10.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 10Chapter 10
Accounts Receivable Accounts Receivable and Inventory and Inventory ManagementManagement
Accounts Receivable Accounts Receivable and Inventory and Inventory ManagementManagement
10.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1. List the key factors that can be varied in a firm's credit policy and understand the trade-off between profitability and costs involved.
2. Understand how the level of investment in accounts receivable is affected by the firm's credit policies.
3. Critically evaluate proposed changes in credit policy, including changes in credit standards, credit period, and cash discount.
4. Describe possible sources of information on credit applicants and how you might use the information to analyze a credit applicant.
5. Identify the various types of inventories and discuss the advantages and disadvantages of increasing/decreasing inventories
6. Describe, explain, and illustrate the key concepts and calculations necessary for effective inventory management and control, including classification, economic order quantity (EOQ), order point, safety stock, and just-in-time (JIT).
After Studying Chapter 10, After Studying Chapter 10, you should be able to:you should be able to:
10.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Credit and Collection Policies
• Analyzing the Credit Applicant
• Inventory Management and Control
Accounts Receivable and Accounts Receivable and Inventory ManagementInventory Management
10.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
(1) Average Collection Period
(2) Bad-debtLosses
Quality ofQuality ofTrade AccountTrade Account
Length ofCredit Period
Possible CashDiscount
FirmCollectionProgram
Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm
10.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The financial manager should continually lower the firm’s credit standards as long as profitability from the change exceeds the extra costs generated by the additional
receivables.
Credit StandardsCredit Standards – The minimum quality of credit worthiness of a credit applicant
that is acceptable to the firm.
Why lower the firm’s credit standards?Why lower the firm’s credit standards?
Credit StandardsCredit Standards
10.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• A larger credit department
• Additional clerical work
• Servicing additional accounts
• Bad-debt losses
• Opportunity costs
Costs arising from relaxing Costs arising from relaxing credit standardscredit standards
Credit StandardsCredit Standards
10.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Basket Wonders is not operating at full capacity Basket Wonders is not operating at full capacity and wants to determine if a relaxation of their and wants to determine if a relaxation of their credit standards will enhance profitability. credit standards will enhance profitability.
• The firm is currently producing a single product with variable costs of $20 and selling price of $25.
• Relaxing credit standards is not expected to affect current customer payment habits.
Example of Relaxing Example of Relaxing Credit StandardsCredit Standards
10.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Additional annual credit sales of $120,000 and an average collection period for new accounts of 3 months is expected.
• The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses Ignoring any additional bad-debt losses that may arise, should Basket Wonders that may arise, should Basket Wonders
relax their credit standards?relax their credit standards?
Example of Relaxing Example of Relaxing Credit StandardsCredit Standards
10.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Profitability of ($5 contribution) x (4,800 units) =additional sales $24,000$24,000
Additional ($120,000 sales) / (4 Turns) =receivables $30,000
Investment in ($20/$25) x ($30,000) =add. receivables $24,000
Req. pre-tax return (20% opp. cost) x $24,000 =on add. investment $4,800$4,800
Yes!Yes! Profits > Required pre-tax return
Example of Relaxing Example of Relaxing Credit StandardsCredit Standards
10.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
(1) Average Collection Period
(2) Bad-debtLosses
Quality ofTrade Account
Length ofLength ofCredit PeriodCredit Period
Possible CashDiscount
FirmCollectionProgram
Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm
10.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Credit PeriodCredit Period – The total length of time over which credit is extended to a customer to
pay a bill. For example, “net 30” “net 30” requires full payment to the firm within 30 days from the
invoice date.
Credit Terms Credit Terms – Specify the length of time over which credit is extended to a customer
and the discount, if any, given for early payment. For example, “2/10, net 30.”“2/10, net 30.”
Credit TermsCredit Terms
10.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Basket Wonders Basket Wonders is considering changing its credit period from “net 30” “net 30” (which has resulted in 12 A/R “Turns” per year) to “net 60” “net 60” (which is expected to result in 6 A/R “Turns” per year).
• The firm is currently producing a single product with variable costs of $20 and a selling price of $25.
• Additional annual credit sales of $250,000 from new customers are forecasted, in addition to the current $2 million in annual credit sales.
