Credit and inventory

management
 Credit Management: Key Issues
• Granting credit generally increases sales
• Costs of granting credit
• Chance that customers will not pay
• Financing receivables
• Credit management examines the trade-off between increased sales
and the costs of granting credit
 Components of Credit Policy
• Terms of sale
• Credit period
• Cash discount and discount period
• Type of credit instrument
• Credit analysis – distinguishing between “good” customers that will
pay and “bad” customers that will default
• Collection policy – effort expended on collecting receivables
Terms of Sale

• Basic Form: 2/10 net 45

• 2% discount if paid in 10 days
• Total amount due in 45 days if discount not taken

• Buy $500 worth of merchandise with the credit terms given above
• Pay $500(1 - .02) = $490 if you pay in 10 days
• Pay $500 if you pay in 45 days
 Credit Policy Effects
• Revenue Effects
• Delay in receiving cash from sales
• May be able to increase price
• May increase total sales

• Cost Effects
• Cost of the sale is still incurred even though the cash from the sale has not been
received
• Cost of debt – must finance receivables
• Probability of nonpayment – some percentage of customers will not pay for
products purchased
• Cash discount – some customers will pay early and pay less than the full sales
price
 Evaluating a proposed credit policy

• ABC software has been in existence for 2 years that develop computer program.
Currently ABC software sells for cash only. ABC software is evaluating a request from
some major customer to change the current policy to net one month (30 days). To
analyse the proposal, we define the following:

• P = Price/Unit
• V = Variable cost/Unit
• Q = Current quantity sold/month
• Q’ = Quantity sold under new policy/month
• M = Monthly required return

• Note: Ignore discounts and possibility of defaults. Also ignore taxes it does not affect
our conclusion.
 NPV of switching policy
• P = 49
• V = 20
• Q = 100
• Q’ = 110
• Required return, R is 2% per month, should ABC software make the
switch?
 NPV of switching policy

• Current monthly sales of ABC = P * Q

= 49*100 = 4900
Variable cost/month = 20*100 = 2000

Monthly cash flow with old policy = 4900-2000 = 2,900

Note: This is not the total cash flow of ABC. This is all what we need to
look @ because fixed cost and other components of cash flow are same
whether or not switch is made
 NPV of switching policy
• If ABC corporation switch to 30 days credit sales policy, the quantity sold will rise to Q’=110

• Monthly revenue will increase to = Q’*P = 110*49 = 5390

• However, the cost will increase to = Q’*VC = 110*20 = 2200

• Hence cash flow from new policy = (49-20)*110 = 3190

• Relevant incremental cash flow is the difference between the new and old cash flows:
• Incremental cash flow = (P-VC) (Q’-Q)
= (49-20)(110-100)
= 290
Present value of future incremental cash flow = Incremental cash flow / ( R )
= (P-VC) (Q’-Q) / (R)

Note: Monthly cash flow is treated as perpetuity because same benefit will be realized each month
forever.
 NPV of switching policy
• PV of incremental cash flow = (49-20) (110-100) / (0.02)
• PV = 14,500
• Note: We will consider two cost of switching
1. As the number of units sold increased, the cost of producing the same will also
increase: V (Q’-Q)
2. Sales would have been collected this month under current policy (P*Q = 4900),
however under new policy, sales made this month would be collected 30 days later (PQ)
• Hence total cost of switching will be 1 + 2
• Cost of switching = PQ + V (Q’-Q)
= 100*49 + 20 (110-100)
= 4900 + 200
= 5100
 NPV of switching policy
• Hence the NPV of switch will be
• NPV = PV of benefit of switch – PV of cost of switch
• NPV = 200/(0.02) – 5100
• NPV = 14,500-5100
• NPV = 9,400
• Hence ABC corporation can go ahead with switching as NPV is positive.
Example: Evaluating a Proposed Policy

• Your company is evaluating a switch from a cash only policy to a net

30 policy. The price per unit is $100, and the variable cost per unit is
$40. The company currently sells 1,000 units per month. Under the
proposed policy, the company expects to sell 1,050 units per month.
The required monthly return is 1.5%.

