Chapter 6: Account Receivable and Inventory Management PDF

Chapter 6: Account Receivable and Inventory Management Chapter Content 1. Management of Account Receivable 2. Management of Inventory MANAGEMENT OF ACCOUNT RECEIVABLE Introduction Account receivable is the outstanding amount owed to a firm by its customers from credit sales. The size o...

Chapter 6: Account Receivable and Inventory Management Chapter Content 1. Management of Account Receivable 2. Management of Inventory MANAGEMENT OF ACCOUNT RECEIVABLE Introduction Account receivable is the outstanding amount owed to a firm by its customers from credit sales. The size of a firm’s accounts receivable is determined by: Percentage of credit sales to total sales Level of sales – more sales, greater account receivable Credit policies stated by company – credit terms, credit standard, collection policy Both of these factors have a direct relationship with the firm’s credit and collection policies. Objective account receivables management To ensure that cash is not tied up in account receivable To make sure that we can manage our collection period efficiently Credit Policy Credit policy is a system or procedure in managing accounts receivable that includes credit standards, credit terms, and collection activities. Some policies are sales oriented and accept higher risk while others are conservative and sacrifices sales for safety. Credit Standards The credit standard provides the basis for specifying acceptable levels of credit risk that a firm is willing to bear and in deciding who will receive credit. It looks at the minimum financial strengths and moral standings the applicants should have in order to receive the credit facilities. The purpose of credit standards is to screen potential credit customers for their ability and willingness to pay the credit facilities given. The determination of credit risks focuses on several specific factors known as 5C’s of credit. 6C’s of Credit Character Capacity Capital Condition Collateral 5C’s of Credit Character A customer’s character will determine his willingness to pay. A measure of his moral obligations to fulfill his promise, and can be determined by looking at his business and social reputation, his past payment records, other factors or events that affects his character. Capacity A function of cash flow and will determine a customer’s ability to pay. Involves his ability to manage the business in meeting all current obligations without affecting his business operations. 6C’s of Credit Capital Will determine the customer’s ability to pay. Concerned with the availability of resources in possession, or the ability to generate resources to pay debt when due. Condition Concerned with external factors which may affect a customer’s operations, hence his ability to pay. The firm must anticipate external factors such as: Changes in the business environment; Political instability; Changes in social values; and Other factors which may affect the firm’s cash flow. 5C’s of Credit Collateral Collateral, whether the assets (tangible or intangible) offers to the bank as commitment, is a guarantee that the debt will be paid on time. In order to be accepted as collateral, the asset must have value, liquid, and transferable. Credit Terms The conditions which credit is given to customers. Concerns with: – Cash discount for early payment – Discount period – The length of time credit outstanding – Financial charges for late payment (if any) Possible discount for early payment =a Discount period =b Total credit period =c A % discount will be given if the accounts is paid within b days, otherwise debtors have c days to settle the debts.  Change in credit terms have a direct impact on Common Credit/ Payment Terms average collection period and the level of receivables. Open terms A line of credit is granted Cash before A firm must receive cash before deliveries can be made. delivery (CBD) No risk involves as no credit is granted. Cash in advance Similar to CBD (CIA) Cash with order Similar to CBD Cash on delivery Customer will pay for shipment or goods when it is received. Some risk is involved as customer may refuse to accept shipment or give bad cheques. Net 30 Payment in full is due within 30 days after date of shipment. The offer of cash discount is to induce early payments from credit customers. Common Credit/ Payment Terms Net 10 EOM EOM stands for end of month. A payment in full is due before the 10th day of the following month. E.g. if shipment is in January, the due date is before 10th February. 