CHAPTER FOUR

MANAGING CURRENT ASSETS

4.1. Working capital terminologies

Every business needs funds for short-term purposes to finance current operations.
Working capital is the capital required for day-to-day working of the concerned organization.
Investment in short term assets like cash, inventories, account receivables etc., is called
Short-term funds or working capital. The working capital can be categorized, as funds
needed for carrying out day-to-day operations of the business smoothly.

Working capital

Current Current

asset liability

Cash in hand Bills payable

Cash at bank outstanding expenses
Bill receivables Short term loans advances
Accounts Receivables Dividend payable
Inventories Bank overdraft
Prepaid expenses Provision for taxation
Accrued incomes
Short-term Investments
Working capital management is the administration of the company‘s current assets and
the financing needed to support current assets.
Working capital management is an act of planning, organizing and controlling the
components of working capital like cash, bank balance, inventory, receivables, payables,
overdraft and short-term loans.
Working capital management is the administration of current assets and current
liabilities. Effective management of working capital ensures that the organization is

1|Page
maximizing the benefits from net current assets by having an optimum level to meet
working capital demands.
Working capital management is concerned with the problems that arise in attempting to
manage the current assets, current liabilities and the interrelationship that exist between
them.

The objective of working capital management is to manage the company‘s current assets
and liabilities in a way that a reasonable level of working capital is maintained. If a
company is unable to keep up a suitable level of working capital; it is likely to turn out to
be bankrupt and may even be forced into insolvency. The current assets must be adequate
to cover up its current liabilities in order to make sure a rational margin of wellbeing.
Each of the current assets must be managed effectively in order to keep up the liquidity of
the company whilst not retaining too high level of any one of those.

The Concept of Working Capital Management

There are two major concepts of working capital net working capital and gross working
capital.
When accountants use the term working capital, they are generally referring to net
working capital, which is the dollar difference between current assets and current
liabilities. This is one measure of the extent to which the firm is protected from liquidity
problems.
NWC = C A – CL
Gross Working Capital is the general concept which determines the working capital concept.
Thus, the gross working capital is the capital invested in total current assets of the business
concern. Gross Working Capital is simply called as the total current assets of the concern.
GWC = TCA
4.2. Alternative current asset investment policies

Working Capital Issues

In determining the appropriate amount, or level, of current assets, management must

consider the trade-off between profitability and risk. To illustrate this trade-off, suppose
that, with existing fixed assets, a firm can produce up to 100,000 units of output a year.
Production is continuous throughout the period under consideration, in which there is a

2|Page
particular level of output. For each level of output, the firm can have a number of different
levels of current assets. Let‘s assume, initially, three different current asset policy
alternatives. The relationship between output and current asset level for these alternatives
is illustrated below:

We see from the figure that the greater the output, the greater the need for investment in
current assets to support that output (and sales). However, the relationship is not linear;
current assets increase at a decreasing rate with output. This relationship is based on the
notion that it takes a greater proportional investment in current assets when only a few
units of output are produced than it does later on, when the firm can use its current assets
more efficiently.

If we equate liquidity with conservativeness, Policy A is the most conservative of the

three alternatives. At all levels of output, Policy A provides for more current assets than
any other policy. The greater the level of current assets, the greater the liquidity of the
firm, all other things equal. Policy A is seen as preparing the firm for almost any
conceivable current asset need; it is the financial equivalent to wearing a belt and
suspenders. Policy C is least liquid and can be labeled aggressive.

If we can reduce the firm‘s investment in current assets while still being able to properly
support output and sales, ROI will increase. Lower levels of cash, receivables, and
inventory would reduce the denominator in the equation; and net profits, our numerator,
would remain roughly the same or perhaps even increase. Policy C, then, provides the
highest profitability potential as measured by ROI.