Example of Relaxing Example of Relaxing the Credit Periodthe Credit Period
10.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses Ignoring any additional bad-debt losses that may arise, should Basket Wonders that may arise, should Basket Wonders
relax their credit period?relax their credit period?
Example of Relaxing Example of Relaxing the Credit Periodthe Credit Period
10.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Profitability of ($5 contribution)x(10,000 units) =additional sales $50,000$50,000
Additional ($250,000 sales) / (6 Turns) =receivables $41,667
Investment in add. ($20/$25) x ($41,667) =receivables (new sales) $33,334
Previous ($2,000,000 sales) / (12 Turns) =receivable level $166,667
Example of Relaxing Example of Relaxing the Credit Periodthe Credit Period
10.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
New ($2,000,000 sales) / (6 Turns) =receivable level $333,333
Investment in $333,333 - $166,667 =add. receivables $166,666 (original sales)
Total investment in $33,334 + $166,666 =add. receivables $200,000
Req. pre-tax return (20% opp. cost) x $200,000 =on add. investment $40,000$40,000
Yes! Yes! Profits > Required pre-tax return
Example of Relaxing Example of Relaxing the Credit Periodthe Credit Period
10.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
(1) Average Collection Period
(2) Bad-debtLosses
Quality ofTrade Account
Length ofCredit Period
Possible CashPossible CashDiscountDiscount
FirmCollectionProgram
Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm
10.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cash DiscountCash Discount – A percent (%) reduction in sales or purchase price allowed for early payment of invoices. For example, “2/10” “2/10”
allows the customer to take a 2% cash discount during the cash discount period.
Cash Discount PeriodCash Discount Period – The period of time during which a cash discount can be taken for
early payment. For example, “2/10”“2/10” allows a cash discount in the first 10 days from the
invoice date.
Credit TermsCredit Terms
10.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A competing firm of Basket Wonders is considering changing the credit period from “net “net
60” 60” (which has resulted in 6 A/R “Turns” per year) to “2/10, net 60.”“2/10, net 60.”
• Current annual credit sales of $5 million are expected to be maintained.
• The firm expects 30% of its credit customers (in dollar volume) to take the cash discount and thus increase A/R “Turns” to 8.
• (30% x 10 days + 70% x 60 days = 3 + 42 days = 45 days
• 360 days per year / 45 days = 8 turns per year
Example of Introducing Example of Introducing a Cash Discounta Cash Discount
10.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%.
Ignoring any additional bad-debt losses Ignoring any additional bad-debt losses that may arise, should the competing firm that may arise, should the competing firm
introduce a cash discount?introduce a cash discount?
Example of Introducing Example of Introducing a Cash Discounta Cash Discount
10.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Receivable level ($5,000,000 sales) / (6 Turns) =(Original) $833,333
Receivable level ($5,000,000 sales) / (8 Turns) =(New) $625,000
Reduction of $833,333 - $625,000 =investment in A/R $208,333
Example of Using Example of Using the Cash Discountthe Cash Discount
10.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Pre-tax cost of 0.02 x 0.3 x $5,000,000 =the cash discount $30,000$30,000..
Pre-tax opp. savings (20% opp. cost) x $208,333 =on reduction in A/R $41,667$41,667..
Yes! Yes! Savings > Costs
The benefits derived from released accounts receivable exceed the costs of providing the
discount to the firm’s customers.
Example of Using the Example of Using the Cash DiscountCash Discount
10.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Avoids carrying excess inventory and the associated carrying costs.
• Accept dating if warehousing costs plus the required return on investment in inventory exceeds the required return on additional receivables.
Seasonal DatingSeasonal Dating – Credit terms that encourage the buyer of seasonal products
to take delivery before the peak sales period and to defer payment until after the peak
sales period.
