Finance Assignment for Ocean Yacht

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Submission

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Contents:1.What is working capital management?

Explain the various concepts of working capital management.

Estimation of working capital.

Explain the operating cycle .

Explain the Various modes of working capital .

What are the motives of holding cash?

2. Basic strategies of Cash Management.

Explain the Cash management techniques

3. What is Receivable Management?

Explain the obectives of !eceivable "anagement.

#iscuss and illustrate !eceivable "anagement process.

. What is inventor!?

Why do firms maintain inventory?

What are the cost and benefit associated with inventory?

What is $%C analysis?

What is E&' model?

What is safety stock?

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Q.1. What is working capital management?

$ managerial accounting strategy focusing on maintaining efficient levels of both components ofworking capital( current assets and current liabilities( in respect to each other. Working capital

management ensures a company has sufficient cash flow in order to meet its short)term debtobligations and operating expenses.

*mplementing an effective working capital management system is an excellent way for many companies

to improve their earnings. +he two main aspects of working capital management are ratio analysis and

management of individual components of working capital.

$ few key performance ratios of a working capital management system are the working capital ratio(

inventory turnover and the collection ratio. !atio analysis will lead management to identify areas of focus

such as inventory management( cash management( accounts receivable and payable management.

Working capital is the cash needed to pay for the day to day operation of the business.*t is thedifference between the current assets of a business and its current liabilities.

Explain the various concepts of working capital management.

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Concepts of working capital

1. Gross Concepts:

+he ,ross concept of working capital deals with firms current assets. +he sum total of currentassets of firm is termed as working capital. -rom the perspective of working capital needs( ,ross

concept of working capital is the investment in circulating assets or in inventory and accounts

receivables( comprising the operating cycle of a manufacturing firm. *nvestment in assetswhich be converted in cash within an accounting year( which includes cash( short term securities(

debtor( bills receivable and inventories. *n short( according to gross concept working capital

refers to the sum total of all current assets of the firm employed in the business process.

. !et Working Capital

+he term /0et Working Capital1 has been defined in two different ways

i. *t is the excess of current assets over current liabilities. +his is( as a matter of fact( the mostcommonly accepted definition. 2ome people define it as only the difference between current

assets and current liabilities. +he former seems to be a better definition as compared to the latter.

ii. *t is that portion of a firm3s current assets which is financed by long)term funds.

". #ermanent Working Capital

+his refers to that minimum amount of investment in all current assets which is required at alltimes to carry out minimum level of business activities. *n other words( it represents the current

assets required on a continuing basis over the entire year. +an don Committee has referred to this

type of working capital as /Core current assets1. +he following are the characteristics of this typeof working capital

4. $mount of permanent working capital remains in the business in one form or another.

+his is particularly important from the point of view of financing. +he suppliers of such working

capital should not expect its return during the life)time of the firm.5. *t also grows with the si6e of the business. *n other words( greater the si6e of the business(

greater is the amount of such working capital and vice versa 7ermanent working capital is

permanently needed for the business and therefore it should be financed out of long)term funds.

$. %emporar& Working Capital

+he amount of such working capital keeps on fluctuating from time to time on the basis ofbusiness activities. *n other words( it represents additional current assets required at different

times during the operating year. -or example( entrain venture has to be maintained to support

sales during peak sales period. 2imilarly( receivable also increase and must be financed during

period of high sales. &n the other hand investment in inventories( receivables( etc.( will decreasein periods of depression. 2uppliers of temporary working capital can expect its return during off

season when it is not required by the firm. 8ence( temporary working capital is generally

financed from short)term sources of finance such as bank credit.

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What are the main factors considered in the estimation

of working capital reuirement!+he nature of business and sector)wise norms

-actors such as seasonality of raw materials or of demand may require a high level of inventory

being maintained by the company. 2imilarly( industry norms of credit allowed to buyers

determine the level of debtors of the company in the normal course of business.

+he level of activity of the business

*nventories and receivables are normally expressed as a multiple of a day3s production orsale. 8ence( higher the level of activity( higher the quantum of inventory( receivables and

thereby working capital requirement of the business. 2o in order to arrive at the working

capital requirement of the business for the year( it is essential to determine the level ofproduction that the business would achieve. *n case of well)established businesses( the

previous year3s actuals and the management proections for the year provide good

indicators. +he problems arise mainly in the case of determining the limit for the first

time or in the initial few years of the business. %anks often adopt industry standard normsfor capacity utili6ation in the initial years.

What are the steps involved in arriving at the level of Working Capital Requirement ?

%ased on the level of activity decided and the unit cost and sales price proections( the

banks calculate at the annual sales and cost of production.

+he quantum of current assets 9C$: in the form of !aw "aterials( Work)in)progress(

-inished goods and !eceivables is estimated as a multiple of the average daily turnover.

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+he multiple for each of the current assets is determined generally based on the industry

norms.

