Financial Management

Q.1 Examine the reasons for holding inventories by a firm & also discuss the techniques of inventory control.

Whether a business is in retailing or manufacturing, there are several cogent reasons for holding inventory. Businesses may hold stocks of raw materials, spare parts for machinery, work in progress or finished goods. Given that there are costs involved with purchases, orders and carriage inwards, a firm might want to minimize its order costs and utilize storage space efficiently. While a business would incur holding costs when storing inventory, these costs can be offset if there are good business reasons for so doing.

Purpose of inventory The purpose of holding inventory is to achieve efficiency through cost reduction and increased sales volume. Figure 1.1 displays various purposes involved in holding inventories:

Purpose

sales

To avail quantity discount

Reduce risk of production stoppages

Reducing ordering costs and time

Figure 13.3: Purpose for holding inventory Sales Customers place orders for goods only when they need it. But when customers approach the firm with orders the firms must have adequate inventory of finished goods to execute it. This is possible only when firms maintain ready stock of finished goods in anticipation of orders from the customers. If a firm suffers from constant customer complaints about the product being out of stock, customers may migrate to other producers. This will affect the firms customers base, customer loyalty and market share.

To avail quantity discounts Suppliers give discounts for bulk purchases. Such discounts decrease the cost per unit of inventory purchased. Such cost reduction increase firms profits. Firms may go in for orders of large quantity to avail themselves of the benefit of quantity discounts. Reduce risk of production stoppages Manufacturing firms require a lot of raw materials and spares and tools for production and maintenance of machines. Non availability of any vital item can stop the production process. Production stoppage has serious consequences. Loss of customers on account of the failure to execute their orders will affect the firms profitability. To avoid such situations, firms maintain inventories as hedge against production stoppages Reducing ordering costs and time Every time a firm places an order it incurs cost of procuring it. It also involves a lead time in procurement. In some cases the uncertainty in supply due to certain administrative problems of the supplier of the product will affect the production schedules of the organisation. Therefore, firms maintain higher levels of inventory to avoid the risks of lengthening the lead time in procurement. Therefore, to save on time and costs, firms may place orders for large quantities. Therefore, it can be concluded that the motives for holding inventories are Transaction motive: For making available inventories to facilitate smooth production and sales Precautionary motive: For guarding against the risk of unexpected changes in demand and supply Speculative motive: To take benefit out of the changes in prices, firms increase or decrease in the inventory levels

1. To meet expected demand A business must ensure that it has adequate supplies to meet expected demand for its goods, regardless of whether it is a retailing or production environment. Particularly where a business has a high demand and rapid turnover, having stock in storage ensures that the firm can comfortably meet anticipated demand. 2. To guard against shortages Holding inventory can act as insurance against future shortages. Unexpected shortages in the supply of raw materials or finished goods can affect the production run of a

business or its ability to meet demand. Holding inventories allows a degree of continuity for the activities of an enterprise. 3. To benefit from discounts Suppliers often offer trade discounts for bulk purchases, once those purchases are above a certain amount. A business can reduce the unit cost of materials and its ordering costs (delivery, import duties) by purchasing a large amount of goods/ raw materials to hold in stock. 4. To deal with variations in usage or demand "Usage" refers to production consumption in a manufacturing process. Increased usage can increase the demand for materials. This is the result of either increased inefficiency or increased production levels. Sometimes a business might cater for special orders or have high seasonal demand that it must address, requiring additional stock to facilitate such occurrences. 5. To facilitate the production process Stock can allow the manufacturing process to flow smoothly and help the business to respond quickly and effectively to contingencies. 6. In times of high inflation/ supply shortages Holding vast supplies of inventories can be a deliberate strategy in response to unusual or difficult economic circumstances. In times of high inflation, a business might not wish to purchase stock at increasingly higher prices. Once the business determines that it is feasible to hold additional inventory beyond the usual levels, this is a very sensible strategy. 7. Some processes require holding work in progress Inventory can also include work in progress. Some products might have longer production cycles than others (like wine or cheese for instance). It is necessary to hold a high volume of inventory to cater for the inherent nature of production in some business contexts. Naturally, there are restrictions on how much inventory a business could or should hold. The nature of the product, regulations and maximum storage capacity are some elements that limit or deter a business from holding too much inventory. Once a

business decides to hold inventory, then a proper inventory management and control system is necessary to optimize both the stock levels and inventory costs. Inventory Control Inventory control is concerned with the acquisition, storage, handling and use of inventories so as to ensure the availability of inventory whenever needed, providing adequate provision for contingencies, deriving maximum economy and minimizing wastage and losses. Hence Inventory control refers to a system, which ensures the supply of required quantity and quality of inventory at the required time and at the same time prevent unnecessary investment in inventories. Inventories Control Techniques

What are the main Techniques of Inventory Material Control?

