Accounts Receivable and Inventory

Learning Objectives
How and why firms manage accounts receivable and inventory. Computation of optimum levels of accounts receivable and inventory. Alternative inventory management approaches. How firms make and evaluate credit policy decisions

Why do firms accumulate accounts receivable and inventory?

Given that accounts receivable and inventory are assets that do not provide an explicit rate of return, it is important to understand why firms might still want to have these investments. Granting credit, resulting in Accounts Receivable, is often an essential business practice and can enhance sales. (But also will increase costs.) Holding adequate inventory is necessary to avoid loss of sales due to stock-outs and have an efficient manufacturing process.

Finding the Optimum Level of Accounts Receivable

Accounts Receivable represent your money sitting in someone elses bank account. It earns you nothing! So, if the firm does grant credit, how do we minimize the impact on cash flow Firms managers must review the firms credit policies and evaluate the impact of any proposed changes in policies based on the NPV of incremental cash flows due to the proposed changes

Accounts Receivable - Terms

The terms of sale are generally stated in the form X / Y, n Z This means that the customer can deduct X percentage if the account is paid within Y days; otherwise, the full amount must be paid within Z days. Example: 2/10 n 30 The company offers a 2% discount if the invoice is paid in 10 days. Otherwise, Balance due in 30 days.

Average Collection Period (ACP)

Old Policy; 2/10, n30 35% of customers pay in 10 days 62% of customers pay in 30 days 3% of customers pay in 100 days ACP=(.35x10)+(.62x30)+(.03x100)=25.1 days New Policy; 2/10, n40 35%of customers pay in 10 days 60% of customers pay in 40 days 5% of customers pay in 100 days ACP=(.35x10)+(.60x40)+(.05x100)=32.5 days (If sales are $1M per day, this will cost $7.4M!)

Analysis of Accts. Receivable Changes to Credit Policy

Develop pro forma financial statements for each policy under consideration. Use the pro formas to estimate incremental cash flows by comparing forecasts to current policy cash flows. Use the incremental cash flows to estimate the NPV of each policy change. Choose the policy change that maximizes the value of the firm (highest NPV).

Analysis of Accts. Receivable Changes

Example: ABC Corporation is considering a credit policy change from offering no credit to offering 30 days credit with no discount Why might they do this? -Increase sales -Increase market share What costs will the firm incur as a result? -Cost of carrying accounts receivable -Potential increase in bad debts -Credit analysis and collection costs

Analysis of Accts. Receivable Changes

Assume the Net Incremental Cash Flows associated with ABCs new credit policy are as follows: (They lose one month of cash flow which they will have to borrow) External financing (Init. Investment) = $28,000 t=0 Increase in sales = $30,000 Increase in COGS = $15,000 Increase in Bad Debts = $3,000 increase in Other Expenses = $5,000 Increase in Interest Expense = $500 Increase in Taxes = $2,600 Total Incr. Operating Cash Flow = $3,900/yr.

Analysis of Accts. Receivable Changes

Calculate the NPV of the change (k = 12%): PV of the expected inflows of $3,900 per year from t = 0 to infinity (perpetuity) = $3,900/.12 = $32,500 NPV = PV of inflows - initial investment = $32,500 - $28,000 = $4,500 Since NPV > 0, ABC should undertake the credit policy change

Methods of Collection
Most firms use some of the following:

Send reminder letters. Make telephone calls. Hire collection agencies. Sue the customer. Settle for a reduced amount. Write off the bill as a loss. Sell accounts receivable to factors.

Inventory Management
Typically, inventory accounts for about four to five percent of a firm's assets. In manufacturing firms, this could be 20 to 25% of the firms assets. Inventory sitting on your shelf earns nothing! In fact, it costs you 20 to 30% of the value of the inventory just to keep and maintain it. Therefore, the objective is to minimize the investment in inventory without sacrificing production requirements

Inventory Mangement
In order to effectively manage the investment in inventory, two problems must be dealt with: how much to order and how often to order. The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs.

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Inventory Management
Determining Optimal Inventory (where total costs are minimized)
Total Inventory = Costs Total Carryin + g Costs Total Ordering Costs

Note: We are not talking about the cost of the Inventory itself, but costs of holding and maintaining the inventory

Inventory Costs
Carrying Costs
Warehouse rent, insurance, security costs, utility costs, maintenance costs, property taxes, move and re-arrange, obsolescence, and opportunity cost, i.e., using cash for profitable projects rather than being tied up in inventory.

Ordering costs
Clerical expense, telephone, Material Resource Planning (MRP) system, management time, receiving costs, etc.
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The EOQ Model assumes the firm orders a fixed amount (Q) at equal intervals.
Inventory Level (units) Order Quantity Q

Time

The EOQ Model

Inventory Level (units) Order Quantity Q
Average inventory =

Order Quantity 2

Time

Total Total Inventory = Carrying + Costs Costs Total Inventory = Costs

Total Ordering Costs

OQ S ) CC + ( OQ ) OC 2

Where: OQ = Order Size (order quantity) S = Annual Sales Volume CC = Carrying Cost per Unit OC = Ordering Cost per Order

Ordering Costs = ( S )OC OQ

Cost ($)

Ordering Costs, per unit

Ordering costs per unit go down as order size increases. Assumes ordering costs are relatively fixed.

Order Size (units)

Ordering Costs = ( S )OC OQ Carrying Costs = ( OQ ) CC 2

Cost ($)

Carrying Costs
Carrying costs increase as the size of the inventory increases.

Order Size (units)

Ordering Costs = ( S )OC OQ Carrying Costs = ( OQ ) CC 2 Total Costs = Carrying Costs + Order Costs Total Cost = OQ x CC + S x OC 2 OQ

Cost ($) Y

The economic order quantity is the intersection of the X and Y points where total inventory cost is minimized

Order Size (units)

Inventory Management
Determining Optimal Inventory The ordering quantity that minimizes the total costs of inventory.
OQ = 2 x S x OC CC

Inventory Management
Determining Optimal Inventory Economic Order Quantity (EOQ)
Example: Awesome Autos expects to sell 1,560 new automobiles in the next year. It currently costs $40 per order placed with the manufacturer. Carrying costs amount to $50 per auto. How many autos should they order each time they place an order? 2 x S x OC CC

OQ =

2(1560)40 50

= 49.96 50 cars

Inventory Management
Determining Optimal Inventory Economic Order Quantity (EOQ)
Example: Awesome Autos expects to sell 1,560 new automobiles in the next year. It currently costs $40 per order placed with the manufacturer. Carrying costs amount to $50 per auto. How many autos should they order each time they place an order? How many orders per year?

OQ 50autos in each order

Place 1,560/ 50 = 31.2 orders each year Order cost = 31.2 x $40 = $1,248

Inventory Reorder Point

If total demand is 1560 and 52 weeks in year, then 1,560 / 52 or 30 cars sold per week. If it takes one week to get a shipment of cars from the manufacturer, then 1 x 30 or when you get down to 30 cars, they would reorder

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Safety Stock
Assume Awesome autos does not want to risk running out of cars and lose sales They determine that to offset variations in the delivery cycle, they need a safety stock of 20 autos The amount of safety stock is added to the inventory reorder point So the new inventory reorder point would be 30 plus 20 or 50 autos
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Inventory Management with Safety Stock- Order before inventory is at zero.

Inventory Level (units) 70 Inventory Order Point

EOQ

50
Depleted Stock During Delivery Safety 20 Stock Actual Delivery Time

Time