+he current liabilities 9C;: in the form of credit availed by the business from its creditors

or on its manufacturing expenses are deducted from the current assets 9C$: to arrive at

the Working Capital !equirement 9WC!:.

Standard Formulae for determination of Working Capital

+he issue of computation of working capital requirement has aroused considerable debate

and attention in this country over the past few decades. $ directed credit approach was

adopted by the !eserve %ank of ensuring the flow of credit to the priority sectors forfulfillment of the growth obectives laid down by the planners. Consequently( the

quantum of bank credit required for achieving the requisite growth in *ndustry was to be

assessed. Various committees such as the +andon Committee and the Chore Committeewere constituted and studied the problem at length.

0orms were fixed regarding the quantum of various current assets for different industries

9as multiples of the average daily output: and the "aximum 7ermissible %ank -inancing

9"7%-: was capped at a certain percentage of the working capital requirement thusarrived at.

Working Capital assessment on the formula prescribed by the Tandon Committee.

Working Capital !equirement 9WC!:< =Current assets i.e. C$ 9as per industry norms: > Current

;iabilities i.e. C;7ermissible %ank -inancing =7%-@ < WC! > 7romoter3s "argin "oney i.e. 7"" 9to be

brought in by the promoter:

$s per -ormula 4 7"" < 5AB of =C$ > C; and thereby 7%- < AB of =C$ > C;

$s per -ormula 5 7"" < 5AB of C$ and thereby 7%- < AB=C$ > C;

$s is apparent -ormula 5 requires a higher level of 7"" as compared to -ormula 4. -ormula 5

is generally adopted in case of bank financing. *n cases of sick units where the promoter is

unable to bring in 7"" to the extent required under -ormula 5( the difference in 7"" between-ormulae 4 and 5 may be provided as a Working Capital +erm ;oan repayable in installments

over a period of time.

llustrative !"ample#

+urnover of a manufacturing unit !s. AD lakh p.a 9assumed uniform across the year:$ssumed value addition norm ADB 9i.e. cost of raw material < ADB of !ealisation:

#romoter #ro'ections

Current (ssets Current )ia*ilities

) !aw materials !s. AD lakh ) 7ayables !s. A lakh

) Work in progress !s. 5A lakh

) -inished ,oods !s. FD lakh

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) !eceivables !s. 45A lakh

!equirement assessed as per norms applicable for the industry

+n,ustr&

!orm -a

(mount as per

!orm -*

#romoter

#ro'ection -c

(pplica*le

norm -,

Current $sset

) !aw material 4 month !s. 4.5A lakh !s. AD lakh !s. 4.5A lakh

) Work in 7rogress 9assumed

at ADB complete:4D days !s. 4A.F5 lakh !s. 5A lakh !s. 4A.F5 lakh

) -inished ,oods 4A days !s. 4.5A lakh !s. FD lakh !s. 4.5A lakh

) !eceivables4.A months !s. 445.AD lakh !s. 45A lakh !s. 445.AD lakh

/s. 10.2 lakh /s. 2. lakh /s. 10.2 lakh

Current ;iabilities

) 7ayables 4A days !s. 4G.GD lakh !s. A lakh !s. 4G.GD lakh

Working Capital

/e3uirement/s. 141.5 lakh /s. 6. lakh /s. 141.5 lakh

$otes#

%ssumptions here include# $o e"port turnover& uniform 'orking capital requirementthrough out the year

ndustry norms have been specified in the Tandon Committee Report for all important

industry categories

Ra' materials have been valued at cost of ra' material (assumed at )*+ of reali,ation-

Work in progress has been valued at )*+ complete basis

%pplicable norm (d- is the more conservative of (b- or (c- from the banks point of vie'.

Computation of 'orking capital requirement

Working Capital !equirement arrived at therefore is !s. 44.G5 lakh

7ormula 1

7"" 97romoter "argin "oney: as per formula 4 < 5AB of 44.G5 lakh < !s. H5.IA lakh J !s.H lakh

8ence( 7ermissible %ank -inance 4 < !s. 45I lakh

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7ormula

7"" as per formula 5 < 5AB of !s. 4ID.F lakh < !s. H.FA lakh

7ermissible %ank -inancing as per formula 5 < =AB of 4ID.F lakh > !s. 4G.G lakh < !s. 45H.4lakh

+he difference between the 5 methods is !s. H.ID lakh 9which maybe extended as a WorkingCapital +erm ;oan in case of sick units.

+hus the 7"" while being at 5AB of the Working Capital requirement4 could actually translateto as high as !s. 55A lakh > !s. 45H lakh i.e. !s. 4D4 lakh assuming that the promoter proections

really reflect his genuine need for working capital. *t should however be understood by the

entrepreneur that he ought to keep his working capital requirements to the minimum 9whether ornot bank financing is available: to ensure that his interest burden and capital blocked is kept to

the minimum.

