Chapter 20 – Credit and Inventory Management
1. Collection Policy
A. Monitoring receivables
Keeping track of payments to try to spot potential problems
(chronic late-payers and possible defaults) to reduce losses.
Aging schedule – a break-down of receivables accounts by age
Lecture Tip: Wilbur Lewellen and Robert Johnson demonstrate
that two of the traditional receivables monitoring tools – average
collection period and the aging schedule – are influenced by the
pattern of sales and may be misinterpreted by managers that are
unaware of this effect. Fortunately, eliminating this problem is
straightforward; use outstanding balances as a percentage of the
original sales that generated them. Their solution is discussed in
detail in “Better Way to Monitor Accounts Receivable,” Harvard
Business Review, May-June, 1972, pp. 101 – 109.
B. Collection Effort
The sequence of steps taken in collecting overdue accounts.
Typical steps:
-Send delinquency letter
-Call customer
-Employ collection agency
-Initiate legal proceedings
Real-World Tip: Health-care providers face unusual challenges in
dealing with collection policy. A correspondent on the financial
management listserv made the following comments regarding
collection policy and procedure for a multi-specialty physician’s
group:
“When patients have to pay after all insurance has been
collected, you can either devote a staff person to make the
laborious calls, etc. or turn it over to an A/R firm. To reduce
staff time, have staff make one letter billing in 15 days and one
call 15 days later.”
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Chapter 20 – Credit and Inventory Management
“If patient hasn’t paid in 30 days, turn it over to the A/R firm.
This firm contacts the patient for up to 60 days as a ‘billing
agent’ NOT COLLECTION FIRM to ask the patient to comply
in a ‘soft’ manner – YOU DO NOT WANT TO UPSET
PATIENTS!!” (emphasis in original)
“After 60 days, the account turns into aggressive collection
and the A/R firm turns into an aggressive COLLECTION
AGENCY with all the powers to collect.”
In other words, the steps in the collection policy used at this firm
progress from mild to aggressive, as suggested in the text.
Real-World Tip: Securitization involves selling an expected series
of cash flows to investors. It works something like this: a company
has accounts receivable of $10 million with an average collection
period of 45 days. The accounts receivable might be packaged as
securities and sold to investors at 95% of its value, or $9.5 million.
When customers make payments on their accounts, the money is
forwarded to the investors. The company receives its cash much
sooner, and the investor bears the risk of default on the accounts.
The larger the probability of default on the accounts, the larger the
discount the investor will require. Similar securities have been
developed for mortgages, student loans, etc., although the
attractiveness of such securities declined with the credit crisis in
2008.
2. Inventory Management
A. The Financial Manager and Inventory Policy
Many people, not just those in the finance function, influence the
level of inventory. Nonetheless, financial managers see the results
of inventory decisions in many places – ROA, inventory turnover
and Days’ Sales in Inventory ratios, to name a few.
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Lecture Tip: Dell has one of the best inventory management
systems in place. There have been numerous articles written in the
financial press concerning their policies. The management at Dell
believes that by carrying low levels of inventory on hand, they are
able to pass the savings along to customers when component
prices drop, which happens regularly. They are also able to stay
on top of the new technology and offer it to customers as soon as it
becomes available instead of trying to get rid of out-dated
equipment. In fact, Dell is so effective at managing its inventory
and receivables, that it has historically had a negative cash cycle,
meaning that the firm is selling and collecting on inventory before
it is paying for it!
B. Inventory Types
For a manufacturer, inventory is classified into one of three
categories:
-Raw materials
-Work-in-progress
-Finished goods
Classification into one of these categories depends on the firm’s
business; what are raw materials for one firm may be finished
goods for another. Inventory types have different levels of
liquidity. Demand for raw materials and work-in-progress depends
on the demand for finished goods.
C. Inventory Costs
There are two basic types of costs associated with current assets in
general and inventory in particular – carrying costs and shortage
costs.
Lecture Tip: Boeing Corporation is one of the largest
manufacturers of military aircraft in the world. For many years,
the firm has employed hundreds of subcontractors not only to
produce aircraft components, but also to maintain stocks of raw
materials inventory for the firm. Inventory managers have found
that it is often less costly to pay someone else to maintain these
inventories.
3. Inventory Management Techniques
A. The ABC Approach
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Chapter 20 – Credit and Inventory Management
Inventory is subdivided into three (or more) groups, and the groups
are analyzed to determine the relationship between inventory value
and quantity represented in each group.
B. The Economic Order Quantity Model
EOQ – the restocking quantity that minimizes total inventory costs
based on the assumption that inventory is depleted at a steady pace.