Seasonal DatingSeasonal Dating
10.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
(1) Average Collection Period
(2) Bad-debtLosses
Quality ofTrade Account
Length ofCredit Period
Possible CashDiscount
FirmFirmCollectionCollectionProgramProgram
Credit and Collection Credit and Collection Policies of the FirmPolicies of the Firm
10.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PresentPolicy Policy A Policy B
Demand $2,400,000 $3,000,000 $3,300,000 Incremental sales $ 600,000 $ 300,000 Default losses Original sales 2% Incremental Sales 10% 18% Avg. Collection Pd. Original sales 1 month Incremental Sales 2 months 3 months
Default Risk and Default Risk and Bad-Debt LossesBad-Debt Losses
10.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Policy A Policy B
1. Additional sales $600,000 $300,000 2. Profitability: (20% contribution) x (1)2. Profitability: (20% contribution) x (1) 120,000 120,000 60,000 60,000 3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000 4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000 5. Inv. in add. receivables: (.80) x (4) 80,000 60,000 6. Required before-tax return on
additional investment: (5) x (20%) 16,000 12,000 7. Additional bad-debt losses +7. Additional bad-debt losses +
additional required return: (3) + (6)additional required return: (3) + (6) 76,000 76,000 66,000 66,000
8. Incremental profitability: (2) - (7)8. Incremental profitability: (2) - (7) 44,000 44,000 (6,000) (6,000)
Adopt Policy A but not Policy B.Adopt Policy A but not Policy B.
Default Risk and Default Risk and Bad-Debt LossesBad-Debt Losses
10.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The firm should increase collection collection expenditures expenditures until the marginal
reduction in bad-debt losses bad-debt losses equals the marginal outlay to collect.
Collection Collection Procedures Procedures
• Letters
• Phone calls
• Personal visits
• Legal action
SaturationSaturationPointPoint
Collection ExpendituresCollection Expenditures
Bad
-Deb
t L
oss
esB
ad-D
ebt
Lo
sses
Collection Policy Collection Policy and Proceduresand Procedures
10.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Obtaining information on the credit applicant
• Analyzing this information to determine the applicant’s creditworthiness
• Making the credit decision
Analyzing the Analyzing the Credit ApplicantCredit Applicant
10.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Financial statements• Credit ratings and reports• Bank checking• Trade checking• Company’s own experience
The company must weigh the amount amount of information of information needed versus the time time
and expense requiredand expense required.
Sources of InformationSources of Information
10.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• the financial statements of the firm (ratio analysis)
• the character of the company• the character of management• the financial strength of the firm• other individual issues specific to
the firm
A credit analyst is likely to utilize A credit analyst is likely to utilize information regardinginformation regarding::
Credit AnalysisCredit Analysis
10.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The cost of investigation (determining the type and amount of information collected) is balanced against the
expected profit from an order.
An example is provided in the following three slides 10-31 through 10-33.
Sequential Sequential Investigation ProcessInvestigation Process
10.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
* For previous customers only a Dun & Bradstreet reference book check.
Pending Order
Badpast creditexperience
Dun & Bradstreetreport analysis*
RejectYesNoStage 1$5 Cost
Stage 2$5 - $15
Cost
No prior experience whatsoever
Sample Investigation Sample Investigation Process Flow Chart (Part A)Process Flow Chart (Part A)
10.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Accept
Yes
No
Credit rating“limited” and/or otherdamaging information
unearthed?
No
Yes
Reject
Credit rating“fair” and/or otherclose to maximum
“line of credit”?
Sample Investigation Sample Investigation Process Flow Chart (Part B)Process Flow Chart (Part B)
10.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
** That is, the credit of a bank is substituted for customer’s credit.
Bank, creditor, and financialstatement analysis
Accept RejectAccept, only upon
domestic irrevocableletter of credit (L/C)**
Fair PoorGood
Stage 3$30 Cost
Sample Investigation Sample Investigation Process Flow Chart (Part C)Process Flow Chart (Part C)
10.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Line of CreditLine of Credit – A limit to the amount of credit extended to an account. Purchaser can buy on
credit up to that limit.
• Streamlines the procedure for shipping goods.
Credit-scoring SystemCredit-scoring System – A system used to decide whether to grant credit by assigning numerical scores to various characteristics
related to creditworthiness.
Other Credit Other Credit Decision IssuesDecision Issues
10.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Credit decisions are made• Ledger accounts maintained• Payments processed• Collections initiated
Decision based on the core competencies of the firm.
Outsourcing Credit and CollectionsOutsourcing Credit and Collections
The entire credit and/or collection function(s) are outsourced to a third-party company.
Other Credit Other Credit Decision IssuesDecision Issues
10.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Raw-materials inventory• Work-in-process inventory• In-transit inventory• Finished-goods inventory
Inventories form a link between production and sale of a product.