+he following further points maybe worth mentioning here

*n case of export financing sought by the entrepreneur( the quantum of bank financing for

the Working Capital build up for this purpose would normally be at a higher percentage

Within the overall limits( there could be sub)limits for bills financing 9in case of

receivables: with the result that such limits might not be fully available to the business.

+he %ank -inancing ;imit arrived above is the &verall limit for the year. +he actual quantum of

bank financing that could be availed by the unit at a given point in time depends upon its

drawing power based on its periodical returns filed to the banker

Explain the 8perating C&cle (nal&sis

8perating C&cle 9efinition

+he &perating cycle definition( also known as cash operating cycle or cash conversion cycle orasset conversion cycle( establishes how many days it takes for a company to turn purchases of

inventory into cash receipts from its eventual sale. &perating cycle has three components of

payable turnover days( inventory turnover days and accounts receivable turnover days. +hesecome together to form the complete measurement operating c&cle ,a&s. +he operating cycle

formula and operating cycle analysis stems logically from these.

8perating C&cle 7ormula

&perating cycle calculations are completed simply with this formula

&perating cycle < #*& K #2& ) #7&

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Where

#*& represents days inventory outstanding

#2& represents day sales outstanding

#7& represents days payable outstanding

8perating C&cle Calculation

Calculating operating cycle may seem daunting but results in extremely valuable information.

#*& < 9$verage inventories L cost of sales: M FA #2& < 9$verage accounts receivables L net

sales: M FA

#7& < 9$verage accounts payables L cost sales: M FA

Example $ company has ID days in days inventory outstanding( FD days in days sales

outstanding and D in days payable outstanding.

&perating cycle < ID K FD ) D < GD

+his means that on average it takes GD days for a company to turn purchasing inventories into

cash sales. *n regards to accounting( operating cycles are essential to maintaining levels of cash

necessary to survive. "aintaining a beneficial net operating c&cle ratio is a life or death matter.

8perating C&cle (pplications

+he operating cycle concept indicates a company3s true liquidity. %y tracking the historical

record of the operating cycle of a company and comparing it to its peer groups in the sameindustry( it gives investors investment quality of a company. $ short company operating cycle is

preferable since a company reali6es its profits quickly and allows a company to quickly acquire

cash that can be used for reinvestment. $ long business operating cycle means it takes longer

time for a company to turn purchases into cash through sales. *n general( the shorter the cycle(

the better a company is since less time capital is tied up in the business process

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Explain the arious mo,es of working capital.

"ario#s mo$es of working capital.

$ firm has to decide how it is to be financed. +he need four financing arises

mainly because the investment in working capital.

/arious modes of 'orking capital financing# $lthough long)term funds portly finance

current assets and provide the margin money for working capital( such working capital

virtually exclusively supporting by short )term sources.

+he main modes of working capital financing( namely( trade credit( bank credit

!%* framework( factoring and commercial papers e.t.c

%ra$e cre$it: +rade credit refers to the credit that a customer gets from suppliers of

goods in the normal course of business.

$ccording to trade practices cash is not paid immediately for purchases but after

an agreed period of time. +hus deferral of payment represents a source of finance for

credit purchases.

&$vantages of tra$e cre$it: +rade credit is normally available to a firmN it is a

spontaneous source of financing. +he maor advantages of trade credit are as follows

Easy availability

-lexibility

*nformality

Cost of tra$e cre$it:+rade credit does not involve any explicit interest change. +here is

an implicit cost of trade credit. *t depends on the credit terms offered by the suppliers of

goods. +he cost of trade credit is generally very high beyond the discount period( firms

should avoid of the discount on prompt payment

We can use the following formula to calculate the implicit rate of interest.

*mplicit *nterest !ateanking

*n this system of decentrali6ed collection of accounts receivable( large firms which have a large numberof branches at different places( select some of the strategically located branches is collection centers for

receiving payment from customers. -unds beyond a predetermined minimum are transferred daily to a

central or disbursing or concentrationbank or account. $ concentration bank is one with which the firm

has a maor account > usually a disbursement account. 4F hence( this arrangement is referred to as

concentration banking.

Concentration banking( as a system of decentrali6ed billing and multiple collection points( is a useful

technique to expedite the collection of accounts receivable. *t reduces the time needed in the collection

process by reducing the mailing time. 2ince the collection centre are near the customers( the time

involved in sending the bill to the customer is reduced. "oreover the time)lag between the dispatch of the

cheque by the customers and its receipt b the firm is also reduced. "ailing time is saved both in respect of

sending the bill to the customes as well as in the receipt of payment. +hus( the arrangement of multiple

collection centres with concentration banking results in a saving of time in both mailing and clearance of

customer payments and leads to a reduction in the operating cash requirement. $nother advantage is that

concentrationpermits the firm to Tstore3 its cash more efficiently.

