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Chapter 21

Management of short-term assets:

liquid assets and accounts receivable

Solutions to questions

1. The major types of short-term assets are:

(a)

inventory;

(b)

liquid assets, comprising cash and short-term investments; and

(c)

accounts receivable.

See Section 21.3 for definitions.

2. Retailers maintain relatively large inventories. Wholesalers also maintain relatively large inventories (to maintain supplies to retailers). They also hold high levels of accounts receivable. Because wholesalers have relatively few customers, most of whom deal with those wholesalers on a regular basis, this sector of business is well suited to credit provision. Hence the high level of accounts receivable.

3. Cash is held for liquidity purposes rather than profit. There is, therefore, an incentive to keep cash balances to a minimum. Outside the finance sector, short-term investments are generally held as a cash substitute rather than as investments for their own sake, so similar principles apply.

4. All of a company’s actions should have the ultimate goal of maximising shareholders’ wealth. However, cash and, to a lesser extent, inventory, are more easily considered as cost-minimisation problems. In principle, accounts receivable could be treated as an asset like any other asset. Chapter 22 applies NPV analysis to accounts receivable management.

5. The ‘maturity matching’ concept involves the maintenance of a balance between the maturity structures of assets and liabilities. Many companies believe that such a policy reduces risk. For example, a long-term asset will probably yield returns throughout its life, and those returns can then be used to meet commitments on long-term debt.

6. Obviously, forecasting is more difficult where there is uncertainty than where there is certainty. Note, however, that making a forecast of an aggregate amount (such as the total value of accounts receivable) is generally easier than making a forecast of a component amount (such as the value of a particular account receivable). Financial

managers are often more concerned with the total picture than with the constituent parts of the picture. Steps to minimise risk include the following:

(a) examining past trends in order to predict future needs;

(b)

being aware of regular cycles in company activity—for example, weekly wages bills and monthly or quarterly interest payments;

(c)

holding marketable securities as a ‘second line of defence’; and

(d)

arranging sources of finance to be called on when required—for example, overdraft or bill facilities.

7. The proportion of a company’s assets held in inventory depends on the nature of the business. Retailers, for example, are in the business of supplying goods to customers and will try to avoid a stockout. Inventory is, therefore, relatively large. In the service sector, inventory is smaller; it is impossible, for example, to maintain an inventory of ‘dental services’ or ‘accounting services’.

8. The benefits of holding inventory for a retailer include avoidance of stockout costs and maintenance of customer goodwill. In addition, costs such as the fixed costs of ordering will be incurred less frequently. It is convenient to think of the benefits as ‘costs avoided’. As a result, inventory management becomes a problem of cost minimisation.

Costs include acquisition costs (such as the ordering costs, and freight and handling costs), carrying costs (such as the opportunity cost of investment, costs of storage, insurance, deterioration and price movements) and stockout costs (such as lost sales).

Similar costs apply to the raw materials inventory held by a manufacturer. The major difference is that stockout costs refer to the costs of distribution to the production process. For example, labour and equipment may be left idle if a stockout occurs.

9. Many companies reorder inventory even though the inventory on hand exceeds the expected inventory usage during the lead time between reordering and receiving new supplies. The amount of the excess (over the expected usage) is often called ‘safety

stock’. For example, if average monthly usage is 1000 units and the lead time is 1 month,

a policy of reordering when the inventory level is 1250 units corresponds to a safety stock of 250 units.

A negative safety stock means that a new order is not placed until the current inventory level falls below the expected usage during the lead time. It is, therefore, very likely that

a stockout will occur before the end of the lead time. However, provided that the

stockout (if it occurs at all) does not occur until towards the end of the lead time, the

company may still be able to provide a high customer-service level throughout most of the lead time. Therefore, expected customer services can be at a high level notwithstanding that a negative safety stock is held.

10. While it is true that it is impossible to obtain precise measures of the necessary data, it does not follow that theoretical inventory management models are useless. This is because most such models are fairly robust to estimation errors, and, hence, can still work well in practice.

A demonstration of the robustness of the EOQ model can be found in Section 22.10.2

Solutions to problems

1. Q *

Use:

=

where

a

=

D

=

c

=

Then:

Q *

=

 

=

2 aD c
2
aD
c

$25 (per order)

5 000 (bottles per year)

$0.16 (per bottle per year) (2) (25) (5 000) 0.16
$0.16 (per bottle per year)
(2) (25) (5 000)
0.16

1 250 bottles

The economic order quantity is 1 250 bottles. As demand is 5 000 bottles per year, this suggests that orders should be placed 5 000/1 250 = 4 times per year. The period between orders will be 3 months.