• What is the NPV of the switch?

• Should the company offer credit terms of net 30?

 Example: Evaluating a Proposed Policy
• Incremental cash inflow
• (100 – 40)(1,050 – 1,000) = 3,000
• Present value of incremental cash inflow
• 3,000/.015 = 200,000
• Cost of switching
• 100(1,000) + 40(1,050 – 1,000) = 102,000
• NPV of switching
• 200,000 – 102,000 = 98,000
• Yes, the company should switch
 Inventory Management
• Like receivables, inventories represent a significant investment for
many firms.
• Credit policy and inventory policy drives sales
• The two policies should be coordinated to ensure that the process of
acquiring inventory, selling it and collecting on the sale is smooth one.
• Change in credit policy designed to simulate sales must be
accompanied by planning for adequate inventory.
 Inventory Management
• Inventory can be a large percentage of a firm’s assets
• There can be significant costs associated with carrying too much
inventory
• There can also be significant costs associated with not carrying
enough inventory
• Inventory management tries to find the optimal trade-off between
carrying too much inventory versus not enough
 Types of Inventory

• Manufacturing firm
• Raw material – starting point in production process
• Work-in-progress
• Finished goods – products ready to ship or sell
• Remember that one firm’s “raw material” may be another firm’s
“finished goods”
• Different types of inventory can vary dramatically in terms of liquidity
 Inventory Costs
• Carrying costs – range from 20 – 40% of inventory value per year
• Storage and tracking
• Insurance and taxes
• Losses due to obsolescence, deterioration, or theft
• Opportunity cost of capital
• Shortage costs
• Restocking costs
• Lost sales or lost customers
Inventory Costs
• Consider both types of costs, and minimize the total cost

• A basic trade-off exists in inventory management because carrying

costs increase with inventory levels, whereas shortage or restocking
costs decline with inventory levels.
 EOQ Model

• The EOQ model minimizes the total inventory cost

• Total carrying cost = (average inventory) x (carrying cost per unit) =
(Q/2)(CC)
• Total restocking cost = (fixed cost per order) x (number of orders) =
F(T/Q)
• Total Cost = Total carrying cost + total restocking cost = (Q/2)(CC) +
F(T/Q)
2TF
Q *

CC


 Example: EOQ
• Consider an inventory item that has carrying cost = $1.50 per unit.
The fixed order cost is $50 per order, and the firm sells 100,000 units
per year.
• What is the economic order quantity?
 Example: EOQ

2(100,000)(50)
Q 
*
 2,582
1.50


1. The ABC corporation has annual sales of $29.5 Million. The average
collection period is 27 days. What is the average investment in
accounts receivable?
3. Chen Incorporation has an average collection period of 34 days. Its average
daily investment in receivables is $61,300. What are the annual credit sale?
What is the receivable turnover?

4. ABC corporation sells 5,450 units of its perfume collection each year at
price per unit of $480. All sales are on credit with terms of 1/10, net 40. The
discount is taken by 35% of the customers. What is average receivable?
In reaction to sales by its main competitor, ABC corporation is considering a
change in its credit policy to terms of 2/10, net 30 to preserve its market
share. How will this change in policy affect accounts receivable?
5. The Cold Fusion Corp. is considering a new credit policy. The current
policy is cash only. The new policy would involve extending credit for
one period (net one month). Based on the following information,
determine if a switch is advisable.
Required return 0.95%   
       
  Current Policy   New Policy
Price per unit $ 720   $ 720
Cost per unit $ 495   $ 495
Unit sales per month 1,130   1,190
6. ABC corporation uses 1,860 switch assemblies per week and then
reorders another 1,860. If the relevant carrying cost per switch assembly
is $6.25 and the fixed cost is $730, is the company’s inventory policy
optimal? Why or why not?

7. ABC store begins each week with 675 stock. This stock is depleted
each week and reordered. If the carrying cost per stock is $73 per year
and the fixed order cost is $340, what is the total carrying cost? What is
the restocking cost? Should the company increase or decrease its order
size? Describe an optimal inventory policy for the company in terms of
order size and order frequency?