)ock@>ox =&stem :

+he concentration banking arrangement is instrumental in reducing the time involved in mailing and

collection. %ut with this system of collection of accounts receivable( processing for purpose of internal

accounting is involved( that is( some time elapses before a cheque is deposited by the local collection

centre in its account. +he lock)box system takes care of this kind of problem( firms hire a post office lock)

box at important collection centers. +he customers are required to remit payments to the post office lock)

box. +he local banks of the firm( at the respective places( are authori6ed to open the box and pick up the

remittances 9cheques: received from the customers(

+hus( the lock)box system is like concentration banking in that the collection is decentralised and is done

at the branch level. %ut htey differ in one very important respect. While the customer sends the cheques(

under the concentration banking arrangement( to the collection centers. While the customer send the

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cheques( under the concentration banking arrangement( to the colection centres( he send them to a post

office box under the lock)box system.

*n a way( the lock)box arrangement is an improvement over the concentration banking system. *tssuperiority arises from the fact that one step in the collection process is eliminated with the use of lick)

box the receipt and deposit of cheques by the firm.

+hus( the lock)box system( as a methods of collection of receivables( has a two)fold advantage 9i: the

bank performs the clerical task of handling the remittances prior to deposits( services which the bank may

be able to perform at lower costN 9ii: the process of collection of collection through the banking system

begins immediately upon the receipt of the chequesLremittance and does not have to wait until the firm

completes( its processing for internal accounting purposes.

$lthough the use of concentration banking and lock)box systems accelerate the collection of receivables(

they involve a cost. *t the income exceeds the cost( the system is profitable and should be usedN otherwise(

not. -or this reason( these techniques can be pressed into service only by large firms which receive a large

number of cheques from a wide geographical area.

=lowing 9is*ursements:

$part from speedy collection of accounts receivable( the operating cash requirement can be reduced by

slow disbursements of accounts payable. *n fact( slow disbursements represent a source of funds requiring

no interest payments. +here are several techniques to delay payment of account of accounts payable(

namely( 9i: avoidance of early paymentsN 9ii: centralised disbursementsN 9iii: floats and 9iv: accruals.

(voi,ance of Earl& #a&ments

&ne way to delay payments is to avoid early payments. $ccording to the terms of credit( a firm is required

to make a payment within a stipulated period. *t entitles a firm to cash discounts. *f( however( payments

are delayed beyond the due date( the credit standing may be adversely payable before the due date it has

no special advantage. +hus( a firm would be well advised not to make payments early that is( before the

due date.

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Centralise, 9is*ursements

$nother method to slow down disbursements is to have centralised disbursements. $ll the payments

should be made by the head office from a centralised disbursement account. 2uch an arrangement wouldenable a firm to delay payments and conserve cash for several reasons. -irstly( in involves increase in the

transit time. +he second reason for reduction in operating cash requirement is that since the firm has a

cenralised bank account( a relatively smiller total cash balance will be needed. -amily( schedules can be

tightly controlled and disbursement made exactly on the right day.

7loat

$ very important technique of slow disbursements is float. +he term float refers to the amount of money

tied up in cheques that have been written( but have yet to be collected and encased. $lternatively( float

represents the difference between the bank balance and book balance of cash of a firm. +he difference

between the balance as shown by the firm3s record and the actual bank balance is due to transit and

processing delays. +here is a time)lag between the issue of a cheque by the firm and its presentation to its

bank by the customer3s bank for payment. Cash would be required later when the cheque is presented for

encashment. +herefore( a firm can send remittances. -loat used in this sense is called as cheque kiting.4I

+hee are two ways of doing it 9a: paying from a distant bank( 9b: scientific cheque)cashing analysis.

#a&ing from a 9istant >ank

+he firm may issue a cheque on banks away from the creditor3s bank. +his would involve relative longer

transit time for the creditor3s bank to get payment and( thus( enable the firm to use its funds longer.

Che3ue@encashment (nal&sis

$nother way to make use of float is to analyse( on the basis of past experience( the time)lag in the issue of

cheques and their encashment. -or instance( cheques issued to pay wages and salary may not be encasedimmediatelyN it may be spread over a few days( say( 5A per cent on one day( AD per cent on the second day

and the balance on the third day. *t would mean that the firm should keep in the bank not the entire

amount of a payroll but only a fraction represented by the actual withdrawal each day. +his strategy

would enable the firm to save operating cash.

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(ccruals

-inally( a potential tool for stretching accounts payable is accruals which are defined as current liabilities

that represent a service or goods received by a firm but not yet paid for. -or instance( payroll( that is(

remuneration to employees who render service in advance and receive payment later. $ period at the end

of which they are paid( say( a week or a month. +he longer the period after which payment is made( the

greater is the amount of free financing consequently and the smaller is the amount of cash balances

required . +hus( less frequent payrolls( that is( weekly as compared to monthly( are an important source of

accrual.

Q.". What is /eceiva*le ;anagement?

/eceiva*le ;anagement

*ntro$#ction:++he receivables represent an important component of the current assets of the

firm.+he amount of investment in accounts receivable for mostfirms. +he amount of investment

in accounts receivable for most firms also represents a very substantial portion of current assets.