3|Page
However, a movement from Policy A toward Policy C results in other effects besides
increased profitability. Decreasing cash reduces the firm‘s ability to meet financial
obligations as they come due. Decreasing receivables, by adopting stricter credit terms
and a harsher enforcement policy, may result in some lost customers and sales.
Decreasing inventory may also result in lost sales due to products being out of stock.
Therefore more aggressive working capital policies lead to increased risk.

HIGH LOW

Liquidity Policy A Policy B Policy C

Profitability Policy C Policy B Policy A

Risk Policy C Policy B Policy A

Ultimately, the optimal level of each current asset (cash, marketable securities,
receivables, and inventory) will be determined by management‘s attitude to the
trade-off between profitability and risk.

Objectives of working capital management

One of the two key objectives of working capital management is to ensure liquidity.
A business with insufficient working capital will be unable to meet obligations as
they fall due, leading to late payments to employees, suppliers and other providers of
credit. Late payments can result in lost employee loyalty, lost supplier discounts and
a damaged credit rating. Non-payment (default) can lead to the compulsory
liquidation of assets to repay creditors.

The other key objective is profitability. Funds tied up in working capital tend to earn
little, or no, return. Hence, a company with a high level of working capital may fail
to achieve the return on capital employed (Operating profit ÷ (Total equity and long-
term liabilities)) expected by its investors. Therefore, when determining the
appropriate level of working capital there is a trade-off between liquidity and
profitability:

4|Page
Although an optimal level of working capital may exist it may not be achievable due to
factors beyond management‘s control, such as an unreliable supply chain influencing
inventory levels. However businesses must at least avoid the extremes:

 Over-trading - insufficient working capital to support the level of business activities.

This can also be described as under-capitalization and is characterized by a high and
rising proportion of short-term finance to long-term finance
 Over-capitalization - an excessive level of working capital, leading to inefficiency.
Main Components of Working Capital management

1. Cash management

Cash is one of the important components of current assets. It is needed for performing all
the activities of a firm, i.e. for acquisition of raw materials to marketing of finished goods.
Therefore it is essential for a firm to maintain an adequate cash balance. One of the
important functions of a finance manager is to match the inflows and outflows of cash so
as to maintain adequate cash.
i. Meaning of Cash: With reference to cash management cash has two
meanings-ready cash and near cash. Currency notes, coins, bank balances are the
examples of ready cash whereas marketable securities, treasury bills, etc. are the
examples of near cash. Management of cash means management of both ready
cash as well as near cash.
ii. Reasons for Holding Cash: three reasons for holding cash.

5|Page
 Transaction Motive: The need to hold cash to satisfy normal disbursement and
collection activities associated with a firm’s ongoing operations, the need to have
cash on hand to pay bills. This refers to holding of cash to meet routine payments
such as purchases, wages, operating expenses, etc. Cash is collected from sales, the
selling of assets and new financing.

Precautionary Motive: This refers to holding of cash to meet unexpected demands

for cash such as to meet the extra cash payment for purchase of raw materials due to
increase in cost of raw materials. It is the need for a safety supply to act as a
financial reserve. Once again, there probably is a precautionary motive for liquidity.

Speculative Motive: This refers to holding of cash to take advantage of favorable

market conditions such as to purchase excess quantity of raw materials for getting a
handsome discount. In this case the need to hold cash to take advantage of
additional investment opportunities, such as bargain purchases is the need to hold
cash in order to be able to take advantage,

Cash management cycle

Cash is the form of money, which is involved, with all operations of business as
inflows or outflows. Cash management can basically categorize into;

 Cash outflow like, purchases, payment to expenses and

services;
 Cash balance held at any point of time.
A cash management cycle is used to explain the basic function of cash management.
It is defined as the process of identifying various cash inflows and making them
available to business needs as cash outflows, maintaining the objective of liquidity
and profitability. The following diagram explains the basic process of cash
management cycle.

