Chapter 19

Accounts Receivable and Inventory Management

Accounts Receivable consists of money owed to a firm for goods and services sold on credit.
a. Trade or Commercial Credit credit which the firm extend to other firms.
b. Consumer or Retail Credit credit which the firm extends to its final customers.
Objectives of Accounts Receivable Management:
-

To ensure that the firms investment in accounts receivable is appropriate and contributes to
shareholder wealth minimization.

Credit Policy - set of guidelines for extending credit to customers. The success or failure of a business
depends primarily on the demand for its products as an example, the higher the sales, the larger its
profits and the higher the value of its stocks.
Credit policy generally covers the following variables:
1. Credit Standards - refer to minimum financial strength of acceptable credit customer and the amount
of available to different customer.
- can significantly influence sales. If credit policy is relaxed, while sales may increase,
the quality of accounts receivable may suffer. This may result into longer average collection period.
To measure credit quality and customers worthiness, the following areas are generally evaluated:
a. Character refers to the probability that the customers will pay their debts or obligations. Credit
reports provide the background information on people and firms past performances from a firms
bankers, their other suppliers, their customers, and even their competitors.
b. Capacity judgment of customers abilities to pay. It is determined in part by the customers past
records and business methods.
c. Capital measured by the general financial condition of a firm as indicated by an analysis of its
financial statements.
d. Collateral represented by assets that customers may offer as security in order to obtain credit.
e. Conditions refer both to general economic trends and to special developments in certain
geographic regions or sectors of the economy that might affect customers abilities to meet their
obligations.
2. Credit Terms involve both the length of the credit period and the discounts given. Credit period is
the length of time buyers are given to pay for their purchases. Discounts are price reductions for early
payment.

3. Collection Policy refers to the procedures the firm follows to collect past-due accounts. Within a
reasonable range, the proportion of bad-debt losses and the shorter the average collection period if all
other things remain the same.
4. Deliquency and Default whatever credit policies a business may adopt, there will be some
customers who will delay and others who will default entirely, thereby increasing the total accounts
receivable costs.
Costs associated in Accounts Receivable
1. Credit analysis, accounting and collection costs the cost of hiring manager plus assistants and
bookkeepers within the finance department, acquiring credit information sources; and maintaining and
operating a credit and collection department.
2. Capital Costs once the firm extends credit, it must raise funds in order to finance it. The interest to
be paid if the funds are borrowed or the opportunity cost of equity capital will constitute the cost of
funds that will be tied up in the receivables.
3. Deliquency Costs costs that are incurred when the customer is late in paying. It also creates an
opportunity cost for any additional time the funds are tied up after the normal collection period.
4. Default Costs incurred when the customer fails to pay their outstanding balance. At this point, the
firm loses the cost of goods sold not paid for. It has to write off the entire sales once it decides the
delinquent account has defaulted and is no longer collectible.
SUMMARY OF TRADE-OFFS IN CREDIT AND COLLECTION POLICIES
PARTICULARS
1. Relaxation of credit standards

BENEFITS
in sales and total contribution
margin

2. Lengthening of credit period

in sales and total contribution

margin

3. Granting cash discount

in sales and total contribution

margin
default costs, opportunity
cost or capital cost

4. Intensified collection reports

COSTS
in credit and processing costs,
collection costs, default costs
(bad debts), capital costs (
opportunity costs)
capital costs (opportunity cost
of higher investment in
receivables)
profit or net income
higher collection expenses

Marginal or Incremental Analysis of Credit Policies

Marginal Analysis performed in terms of a systematic comparison of the incremental returns and the
incremental costs resulting from a change in the firms credit policy.
a.) Incremental Profit Contribution> Incremental Cost; accept the change in credit policy

b. Incremental Profit Contribution < Incremental Cost; reject the change in credit policy
c. Incremental Profit Contribution = Incremental Cost ; indifferent to the change in credit policy
Inventory Management
Inventories are essential part of virtually all business operations and must be acquired ahead of sales.
The main classifications of inventories are :
a. Manufacturing raw materials, goods-in process, finished goods, factory supplies
b. Trading merchandise
Objective of Inventory Management
-

To maintain a sufficient amount of inventory to insure the smooth operation of the firms
production and marketing functions and at the same time tying up funds in excessive and slowmoving inventory.

Functions of Inventory
a. Pipeline or Transit Inventories inventories which are being moved or transported from one location
to another.
b. Organizational or decoupling inventories inventories that are maintained to provide each in the
production-distribution chain a certain degree of independence from the others. These will also take
care of random fluctuations in the deman/supply.
c. Seasonal or anticipation stock built up in anticipation of heavy selling season or in anticipation of
price increase or as part of promotional sales campaign.
d. Batch or lot-size inventories inventories that are maintained whenever the user makes or buys
material in larger lots than are needed for his immediate purposes.
e. Safety or buffer stock inventories that are maintained to protect the company from uncertainties
such as unexpected customer demand, delays in delivery of goods ordered.
Costs Associated with Inventories:
a. Carrying Cost cost of capital tied in inventory, storage and handling cost, insurance, property taxes,
depreciation and obsolescence, administrative
b. Ordering shipping and receiving costs cost of placing orders including production and setup costs
shipping and handling costs.
c. Costs of running short loss of sales, loss of customer goodwill, and description of production
schedules.

Inventory Management Techniques:

1. Economic Order Quantity
Formula =

(2 x annual demand in units x costs per order)

Carrying Costs per unit

a.) Total Inventory Costs = Total Ordering Costs + Total Carrying Costs
b.) Total Ordering Costs = (Annual demand in units/ EOQ or order size) X Ordering Cost per order
c.) Total Carrying Cost = Average Inventory x Carrying costs per unit
d.) Average Inventory = (EOQ or order size)/2
2. Reorder Point = Lead time usage + Safety Stock
Level of Monitoring and Inventory Control Systems:
Inventory Control is the regulation of inventory within predetermined limits. Effective inventory
management should provide adequate stocks to meet the requirements of the business, while at the
same time keeping the required investment at a minimum.
1. Fixed Order Quantity System system wherein each time the inventory goes down to a
predetermined level known as the reorder point, an order for a fixed quantity is placed. It requires the
perpetual inventory records of the continuous monitoring of inventory level.
2. Fixed Reorder Cycle System also known as periodic review of replacement system where orders
are made after a review of inventory levels has been done at regular intervals. An order is placed at the
time of the review the inventory level had gone down since the preceding review.
3. Optional Replenishment System system which represents a combination of the important control
mechanisms of the other two systems described above.
4. ABC Classification System segregation of materials for selective control is made. Inventories are
classified into A or high value items, B or medium cost items, and C or low cost items.