$ccording to *.".7andeyU+rade credit is the most prominent force of the modern business. *t isconsidered as an essential marketingtool( acting as a bridge for the movement of goods from production and

distributionstages to customers finally.+he interval period between the date of sale and the date of

receipt of payment has to be financed out of working capital funds. +hus( trade debtors representinvestment.$s substantial amount are tied)up in trade debtors or receivables( it needs

carefulanalysis and proper management.

"eaning of !eceivables)

Emerson as has defined the term receivablesX Uwhen goods or services are soldunder an arrangement

permitting the customers to pay for them at a letter date( theamount due from the customer isrecorded receivable. +his is an asset account(representing claim to future payment of cash from

the customer.

Explain the o*'ectives of /eceiva*le ;anagement.

8*'ectives of /eceiva*les ;anagement:@

+he basic obective of receivables management is to maximi6e the value of the firm by achievinga tradeoff between liquidity and profitability. *n fact( the firm shouldmanage its credit in such a

way that sales are expanded to an extent to which risk remains within an acceptable limit. +hus(

to achieve the obective to maximi6ing thevale( the firm should manage its credit

9i: +o obtain optimum volume of sales.

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9ii:+o control the cost of credit and keep it at minimum.

9iii:+o maintain investment in debtors at optimum level.

+he purpose of credit management is not sales maximi6ation. %ut efficient andeffective credit

management does help to expand sales and can prove to be aneffective credit management does help to

expand sales and can improve to be aneffective tool of marketing( thus( the obective of receivablesmanagement is to promote sales and profits until that pint is reached where the return on

investment infurther funding of receivables is less than the cost of funds raised to finance

thatadditional credit.

(CC8A!% /ECE+(>)E ;(!(GE;E!% #/8CE==:

Effectively managing accounts receivable requires a thorough understanding of the Credit)to)Cash Cycle.

Customer (c3uisition

+he first step in the process is to determine the riskLreward of extending credit terms to the

potential client and granting the proper level of credit. $sk for and review credit references and

possibly purchase a credit report on the customer to determine their payment history.

>illing ;anagement

+he next step is to manage the billing process effectively. *tQs important to send invoices that are

accurate( professional in appearance( and mailed in a timely manner. Sou may also want to

establish customer service centers to handle billing inquiries.

9elin3uenc& ;anagement

Onfortunately( managing delinquent accounts is often one of the most time)consuming aspects of

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the accounts receivable management process. +he goal is to set priorities and strategies for

collecting on these accounts while balancing results( costs( and the need to preserve the customer

relationship ) an important consideration as most companies understand that itQs more profitableto keep a current customer than to acquire a new one.

+he ,reen-lag 7rofit !ecovery 2ystem streamlines delinquency management. &ur proactiveapproach not only improves our clientsQ cash flow by starting early in the collection phase( but it

also reduces the number of delinquent accounts by incorporating third party involvement and aconsistent approach to collecting on past due accounts.

/ecover&

*n the unfortunate event that an account has been Ycharged)off(Y businesses typically will passthe account to a third party to recover the cash in a legal and responsible manner( while at the

same time insulating the client from negative associations. +he recovery process often utili6es

professional collection agencies and attorneys to do everything from purchasing past)due

portfolios to assisting on bankruptcy claims. -or more information on how the ,reen-lag 7rofit

!ecovery 2ystem can help to optimi6e your accounts receivable process.

Q.$.What is +nventor&?

+nventor&

$nswer

*nventory mean3s a companyQsmerchandise( raw materials( and finished and unfinished

products which have not yet been sold. +hese are considered liquid assets( since they can beconverted into cash quite easily. +here are various means of valuing these assets( but to be

conservative the lowest value is usually used in financial statements.

+he valueof materialsand goods heldby an organi6ation 94: to supportproduction9raw

materials( subassemblies( work in process:( 95: for support activities 9repair( maintenance(

consumables:( or 9: for sale or customer service 9merchandise( finished goods( spare parts:.

*nventory is the merchandise that a shop has on handN Ythey carried a vast inventory of

hardwareYN Ythey stopped selling in exact si6es in order to reduce inventoryY. Commoditiesoffered for saleN Ygood business depends on having good merchandiseYN Ythat store offers a

variety of productsY. -rom the above definition we get the following short note about the

inventory)))))))))))

M $n itemi6ed catalog orlist of tangible goods or property( or the intangible attributes or

qualities.

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M +he value of a firmQs current assets including raw materials and work in progress and finished

goods.

M "aking an itemi6ed list of merchandise or supplies on handN Yan inventory may be necessary to

see if anything is missingYN Ythey held an inventory every monthY.

M$ complete listing of merchandise or stock on hand( work in progress( raw materials( finished

goods on hand( etc.( made each year by abusinessconcern.

M+he aggregate value of a stock of goods.

Wh& ,o firms maintain inventor&?

