purpose of cash planning is to help finance/treasury managers to manage their liquidity
requirement. Typically, UNDP pays staff, vendors, projects, government (NEX) and
agencies (Agency execution or implementation). By knowing how much, in what currency,
and when it is needed , the financial obligations of the organization can be discharged in a
timely fashion, and the unused funds, managed by UNDP Treasury, can be invested to
generate interest income. Country offices must follow local currency control and foreign
exchange regulations. To the greatest extent possible, all local expenditure of a country office
must be paid in non-convertible local currency where non-convertible currency is accepted
and available in UNDP bank accounts. After full utilization of non-convertible currency,
convertible local currency must be used. Local currency should be used to settle all local
vendor and local payroll obligations except when the local economy is "dollarized" de jure
(e.g., El Salvador, Ecuador) or de facto (e.g., Liberia). The same rule applies to use of Euro.
When undertaking international procurement, local vendors may submit quotes in USD, but
the obligation must be settled in the local currency equivalent at the UN operational rate. If a
local vendor will not accept non-convertible currency, the reason should be documented.
Local USD accounts may be used for the following payments:
a. When there is significant demand for USD DSA for international travellers and related
travelling costs and said demand cannot be satisfied through alternative means.
b. Other special circumstances (e.g., replenishment of local currency accounts when other
modes of replenishment are not effective or result in significant delay).
Use of hard currencies (for example USD and EURO) for vendor and or staff payments
should be limited to the following types of transactions:
a. Cross border payments to foreign vendors.
6. b. Payments to local vendors where the vendor has demonstrated a need to pay their supplier
in hard currency and where there is no contravention of local currency and exchange control
regulations in doing so.
c. International staff electing to receive salaries in hard currency.
d. Purchases of local currencies to replenish local currency bank accounts.
For exceptions to the guidance provided above, especially in situations where country offices
are operating in highly volatile local economic conditions with restrictive and/or
underdeveloped banking sector or where local laws conflict with the UNDP guidelines,
please contact Treasury for assistance.
Country offices shall use their USD or EURO Zero Balance Accounts for payments in hard
currency. Country offices can make payments from Headquarters hard currency bank
accounts when payments are required in hard currencies in which the country office does not
operate a bank account.
Cash flow management
Cash flow management is the process of monitoring, analyzing, and adjusting your business'
cash flows. For small businesses, the most important aspect of cash flow management is
avoiding extended cash shortages, caused by having too great a gap between cash inflows and
outflows. You won't be able to stay in business if you can't pay your bills for any extended
length of time! Therefore, you need to perform a cash flow analysis on a regular basis, and
use cash flow forecasting so you can take the steps necessary to head off cash flow problems.
Many software accounting programs have built-in reporting features that make cash flow
analysis easy. This is the first step of cash flow management. The second step of cash flow
management is to develop and use strategies that will maintain an adequate cash flow for
your business. One of the most useful strategies for small businesses is to shorten your cash
flow conversion period so that your business can bring in money faster.
Optimal Cash Models
A number of mathematical models have been developed to assist the financial manager in
distributing a company's funds so that they provide a maximum return to the company.
William Baume Model
The model developed by William Baume can determine the optimum amount of cash for a
company to hold under conditions of certainty. The objective is to minimize the sum of the
fixed costs of transactions and the opportunity cost of holding cash balances that do not yield
a return. This is similar to the EOQ model used in inventory management. The costs can be
expressed as follows, according to his model:
F (T/C) + I (C/2)
7. Where: F = Fixed costs of a transaction
T =
Total cash required for the specified
time period
I = Interest rate on marketable securities
C = Cash balance
The optimal level of cash is determined using the
following formula:
Optimal level of cash = √(2FT / I)
Miller-Orr Model
When the cash payments are uncertain, Miller-Orr model can be used. This model places
upper and lower limits on cash balances. When the upper limit is reached, a transfer of cash
to marketable securities is made; when the lower limit is reached, a transfer from securities to
cash is made. As long as the cash balance stays within the limits, no transaction occurs. The
various factors in this model are fixed costs of a securities transaction (F) which is assumed
to be the same for buying and selling, the daily interest rate on marketable securities (I) and
variance of the daily net cash flows, represented by σ2. This model assumes that the cash
flows are random. The control limits in this model are d dollars as an upper limit and zero
dollars at the lower limit. When the cash balance reaches the upper level, d less z dollars of
securities are bought, and the new balance becomes z dollars. When the cash balance equals
zero, z dollars of securities are sold and the new balance again reaches z. According to this
model, the optimal cash balance z is computed as follows:
Z = 3
√(3F σ2)/ 4I
The optimal value for d is computed as 3z.
Average cash balance (approx.) = (z + d)/3
Example Given are the following:
Fixed cost of a securities transaction = $5
Variance of daily net cash flows = $25
Daily interest rate on securities = 0.0003 (10% per annum, so 10%/360 days = 0.0003 daily)
Optimal cash balance = 3
√(3 x $5 x $25) / (4 x 0.0003) => $67.86
(or) $68 rounded off.
Upper limit, d = 3z = 3 x $68 = $204
Average cash balance = ($68 + $204)/3 => $90.67
so, when the upper limit of $204 is reached, $136 ($204 - $68) will be purchased. When the
lower limit of zero dollars is reached, $68 of securities will be sold to again bring it to the
optimal balance of cash calculated as $68 approximately.
8. Ogle’s Model
According to this model, the optimal cash management strategy can be determined through
the use of a multiple linear programming model. It is a model that provides for integration of
cash management with production and other aspects of the firm. The construction of this
model comprises three sections namely:
a. Selection of the appropriate planning horizon
b. Selection of the appropriate decision variables and
c. Formulation of the cash management strategy.
This model uses one year planning horizon with twelve monthly periods because of its
simplicity. It has four basic sets of decision variables which influence cash management of a
firm and which must be incorporated into the linear programming model of the firm.
These are
d. Payment schedule
e. Short-term financing and
f. Purchase and sale of marketable securities and
g. Cash balance.
The familiarity of all the above models provides the financial managers an insight into the
normative framework as to how cash management should be conducted.