Cash management cycle

6|Page
 Increases
Cash inflows

Business
Cash balance
Decreases Cash outflows

Any firm can be successful with its cash management, when it is able to achieve the
following objectives:

1. Cash Planning: the process of estimating cash inflows and outflows to project cash
surplus or deficit for future planning period. A cash budget is used to serve this
objective.
2. Managing cash flows: The cash flows should be properly managed to avoid the
variance between planned events to actual event. Accelerating cash inflows and
decelerating cash outflows can achieve this.
3. Optimum Cash Balance: It is always essential to determine appropriate cash balance.
The cost of excess of cash holding and also the danger of cash deficiency should be
matched to determine the optimum level of cash balance.
4. Investing surplus/Borrowing deficit: The surplus cash balance over and above the
minimum balance should be always is invested in the profitable ventures, while the
deficit balance should be arranged from various financing sources.
Better cash management improving control over cash collection and disbursements can
achieve this. The objective of Cash management can be achieved by accelerating cash
collection and decelerating cash payments to the possible extent. Cash management
should always aim to achieve the following objectives:

• Liquidity: Business units should satisfy the primary objective of cash availability
for all business needs.
• Safety: Cash availability will always impose risk of loss; therefore, the second
objective of cash management is to avoid the risk of loss, or thefts.
• Profitability: final objective of cash management is earning a highest possible
return after satisfying the above two objectives.

7|Page
 Cash management models/estimating cash balances

To help in determining optimum cash balance, several types of cash management

models have been designed. Out of such models, two of them are,

1. Baumol‘s model and 2. The Miller-Orr Model.

1. Baumol’s Model

Baumol‘s model, suggested by William J. Baumol, considers cash management similar to

an inventory management problem. It is a formal approach in determining a firm‘s
optimum cash balance under certainty.
According to this model, optimum cash level is that the level of cash where the carrying
(holding) costs and transactions costs are the minimum. As such, the firm attempts to
minimize the cost of holding cash and the cost of converting marketable securities into
cash.
The Baumol‘s model is subject to the following assumption: -
a) The firm can forecast its cash requirement with certainty.
b) The firm‘s cash payments are uniform over a period of time.
c) The firm‘s opportunity cost of holding cash is known and it is the same
over time.
d) Whenever the firm converts securities into cash, its transaction cost will be
the same.
The objective is to minimize the sum of the fixed costs of transactions and the opportunity cost
of holding cash balances. These costs are expressed as:

b x (T/C) + (iC/2)
where: b=the fixed cost of a transaction (F),

T=the total cash needed for the time period involved,

i=the interest rate on marketable securities, and

C=cash balance. The optimal level of cash or the optimal cash balance is determined
using the following formula:

8|Page
 EXAMPLE: You estimate a cash need for $4,000,000 over a 1-month period where the
cash account is expected to be disbursed at a constant rate. The opportunity interest rate is
6 percent per annum or 0.5 percent for a 1-month period. The transaction cost each time
you borrow or withdraw is $100.
Determine the optimal cash balance and the number of transactions you should make
during the month?
Given: b = 100, T = 4,000,000 and i = 0.005

i. The optimal cash balance is $400,000.

ii. The average cash balance is: C* /2 = $400,000/2 = $200,000
iii. The number of transactions required are: T/ C*
$4,000,000/$400,000 = 10 transactions during the month:
 Carrying (holding) cost: It is the cost of holding cash i.e., the interest foregone on
marketable securities. It is also termed as opportunity cost of keeping cash balance. In case
the opportunity cost is “i”, then the firm‘s carrying cost for maintaining an average cash
balance is: -

Carrying (holding) cost = i(C* /2)

 Transaction cost is the cost involved in getting the marketable securities converted
in to cash. If per-transactions cost is Ct‖, then the total transaction cost is: -
Transactions cost = b (T/ C*)

Total cost = Holding cost + Transaction cost

= i(C*/2) + b (T/C*)