$nswer

*nventory is often the largest item in the current assetscategory( and must be accurately

counted and valued at the endof each accounting periodto determinea companyQsprofitor loss.

+he basic responsibility of the financial manager is to make sure that firm3s cash flows are

managed efficiently. Efficient management of inventory should ultimately result in the

maximi6ation of the owner3s equity or wealth. +o minimi6e cash requirement s( inventory

should be turned over as quickly as possible( avoiding stock)outs that might result in closing

down the production line or lead to a loss of sales. *t implies that while the management shouldtry to pursue the financial obective of turning inventory as quickly as possible( it should at the

same time ensure sufficient inventories to satisfy production and sales demands. *n other words(

the financial manager has to reconcile these two conflicting requirements. 2tated differently( the

obective of inventory consists of two counterbalancing parts)))))))))

i: +o minimi6e investment in inventory( and

ii: +o meet a demand for the product by efficiently organi6ing the production and sales operation.

+he purpose of holding inventory by a firm are given below)))))))

M+o ensure profit earning.

M+o minimi6e the cost requirement of the firm about inventory.

M+o avoid stock)outs.

M+o satisfy sufficient production and sales demand.

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M7rovide benefits to the extent that inventory facilitate the smooth functioning of the firm.

What are the cost an, *enefit associate, with inventor&?

$nswer

&ne operating obective of inventory management is to minimi6e cost. Excluding the cost

of merchandise( the cost associated with inventory fall into two basic categories

$: &rdering Costs

+his category of cost associated with the acquisition or ordering of inventory. -irms have

to place orders with suppliers to replenish inventory of raw materials. +his expense are regarded

as /ordering cost3

&rdering costs are the cost involved inZ

a: 7reparing a purchase order or requisition form and

b: !eceiving( inspecting( and recording the goods received to ensure both

quantity and quality.

2et)up cost) the cost of acquiring materials consists of clerical costs and costs of stationary. *t is

called a cost of set)up.

8ere two points are remind able and they are)

M+he more frequent the acquisition of inventory made( the higher the cost.

M+he higher the inventory( the fewer the acquisitions and the smaller are the order costs.

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%: Carrying Costs

+he maintenance costs of the inventory are the carrying costs. *t is the second broad

category of costs associated with the inventory. +he costs of holding inventory may be dividedinto two categories. +hey are

4. +hose that arise due to the storing of inventory) the main components of this category of

carrying costs are)

i.2torage costs) taxes( depreciation( insurance( maintenance of the building( utilities and

anitorial servicesN

ii.*nsurance of inventory against the fire and theftN

iii.#eterioration in inventory because of pilferage( fire( technical obsolescence( style

obsolescence and price declineN

iv.2erving costs) labor of handling inventory( clerical and accounting costs.

5. +he opportunity cost of funds) +his consists of expenses in raising funds to finance the

acquisition of inventory. *f the funds are not locked up in inventory( they would have earned a

return. +his is the opportunity cost of funds or the financial cost component of the cost.

MM+he carrying cost and the inventory si6e are positively related and move in the

same direction.

*f the level of inventory increases( the carrying costs also increase and vice versa.

+he sum of the order and carrying costs represents the total cost of inventory.

+his is compared with the benefits arising from the inventory holding.

4enefits of inventory#

+he maor benefits of holding inventory are the basic functions of inventory. +he basic

functions of the inventories are as following)

4. 7urchase5. 7roduction and

. 2elling.

+hese interrelated activities of a firm can be carried on independently. *f the sales of a firm

increase( the production and the purchase would also increase and vice versa. *nventories enable

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firms in the short run to produce at a rate greater than purchase of raw materials and vice versa(

or to sale at a rate greater than production and vice versa. +he effect of maintaining inventories

are as follows)

4. %enifits in purchasing) *f the firm purchase great deal of inventory it will result in lower

acquisition costs. $ firm can purchase larger quantities than is warranted by usage in productionor in sales level. +his will enable it to avail of discounts that are available on bulk purchases.

"oreover it will lower the operating cost as fewer acquisitions would be made.

+hus there will a significant savings in costs.

5. %enefits in production) finished goods inventory serves to production and sales. +his enables

production at a rate different from that of sales. +hat is( production can be carried on at a rate

higher or lower than the sales rate. +his would be of special advantage to firms with seasonal

sales pattern.

*n this case the sales rate will be higher than the production rate during the part of the

year and lower during the off)season. 7roduce continuously throughout the year and sale during the period of seasonal demand.

+hus inventory helps a firm to coordinate its production scheduling as to avoid disruptions and

the accompanying expenses.

. %enefits in work)in process)the inventory in work)in process performs two functions.

*n the first place it is necessary because production process is not instantaneous. +he

amount of such inventory depends on technology and the efficiency of production.+he larger the steps involved in the production process the larger the work)in process

inventory and vice versa.+he second purpose is( it uncouples the various stages of production so that all of

them do not have to be performed at the same rate.+he stages involves higher set)up cost may be most efficiently performed in batches

with a work)in process inventory accumulated during a production run.

