Working

Capital Management Management of Accounts Receivable & Inventory

Current ratio & net working capital: good predictors of a firm's ability to meet short
term obligations?
HIGH current ratio and HIGH net working capital
BUT: customers are slow to pay
the company is slow to write off delinquent accounts
- - - BOTH increases accounts receivable
slow-moving or obsolete inventory
ALL WILL NOT improve it's ability to pay current liabilities in a timely manner
3 Useful Tools for Maintaining Control over Accounts Receivable:
1. Ratio analysis: by tracking the average collection period the firm knows
whether customers are taking longer to pay their bills.
2. Aging the accounts receivable allows the firm to determine what
percentage of accounts are past due, how long past due they are, and
whether the situation is getting better or worse.
3. It is useful to track the ratio of bad debts to sales over time to determine
whether the firm should pursue stricter or more liberal credit policies.
Management of Inventory
Purchasing Costs - include costs of goods acquired from suppliers
including incoming freight or transportation costs.
Stockout costs - include costs that result when a company runs out of a
particular item for which there is a customer demand.
These costs require an estimate of lost contribution margin on sales lost
because of a stockout, plus any contribution margin lost on future sales due
to customer ill will.
The optimal safety stock level is the quantity of safety stock that
minimizes the sum of the annual relevant stockout costs and carrying
costs. Safety stock is used as a buffer against unexpected increases in
demand, uncertainty about lead time, and unavailability of stock from
suppliers.
4 Key Cost of Quality areas where costs are most likely to occur:

1. Prevention Costs - which arise when the product does not meet the
specifications
2. Appraisal Costs - incurred by actions which must be taken to detect which
of the individual units of products do not conform with the specification(s)
3. Internal Failure Costs - incurred on defective products before they are
shipped to customers
4. External Failure Costs - incurred on defective products after they are
shipped to customers.
Economic Order Quantity (EOQ) Model
Considerations that should be fully taken into account when developing
inventory related relevant costs for use in an EOQ model.
It is crucial that the costs be INCREMENTAL. Consider:
Incremental Carrying Costs. If they are costs that will change with the
quantity of inventory held, then they are RELEVANT. Relevant carrying
costs are likely to be costs like shrinkage (result from theft of
inventory), breakage, obsolescence, and costs of hiring extra employees
(or having existing employees work overtime) if higher levels of
inventory will make those costs increase.
The annual relevant carrying costs of inventory consists of the sum of
the: incremental costs plus the opportunity costs of capital.
Economic Order Quantity (EOQ) Model
Incremental opportunity cost of capital. If there is a decision to carry
more inventory, then there will be money spent to purchase the
inventory. The opportunity cost of capital is what would the other most
beneficial use of the money be if it wasn't needed to purchase the
higher level of inventory. It is calculated by multiplying the company's
required rate of return by the per unit costs and then by the number of
units purchased for the inventory and incurred at the time the units are
received.
Ordering costs are only those that change with the numbers of orders
placed. These include The costs of preparing, issuing, and paying
purchase orders, plus receiving, matching invoices received, and
inspecting the items included in orders.
Classify the below listed items as either Purchasing Costs, Ordering Costs, Carrying
Costs, Stockout Costs, Costs of Quality, or Shrinkage Costs.

________________ a. costs of obtaining purchase approvals

________________ b. costs resulting from embezzlement by employees
________________ c. internal failure costs
________________ d. opportunity cost of the investment tied up in inventory
________________ e. spoilage of stored items
________________ f. costs of lost sales as a result of not having an item requested by
a customer
________________ g. costs of incoming freight
________________ h. costs of matching invoices received to the items and the
purchase orders
________________ i. costs of wages for work-in-process inspections
________________ j. costs that result from clerical errors
EOQ Calculations:

" # $ # %
1. EOQ = &

2. Average Inventory = EOQ / 2 + Safety Stock

3. Annual carrying costs = Average inventory x Annual unit carrying costs
4. Orders per year = Annual Demand / EOQ
5. Annual ordering costs = Orders per year x Ordering Cost
6. Average daily demand = Annual Demand / Days used per year
7. Reorder point = Lead Time / Average Daily Demand
Reorder point = Delivery Time Stock + safety stock
Swank Products is involved in the production of camera parts and has the
following inventory, carrying, and storage costs:

Orders must be placed in round lots of 200 units

Annual unit usage is 500,000
The carrying cost is 20 percent of the purchase price
The purchase price is 2 per unit.
The ordering cost is 90 per order
The desired safety stock is 15,000 units. (This does not include
delivery-time stock.)
The delivery time is one week.
Assume a 50-week year
EOQ Calculations:
C = 0.40
" # $ # % O = 90
1. EOQ = & S = 500,000
Q* = ?

= 15,000 units
2. Ave. Inventory = EOQ/2 = 15,000/2 = 7,500 + 15,000 = 22,500 units
3. Annual carrying costs = Average inventory x Annual unit carrying costs
= 22,500 x 0.40 = 9,000
EOQ Calculations:
4. Orders per year = Annual Demand / EOQ
Orders per year = 500,000 / 15,000 = 33.33 orders per year
5. Annual ordering costs = Orders per year x Ordering Cost
Annual ordering costs = 33.33 x 90 = 3,000
6. Reorder point = Delivery Time Stock + safety stock
Reorder point = (1/50) x 500,000 + 15,000 = 25,000 units
The Wood Furniture company produces a specialty wood furniture product,
and has the following information available concerning its inventory items:
Relevant ordering costs per purchase order 300
Relevant carrying costs per year:
Required annual return on investment 10%
Required other costs per year 2.80
Annual demand is 20,000 packages per year. The purchase price per package is
32.
Required:
1. Unit Carrying Costs
2. EOQ
3. Relevant Total Costs at EOQ
4. Number of deliveries at EOQ
1. Unit Carrying Costs = ( 32 x 0.10) + 2.80 = 6

" # $ # % " # "',''' # 3 0 0

2. EOQ = EOQ =
& 6
EOQ = 1,414.21 units

3. Relevant Total Costs (RTC) at EOQ =

(20,000 # 300) (1,414.21 # 6)
= +
1,414.21 2
= 8,485.28

4. # of Deliveries at EOQ: 20,000 / 1,414.21 = 14.14