SIMRANJOT

Inventory consists of stock of raw materials, work-in-progress, spare pa consumables for production and finished goods for sale. Thus, inventory com includes control over raw materials, spare parts, consumables, partly finished goods, and finished goods. The following are the common techniques of inventory control: 1. Determination of various levels of materials 2. Economic Order Quantity 3. ABC Analysis 4. Perpetual Inventory System 1. Determination of Various Levels of Materials The store-keeper plays an important role in deciding upon the various levels materials. In order to ensure that the optimum quantity of materials is purchased stocked neither less nor more, the store keeper applies scientific techniques of material management. Fixing of certain levels for each item of materials in one of techniques. These levels are not permanent but require revision according to the change in the factors which determine these levels. The following levels are generally fixed. (a) Re-order Level (b) Maximum Level (c) Minimum Level (d) Average Level (e) Danger Level (a) Re-order Level:

This level is that level of material at which it is necessary to initiate purchase requisition for fresh supplies. This is normally the point lying between the maximum and the minimum levels. Fresh orders must be placed before the actual stocks touch the minimum level. This level is fixed in such a manner that the quantity of materials represented by the difference between the re-order level and the minimum level will be sufficient to meet the requirement of production till such time as the order materialises and materials are delivered. The following factors are taken into account for fixing the Re-order level: (i) Rate of consumption of material (ii) Lead time, i.e., time required to receive the delivery of fresh purchase. (iii) Re-order quantity (iv) Minimum level Re-order level can be calculated by applying the following formula: Re-order level = Minimum level + consumption during period required to get fresh delivery Another formula for Re-order level is: Re-order level = Maximum consumption x Maximum Re-order Period Illustration-1 Calculate Re-order level for a material from the following information: Minimum level - 1,000 units Maximum level - 6,000 units Time required to get fresh delivery - 15 days. Daily consumption of the material - 100 units. Solution: Re-order level = Minimum Level + Consumption during the period required to get fresh delivery = 1,000 units + (100 x 15) = 2,500 units. Calculate Re-order Level from the following particulars: Minimum consumption - 80 units' Maximum consumption - 120 units Re-order period - 10-12 days Solution: Re-order Level = Maximum consumption x maximum Re-order period = 120 units x 12 = 1,440 units (b) Maximum Level: The maximum level is that level of stock which can be held at any time. In other words, it is the level beyond which stock should not be maintained. The purpose is to avoid over-stocking and thereby using working capital in a proper way. This level is fixed after taking into account the following factors: (i) Rate of consumption (ii) Lead time (iii) Availability of capital

(iv) Storage capacity (v) Cost of maintaining stores including insurance cost (vi) Nature of commodity (vii) Possibility of price fluctuation (viii) Possibility of change in fashion, habit, etc. (ix) Restrictions imposed by Govt., local authority or trade associations (x) Re-order level it (xi) Re-order quantity Maximum level can be calculated by applying the following formula: Maximum Level = Re-order level + Re-order Quantity - (Minimum consumption x Minimum Reorder period) (c) Minimum Level: This is the level below which the stock of an item should not fall. This is known as safety or buffer stock. An enterprise must maintain minimum quantity of stock so that the production is not hampered due to non-availability of materials. This level is fixed after considering the following factors: (i) Re-order level (ii) Lead time (iii) Rate of consumption The formula for calculating minimum level is: Minimum level = Re-order level - (Normal consumption x Normal Re-order period) (d) Average Level: Average level can be calculated by applying the following formula: Maximum level + Minimum level Average level = ---------------------------------------------- Or Average level = Minimum level + of Re-order Quantity. (e) Danger Level: Usually stock should not be lower than the minimum level. But if for any reason, stock comes down below the minimum level, it is called danger level. When the stock reaches danger level, it is necessary to take urgent action on the part of the management for immediate replenishment of stock to prevent stock-out situation. The danger level can be calculated by applying the following formula: Danger Level = Average consumption x Maximum Re-order period for emergency purchases

