This document discusses managing short-term assets like accounts receivable and inventory for small businesses. It covers establishing credit policies for customers, using accounts receivable as financing, determining optimal inventory levels, and different inventory management systems. It also addresses determining the value of operating assets like equipment and property. The overall aim is to help small businesses effectively manage their assets.

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Chapter Fifteen
Assets: Inventory and
Operations Management
Copyright 2021 © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.

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Managing Short-Term Assets
Your business is its
assets.
Managing your business
assets to obtain their
maximum value is
critical to ultimate
business success.
This chapter discusses
managing the critical
short-term assets of
accounts receivable
and inventory.
We also look at
managing the essential
long-term assets of
property, plant, and
equipment.

3. © McGraw-Hill Education 3
Accounts Receivable
Accounts receivable are money owed to your business by customers.
• Most small businesses do not provide customer credit, but those in
wholesale distribution often do, and managing receivables is critical.
• What are the pros and cons of offering credit to customers?
There are three negative effects.
• It delays the receipt of cash.
• You must somehow replace the
“missing” cash.
• Your business loses when
customers do not pay.
Four reasons to provide credit.
• Increases sales.
• Increases repeat business.
• Reduces the cost of selling.
• Increases profit.

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The ABC’s of Extending Credit to Your Customers
First complete a written credit policy with these minimum provisions:
• Customer’s permission for a credit check to get a credit score.
• Payment terms – delinquent conditions and prompt payment discount.
• Acceptable forms of payment.
• The specific address to remit payment.
• Penalties and interest imposed on late payments.
• Collection activities made in the event of late payment.
• Recourse you will use for nonpayment.
Providing credit is not to be done casually – work with an attorney in
writing the appropriate policy.
• You can use your bank as a lock box for the receipt of payments.

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Use Your Accounts Receivable as a Source of Financing
You can use receivables in two ways to quickly lay your hands on cash.
• First, you can pledge your receivables as collateral for a loan –
pledging receivables is usually less expensive than factoring.
• Second, you can sell your receivables to a finance company in a
process called factoring – you may receive 75-80% of the total.
Your accounts receivable must be well documented and current.
• The credit check and credit score of each creditor.
• Three to six months’ payment history of each creditor.
• The repayment terms the customer is required to meet.
• The time at which a payment is deemed to be delinquent.

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Managing Inventory
Inventory is a constant, everyday problem for most small businesses.
It is a rare business that has no inventory at all.
The amount and type of inventory is important because:
(1) Supply and demand cannot be matched at all times.
(2) Holding inventory is a nonproductive cash investment.
Inventory is also a source of risk for small businesses.

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Determining the Appropriate Level of Inventory
The right amount of inventory to keep on hand and the right amount to
order at one time is determined by:
• The cost of processing an order.
• The cost of keeping merchandise in inventory.
• The cost of lost sales if you run out.
• The time it takes to receive inventory after it is ordered.
The economic order quantity (EOQ) helps you think in terms of
ordering costs and carrying costs – total cost is the sum of:
• The cost to buy the inventory.
• The cost to store, protect, and maintain inventory.
• The cost of making an order to purchase inventory.

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Exhibit 15.1: Inventory Costs
Costs of Carrying Inventory.
• The opportunity cost of the
funds invested in inventory.
• The cost of keeping inventory
secure and in sellable condition.
• Cost of warehouse or storage –
utilities, transfer, security.
• Insurance and taxes on
inventory.
• Inventory shrinkage.
• Transaction costs for counting
and record keeping.
Costs of Ordering Inventory.
• Transaction costs of preparing
and transmitting an order.
• Investigating and selecting
appropriate vendors.
• Receiving inventory.
• Time required to travel to
suppliers to pick up inventory.
• Inspecting shipments.
• Record keeping.