Total carrying costs = (average inventory)(carrying cost per unit)
= (Q/2)(CC)
Total restocking costs = (fixed cost per order)(number of orders)
= F(T/Q)
Total costs = carrying costs + restocking costs
= (Q/2)(CC) + F(T/Q)
EOQ=
√
2TF
CC
The EOQ is the point where the total carrying costs just equal the
total restocking costs.
Lecture Tip: The EOQ model assumes that the firm’s inventory is
depleted at a constant rate until it hits zero. Firms with seasonal
demand may not be able to use the EOQ model without some
adjustments. One way to adjust the equation is to compute “T”
based on the high sales level and use that number to compute the
EOQ during periods of high sales. Conversely, during periods of
low sales, compute “T” based on the low sales figures and use that
number to compute EOQ. What will happen is that the “optimal”
order quantity will change depending on the seasonality in sales.
Another option is to develop a cost formula that accounts for the
seasonality and then use calculus to minimize the new cost
function.
Lecture Tip: If students have had calculus, you can point out that
this is just the quantity that minimizes the cost function and can be
found by taking the first derivative, setting it equal to zero and
solving for Q.
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Chapter 20 – Credit and Inventory Management
TC=Q
2CC +FT
Q
∂TC
∂Q=CC
2+−FT
Q2=0
CC
2=FT
Q2
Q2=2FT
CC
Q=
√
2FT
CC
C. Extensions to the EOQ Model
Safety stocks – minimum level of inventory that must be kept on
hand; inventory won’t actually reach zero; will increase the
carrying cost component above what is predicted by the EOQ
model
Reorder points – place orders before inventory reaches a critical
level. Designed to account for delivery time
D. Managing Derived-Demand Inventories
Materials Requirements Planning – computer based systems that
manage the manufacturing process to make sure that inventory will
be available when it is required
Just-in-Time Inventory – order inventory so that it will arrive when
needed. Reduces the cost of storing inventory.
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Chapter 20 – Credit and Inventory Management
Lecture Tips: The primary advantage of JIT systems is the
reduction in inventory carrying costs that, for a large
manufacturer, can be substantial. As with every financial decision,
however, there is no increase in return without an increase in risk.
In this instance, the risk is that an interruption in the supply of
inventory items will require the user to shut down production
virtually immediately. As part of a larger program to reduce costs,
GM adopted a variant of the JIT system, but found it necessary to
temporarily halt production of some models in early 1994 as a
result of labor strikes at a supplier’s plants.
4. Summary and Conclusions
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Chapter 20 – Credit and Inventory Management
Appendix 20A
MORE ABOUT CREDIT POLICY ANALYSIS
A. Two Alternative Approaches
1. The One Shot Approach
Do not switch policy: Cash flow = (P – v)Q
Switch policy: invest vQ now, receive PQ next period
Present value of switch net cash flow: PQ / (1 + R) – vQ
NPV = present value of switch net cash flow – no switch cash flow
NPV = PQ / (1 + R) – vQ – (P – v)Q
The firm gets the NPV now and in every period, giving:
PQ / (1 + R) – vQ – (P – v)Q + { PQ / (1 + R) – vQ – (P – v)Q}/R
This reduces to: -[PQ + v(Q – Q)] + (P – v)(Q – Q)/R
2. The Accounts Receivable Approach
Periodic benefit: (P – v)(Q – Q)
Incremental investment in receivables: PQ + v(Q – Q)
Carrying cost per period: [PQ + v(Q – Q)]*R
Net benefit per period: (P – v)( Q – Q) – {[PQ + v(Q –
Q)]*R}
NPV = [(P – v)( Q – Q) – {[PQ + v(Q – Q)]*R}]/R
This reduces to: -[PQ + v(Q – Q)] + (P – v)(Q – Q)/R
Note that both methods simplify to the same equation that we had
earlier.
Example: Suppose we have the following information for Griffie
International, which is considering a change from no credit terms to
terms of net 20. P = 100; v = 75; Q = 1,000; Q = 1,050; R =
1.5% for 20 days
NPV = -[100*1,000 + 75(1,050 – 1,000)] + (100 – 75)(1,050 –
1,000)/.015 = -$20,416.67
To break-even, Griffie needs to sell 63 units more than its unit sales
without extending credit.
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Chapter 20 – Credit and Inventory Management
B. Discounts and Default Risk
Define:
= percentage of credit sales that go uncollected
d = percentage discount allowed for cash customers
P = credit price (no discount)
P = cash price = P(1 – d)
Assuming no change in Q, then:
Net incremental cash flow = [(1 – )P – v]Q – (P – v)Q = PQ(d – )
NPV = -PQ + PQ(d – )/R
A break-even application: = d – R(1 – d) is the break-even default
rate.
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