From the following particulars, calculate the maximum level, minimum level, re-order level and average level: Normal consumption - 300 units per day Maximum consumption - 420 units per day Minimum consumption - 240 units per day Re-order quantity - 3,600 units Re-order period - 10-12 days 2. Economic Order Quantity (EOQ) The economic order quantity, known as EOQ, represents the most favorable quantity to be ordered each time fresh orders are placed. The quantity to be ordered is called economic order quantity because the purchase of this size of material is most economical. It is helpful to determine in advance as to how much should one buy when the stock level reaches the re-order level. If large quantities arc purchased, the carrying costs would be large. On the other hand, if small quantities are purchased at frequent intervals the ordering costs would be high. The economic order quantity is fixed at such a level as to minimise the cost of ordering and carrying the stock. It is the size of the order which produces the lowest cost of material ordered. While determining the economic order quantity, the following three cost factors are taken into consideration: (i) The cost of the material (ii) The inventory carrying cost (iii) The ordering cost Carrying costs are the costs of holding the inventory in the stores. These are: (i) Rent for the storage space. (ii) Salaries and wages of the employees engaged in store keeping department. (iii) Loss due to pilferage and deterioration. (iv) Insurance charges. (v) Stationery used in the stores. (vi) Loss of interest on the capital locked up in materials. Ordering costs are the costs of placing orders for the purchase of materials. These are: (i) Salaries and wages of the employees engaged in purchasing department. (ii) Stationary, postage, telephone expenses, etc. of the purchasing department. (iii) Depreciation on equipments and furniture used by the purchasing department. (iv) Rent for the space used by the purchasing department.

While placing orders for purchasing materials, the total cost to be incurred is kept in view. As discussed earlier, if an order is placed for a large quantity at a time, the ordering cost is less but the carrying cost would be more. On the other hand, if orders are placed for small quantities, the ordering cost is more but the carrying cost would be less; thus the economic order quantity is determined at a point when the ordering costs and the carrying costs are equal. Only at this stage the total of ordering cost and carrying cost is minimum. Determination of Economic Order Quantity: The economic order quantity is determined by using the following formula: Where, EOQ = Economic order quantity. C = Annual consumption or usage of material in units. 0 = Cost of placing one feeder including the cost of receiving the goods. 1 = Cost of carrying one unit of inventory for one year. Assumptions in the Calculation of Economic Order Quantity: The economic order quantity is based on the following assumptions: Quantity of the item to be consumed during a particular period is known with certainty. The pattern of consumption of material is constant and uniform throughout the period. Cost per unit is constant and known and quantity discount is not involved. Ordering cost and carrying cost are known and they are fixed per unit and will remain constant throughout the period. IlIustration-4 From the following information, calculate the economic order quantity: Annual consumption 10,000 units Cost of material per unit - Rs.10 Cost of placing and receiving one order - Rs.50 Annual carrying cost of one unit - 10% of inventory value. Solution: Where, C = Annual consumption of materials in units = 10,000 units O = Cost of placing one order including the cost of receiving = Rs.50 I = Carrying cost per unit per annum = 10% of Rs.10 = Re.1. Economic order quantity can also be calculated by using the tabular method. A comparison of total costs at different order sizes is made to determine the economic order quantity. The order size having the least total cost is accepted as economic order quantity. At this point, both carrying costs and ordering costs would be equal. Taking the figures from the illustration 4, calculate the economic order quantity by using the tabular method. Solution:

The above table reveals that the cost of placing order for materials and the carrying costs are exactly equal when the order quantity is 1,000 units. At this point, the total cost is also the least. Hence, the economic order quantity is 1,000 units and the number of orders per year would be 10. 3. ABC Analysis This technique of inventory control is also known as Always Better Control technique. ABC analysis is an analytical method of control which aims at concentrating efforts on those areas where attention is needed most. This is a principle of selective control. The emphasis of ABC analysis technique is that the management should concentrate its energy in controlling those items that mostly affect the organisational objects. Manufacturing concerns find it useful to group the materials into three classes on the basis of investment involved. Materials having higher values but constitute small percentage of total items, are grouped in 'A' category. On the other hand, a large percentage of items of materials which represent a smaller percentage of the values, are grouped in 'C' category. Items of materials having moderate value 'and moderate size are grouped in 'B' category. On the basis of physical quantities and value of arterials used, the following table illustrates the above classification: After the items of materials are classified into A, B and C category, control can be exercised in a selective manner as follows: (i) Greater care and strict control should be exercised on the items of category 'A' as any loss or breakage or wastage of any item of this category many prove to be very costly. Economic order quantity and re-order level should be carefully fixed for such category of items. (ii) Moderate and relaxed control is required for the items of category 'B'. (iii) There is not much need for exercising control over the items of category 'C' Periodic or annual verification is required for this category of materials. The graphical representation of ABC analysis is given below: Advantages of ABC Analysis: The advantages of ABC analysis are given below:' Close and strict control of costly items is ensured. Investment in inventory can be regulated and funds can be utilised in the, best possible way. Economy is achieved in respect of stock carrying cost. It helps to keep enough safely stock for 'C' category items. Clerical cost can be reduced and inventory is maintained at optimum level. Scientific and selective control helps in maintenance of high stock turnover rate.