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Figure 15.1: Economic Order Quantity Graph
If both the cost of carrying/ordering
inventory and purchase price is
considered, you get the EOQ.
• The quantity at which total cost
of inventory is minimized.
• You do not have to derive the
EOQ equation to use it.
• Substitute your projected
annual sales, cost of placing
one order, and cost of holding
one unit in inventory.
• This gives you a unique
optimum order quantity and the
number of orders you should
place each year.
Access text alternative for this image.

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Scheduling Ordering and Receipt of Inventory
The EOQ tells us how many units to order and how many orders to make,
but it does not tell us when to place an order – determined by:
• The rate of sales.
• The time required to receive new stock.
The optimum stocking level, or the reorder point, considers lost sales,
units sold per day, and days required to receive inventory.
• Unless your product is expensive, the effect of too little inventory is
worse.
• For this reason, most businesses time orders to keep a safety stock
in case sales are greater than forecast or deliveries are delayed.

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Just-in-Time Inventory Systems
Some firms order/receive inventory only after a customer purchase.
• Acquiring inventory in response to a
completed sale is a pull-through system.
• The ultimate extension of pull-through
processing is just-in-time (JIT) inventory.
A JIT system reduces inventory to a minimum by:
• Accepting inventory only as it is sold.
• Assembling products in minimum time.
• Shipping products immediately.
In this way, the three primary inventories of
manufacturing are kept at a minimum – raw
materials, work in process, and finished goods.
• Requires extreme cooperation with vendors.
Some eBay sellers
practice the
ultimate JIT
process –
microinventory.
They never own or
handle the
products sold.
Often shipping
directly from the
wholesaler to the
buyer.

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Other Approaches to Inventory Control
Periodic inventory is the physical counting of assets on a set schedule.
• May be annually, inexpensive, and meets taxing requirements.
Perpetual inventory records receipt/sale of each item as it occurs.
• Provides accurate records but costly in terms of record keeping time.
• Bar coding reduces the cost but you need the equipment.
Point-of-sale (POS) systems integrate inventory into your accounting.
• Every sale is immediately recorded, revenues increase and inventory
decreases simultaneously.
• These systems are now inexpensive enough for small businesses.

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Value of Assets in Your Business
There are two kinds of
assets – short-term
and operating or
capital assets.
As the owner, you
must know the value
of these assets.
Many businesses
have few capital
assets, but some
require them – land,
building, machinery.
The value of the
assets usually far
exceeds the value
you would gain by
selling them.
Custom-made
machinery is a
valuable operating
asset, worth more
than its disposal price.

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Determining the Value of Your Operating Assets
Most small businesses determine the value using some combination of
the four common accounting methods of assigning asset value.
Book value is the difference between purchase price and accumulated
depreciation.
• Not very useful other than for tax purposes.
Disposal value is the net amount you would realize in an arm’s-length
transaction.
• A rough approximation, may not be “true.”
Replacement value is the cost to replace a currently owned capital
asset.
• Can be easily done with accuracy.
Fair market value lies between disposal and replacement values – sets
an “upper level” value.

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Determining the Value of Inventory
The value you assign to inventory sold and on hand affects the amount of
profit you recognize and the value of your business.
• Inventory valuation begins with knowing how much of what you hold.
• At a minimum, conduct a physical inventory at least once a year.
• Once you know what inventory you have, you can assign it a value.
• Inventory loses value in many ways: changes in fashion/technology,
spoilage of food items, and broken, dented, or shopworn items.
Value items using these methods: acquisition cost, replacement cost,
or fair market value.
• Assigning a high value increases cost of goods sold and decreases
sales margin and reported profit – and lowers income taxes.
• Assigning the lowest value makes operations look better, but at the
price of paying increased income tax.

