9780273713654 pp10

10.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 10Chapter 10
Accounts ReceivableAccounts Receivable
and Inventoryand Inventory
ManagementManagement

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 analyze 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).
After Studying Chapter 10,After Studying Chapter 10,
you should be able to:you should be able to:

• Credit and Collection
Policies
• Analyzing the Credit
Applicant
• Inventory Management and
Control
Accounts Receivable andAccounts Receivable and
Inventory ManagementInventory Management

(1) Average
Collection Period
(2) Bad-debt
Losses
Quality ofQuality of
Trade AccountTrade Account
Length of
Credit Period
Possible Cash
Discount
Firm
Collection
Program
Credit and CollectionCredit and Collection
Policies of the FirmPolicies of the Firm

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 standards?Why lower the firm’s credit standards?
Credit StandardsCredit Standards

• A larger credit department
• Additional clerical work
• Servicing additional accounts
• Bad-debt losses
• Opportunity costs
Costs arising from relaxingCosts arising from relaxing
credit standardscredit standards

Basket Wonders is not operating at full capacityBasket Wonders is not operating at full capacity
and wants to determine if a relaxation of theirand 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.
Example of RelaxingExample of Relaxing

• 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 lossesIgnoring any additional bad-debt losses
that may arise, should Basket Wondersthat may arise, should Basket Wonders
relax their credit standards?relax their credit 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

(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length ofLength of
Credit PeriodCredit Period
Possible Cash
Discount
Firm
Collection
Program

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.”
Credit TermsCredit Terms

Basket WondersBasket 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.
the Credit Periodthe Credit Period

• The before-tax opportunity cost for each dollar
of funds “tied-up” in additional receivables is
20%.
that may arise, should Basket Wondersthat may arise, should Basket Wonders
relax their credit period?relax their 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

New ($2,000,000 sales) / (6 Turns) =
receivable level $333,333
Investment in $333,333 - $166,667 =
(original sales)
Total investment in $33,334 + $166,666 =
Req. pre-tax return (20% opp. cost) x $200,000 =
on add. investment $40,000$40,000
Yes!Yes! Profits > Required pre-tax return

(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible CashPossible Cash
DiscountDiscount
Firm
Collection
Program

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.
Credit TermsCredit Terms

A competing firm of Basket Wonders is
considering changing the credit period from “net“net
60”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.
• (30% x 10 days + 70% x 60 days = 3 + 42 days = 45 days
• 360 days per year / 45 days = 8 turns per year
Example of IntroducingExample of Introducing
a Cash Discounta Cash Discount

• The before-tax opportunity cost for each dollar
of funds “tied-up” in additional receivables is
20%.
that may arise, should the competing firmthat may arise, should the competing firm
introduce a cash discount?introduce a cash discount?
Example of IntroducingExample of Introducing
a Cash Discounta 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
Example of UsingExample of Using
the Cash Discountthe Cash Discount

Pre-tax cost of 0.02 x 0.3 x $5,000,000 =
the cash discount $30,000$30,000..
Pre-tax opp. savings (20% opp. cost) x $208,333 =
on reduction in A/R $41,667$41,667..
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 theExample of Using the
Cash DiscountCash Discount

• 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.
Seasonal DatingSeasonal Dating

(1) Average
Collection Period
(2) Bad-debt
Losses
Quality of
Trade Account
Length of
Credit Period
Possible Cash
Discount
FirmFirm
CollectionCollection
ProgramProgram

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 2 months 3 months
Default Risk andDefault 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) 120,000120,000 60,00060,000
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) 76,00076,000 66,00066,000
8. 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.
Default Risk andDefault Risk and
Bad-Debt LossesBad-Debt Losses

The firm should increase collectioncollection
expendituresexpenditures until the marginal
reduction in bad-debt lossesbad-debt losses equals
the marginal outlay to collect.
CollectionCollection
ProceduresProcedures
• Letters
• Phone calls
• Personal visits
• Legal action
SaturationSaturation
PointPoint
Collection ExpendituresCollection Expenditures
Bad-DebtLossesBad-DebtLosses
Collection PolicyCollection Policy
and Proceduresand Procedures

• Obtaining information on the
credit applicant
• Analyzing this information to
determine the applicant’s
creditworthiness
• Making the credit decision
Analyzing theAnalyzing the
Credit ApplicantCredit Applicant

• Financial statements
• Credit ratings and reports
• Bank checking
• Trade checking
• Company’s own experience
The company must weigh the amountamount
of informationof information needed versus the timetime
and expense requiredand expense required.
Sources of InformationSources of 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
A credit analyst is likely to utilizeA credit analyst is likely to utilize
information regardinginformation regarding::
Credit AnalysisCredit Analysis

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 10-31 through 10-33.
SequentialSequential
Investigation ProcessInvestigation Process

* For previous customers only a Dun & Bradstreet reference book check.
Pending Order
Bad
past credit
experience
Dun & Bradstreet
report analysis*
RejectYesNoStage 1
$5 Cost
Stage 2
$5 - $15
Cost
No prior experience whatsoever
Sample InvestigationSample Investigation
Process Flow Chart (Part A)Process Flow Chart (Part A)