There are many techniques of management of inventory. Some of them are as shown in the figure 1.2

Figure 1.2: Inventory management techniques

1. ABC Analysis of Inventories The ABC inventory control technique is based on the principle that a small portion of the items may typically represent the bulk of money value of the total inventory used in the production process, while a relatively large number of items may from a small part of the money value of stores. The money value is ascertained by multiplying the quantity of material of each item by its unit price. According to this approach to inventory control high value items are more closely controlled than low value items. Each item of inventory is given A, B or C denomination depending upon the amount spent for that particular item. A or the highest value items should be under the tight control and under responsibility of the most experienced personnel, while C or the lowest value may be under simple physical control. It may also be clear with the help of the following examples: A Category 5% to 10% of the items represent 70% to 75% of the money value. B Category 15% to 20% of the items represent 15% to 20% of the money. C Category The remaining number of the items represent 5% to 10% of the money value. The relative position of these items show that items of category A should be under the maximum control, items of category B may not be given that much attention and item C may be under a loose control.

Methods of Inventory Control The following are the primary stock control methods that are often used by companies in their production operations. All these methods are well established and have been used in production industry for quite a long period of time. Min-Max Plan

In min-max plan, the cost accountant who is in charge of the inventory control, establishes two levels, the minimum and maximum level of stock. When the items/materials/units, reach the minimum level, the order to replenish the stock is placed. The maximum level is the level that the stock quantity should not exceed, as it will put a considerable strain on the finances of the company and will also create problems such as storage, wastage and over consumption. Two Bin System The two bin system is used to establish a connection between the order and reorder procedures. As mentioned above, from the point of view of a producer, uneven supply of stock and odd consumption is not very healthy. Such unevenness is sorted by twobin system. In such a system, the stock is sorted into two bins, or piles. The first stock (bin 1), is the larger of the two and is used up between the time period that lasts from purchase of stock till the reorder. The second stock (bin 2), can be used from the time when the reorder is placed till the order is actually received. The second stock, has a considerable amount of stand by that can be used for emergencies. Order Cycling System This system is based upon a review timetable. According to this system, a review of the entire inventory is done at regular intervals, such as 30 days, 60 days or 90 days. After the review is done, the cost accountant views stock items with low quantities that will not last up to the next review interval. The purchase order for such a stock item is placed immediately. The order cycling system is not exactly foolproof and one requires a rather experienced cost accountant to efficiently conduct it. ABC Analysis Any stock is segregated into different sections. These items are classified into 3 sections, A, B and C. The logic of segregating these items into sections is that section A consists of limited number of items that are very expensive. Section B has items that are not expensive and the number of units that is to be ordered is also not very large. The section C consists of numerous items, that have a low monetary value. The logic behind such segregation is that every section is viewed differently by the cost accountant, due the difference in order time, reorder time and delivery period. For example, though the unites in section A are less, their monetary value is also high and so is their delivery period. The ABC analysis is a simple and probably the most effective of all stock control methods.

There are many other methods such as FIFO and LIFO (issuance inventory valuation methods) that are considered to be very effective in controlling inventory. In addition to that, you might also refer to some established mathematical formulas such as economic ordering quantity.

Q.2 a.) A bond of Rs. 1000 value carries a coupon rate of 10% and has a maturity period of 6 years. Interest is payable semi-annually. If the required rate of return is 12%, calculate the value of the bond. ( 5marks)

b.) A bond whose par value is Rs. 500 bearing a coupon rate of 10% and has a maturity of 3 years. The required rate of return is 8%. What should be the price of the bond? ( 5marks)

Q.3 Examine the features & evaluation of decision-tree approaches.

Q.4 If the EPS is Rs.5, dividend pay-out ratio is 50%, cost of equity is 20% and growth rate in the ROI is 15%. What is the value of the stock as per Gordons Dividend Equalisation Model?

Q.5 Critically examine the pay-back period as a technique of approval of projects.

Q.6 Two companies are identical in all aspects except in the debt-equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40% and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach.

Q3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke Answer: S= 1000,000/.22 =4545454.5 B=25,00,000 =K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22 0.0496+.142 =.1915 or 19.15% V = 5000000/0.1915 = 26,109,660.57 * Critical assumption is ko remains constant. * An increase in cheaper debt funds is exactly offset by an increase in the required rate of return on equity. * As long as ki is constant, ke is a linear function of..