2. Q *

Use:

=

where

a

=

D

=

c

=

Then:

Q *

=

 

=

2 aD c
2
aD
c

$75 (per order)

1 500 2 = 3 000 (per year)

$1.80 (per handle per year) (2) (75) (3 000) 1.80
$1.80 (per handle per year)
(2) (75) (3 000)
1.80

500 handles

The economic order quantity is 500 handles. Total cost is the sum of acquisition costs and carrying costs:

TC =

aD

Q

cQ

2

Under the present system, Q = 1 500 and therefore:

TC =

($75) (3 000)

($1.80) (1 500)

 
 

1500

2

=

$150 + $1 350

=

$1 500

Under the optimal system, Q = 500 and therefore:

TC =

(75) (3 000)

+

($1.80) (500)

 
 

500

2

=

$450 + $450

=

$900

Compared with the present system, the optimal system will therefore save $1 500 – $900 = $600 each year.

3.

From Problem 1, the optimal quantity to order in the absence of discounts is 1 250 bottles per order. The order quantities to be investigated are therefore 999, 1 250, 2 000, 3 000 and 4 000. Total cost consists of inventory purchase costs, acquisition costs and carrying costs:

TC

pD +

aD

Q

+

cQ

2

where a

=

$25 (per order)

D

=

5 000 (per year)

c

= $0.16 (per item per year)

that is :

TC

(a)

Q

=

TC

=

 

=

(b)

Q

=

TC

=

 

=

(c)

Q

=

TC

=

 

=

(d)

Q

=

TC

=

 

=

(e)

Q

=

TC

=

 

=

= 5 000

p

$125 000

+

Q

+ 0.08 Q

999 and P = 2:

(5000)($2) +

$125 000 + 0.08Q

Q

$10 205.05

1 250 and p = $1.99:

(5 000)($1.99) +

$125 000

1 250

$10 150.000

+ $(0.08)(1 250)

2 000 and p = $1.98:

(5 000)($1.98) +

$125

000 + $(0.08)(2 000)

2 000

$10 122.50

3 000 and p = $1.97:

(5 000)($1.97) +

$125 000

3 000

$10 131.67

+ $(0.08)(3 000)

4 000 and p = $1.96:

(5 000)($1.96) +

$125 000

4 000

$10 151.25

+ $(0.08)(4 000)

The new economic order quantity is 2 000 bottles as this achieves the lowest total cost.

4. If a reorder point of 180 is adopted, then on 2 per cent of occasions, a stockout will occur during the lead time. On these 2 per cent of occasions, demand will be 200 which exceeds the inventory held.

The easiest way to find the reorder point equivalent to an expected customer-service level of 98 per cent is to use trial and error. For example, if a reorder point of 150 is adopted, then:

Probability

Quantity demanded

Customer-service level

0.060

100

1.0000

0.150

120

1.0000

0.460

140

1.0000

0.166

160

150/160 = 0.9375

0.144

180

150/180 = 0.8333

0.020

200

150/200 = 0.7500

Expected customer-service level =

0.060 + 0.150 + 0.460 + (0.166) (0.9375) + (0.144) (0.8333) + (0.020) (0.7500) = 0.9606

The expected customer-service level is 96.06 per cent. Therefore, to achieve an expected customer-service level of 98 per cent, a higher reorder point is needed.

At a reorder point of 160, expected customer service level is:

0.060 + 0.150 + 0.460 + 0.166 + (0.144)

= 0.98

160

180

+ (0.020)

160

200

Therefore, a reorder point of 160 will achieve an expected customer-service level of 98

per cent.

5. (a)

(b)

TC =

aD cD

 

Q

2

where

Q

=

1 500 metres

D

=

4 500 metres

a

=

$250 (per order)

c

=

$1 (per metre per year)

TC

=

$250 (4 500/1 500) + $1 (1 500/2)

 

=

$1 500

If 1 095 metres are ordered, then:

TC

=

$250 (4 500/1 095) + $1 (1 095/2)

=

$1 575

If 2 055 metres are ordered, then:

TC

=

= $1 575

$250 (4 500/2 055) + $1 (2 055/2)

$1 575

$1 500

$1 500

100

5%

Consequently, if any quantity between 1 095 metres and 2 055 metres is ordered, the annual cost is within 5 per cent of the minimum. This implies that the total annual cost is relatively insensitive to errors made in the estimation process.