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Property, Plant, and Equipment
Property, plant, and equipment (PPE) issues are highly important if you
own land, buildings, and machinery.
All capital assets cause you to incur four costs over time: acquiring the
asset, owning the asset, operating the asset, and disposing of the asset.
• When all of the costs are considered before investing in a capital
asset, this is called whole of life costs.
• Acquisition cost includes everything you spend to acquire the asset.
• Costs of owning an asset include loan interest and opportunity costs,
insurance, taxes, value of the footprint, record keeping and security.
• Costs of operating the asset includes energy costs, maintenance,
loss of value from wear, and operator training costs.
• Costs of disposition is the value of activities needed to get rid of the
asset – meeting regulations, disassembly, advertising, commissions,
shipping, insurance, and fees.

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The Capital Budgeting Decision
The process of deciding among various investment opportunities to
create a spending plan is called capital budgeting.
• To do this, alternatives are compared by examining the payback
period and ROI, as well as NPV and IRR.
To illustrate – a sign shop owner has the opportunity to contract with a
growing franchise to install the signs at all new locations.
• The owner needs to invest in a heavy truck and a truck-mounted crane
and has reduced the options down to two truck-crane combinations.
The owner has determined the following criteria:
• The weighted average cost of capital is 20 percent.
• The maximum acceptable payback period is four years.
• Depreciation will use a straight line for a useful life of 10 years.
• Salvage value of each combination is zero.
• Cash flows and profits will differ by the tax effect of depreciation.

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Payback Period
This measure is a statement of how much time must pass before you
receive back the same number of dollars in cash flow as you payed out.
• Only cash flows are considered.
Two decision rules apply in choosing an investment alternative:
• Accept only the alternative for which the time to recoup the investment
is equal to or less than a maximum allowable time from management.
• Accept the alternative with shortest payback period among those that
meet the first criterion.
• The Ford-Skyhook combination pays back in 2 years and 11 months.
• The GMC-Sponco combination requires 3 years and 2.7 months.
• Both meet the four year payback rule but the first is shorter.
This method is easy but it disregards the time value of money and cash
flows that occur after the payback period.

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Table 15.1: Data for Capital Budgeting Decisions
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Rate of Return on Investment
The ROI calculation is straightforward.
ROI = (Average annual profits) / (Average investment).
Two decisions rules apply.
• Accept only alternatives for which the ROI is equal to or greater than
the weighted average cost of capital.
• Accept the alternative with higher ROI among those that meet the first
criterion.
The Ford-Skyhook ROI is 0.707 and the GMC-Sponco ROI is 0.649.
• Both meet the decision rules, we accept the Ford-Skyhook alternative.
ROI is easy to calculate and relies on familiar accounting information, but
profits are not the same as cash and ROI ignores the time value of money.

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Rent or Buy
It is often not necessary, or advisable, to purchase capital assets as many
can be obtained through rental or lease agreements.
Renting and leasing are similar, but not identical processes.
• In each, ownership remains with the entity renting or leasing the asset.
• The primary difference is that renting is usually short-term, while
leasing is longer.
• Also, unlike a rental agreement, leases may provide the lessor to take
ownership of the asset at the end of the lease term.

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Advantages and Drawbacks of Renting
• Requires little or no cash outlay.
• No extensive (and expensive)
application process.
• Protects you from unexpected
cost of repairs.
• An easy cost avoidance if
conditions change.
• Timing of cash outflows is in
the rental contract.
• Provides a fall-back position
should projections be wrong.
Disadvantages to rentals are:
• You do not have an ownership
position – cannot be collateral.
• You must make regular, timely
payments.
• Total money spent on rent
usually exceeds purchase cost.

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Financing with Leases
There are two basic types of leases.
• Operating leases – at the end of the lease, you may return the asset
to the owner, or you may purchase it at its current fair market value.
• Capital leases – at the end of the lease period, you own the asset.
There are benefits to leasing.
• You can usually obtain a very low down payment.
• Negotiating and closing a lease is less complicated then obtaining a
loan and purchasing the asset.
• Easier to replace leased assets than your own assets.
The primary disadvantage is that is usually costs more than a purchase.
• Also, there are likely to be restrictive lease covenants on use,
maintenance, and disposal.