2/ 10 net 30 2% discount within 10 days of shipment. Full payment due within 30 days. 2/ 10 prox, net 30 If invoice is paid on approximately the 10th day following shipment date, a 2% discount is permitted; or else, payment in full is due within 30 days. 2/ 10 EOM, net 40 If invoice is paid by the 10th day of the following month, a 2% discount is permitted; or else payment in full is due in 40 days. 2/ 10 ROI, net 40 ROI stands for receipt of invoice. If invoice is paid within 10 days of receipt of invoice, a 2% discount is permitted; or else, payment in full is due in 40 days. Collection Activities Guidelines for appropriate actions to be taken when accounts are overdue. Sending postcard, duplicate invoice or statement with reminder phrases or Reminder stickers, brief and courteous letters, printed cards etc. Sending successive follow up letters or personal visit. Follow Up Drawing a draft on a customer, collection Drastic by attorney or employing a collection agency. action MANAGEMENT OF INVENTORY Inventory Basic raw Partially Represent ssecorP ni kroW slairetaM waR sdooG dehsiniF materials finished products that purchased goods are from requiring completed in suppliers to additional the initiate the work before production production they become process but process. finished not sold. goods and be sold to customers. Inventory Firms with low inventory may face stock out and production delays. Firms that maintain large inventories can be able to meet demand and provide prompt shipment but will experience high inventory costs. Objectives of Inventory Management To maximize inventory turnover This will release tied up funds in inventories and be used to other more profitable investment; thus increasing profitability. To carry sufficient inventories To satisfy production and sales demands. Objectives of Inventory Management Other objectives are: – It will take some time to order raw materials; – It will be cheaper to buy in large quantities; and – Economies of scale. Inventory Cost Costs associated with fixed clerical costs of placing and receiving and ordering; such as costs of processing, Order Costs telephoning, typing, mailing and receiving orders. Costs associated with the cost of carrying each unit of inventory in the firm’s stock per period, normally on a yearly Carrying basis. Example are transportation, insurance etc. Costs The sum of the Total Ordering Cost and the Total Carrying Cost. Total Cost Inventory Cost Total Ordering Cost (TOC) TOC = (No. of orders per period) X Order cost per order = S X O EOQ Total Carrying Cost (TCC) TCC = Carrying cost per unit (Average inventory) = C X EOQ + SS 2 Total Inventory Cost (TIC) TIC = Total ordering cost + Total Carrying Cost = TOC + TCC Inventory Cost Costs in RM E O Q Total Inventory Cost in g Cost Total Ordering Cost ry l Ca r Tot a Quantity Economic Order Quantity (EOQ) EOQ, the order quantity that minimizes the total inventory costs. EOQ = √2SO C Where: – S – Demand/ Sales per period – O – Order cost in RM – C – Carrying cost per unit in RM Reorder Point and Safety Stock Reorder point act as an indicator of when the firm should place an order for new shipment. ROP = (Lead time in days)(Daily usage rate) + Safety Stock = (L)(Sd) + SS Safety stock optimizes the cost function and safety needs against uncertainty of demand and delivery. SS = 1.85 √(Lf)(S) Where: – SS – Safety stock in units – L – Lead time in days – Lf – Lead time in days to delivery as a fraction of a year – – Daily usage, demand or sales Sd Inventory Usage Inventory usage uses the ‘saw tooth’ Quantity pattern. Implies that the demand for the products is certain and the delivery for supplies is certain. Order Quantity Average Inventory (Q/2) Time (in days) 0 Time between orders When the stock is depleted to zero, the new order will be received instantaneously. Reorder Point and Safety Stock Demand may vary from time to time, and shipment delays are possible. Quantity The reorder point and safety stock will provide allowance for uncertainty in demand and delivery of inventory. Order Quantity Average Inventory (Q/2) + SS ROP Expected lead time demand SS Time (in days) 0 Time between orders  ILLUSTRATION Zenith Berhad sells 7,500 machines per year. Based on the company’s policy, a safety stock of 5% from yearly sales is to be maintained. The cost of carrying a machine is RM14 per unit per year. It costs RM70 to prepare and received an order. The delivery time is 10 days. The inventory planning period is one year. Assume 360 days per year. Calculate a) The EOQ b) The average inventory c) The reorder point d) The total inventory cost for a year SOLUTION 274 UNITS RM9084 Illustration The Abish Corporation has a monthly usage of 4,000 units. The cost of placing an order is RM100 and it takes one week for the shipment to arrive. The inventory carrying cost per unit is RM0.55 per three months. All orders must be placed in lot of 100 units and safety stock is 58 units. Assume that 50 – week in a year. Calculate a) The Reorder point b) The EOQ c) The total inventory cost for a year Illustration S = 4,000 (12) = 48,000 units per year C = RM0.55 (12/ 3) = RM2.20 per year O = RM100 SS = 58 units Illustration ROP = (L)(Sd) + SS = (1(48,000/ 50)) + 58 = 1,018 units EOQ = √2SO/C = √(2(48,000)(100))/RM2.20 = 2,088.93 units  2,100 units Illustration TOC = O (S/Q) = 100 (48,000/2,100) = RM2,285.71 TCC = C((S/2)+SS) = RM2.20 ((2,100/2)+58) = RM2,437.60 TIC = TOC + TIC = RM2,285.71 + RM2,437.60 Exercise Hitam Manis Distributor has determined the following inventory information: – Orders can placed only in multiples of 100 units. – Annual usage is 500,000 units (Assume 50-week a year). – The carrying cost is RM10 per unit. – The ordering cost is RM100 per order. – The desired safety stock is 2,500 units. – Delivery time is 5 days. You are required to calculate: – The EOQ level – The total inventory cost – At what inventory level should a reorder be made? References 1. Financial Management by Rohani A. Ghani and Mohd Sabri Hj Mohd Amin, InED, UiTM Shah Alam. End of Chapter 6 ANY QUESTION