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LEARNING OBJECTIVES At the end of the chapter, you should be able to; Describe the facets of accounts receivable management Describe inventory management Calculate the economic order quantity and optimal level of safety inventory Outline inventory control systems, including just-in-time

Inventory Management Inventories consist of: raw materials, work in progress, and finished goods Inventory levels are influenced by sales and other factors such as the competitive environment and the industry sector The object of inventory management is to balance a set of costs Inventory holding costs increase with larger inventory holdings Inventory ordering costs decrease with larger order sizes

Inventory Management What are examples of inventory holding costs? Warehousing costs – rent & security Interest on funds invested in inventory Insurance Obsolescence Shrinkage What are examples of ordering costs? Transport costs per order Order initiation costs Receiving and management costs Quality control and verification costs Planning and production management due to smaller orders Sourcing costs

Inventory Management Excessive inventories affect profitability: they have substantial carrying costs erode profit margins, and reduce the asset-turnover ratio Alternatively: minimal levels of raw material and work-in-progress inventories could disrupt the production process Adequate inventory levels of finished goods ensures that demand is met rapidly An accurate information system is important : computerised point-of-sales terminals

Inventory Models The Economic Order Quantity( EOQ) model assumes that two types of costs exist: The holding cost - increases as order size gets larger The ordering cost – decreases as order size gets larger If carrying costs are added to ordering costs, the sum= total ordering and holding costs The intersection point = minimal total cost which is the EOQ The main assumptions of EOQ are: Sales can be forecasted perfectly Sales are evenly distributed throughout the year Orders are received with no unexpected delays

EOQ Formula

EOQ Graph

Inventory Control Systems EOQ model establishes the optimum ordering quantity and the level of inventory An inventory ordering and control system is essential. Re-order points are determined by demand patterns Physical methods for re-order points can be used - bin/reserve bin system Computerised inventory-control systems automatically update inventory records Bar coding by means of an optical scanner updates inventory records Management should concentrate on high value items- 10% physical quality = 90% of value

Inventory Management Assumption: 50 weeks in a year Therefore weekly demand = 2 000 units/50 = 40 units per week

Inventory Management Example: “Keep-fit” books. Selling price is R400 and cost is R200 per book. The ordering cost is R125 per unit and the carrying cost is R50 per unit per year. Annual demand is 2 000 units per year. EOQ Average inventory is 100/2 = 50 units Total cost at EOQ is:  

Uncertain Demand and Safety Inventory

ABC Inventory System Items are evaluated on their costs, frequency of usage, seriousness of being out of inventory, order lead time Category A: expensive, frequently used, long order lead times (monthly) Category B: less important and less frequently used (adjusted less frequently) Category C: unimportant and least frequently used (reviewed annually)

Just-in-Time (JIT) Inventory Management Delivery of materials and components from suppliers just as they are required for production A business using JIT inventory system does not require warehousing and other storage facilities and holding costs are minimised. Efficiency and quality A small number of reliable suppliers - to deliver frequently and guarantee quality The aim of JIT is to reduce the total cycle time from raw material to sale

Just-in-Time continued… The Risks JIT has resulted in improvements in quality and reduction of costs But there are risks: the system is fully optimised, interdependencies are compounded and there are higher risks of shutdown companies should not rely on only one supplier for any component or material increases in insurance premiums and transportation costs higher risks of business disruption , increase in insurance risk and higher levels of inventory volatility of input pricing Hold inventories of components and materials that are critical, purchased from one supplier, and at a higher risk of disruption of supply.

Material Requirements Planning (MRP) Manufacturing Resource Planning (MRP II) Enterprise Resource Planning (ERP)

Credit Policy What are the costs associated with selling on credit? The cost of bad debts The cost of financing debtors The administrative costs of managing debtors In contrast: An optimal credit policy can enhance sales and maximise net profits in relation to relevant risks Credit sales reduce finished goods inventory and create accounts receivable Sales are pivotal to greater turnover and increase in profitability Some controllable factors of sales are: the quality of the product, the pricing and credit policy The credit policy involves making decisions regarding: creditworthiness Collection policy and settlement discounts

Creditworthiness The credit manager, in assessing the creditworthiness of a potential customer needs to consider the customer’s: Attitude and commitment (Character) Credit history (Capacity) Financial position (Capital) Security offered (Collateral) The environment in which the customer operates (Conditions) The state of the general economy will also impact on the decision. Why? The creditworthiness of any customer is enhanced when the economy is doing well and the customer’s business is performing well.

Setting the Collection Policy The procedure for collection of overdue accounts could affect : sales, collection period, losses arising from bad debts and the percentage of customers taking discounts

Setting Settlement Cash Discount Policy The use of settlement discounts encourages early payment The policy is determined by: Cost of discount -vs.- benefit of cash flow The benefits to this system are : It attracts customers who perceive discounts as price reductions It reduces the average collection period

Analysing the Impact of a Change in Credit Policy on Profitability (net income) Management is primarily concerned with the balance between risk and return A change in credit policy would affect the following: The turnover of the firm and its gross profit The amount of receivables outstanding As credit quality has changed, there is likely to be a change in bad debt losses If there is a change in the discount policy , there will be a change in the cost of discounts

Example: Analysis of a Change in Credit Policy The terms of the formula may be positive or negative All terms in this formula need not be used in a particular analysis e.g. a change in credit policy may increase the cost of a discount but have no impact on bad debts

Analysis of a Change in Credit Policy Orix Ltd is changing its credit terms from : 3/15 net 30, to 5/10 net 60. All sales are on credit – 70% of customers currently take advantage of the 3% cash discount Under new credit policy: 60% of customers to take advantage of the cash discount and the average collection period to increase from 20 days to 30 days. Sales are to increase from R240m to R270m. Gross profit margin remains unchanged at 20%. Bad debts losses = 2% of sales. Opportunity cost =10% per annum. The increase in gross profit will be : 20% x R30 000 000 = R6000 000

Example 12.1 (continued) Why 0.8? Existing Sales New Sales Increase in incremental investment–new and existing sales Expected incremental investment relating to existing sales=Increase in average collection period x existing turnover ÷ no of days in the year. The investment in relation to new sales will be the investment required to cover the cost of sales. Total = R6 575 342 + R1 972 603 = R8 547 945 Cost of carrying receivables = 10% x 8 547 945 = R854 795 Cost of bad debts = R720 000 [270m x 0.4 x 2% - 240m x 0.3 x 2% ] Cost of discounts = R3 060 000 [(270m x 60% x 5%) – (240m x 70% x 3%) ] Change in net income = R6 000 000 - R854 795 - R720 000 - R3 060 000 = + R1 365 205 Why 0.8? Existing Sales New Sales NB: cost of bad debt applies only to credit sales who do not take the early discount

Accounts Receivable Management Management of accounts receivable starts with the decision to grant credit This is the responsibility of the credit manager who needs an effective accounts receivable control system An accounts receivable control system monitors the credit policy application. It helps prevent; the build up of receivables, the decline of cash flows, and increases in bad debts The total amount of accounts receivable is determined by: The volume of credit sales The average length of time between sales and collections Accounts receivable = credit sales per day x collection period

Accounts Receivable Management: Aging Analysis Comparison of the average collection period to the credit terms Use Aging schedule to analysis status of debtors