Accept
Yes
No
Credit rating
“limited” and/or other
damaging information
unearthed?
No
Yes
Reject
Credit rating
“fair” and/or other
close to maximum
“line of credit”?
Process Flow Chart (Part B)Process Flow Chart (Part B)

** That is, the credit of a bank is substituted for customer’s credit.
Bank, creditor, and financial
statement analysis
Accept Reject
Accept, only upon
domestic irrevocable
letter of credit (L/C)**
Fair PoorGood
Stage 3
$30 Cost
Process Flow Chart (Part C)Process Flow Chart (Part C)

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.
Other CreditOther 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.
Other CreditOther Credit
Decision IssuesDecision Issues

• 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 types:Inventory types:
InventoryInventory
Management and ControlManagement and Control

• Purchasing
• Production scheduling
• Efficient servicing of customer
demands
Inventories provide flexibilityInventories provide flexibility
for the firm in:for the firm in:
InventoryInventory
Management and ControlManagement and Control

Employ a cost-benefit analysisEmploy a cost-benefit analysis
Compare the benefits of economies of
production, purchasing, and product
marketing against the cost of the
additional investment in inventories.
How does a firm determineHow does a firm determine
the appropriate level ofthe appropriate level of
inventories?inventories?
AppropriateAppropriate
Level of InventoriesLevel of Inventories

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 ofABC method of
inventory controlinventory control
0 15 45 1000 15 45 100
Cumulative PercentageCumulative Percentage
of Items in Inventoryof Items in Inventory
7070
9090
100100
CumulativePercentageCumulativePercentage
ofInventoryValueofInventoryValue
AA
BB
CC
ABC Method ofABC Method of
Inventory ControlInventory Control

Forecast usage
Ordering cost
Carrying cost
Ordering can mean either the purchase orOrdering can mean either the purchase or
production of the item.production of the item.
The optimal quantity to orderThe optimal quantity to order
depends on:depends on:
How Much to Order?How Much to Order?

CC: Carrying costs per unit per period
OO: Ordering costs per order
SS: Total usage during the period
Total inventory costs (T) =Total inventory costs (T) =
CC ((Q / 2Q / 2) +) + OO ((SS // QQ))
TIMETIME
Q / 2Q / 2
QQ
AverageAverage
InventoryInventory
INVENTORYINVENTORY
(inunits)(inunits)
Total Inventory CostsTotal Inventory Costs

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
Economic Order QuantityEconomic Order Quantity

Basket WondersBasket 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?
Example of theExample of the

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).
Q*Q* ==
2 (2 ($200) () (10,00010,000))
$1$1
Q*Q* == 2,000 Units2,000 Units

EOQ (Q*) represents the minimumEOQ (Q*) represents the minimum
point in total inventory costs.point in total inventory costs.
Total Carrying CostsTotal Carrying Costs
Total Ordering CostsTotal Ordering Costs
Q*Q* Order Size (Q)Order Size (Q)
CostsCosts

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 PointOrder Point (OPOP) = Lead timeLead 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.
When to Order?When to Order?

Julie Miller of Basket WondersBasket 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 timeLead time == 2 days2 days
Daily usageDaily usage = 10,000 yards / 100 days= 10,000 yards / 100 days
== 100 yards per day100 yards per day
Order PointOrder Point == 2 days2 days xx 100 yards per day100 yards per day
== 200 yards200 yards
Example of When to OrderExample of When to Order

00 18 20 38 4018 20 38 40
LeadLead
TimeTime
200200
20002000
OrderOrder
PointPoint
UNITSUNITS
DAYSDAYS
Economic Order Quantity (Q*)Economic Order Quantity (Q*)
Example of When to OrderExample of When to Order

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.
Safety StockSafety Stock

0 18 20 380 18 20 38
400400
20002000
OrderOrder
PointPoint
UNITSUNITS
DAYSDAYS
22002200
200200
Order PointOrder Point
with Safety Stockwith Safety Stock

UNITSUNITS
DAYSDAYS
Actual leadActual lead
time is 3 days!time is 3 days!
(at day 21)(at day 21)
22002200
20002000
OrderOrder
PointPoint
400400
200200
0 18 210 18 21
The firm “dips”The firm “dips”
into the safety stockinto the safety stock
Order PointOrder Point
with Safety Stockwith 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 ofWhat is the proper amount of
safety stock?safety stock?
Depends on theDepends on the::
How Much Safety Stock?How Much Safety Stock?

• 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::
Just-in-TimeJust-in-Time

• JIT inventory control is one link in SCM.
• The internet has enhanced SCM and
allows for many business-to-business
(B2B) transactions
• Competition through B2B auctions helps
reduce firm costs – especially
standardized items
Supply Chain Management (SCM)Supply Chain Management (SCM) – Managing
the process of moving goods, services, and
information from suppliers to end customers.
Supply Chain ManagementSupply Chain Management

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