Notes

9|Page
 The average cash balance = C* /2
The number of transactions required = T/ C*
Interest income forgone = Average cash balance x Interest rate for the cash planning period;
Interest rate = annual yield/4
Cost of cash conversion= Number of cash conversion x Cost per conversion.
Total cost of converting and holding cash = Interest income forgone + Cost of cash
conversion.
Illustration: A firm anticipates Br. 240,000 cash outlays/ annual demand per annum.
Investment earnings rate is given as 12 percent per annum and the cost per transaction of
investment is Br.100 per sale/purchase. Calculate:

a.The optimum cash balance of the firm/ economic conversion quantity

b. The number of conversions
c.The total cost
Limitation of the Baumol model
 Unrealistic assumption of the constant cash demand: in practice the
demand for cash usually is fluctuating.
 ignores cash receipts during the period
 doesn’t allow for safety cash reserves
 There are uncertainties in the pattern of future cash flows.
THE MILLER-ORR MODEL

Miller-Orr (MO) Model helps in determining the optimum level of cash when the demand
for cash is not steady and cannot be known in advance. Thus, this model helps to
overcome the limitation of Baumol‘s model where the cash flows are not allowed to
fluctuate.

Cash management system designed to deal with cash inflows and outflows that fluctuate
randomly from day to day. With this model, we again concentrate on the cash balance, but,
in contrast to the Baumol model, we assume that this balance fluctuates up and down randomly
and that the average change is zero.
The Miller–Orr model places an upper and lower limit for cash balances.

10 | P a g e
  When the upper limit is reached a transfer of cash to marketable securities or other
suitable investments is made.
 When the lower limit is reached a transfer from securities to cash occurs. A transaction
will not occur as long as the cash balance falls within the limits.
In order to manage its cash balance, the company can employ a mathematical model, one of
which is the Miller-Orr model. The Miller-Orr model helps the company to meet its cash
requirements at the lowest possible cost by placing upper and lower limits on cash
balances. The operation of the model is as follows:
(i) A company should have its desired cash level, an upper limit and lower limit on cash
balances.

(ii) When the cash balance reaches the upper limit, the company has too much cash. It then
should use its cash to buy marketable securities in order to bring the cash balance back
to its desired cash level.

(iii) When the cash balance hits the lower limit, the company lacks cash. It then sells its
securities in order to bring the cash balance back to its desired cash level.

(iv) If the cash balance lies between the upper and lower limits, there will be no transaction in
securities.
The Miller-Orr model increases its practicability by incorporating an assumption that cash
balances randomly fluctuate and therefore are uncertain.
a. The formula in determining the desired (target) cash level is as follows:

where z = desired cash level

Z=
4r √
3 Fσ 2
3
+L

F = fixed transaction cost of buying and selling marketable securities

σ2 = variance of daily cash flows (which indicates its randomness)
r = daily interest rate on marketable securities
L = minimum cash balance
b. The upper limit cash balance is then determined as:

Upper Limit = 3Z – 2L

11 | P a g e
 c. The average cash balance:

- 􀀀L
ACB = 4Z
3
Example: ABC co. wants to maintain a minimum cash balance of $500,000. The estimated
variance of the daily cash flows is $1,200,000 per day and the cost for each transaction of
buying and selling marketable securities is fixed at $10,000. The marketable securities yield 3%
per year. ABC co. wants to use the Miller-Orr model to determine its desired cash balance.

a. ABC co.’s desired (target) cash level is:

given: F = 10,000
σ2 = 1,200,000
L = 500,000
r = 0.03/365

Z=
√3 3(10 , 000)1 ,200 , 000
4 (0 .03/365)
+ 500 ,000

= 547,356
b. The upper limit for ABC co.’s cash balance is:

Upper Limit = 3(547,356) – 2(500,000)

