WCM0 Apple Co has annual sales revenue of $6 million and all sales are on 30 days’ credit, although customers in

average take ten days more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts.
Accounts Receivable are financed by an overdraft at an annual interest rateof 7%

Apple Co plan to offer an early settlement discount of 1.5% for payment within 15 days and to extend the maximum credit
offered to sixty days. The company expects that these changes will increase annual credit sales by 5%, while also leading to
additional incremental cost equal to 0.5% of sales revenue. The discount is expected to be taken by 30% of customers, while the
remaining customers taking an average 60 days to pay.

Requirements:
Evaluate whether the proposed change in credit policy will increase the profitability of Apple co.

ANS
Evaluation of change in credit policy
Current average collection period= 30+10=40 days
Current account receivable= 6m x 40/365 = $ 657,534
Average collection period under new policy = (0.3 x 15) = (0.7 x 60) =46.5 days
New level of credit sales =$6.3 million
Account Receivable after policy change=6.3 x 46.5 /365= $802,603
Increase in financing cost ( $802,603-$ 657,534)

$
Increase in financial cost 10,155
Incremental costs 6.3 m x0 .005 = 31,500
Cost of discount = 6.3 x 0.015 x 0.3 = 28,350
Increase in cost 70,005
Contribution from increased sales = 6m x 0.05 x 0.6 180,000
Net benefit of the policy change 109,995

The proposed policy change will increase the profitability of Apple co.

WCM1 FLG Co has annual credit sales of $4·2 million and cost of sales of $1·89 million. Current assets
consist of inventory and accounts receivable. Current liabilities consist of accounts payable and an overdraft with an
average interest rate of 7% per year. The company gives two months’ credit to its customers and is allowed, on
average, one month’s credit by trade suppliers. It has an operating cycle of three months.

Other relevant information:

Current ratio of FLG Co 1·4

Cost of long-term finance of FLG Co 11%

Required:

(a) Discuss the key factors which determine the level of investment in current assets. (6 marks)

(b) Calculate the size of the overdraft of FLG Co, the net working capital of the company and the total cost of
financing its current assets. (6 marks)

(c) FLG Co wishes to minimise its inventory costs. Annual demand for a raw material costing $12 per unit is 60,000
units per year. Inventory management costs for this raw material are as follows:

Ordering cost: $6 per order

Holding cost: $0·5 per unit per year

The supplier of this raw material has offered a bulk purchase discount of 1% for orders of 10,000 units or more. If
bulk purchase orders are made regularly, it is expected that annual holding cost for this raw material will increase to
$2 per unit per year.

Required:

(i) Calculate the total cost of inventory for the raw material when using the economic order quantity. (4
marks)

(ii) Determine whether accepting the discount offered by the supplier will minimise the total cost of inventory
for the raw material. (4 marks)

ANS

(a) There are a number of factors that determine the level of investment in current assets and their relative importance varies from
company to company.
Length of working capital cycle
The working capital cycle or operating cycle is the period of time between when a company settles its accounts payable and when
it receives cash from its accounts receivable. Operating activities during this period need to be financed and as the operating
period lengthens, the amount of finance needed increases. Companies with comparatively longer operating cycles than others in
the same industry sector, will therefore require comparatively higher levels of investment in current assets.
Terms of trade
These determine the period of credit extended to customers, any discounts offered for early settlement or bulk purchases, and any
penalties for late payment. A company whose terms of trade are more generous than another company in the same industry sector
will therefore need a comparatively higher investment in current assets.
Policy on level of investment in current assets
Even within the same industry sector, companies will have different policies regarding the level of investment in current assets,
depending on their attitude to risk. A company with a comparatively conservative approach to the level of investment in current
assets would maintain higher levels of inventory, offer more generous credit terms and have higher levels of cash in reserve than
a company with a comparatively aggressive approach. While the more aggressive approach would be more profitable because of
the lower level of investment in current assets, it would also be more risky, for example in terms of running out of inventory in
periods of fluctuating demand, of failing to have the particular goods required by a customer, of failing to retain customers who
migrate to more generous credit terms elsewhere, and of being less able to meet unexpected demands for payment.
Industry in which organisation operates
Another factor that influences the level of investment in current assets is the industry within which an organisation operates.
Some industries, such as aircraft construction, will have long operating cycles due to the length of time needed to manufacture
finished goods and so will have comparatively higher levels of investment in current assets than industries such as supermarket
chains, where goods are bought in for resale with minimal additional processing and where many goods have short shelf-lives.

(b) Calculation of size of overdraft

Inventory period = operating cycle + payables period – receivables period = 3 + 1 – 2 = 2 months
Inventory = 1·89m x 2/12 = $315,000
Accounts receivable = 4·2m x 2/12 = $700,000
Current assets = 315,000 + 700,000 = $1,015,000
Current liabilities = current assets/current ratio = 1,015,000/1·4 = $725,000
Accounts payable = 1·89m x 1/12 = $157,500
Overdraft = 725,000 – 157,500 = $567,500
Net working capital = current assets – current liabilities = 1,015,000 – 725,000 = $290,000
Short-term financing cost = 567,500 x 0·07 = $39,725
Long-term financing cost = 290,000 x 0·11 = $31,900
Total cost of financing current assets = 39,725 + 31,900 = $71,625

