1 Managing Working Capital cntd.... (EOQ - Example) • A Manufacturing Company expects to use 8000 steel
plates in the coming year. The estimated cost of placing an order (including follow up costs and written verification) is £20. Each plate costs £10 and it is estimated that annual carrying costs per plate runs at approximately 30%. Required: Calculate and interpret the EOQ.
Class Exercise
2 EOQ Model (Solution)
• Solution
D = Annual usage = 8000
S = Cost of Placing Order = 20 Ic = Carrying Cost per unit = 3
EOQ = 2DS
Ic
= 2 x 8000 x 20
3
3 EOQ Model (Solution)
• So, order 327 units at a time.
Place 24 orders of approximately 327 units. (24 x 327 = 8000 approx)
• Limitations:
Assumes that delivery is instantaneous and lead-time is zero days.
Assumes usage is constant throughout the year.
EOQ Model and Lead Times • Lead Time = Time from order to delivery.
• To get over the first limitation , reorder point thus should be:
Lead time x Daily usage
• So, if an order takes five days to be delivered re-order steel plates when ?
5 EOQ Model and Buffer Stock
• To get over the second limitation (that usage remains constant throughout the year), management may wish to hold a buffer (safety stock) of units to accommodate an unexpected increase in demand.
EG: A buffer of 50 units is held
• So, reorder at when level reaches 160 units.
• Level of safety stock is a trade-off between the risk of running out of stock, and the increased cost associated with carrying more inventory.
6 Other Inventory Management Systems
• Materials Requirements Planning (MRP)
Manufacturing Resource Planning (MRP II)
• These systems calculate the total quantities of materials required to manufacture the finished products.
May also consider additional factors including capacity planning, shopfloor control and management accounting on an integrated platform.
7 Other Inventory Management Systems
"Just-in-time" inventory control (JIT)
• Originated in Toyota, Japan.
• Concept is to keep a minimum level of inventory on-hand, relying on suppliers to furnish required parts, just-in-time. • Suitable to high-volume repetitive manufacturing
environments.
• Can save a lot of cost in times of high interest rates.
Accounts Receivable Management • Credit sales lead to the establishment of accounts
receivable.
• Credit terms are an important element in marketing.
• Accounts receivable represent a major investment for most companies.
• As before, the management of accounts receivable involves consideration of the risk versus return trade-off.
9 Accounts Receivable Management
• Good accounts receivable management involves:
- Establishing a clear credit policy. - Concise collection procedures. - Constant monitoring / reports. Credit Policy
• While general economic conditions have some effect, management can increase or decrease the level of accounts receivable by lowering or tightening credit policy.
• Lowering the credit standard should aid marketing and sales.
10 Accounts Receivable Management - Credit Policy • Lowering credit standards may lead to:
- Higher collection costs
- Increased working capital needs. - Greater probability of bad debts.
• Like many financial decisions, credit policy involves much judgement and awareness.
• Quantitative analysis will only provide some of the information !
• Most companies consider their own marketing and manufacturing objectives, the level of bad debt they are comfortable with, and general economic conditions.
11 Accounts Receivable Management - Credit Policy • In addition companies typically use one, some or all of the
following techniques:
Financial statement Analysis
Measure a company's financial strength / ability to pay. (Ratio Analysis)
5 C's of Credit Analysis
- Character: Customers willingness to pay.
Past payment pattern.
- Capacity: Customers ability to generate cash flow.
Liquidity position / projected cash flow.
Accounts Receivable Management - Credit Policy /…..cntd
- Capital: Customers overall financial resources.
Financial Ratios / Balance Sheet.
- Collateral: Assets an applicant might pledge as security in return for credit.
Do you really want to have to foreclose on an
13 Numerical Credit Rating
• Perhaps a rating from a specialist ratings company. (EG : Dun & Bradstreet, S&P etc…)
• Compare rating / score to a minimum acceptable standard.
Varying Credit Policy
• As mentioned previously, varying your credit terms can have a dramatic effect on sales.
• Financial managers should ensure that a thorough cost-benefit analysis of the likely outcome is carried out, before embarking on extending additional credit.
14 Credit Terms
• Open Book (No Contract)
• Instalment Credit (Hire Purchase)
• Revolving Credit (Regular Minimum Amount) • Time Draft (Cheque presented to be cashed in x days) • Bankers Acceptance (A time draft guaranteed by the bank) • Credit period is usually determined by the custom of the
trade / nature of the business.
• Shelf life of product, destination, and size of order may also be factors influencing credit period.
15 Credit Terms
• Terms may include a discount for early payment. e.g. "1/10, net 30"
• Customer can take a discount of 1% by clearing the invoice within 10 days, or else the total amount is due within 30 days.
• What is the cost to a company of offering the above discount ?
• You are effectively offering 1% to obtain money 20 days before it is due
• Annual cost of Discount is thus :
1% x 365 /20 = 18.25%
Credit Terms
• Your terms may state "1/10, net 30" but companies often take longer than 30 days.
• In Ardmore's case for instance, 79 days was the average age of accounts receivable.
• The real cost of offering a 1% discount to receive cash 69 days earlier (on average) is thus :
17 Reservation of Title
• Clause / Statement on an invoice indicating that the vendor reserves ownership of the goods until paid for in full. • Goods upon which title has been reserved must be returned
to the owner in the event of bankruptcy. • Documentation and wording must be exact. • Effect on inventory valuation ???
• Many company's take out credit insurance to insure against bad debts.
• Sellers market - costly!
• The government provides export credit insurance in the high risk international sector.