= 642,068
c. The average cash balance; ACB = 4Z - L
3
4*547,356 – 500,000
3
= 563,141
The decision rule by the Miller-Orr model is then as follows:
(i) Sweets Ltd. should set the desired cash balance at $547,356.
(ii) When the cash balance reaches the upper limit of $642,068, Sweets Ltd. has too much cash. It
then should use its cash to buy $94,712 ($642,068 - $547,356) marketable securities in order
to bring the cash balance back to its desired cash level (i.e. $547,356).
(iii) When the cash balance hits the lower limit of $500,000, the company lacks cash. It then sells
$47,356 ($547,356 - $500,000) of its securities in order to bring the cash balance back to its
desired cash level (i.e. $547,356).
(iv) If the cash balance lies between the upper and lower limits (i.e. between $500,000 and
$642,068), there will be no transaction in securities.
12 | P a g e
Note 1: The return (r) used in the Miller-Orr model represents daily return. If the given return is
annual interest rate, remember to divide it by 365 (number of days in the year) to obtain the
daily interest rate.
Note 2: The desired cash level and the upper limit of cash balance are affected by three factors:
(i) fixed transaction costs; (ii) variance of cash flows; and (iii) interest rate of marketable
securities as return.
RECEIVABLES MANAGEMENT

Granting credit to the customers is the essential marketing principle, which expands the
volume of sales for every business unit. A firm granting credit to its customers does not
receive cash immediately for its sales, but creates receivables that constitute a substantial
portion in the current assets. The time interval between the date of sale and the date of
collection has to be financed out of working capital. Such funds have to arrange from
banks or other financing sources that consume additional interest expenses. Thus, the
receivables investment represents investment in credit sales that increase profitability on
one hand and additional investment cost (interest on additional borrowings both on
investment and extended period of repayment).

A company allows its customers to purchase on credit (i.e. without paying at once). After
some days (credit period) lapse, the customers will settle the accounts according to the
sales agreement previously fixed. If the customers default on the payments, the company
would suffer from bad debts loss. This must be controlled by a strong and flexible ‗Credit
Policy‘.

Factors Affecting the Size of Receivables:

The size of receivables is determined by a number of factors for receivables being a major
component of current assets. As most of them varies from business to business in
accordance with the nature and type of business. Therefore, to discuss all of them would
prove irrelevant and time consuming. Some main and common factors determining the
level of receivable are discussed below:

Stability of Sales - Stability of sales refers to the elements of continuity and

consistency in the sales. In other words, the seasonal nature of sales violates the
continuity of sales in between the year. So, the sale of such a business in a particular

13 | P a g e
 season would be large needing a large a size of receivables. Similarly, if a firm
supplies goods on installment basis it will require a large investment in receivables.

Terms of Sale A firm may affect its sales either on cash basis or on credit basis.
As a matter of fact, credit is the soul of a business. It also leads to higher profit level
through expansion of sales. The higher the volume of sales made on credit, the
higher will be the volume of receivables and vice-versa.

The Volume of Credit Sales It plays the most important role in determination of
the level of receivables. As the terms of trade remains more or less similar to most of
the industries. So, a firm dealing with a high level of sales will have large volume of
receivables.

Establishment of credit policy

Finance manager can affect the volume of credit sales and collection period and
consequently, investment in accounts receivables. This is possible through establishment
of credit policy, retaining the terms of credit under the control of the business.

Components of Credit Policy

If a firm decides to grant credit to its customers, then it must establish procedures for
extending credit and collecting. The firm will have to deal with the following components
of credit policy:

a. Credit standards: This criterion will decide the type of customer to whom
credit can be allowed with the credit limit. Allowing credit to more slow-repaying
customer will increase investment in receivables and vice-versa. Increase in
investment may result in increase in risk of default (non-collection of debt).
b. Credit terms: It specifies duration of credit (in time) and terms of
payments (discounts) by the customer. Investment in accounts receivables will be
high if customers are allowed extended credit period in making payments and
decreases with reduction in credit period. Alternatively offering a discount on
early payments by the customer will reduce the investments as well as the credit
period. This is also referred as accelerating collection policy.
c. Collection efforts/policy.: Collection efforts will increase the expenses on
investment by payment of charges of collection in case of collection done by

14 | P a g e
 outsiders, and payroll expenses if done by internal staff. Collection charges will
depend on the collection period. Lower the collection period lower will the
collection charges and vice-versa. The policy, practice and procedure adopted by a
business enterprise in granting credit, deciding as to the amount of credit and the
procedure selected for the collection also greatly influence the level of receivables
of a concern.

