Cash Management Model

The economic-order quantity (EOQ) formula, basically used in inventory decision, has now come to be
popularly employed to determine the optimal level of cash holding for the firm. William Baumol was the
first man who applied the inventory model to the problem of cash management

According to the EOQ model, optimum level of cash should be determined by balancing the carrying cost
of holding cash (the interest foregone on marketable securities) against the fixed cost of transferring
marketable securities to cash or vice-versa so as to minimize total costs.

The level of cash at which the sum of inventory carrying costs and the fixed costs associated with
transferring marketable securities is minimum, will be the optimum cash balance of the firm:

Baumol model

Optimal level of cash can also be determined

algebraically by using the following formula:

where Q = Optimum size of cash inventory

C = Average fixed cash for securing cash from market

B = Total amount of transaction demand for cash over the period of time involved.

K = Cost of carrying the inventory of cash i.e., interest rate on marketable securities for the period.
The following illustration will make the mechanism of determination of optimal level of cash more
understandable:

Illustration I:

Jackson Company Limited estimated cash payments of Rs. 4 lakhs for a one-month period. The average
fixed cost for securing capital from the market is Rs. 1000 and the interest rate on marketable securities
is 12 percent per annum or 1.0 percent for one month period. What is the economic order size of cash?

Economic order size of cash in this instance will be:

The optimal transaction size of the company is Rs. 2,82,843 and the average cash balance is Rs. 1,41,421
(Rs. 2,82,843/2).

Evaluation

Inventory model of cash management is very useful to the firm in as much as it helps in determining
optimum level of cash holding. By using this model, finance manager can minimize costs of carrying and
maintaining cash. This model clearly indicates the idle cash balance which can be gainfully employed in
securities. It also saves the firm from dangers of illiquidity by furnishing advance signal and advising
when the securities of the firm have to be sold to obtain cash.

Thus, the finance manager can improve the efficiency of cash management with the help of the
inventory model. However, this model suffers from several practical problems. One such difficulty is
related with determination of fixed cost associated with replenishing cash. The fixed cost consists of
explicit and implicit cost. While explicit cost is determinable, it is very difficult to compute implicit cost.

Another limitation is that this model assumes a constant rate of inflow and outflow per period.
However, in real life cash flows are of stochastic nature, where cash flows are expected to be steady,
this model is applicable.
Cash Management Model # 2. Stochastic Model:

This model is based on the basic assumption that cash balances change randomly over a period of time
both in size and direction and form a normal distribution as the number of periods observed increases.
The stochastic nature of cash balances

The model prescribes two control limits—upper limit and lower limit. When cash balances reach the
upper limit a transfer of cash to investment account should be made and when cash balances reach the
lower point, a portion of securities constituting investment account of the firm should be liquidated to
return the cash balances to its normal point.

The upper and lower limits of control are set after taking into account fixed cost associated with
convening securities into cash and the vice-versa, and the cost of carrying stock of cash. Miller and Orr
have provided the simplest model to determine the optimal behaviour in a stochastic situation.

The model is essentially a control-limit model designed to determine the time and size of transfers
between an investment account and cash account.
The Miller and Orr model specifies two control limits designating ‘h’ for upper limit and 0 (zero)
for the lower limit. The model is illustrated in figure 36.4. According to the model, when cash balances
of the firm reach the upper limit, cash equal to h-z should be invested in marketable securities (i.e.
investment account) so that new cash balance touches Z point.

If the cash balances touch 0 point, the finance manager should immediately liquidate that much portion
of the investment portfolio which could return the cash balance to Z point.

It may be interesting to note that cash balances are allowed to wander in h, z space and no control is
called for so long as the cash balance stays there. The model sets Z as the target cash balance level.

Z and h, therefore, become levels determined to maximise profits.

The optimal value of Z is determined by the following formula:

Q2. Inventory management: Introduction, type of control required, other

control devices.
Ans2. INTRODUCTION

Inventory management is concern with keeping enough product on hand to avoid running out
while at the same time maintaining a small enough inventory balance to allow for a reasonable return
on investment. Proper inventory management is important to the financial health of the corporation;
being out of stock forces customers to turn to competitors or results in a loss of sales. Excessive level of
inventory, however, results in large inventory carrying costs, including the cost of capital tied up in
inventory warehouse fees, insurance etc.

OBJECTIVES

There are two objectives of investment management:

To minimize investment in inventory,

To meet a demand for a product by efficiently organizing the production and sales operations.
That the firm should minimize investment implies that maintaining inventory involves costs, such that
the smaller the inventory, the lower is the cost to the firm. But inventories also provide benefits to the
extent that they facilitate the smooth functioning of the firm : the larger the inventory, the better it is
from this point of view. An optimum level of inventory should be determined on the basis of the trade-
off between costs and benefits associated with the level of inventory.

COSTS OF HOLDING INVENTORY

The cost associated with inventory fall into to basic categories:

Ordering costs,
Carrying costs.

Ordering cost is associated with the acquisition or ordering of inventory. Ordering costs are the costs
involved in:

Preparing of purchase order or requisition form.

Receiving, inspecting, and recording the goods received to ensure both quality and quantity.

It is generally fixed per order placed. The acquisition costs are inversely related to the size of inventory.

Carrying costs are associated with maintaining inventory. This may be divided into two broad
categories:

1. Cost of storing inventory :(i) Storage cost, that is, tax, depreciation, insurance
(ii) Insurance of inventory against fire and theft.

2. The opportunity cost of funds:

This consists of expenses in raising funds to finance the acquisition of inventory. If funds not locked up
in inventory, they would have earned a return.
TECHNIQUES OF INVENTORY MANAGEMENT

There are four methods of inventory control which are as follows:

ABC System
EOQ Model
Order point problem.

ABC System: The ABC System classifies different types of inventories to determine the type and
degree of control required for each. This technique is based on the assumption that a firm should
not exercise the same degree of control on all items of inventory. It should rather keep a more
rigorous control on items that are the most costly, while items at are less expensive should be given
less control effort.

On the basis of cost involved, the various inventory items are categorized into three classes(i) A
(ii) B and (iii) C. The items included in group A involved the largest investment. Inventory control
should be the most rigorous and intensive and the most sophisticated inventory control techniques
should be applied on these items. The C group consists the items of inventory which involve
relatively smaller investments although the number of items is fairly large. These items deserve
minimum attention. The group B stands midway. It deserve less attention then A but more than C.
It can be controlled by employing less sophisticated techniques.

EOQ Model: It is necessary for every firm to determine that quantity of inventory which it requires to
purchase in a lot, which (i) does not result in blockage of money in idle inventory, (ii) does not affect
smooth production process. In other words a firm should not place neither too large nor too small
orders. Costs associated with inventory are of two types

Ordering costs
Carrying costs

On the basis of a trade-off between benefits derive from the availability of inventory and the cost of
carrying that a level of inventory, the optimum level of the order to be placed should be determined.
This optimum level is known as economic order quantity (EOQ).

Assumptions:

1. The firm known with certainty the annual usage of a particular item of inventory.
2. The rate at which the firm uses inventory steady over time.
3. The orders placed to replenish inventory stocks are received at exactly that point in time when
inventories reach zero.

Limitations:

1. The assumption of a constant usage and the instantaneous replenishment of inventories are of
doubtful validity.
2. The assumption of a known annual demand for inventories is open to question.