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Fractional Ownership and Other Forms of Joint Ventures
A joint venture is simply a formalized partnership between two firms.
• They make sense when each party has limited use of an expensive
asset.
• Or faces major investments that partnering help sidestep.
One area with common joint ventures is ownership
of airplanes.
• One plane may be owned by a partnership of
several businesses.
• Each business shares the costs in proportion to
their use of the plane.
• Fractional ownership is similar but a smaller
scale so small businesses may join.
Asset management
works if you take
the time to do it or
have it done for
you.

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Managing Operations
Operations management is concerned with directing and controlling.
• Planning, organizing, and staffing are executive management
functions.
• The overriding goal is to be constantly improving the organization.
• This is done with more efficient use of resources, and improved or
expanded service to customers.
• Here, “customer” means the next process as well as the end user.
• There is an operations element in every function of your business.

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Figure 15.3: The Operations Process
The inputs are
determined by your
objectives.
Operations is taking
raw materials and
turning it into a product.
Outputs are the
service/product for
sale.
Operations depends on
informational,
corrective, and
reinforcing feedback.
Access text alternative for this image.

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Measuring and Improving Productivity
The major outcome of operations and production management is
improved productivity.
• Productivity is simply the ratio of outputs to inputs.
Productivity = Outputs / Inputs.
• If you sell a product for $10.00 that costs you $2.50 to make, your
productivity ratio is 4:1.
• If you cut your production cost to $2.00, your productivity rises to 5:1.
• This means you improved the efficiency of your production process.
There is another way to improve productivity, through improved quality.
• Measured by durability, reliability, serviceability, style, ease of use, and
overall dependability.
• If you can charge more ($11), this increases your productivity.
• 11:2.50 or 4.4:1 – a 10 percent gain in productivity.

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Outsourcing to Improve Productivity
Technology has made outsourcing available and does not necessarily
require dealing with foreign firms – follow four simple rules:
• Know yourself.
• Keep strategy decisions in-house.
• Fully specify tasks that are to be outsourced.
• Know with whom you are contracting.
The most commonly outsourced functions are legal and accounting.
The web allows you to find competent companies for outsourcing.
• The best-known for manufacturing is Alibaba.
• For contracting with individuals, Upwork has 10 million contractors.

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Operations Management Challenges for Product-Based Firms
Products-based firms take materials, add labor and technology and create
a product – there are two major sources of efficiencies.
• One is to increase the amount, speed, or accuracy of work – done
through scheduling improvements.
• Another approach is to improve parts of the supply chain so raw
materials get into production faster and to customers faster.
There are sources of expertise you can use.
• The SBA and SCORE offers help, much of it low-cost or even free.
• Trade and professional associations often publicize best practices for
your industry.
• Top-performing firms may share their secrets of success.
• Vendors can offer free advice.

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Operations Management Challenges for Service Firms
The intangibility, inseparability, and perishability of services confound and
limit strategic choices and tactical decisions available to you.
• Part of the answer is deciding on a part of the service to focus on.
• Services tend to have differing degrees of four components.
• The components are the explicit service, the supporting facility, the
friendliness of staff, and a supporting good which is tangible.
Keep these four elements in mind when improving the service.
• Improve the supporting facility with better lighting or more parking.
• Improve or expand the explicit service.
• Improve cleanliness or staff friendliness.
• Offer coupons as a supporting good.
Include employees in the process to ease your work burden and to gain
the advantage of their expert input into the process.

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Documenting the Operations of Your Business
First, understand how processes, procedures, and work instructions relate.
• A process is what a firm does when converting raw materials into a
valuable output.
• A procedure is the step-by-step method by which a process is done.
• Work instructions specify how the job is to be done – can be large.
You can start documenting in a notebook if your
firm is still a one-person operation.
• If your firm is larger, enlist your employees.
Start from the top down and realize every process
does not need extensive documentation.
• Document processes that are regulated or that
are essential to your business.
Documentation
makes selling your
business much
easier when the
time comes to do
so.

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