The Investment in Receivables

The total amount of accounts receivable outstanding at any given time is determined by
two factors: (1) the credit sales per day and (2) the average length of time it takes to
collect cash on accounts receivable:

Accounts receivable = Credit sales per day × Length of collection period

For example-Boston Lumber Company , a wholesale distributor of lumber products,

opens a warehouse on January 1 and, starting the first day, makes sales of $1,000 each
day. For simplicity, we assume that all sales are on credit and that customers are given 10
days to pay. Find Account receivable?

Accounts receivable = Credit sales per day × Length of collection period

= $1,000 × 10 days = $10,000

If either credit sales or the collection period changes, these changes will be reflected
in the accounts receivable balance..

Credit Policy Effects

In evaluating credit policy, there are five basic factors to consider:

1. Revenue effects: If the firm grants credit, then there will be a delay in revenue
collections as some customers take advantage of the credit offered and pay later.
However, the firm may be able to charge a higher price if it grants credit and it may be
able to increase the quantity sold. Total revenues may thus increase.
2. Cost effects: Although the firm may experience delayed revenues if it grants credit, it
will still incur the costs of sales immediately. Whether the firm sells for cash or credit,
it will still have to acquire or produce the merchandise (and pay for it).

15 | P a g e
3. The cost of debt: When the firm grants credit, it must arrange to finance the resulting
receivables. As a result, the firm‘s cost of short-term borrowing is a factor in the
decision to grant credit.
4. The probability of nonpayment: If the firm grants credit, some percentage of the
credit buyers will not pay. This can‘t happen, of course, if the firm sells for cash.
5. The cash discount: When the firm offers a cash discount as part of its credit terms,
some customers will choose to pay early to take advantage of the discount.
Optimum credit policy
Investment in credit sales will accumulate costs in the form of bad debts losses, collection
charges, and interest on additional borrowings. An increase in investment in the
accounts receivables increases such costs. A reduction in the investment in accounts
receivables reduces such costs but also decreases profitability of firms as decrease in
receivables means decrease in sales. An optimum credit policy is one that maximizes
value of the firm, by minimizing the associated costs of credit sales and providing
incremental revenue to the business.

Optimum credit policy is a trade-off between the increased profitability and increased
cost can be arrived with an efficient credit policy. Optimum credit policy is the point
where operating profit is maximum and firms total cost on investment in receivables is
minimum.
Credit Evaluation and Scoring
There are no magical formulas for assessing the probability that a customer will not pay.
In very general terms, the classic five Cs of credit are the basic factors to be evaluated:
i. Character: The customer‘s willingness to meet credit obligations.
ii. Capacity: The customer‘s ability to meet credit obligations out of operating cash
flows.
iii. Capital: The customer‘s financial reserves.
iv. Collateral: An asset pledged in the case of default.
v. Conditions: General economic conditions in the customer‘s line of business.

Credit scoring is the process of calculating a numerical rating for a customer based on
information collected; credit is then granted or refused based on the result. For example, a
firm might rate a customer on a scale of 1 (very poor) to 10 (very good) on each of the
five Cs of credit using all the information available about the customer. A credit score
16 | P a g e
could then be calculated by totaling these ratings. Based on experience, a firm might
choose to grant credit only to customers with a score above, say, 30.

Because credit-scoring models and procedures determine who is and who is not
creditworthy, it is not surprising that they have been the subject of government regulation.
In particular, the kinds of background and demographic information that can be used in
the credit decision are limited.

Collection policy is the final element in credit policy. Collection policy involves
monitoring receivables to spot trouble and obtaining payment on past-due accounts.