H. %enefits in sales) +he maintenance of inventory also helps a firm to enhance its sales

effort.

*f there are no inventories of finished goods( the level of sales will depend on the level of

current production. $n inventory serves to bridge the gap between current production and actual sales.

*nventory serves as a competitive marketing tool to meet customer demands.

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*nventories ensures a continued patronage of customers

+hus the inventory benefits the firm3s sales to maximi6e the profitability by combining the

production and sales.

What is (>C (nal&sis?

$%C analysis is a business term used to define an inventory categori6ation technique oftenusedin materials management. *t is also known as 2elective *nventory Control.

$%C analysis provides a mechanism for identifying items which will have a significant impact

on overall inventory cost whilst also providing a mechanism for identifying different categoriesof stock that will require different management and controls

When carrying out an $%C analysis( inventory items are valued 9item cost multiplied by quantity

issuedLconsumed in period: with the results then ranked. +he results are then grouped typically

into three bands. +hese bands are called $%C codes.

(>C Co,es:

/$ classY inventory will typically contain items that account for GDB of total value( or 5DB

of total items.

/% classY inventory will have around 4AB of total value( or DB of total items. 1C classY inventory will account for the remaining AB( or ADB of total items.

$%C $nalysis is similar to the 7areto principle in that the Y$ classY group will typically account

for a large proportion of the overall value but a small percentage of the overall volume of

inventory.

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[What is E8Q mo,el?

E8Q ;o,el

,conomic or$er -#antit!

While purchasing raw materials of finished goods( the questions to be addressed are 8ow much

inventory should be bought in one lot under one order on each replenishment? 2hould the

quantity to be purchased be large or small? &r( should the requirement of materials during a

given period of time 9say( one year: be acquired in one lot or should it be acquired in installments

or in several small lots? 2uch inventory problems are called order quantity problems.

+he determination of the appropriate quantity to be purchased in each lot to replenish stock as a

solution to the order quantity problem necessitates resolution of conflicting goals. %uying in

large quantities implies a higher average inventory level which will assure i: smooth

productionLsale operations( and ii: lower ordering or step)up costs. %ut it will involve higher

carrying costs. &n the other hand( small orders would reduce the carrying cost of inventory by

reducing the average inventory level but the ordering costs would increase as there is a

likelihood of interruption in the operations due to stock)outs. $ firm should place neither too

large nor too small orders. &n the basis of a trade)off between benefits derived from theavailability of inventory and the cost of carrying that level of inventory( the appropriate or

optimum level of the order to be placed should be determined. +he optimum level of inventory is

popularly referred to as the economic quantity order model 9E&':. *t is also known as the

economic lot si6e. +he E&' may be defined as that level of inventory order that minimi6es the

total cost associated with inventory management. +he costs associated with inventories are i:

ordering costs( and ii: carrying costs. 2tated with reference to cost perspectives( E&' refers to

the level of inventory at which the total cost of inventory comprising acquisitionLorderingLset)up

costs and carrying costs is minimal.

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E8Q ;o,el:

Economic or,er 3uantit&is the level of inventory that minimi6es the total inventory holding

costs and ordering costs. *t is one of the oldest classical production scheduling models. +he

framework used to determine this order quantity is also known as Wilson E8Q ;o,el or

Wilson 7ormula. +he model was developed by -. W. 8arris in 4I4( but !. 8. Wilson( a

consultant who applied it extensively( is given credit for his early in)depth analysis of it.

An,erl&ing assumptions

+he E&' model( as the technique to determine the economic order quantity( is based on

the following restrictive assumptions

4. +he firm knows with certainty the annual usage 9Consumption: of a particular item of

inventory.

5. +he ordering cost is constant.

. +he rate at which the firm uses inventory is steady over time.

H. +he lead time is fixed

A. +he purchase price of the item is constant i.e. no discount is available.

F. +he orders placed to replenish inventory stocks are received at exactly that point in time

when inventories reach 6ero.

. +he replenishment is made instantaneously( the whole batch is delivered at once.

G. +he rate of demand is constant over time.

I. +here is no uncertainty about the quantity or timing of demand.

4D. +here is no capacity constraint and the entire lot is produced simultaneously.

44. Either there is only a single product or conditions exist that ensure reparability of

products.

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E&' is the quantity to order( so that ordering cost K carrying cost finds its minimum. 9$

common misunderstanding is that the formula tries to find when these are equal.:

What is safet& stock?

=afet& stock: At certain points of time the demand may exceed the anticipated

level. In other words, a discrepancy between the assumed

(anticipated/expected) and actual usage rate of inventory is likely to occur in

practice. imilarly, the receipt of inventory from the suppliers may be

delayed beyond the expected lead time. !he delay may arise from strikes,

"oods, transportation and other bottlenecks. !hus, a #rm would come across

situations in which the actual usage of inventory is higher than the

anticipated level or the delivery of the inventory from the suppliers is

delayed.

