Chapter # 10

Question # 4: The Acme Aglet Corporation has a 12 percent opportunity cost of funds and currently sells on terms
of “net/10, EOM.” (This means that goods shipped before the end of the month must be paid for by the tenth of the
following month.) The firm has sales of $10 million a year, which are 80 percent on credit and spread evenly over
the year. The average collection period is currently 60 days. If Acme offered terms of “2/10, net 30,” customers
representing 60 percent of its credit sales would take the discount, and the average collection period would be
reduced to 40 days. Should Acme change its terms from “net/10, EOM” to “2/10, net 30”? Why?

Solution:
Sr. #: Description Computations
1. Original investment in A/R: (A) = (60/360) * {(80%) * 10,000,000}= 1,333,333

2. New investment in A/R: (B) (40/360) * {(80%) * $10,000,000} = 888,889

3. Reduction: A-B = 444,444

4. Profitability: (C) 12% * 444,444= 53,333
5. Cost: (D) 2% * 8,000,000*60% = 96,000
6. Decision: Compare C & D
Question # 5: Porras Pottery Products, Inc., spends $220,000 per annum on its collection department. The company
has $12 million in credit sales, its average collection period is 2.5 months, and the percentage of bad-debt losses is 4
percent. The company believes that, if it were to double its collection personnel, it could bring down the average
collection period to 2 months and bad-debt losses to 3 percent. The added cost is $180,000, bringing total collection
expenditures to $400,000 annually. Is the increased effort worthwhile if the before-tax opportunity cost of funds is
20 percent? If it is 10 percent?

Solution:

Sr. Description Computation Computation Computation

#:
Current Situation Alternate (A) Alternate (B)
Sales 12M 12M 12M
A/R Turnover =360/75=4.8 =360/60=6 =360/60=6
Level of A/R =12M/4.8=2.5M =12M/6=2M =12M/6=2M
Reduction from current 0.5M 0.5M
situation
Return on reduction =20%*0.5M=0.1M =10%*0.5M=0.05M
Percentage of Bad debts: 4% 3% 3%
Loss due to bad debts: =4%*12M=0.48M =3%*12M=0.36M =3%*12M=0.36M
Reduction in bad debts =0.48-0.36=0.12M =0.48-0.36=0.12M
Total benefit: =0.1M+0.12M=0.22M =0.05M+0.12M=0.17M
Increased Collection 0.18M 0.18M
Expense
Benefit – Cost Yes No
Question # 7: A college bookstore is attempting to determine the optimal order quantity for a popular book on
psychology. The store sells 5,000 copies of this book a year at a retail price of $12.50, and the cost to the store is 20
percent less, which represents the discount from the publisher. The store figures that it costs $1 per year to carry a
book in inventory and $100 to prepare an order for new books.
a. Determine the total inventory costs associated with ordering 1, 2, 5, 10, and 20 times a year.
b. Determine the economic order quantity.
c. What implicit assumptions are being made about the annual sales rate?

Total Cost = C(Q/2)+O(S/Q)

C= Carrying cost per unit per period
O=Ordering costs per order
S=Total usage during the period
a.
Option 1; TC = 1(5,000/2) + 100 (5,000/5,000) = 2,600
Similarly for other options (2, 5, 10, 20)
b.

2(𝑂)(𝑆)
EOQ =√
𝐶

2(100)(5000)
=√ =1,000
1

c. Sales are evenly distributed over the period.

8. The Hedge Corporation manufactures only one product: planks. The single raw material used in making planks is
the dint. For each plank manufactured, 12 dints are required. Assume that the company manufactures 150,000
planks per year, that demand for planks is perfectly steady throughout the year, that it costs $200 each time dints are
ordered, and that carrying costs are $8 per dint per year.
a. Determine the economic order quantity of dints.
b. What are total inventory costs for Hedge (total carrying costs plus total ordering costs)?
c. How many times per year would inventory be ordered?

a.

2(𝑂)(𝑆)
EOQ =√
𝐶

Number of dints= 12*150,000=1,800,000

2(200)(1,800,000)
=√ = 9,487
8

b.
Total Cost = C(Q/2)+O(S/Q)
C= Carrying cost per unit per period
O=Ordering costs per order
S=Total usage during the period

TC = 8(9,487/2) + 200 (1,800,000/9,487) = 75,895

c.
1,800,000/9,487 = 190 times/ year
9. A firm that sells 5,000 blivets per month is trying to determine how many blivets to keep in inventory. The
financial manager has determined that it costs $200 to place an order. The cost of holding inventory is 4 cents per
month per average blivet in inventory. A five-day lead time is required for delivery of goods ordered. (This lead
time is known with certainty.)
a. Develop the algebraic expression for determining the total cost of holding and ordering inventory.
b. Plot the total holding costs and the total ordering costs on a graph where the horizontal axis represents size of
order and the vertical axis represents costs.
c. Determine the EOQ from the graph.
Total Cost = C(Q/2)+O(S/Q)
C= Carrying cost per unit per period
O=Ordering costs per order
S=Total usage during the period
TC = 0.04(Q/2) + 200 (5,000/Q)
Sr. #: Q HC OC TC

1. 1,000 20 1,000 1,020

2.

3.

4.

5.

6.

7.

8.

c. Draw the chart studied in class on slide 44 of chapter 10.

10. Common Scents, Inc., makes various scents for use in the manufacture of food products. Although the company
does maintain a safety stock, it has a policy of maintaining “lean” inventories, with the result that customers
sometimes must be turned away. In an analysis of the situation, the company has estimated the cost of being out of
stock associated with various levels of safety stock:
LEVEL OF SAFETY ANNUAL COST
STOCK (in gallons) OF STOCKOUTS
Present safety stock level 5,000 $26,000
New safety stock level 1 7,500 14,000
New safety stock level 2 10,000 7,000
New safety stock level 3 12,500 3,000
New safety stock level 4 15,000 1,000
New safety stock level 5 17,500 0
Carrying costs are $0.65 per gallon per year. What is the best level of safety stock for the company?
Sr. Safety Carrying cost Incremental Cost saving
#: Stock – of safety stock cost on
level incremental
stockouts
5,000 3,250
7,500 4,875 1,625 12,000
10,000 6,500 1,625 7,000
12,500 8,125 1,625 4,000
15,000 9,750 1,625 2,000
17,500 11,375 1,625 1,000

After 15,000 incremental benefits becomes lesser than incremental cost.