(c) (i) Economic order quantity = (2 x 6 x 60,000/0·5)0·5 = 1,200 units

Number of orders = 60,000/1,200 = 50 order per year
Annual ordering cost = 50 x 6 = $300 per year
Average inventory = 1,200/2 = 600 units
Annual holding cost = 600 x 0·5 = $300 per year
Inventory cost = 60,000 x 12 = $720,000
Total cost of inventory with EOQ policy = 720,000 + 300 + 300 = $720,600 per year
(ii) Order size for bulk discounts = 10,000 units
Number of orders = 60,000/10,000 = 6 orders per year
Annual ordering cost = 6 x 6 = $36 per year
Average inventory = 10,000/2 =5,000 units
Annual holding cost = 5,000 x 2 = $10,000 per year
Discounted material cost =12 x 0·99 = $11·88 per unit
Inventory cost = 60,000 x 11·88 = $712,800
Total cost of inventory with discount = 712,800 + 36 + 10,000 = $722,836 per year
The EOQ approach results in a slightly lower total inventory cost

WCM2 WQZ Co is considering making the following changes in the area of working capital management:
Inventory management
It has been suggested that the order size for Product KN5 should be determined using the economic order quantity
model (EOQ).

WQZ Co forecasts that demand for Product KN5 will be 160,000 units in the coming year and it has traditionally
ordered 10% of annual demand per order. The ordering cost is expected to be $400 per order while the holding cost
is expected to be $5·12 per unit per year. A buffer inventory of 5,000 units of Product KN5 will be maintained,
whether orders are made by the traditional method or using the economic ordering quantity model.

Receivables management

WQZ Co could introduce an early settlement discount of 1% for customers who pay within 30 days and at the same
time, through improved operational procedures, maintain a maximum average payment period of 60 days for credit
customers who do not take the discount. It is expected that 25% of credit customers will take the discount if it were
offered.

It is expected that administration and operating cost savings of $753,000 per year will be made after improving
operational procedures and introducing the early settlement discount.

Credit sales of WQZ Co are currently $87·6 million per year and trade receivables are currently $18 million. Credit
sales are not expected to change as a result of the changes in receivables management. The company has a cost of
short-term finance of 5·5% per year.

Required:
(a) Calculate the cost of the current ordering policy and the change in the costs of inventory management that
will arise if the economic order quantity is used to determine the optimum order size for Product KN5. (6
marks)

(b) Briefly describe the benefits of a just-in-time (JIT) procurement policy. (5 marks)

(c) Calculate and comment on whether the proposed changes in receivables management will be acceptable.
Assuming that only 25% of customers take the early settlement discount, what is the maximum early
settlement discount that could be offered? (6 marks)

ANS
(a) Cost of the current ordering policy
Order size = 10% of 160,000 = 16,000 units per order
Number of orders per year = 160,000/16,000 = 10 orders per year
Annual ordering cost = 10 x 400 = $4,000 per year
Holding cost ignoring buffer inventory = 5·12 x (16,000/2) = $40,960 per year
Holding cost of buffer inventory = 5·12 x 5,000 = $25,600 per year
Total cost of current policy = 4,000 + 40,960 + 25,600 = $70,560 per year
Cost of the ordering policy using the EOQ model
Order size = (2 x 400 x 160,000/5·12)0·5 = 5,000 units per order
Number of orders per year = 160,000/5,000 = 32 orders per year
Annual ordering cost = 32 x 400 = $12,800 per year
Holding cost ignoring buffer inventory = 5·12 x (5,000/2) = $12,800 per year
Holding cost of buffer inventory = 5·12 x 5,000 = $25,600 per year
Total cost of EOQ policy = 12,800 + 12,800 + 25,600 = $51,200 per year
Change in costs of inventory management by using EOQ model
Decrease in costs = 70,560 – 51,200 = $19,360
Examiner’s Note, Since the buffer inventory is the same in both scenarios, its holding costs do not need to be included in
calculating the change in inventory management costs.
(b) Holding costs can be reduced by reducing the level of inventory held by a company. Holding costs can be reduced to a
minimum if a company orders supplies only when it needs them, avoiding the need to have any inventory at all of inputs to the
production process. This approach to inventory management is called just-in-time (JIT) procurement.
The benefits of a JIT procurement policy include a lower level of investment in working capital, since inventory levels have been
minimised: a reduction in inventory holding costs; a reduction in materials handling costs, due to improved materials flow
through the production process; an improved relationship with suppliers, since supplier and customer need to work closely
together in order to make JIT procurement a success; improved operating efficiency, due to the need to streamline production
methods in order to eliminate inventory between different stages of the production process; and lower reworking costs due to the
increased emphasis on the quality of supplies, since hold-ups in production must be avoided when inventory between production
stages has been eliminated.

(c) Evaluation of changes in receivables management

The current level of receivables days = (18/87·6) x 365 = 75 days
Since 25% of credit customers will take the discount, 75% will not be doing so.
The revised level of receivables days = (0·25 x 30) + (0·75 x 60) = 52·5 days
Current level of trade receivables = $18m
Revised level of trade receivables = 87·6 x (52·5/365) = $12·6m
Reduction level of trade receivables = 18 – 12·6 = $5·4m
Cost of short-term finance = 5·5%
Reduction in financing cost = 5·4m x 0·055 = $297,000
Administration and operating cost savings = $753,000
Total benefits = 297,000 + 753,000 = $1,050,000
Cost of early settlement discount = 87·6m x 0·25 x 0·01 = $219,000
Net benefit of early settlement discount = 1,050,000 – 219,000 = $831,000
The proposed changes in receivables management are therefore financially acceptable, although they depend heavily on the
forecast savings in administration and operating costs. Maximum early settlement discount
Comparing the total benefits of $1,050,000 with 25% of annual credit sales of $87,600,000, which is $21,900,000, the
maximum early settlement discount that could be offered is 4·8% (100 x (1·050/21·9)).