+he effect of increased andLor slower delivery would be a shortage of inventory. +hat is( the firm

would face a stock)out situation. +his( in turn( as explained in detail below( would disrupt the

production schedule and alienate the customers. +he firm would( there( be well advised to keep a

sufficient safety margin by having additional inventory to guard against a possible shortage of

inventory caused either be increased usage or delayed delivery of inventor. +he safety stock may(

then( be defined as the minimum additional inventory to serve as a safety margin or buffer or

cushion to meet an unanticipated increase in usage resulting from an unusually high demand and

or an uncontrollable late receipt of incoming inventory.

=afet& stock9also called *uffer stock: is a term used by logisticiansto describe a level of extra

stock that is maintained to mitigate risk of stockouts9shortfall in raw material or packaging: due

to uncertainties in supply and demand. $dequate safety stock levels permit business operations to

proceed according to their plans. 2afety stock is held when there is uncertainty in the demand

level or lead timefor the productN it serves as an insurance against stockouts.

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With a new product( safety stock can be utili6ed as a strategic tool until the company can udge

how accurate their forecast is after the first few years( especially when used with a material

requirements planning worksheet. +he less accurate the forecast( the more safety stock is

required. With a material requirements planning 9"!7: worksheet a company can udge how

much they will need to produce to meet their forecasted sales demand without relying on safety

stock. 8owever( a common strategy is to try and reduce the level of safety stock to help keep

inventory costs low once the product demand becomes more predictable. +his can be extremely

important for companies with a smaller financial cushion or those trying to run on lean

manufacturing( which is aimed towards eliminating waste throughout the production process.

+he amount of safety stock an organi6ation chooses to keep on hand can dramatically affect their

business. +oo much safety stock can result in high holding costs of inventory. *n addition(products which are stored for too long a time can spoil( expire( or break during the warehousing

process. +oo little safety stock can result in lost sales and( thus( a higher rate of customer

turnover. $s a result( finding the right balance between too much and too little safety stock is

essential.

+he safety stock involves two types of costs i: stock)out( and ii: carrying costs. +he ob of the

financial manager is to determine the appropriate level of safety stock on the basis of a trade)off

between these two types of conflicting costs.

+he term stock)out costs refers to the cost associated with the shortage of inventory. *t is( in fact(

an opportunity cost in the sense that due to the shortage of inventory the firm would be deprived

of certain benefits. +he first and most obvious( of these costs is the loss of profit which the firm

could have earned from increased sales if there was no shortage of inventory. $nother category

of is the damage to the relationship with the customers. *t should of course be understood that

this types of cost cannot be easily and precisely quantified. ;ast( the shortage of inventory may

disrupt the production schedule of the firm. +he production process would grind to a halt

involving idle time.

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+he carrying costs are the costs associated with maintenance of inventory. 2ince the firm is

required to maintain additional inventory( in excess of the normal usage( additional carrying

costs are involved.

+he stock)out and the carrying costs are counterbalancing. +he larger the safety stock( the larger

would be the carrying costs and vice versa. Conversely( the larger is the safety stock( the smaller

would be the stock)out costs. +he obect of the financial managers should be to have the lowest

total cost. +he safety stock with the minimum carrying cost and stock)out costs is the economic

level which financial managers should aim at. *n brief( the appropriate level of safety stock is

determined by the trade)off between the stock)out and carrying costs.

"easons for safet# stock

2afety stocks are mainly used in a Y"ake +o 2tockY manufacturing strategy. +his strategy is

employed when the lead time of manufacturing is too long to satisfy the customer demand at the

right costLqualityLwaiting time.

+he main goal of safety stocks is to absorb the variability of the customer demand. *ndeed( the

7roduction 7lanning is based on a forecast which is 9by definition: different form the real

demand. %y absorbing this variations( the safety stock allow to improve the customer service

level.

%y creating a safety stock( you will also prevent from other variations

an upward trend in the demand

a problem in the incoming product flow 9machinery breakdown( supplies delayed(

strike( ...:

"educing safet# stock

2afety stock is used as a buffer to protect organi6ations from stockouts caused by inaccurate

planning or poor schedule adherence by suppliers. $s such( its cost 9in both material and

management: is often seen as a drain on financial resources which results in reduction initiatives.

*n addition( time sensitive goods such as food( drink( and other perishable items could spoil and

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go to waste if held as safety stock for too long. Various methods exist to reduce safety stock(

these include better use of technology( increased collaboration with suppliers( and more accurate

forecasting *n a lean supply environment( lead times are reduced which can help minimi6e safety

stock levels thus reducing the likelihood and impact of stockouts. #ue to the cost of safety stock(

many organi6ations opt for a service level led safety stock calculationN for example( a IAB

service levelcould result in stockouts( but is at a level which is satisfactory to the company. +he

lower the service level( the lower the requirement for safety stock.