Monitoring the Receivables Position

When a credit sale is made, the following events occur:

i. Inventories are reduced by the cost of goods sold;

ii. Accounts receivable are increased by the sales price; and
iii. The difference is reported as a profit, which is adjusted for taxes and then
added to the previous retained earnings balance.

If the sale is for cash, then the cash from the sale has actually been received by the firm
and the scenario just described is completely valid. If the sale is on credit, however, then
the firm will not receive the cash from the sale unless and until the account is collected.
An analysis along the lines suggested in the following sections will detect any such
questionable practice.

Days Sales Outstanding (DSO): How long it takes for account receivable to be cleared
(collected). It represents the number of days for which credit sales are locked in with
debtors (as account receivables).

Suppose Super Sets Inc., a television manufacturer, sells 200,000 television sets a year at
a price of $198 each. Assume that all sales are on credit under the terms 2/10, n/30.
Finally, assume that 70% of the customers take the discount and pay on Day 10 and that
the other 30% pays on Day 30. Find the DSO?

17 | P a g e
  DSO (ACP) = 0.7(10 days) + 0.3(30 days) =16 days

 Receivables =DSO X ADS =16 * 108,493= $1,735,888

Note that DSO, or average collection period, is a measure of the average length of time it
takes the firm‘s customers to pay off their credit purchases.

Inventory Management

Inventories constitute the most significant part of current assets. Because of the larger
size of investments in current assets, considerable funds are committed on inventories. It
is essential for every firm to minimize such investments by avoiding unnecessary storing
costs, obsolescence costs, and purchasing costs. Business units that are unable to control
inventories investment, end-up with decrease in profitability in the long run. The primary
objective of inventory management is to ensure sufficient levels of inventories to maintain
an acceptable level of availability on demand, and minimizing the associated holding and
administrative costs.

The Financial Manager and Inventory Policy

Despite the size of a typical firm‘s investment in inventories, the financial manager of a
firm will not normally have primary control over inventory management. Instead, other
functional areas such as purchasing, production, and marketing will usually share
decision-making authority regarding inventory. Inventory management has become an
increasingly important specialty in its own right, and financial management will often
only have input into the decision

Inventory Types

For a manufacturer, inventory is normally classified into one of three categories.

The first category is raw material. This is whatever the firm uses as a starting point in its
production process.

The second type of inventory is work-in-progress, which is just what the name suggests
unfinished product.

18 | P a g e
The third and final type of inventory is finished goods, that is, products ready to ship or
sell.

Inventory Costs

There are two basic types of costs associated with current assets in general and with
inventory in particular. The first of these is carrying costs. Here, carrying costs represent
all of the direct and opportunity costs of keeping inventory on hand. These include:

 Storage and tracking costs

 Insurance and taxes
 Losses due to obsolescence, deterioration, or theft
 The opportunity cost of capital on the invested amount
The other type of costs associated with inventory is shortage costs. Shortage costs are
costs associated with having inadequate inventory on hand. The two components of
shortage costs are restocking costs and costs related to safety reserves.
 Depending on the firm‘s business, restocking or order costs are either the costs of
placing an order with suppliers or the costs of setting up a production run.
 The costs related to safety reserves are opportunity losses such as lost sales and
loss of customer goodwill that result from having inadequate inventory.
A basic trade-off exists in inventory management because carrying costs increase with
inventory levels, whereas shortage or restocking costs decline with inventory levels. The
basic goal of inventory management is thus to minimize the sum of these two costs. We
consider ways to reach this goal in the next section.
Objectives of inventories management

An efficient inventory management should always aim for the following objectives:

• Ensure a continuous supply of materials to facilitate un-interrupted production.

• Maintain sufficient quantities of inventories in period of short supply and
unanticipated price changes.
• Maintain sufficient volume of finished goods inventories for smooth sales
operations, and efficient customer services.
• Minimize the carrying cost of inventories.
• Control investments in inventories and maintain optimum level.

19 | P a g e