Inventory types:Inventory types:
Inventory Inventory Management and ControlManagement and Control
10.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Purchasing• Production scheduling• Efficient servicing of customer
demands
Inventories provide flexibility Inventories provide flexibility for the firm in:for the firm in:
Inventory Inventory Management and ControlManagement and Control
10.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Employ a cost-benefit analysisEmploy a cost-benefit analysis
Compare the benefits of economies of production, purchasing, and product
marketing against the cost of the additional investment in inventories.
How does a firm determine How does a firm determine the appropriate level of the appropriate level of
inventories?inventories?
Appropriate Appropriate Level of InventoriesLevel of Inventories
10.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Method which controls expensive inventory
items more closely than less expensive items.
• Review “A” items most frequently
• Review “B” and “C” items less rigorously and/or less frequently.
ABC method of ABC method of inventory controlinventory control
0 15 45 1000 15 45 100
Cumulative Percentage Cumulative Percentage of Items in Inventoryof Items in Inventory
7070
9090
100100
Cu
mu
lati
ve P
erce
nta
ge
Cu
mu
lati
ve P
erce
nta
ge
of
Inve
nto
ry V
alu
eo
f In
ven
tory
Val
ue
AA
BBCC
ABC Method of ABC Method of Inventory ControlInventory Control
10.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Forecast usage Ordering cost Carrying cost
Ordering can mean either the purchase or Ordering can mean either the purchase or production of the item.production of the item.
The optimal quantity to order The optimal quantity to order depends on:depends on:
How Much to Order?How Much to Order?
10.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
CC: Carrying costs per unit per periodOO: Ordering costs per orderSS: Total usage during the period
Total inventory costs (T) =Total inventory costs (T) =CC ( (Q / 2Q / 2) + ) + OO ( (SS / / QQ))
TIMETIME
Q / 2Q / 2
QQAverageAverage
InventoryInventory
INV
EN
TO
RY
IN
VE
NT
OR
Y
(in
un
its)
(in
un
its)
Total Inventory CostsTotal Inventory Costs
10.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The EOQ or optimal quantity (Q*) is:
The quantity of an inventory item to order so that total inventory costs are minimized
over the firm’s planning period.
Q* Q* ==2 (2 (O) () (SS))
CC
Economic Order QuantityEconomic Order Quantity
10.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Basket Wonders Basket Wonders is attempting to determine the economic order quantity for fabric used in the
production of baskets. • 10,000 yards of fabric were used at a constant
rate last period.• Each order represents an ordering cost of $200.• Carrying costs are $1 per yard over the 100-day
planning period.
What is the economic order quantity?What is the economic order quantity?
Example of the Example of the Economic Order QuantityEconomic Order Quantity
10.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
We will solve for the economic order quantity given that ordering costs are $200 per order, total usage over the period was 10,000 units,
and carrying costs are $1 per yard (unit).
Q* Q* ==2 (2 ($200) () (10,00010,000))
$1$1
Q* Q* = = 2,000 Units2,000 Units
Economic Order QuantityEconomic Order Quantity
10.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
EOQ (Q*) represents the minimum EOQ (Q*) represents the minimum point in total inventory costs.point in total inventory costs.
Total Inventory CostsTotal Inventory Costs
Total Carrying CostsTotal Carrying Costs
Total Ordering CostsTotal Ordering Costs
Q*Q* Order Size (Q)Order Size (Q)
Co
sts
Co
sts
Total Inventory CostsTotal Inventory Costs
10.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Order PointOrder Point – The quantity to which inventory must fall in order to signal that an order must
be placed to replenish an item.
Order Point Order Point (OPOP) = Lead time Lead time X Daily usage
Issues to considerIssues to consider::Lead TimeLead Time – The length of time between the
placement of an order for an inventory item and when the item is received in inventory.
When to Order?When to Order?
10.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Julie Miller of Basket Wonders Basket Wonders has determined that it takes only 2 days to receive the order of
fabric after the placement of the order.
When should Julie order more fabric?When should Julie order more fabric?
Lead time Lead time = = 2 days2 days
Daily usage Daily usage = 10,000 yards / 100 days = 10,000 yards / 100 days = = 100 yards per day100 yards per day
Order PointOrder Point = = 2 days 2 days xx 100 yards per day100 yards per day== 200 yards200 yards
Example of When to OrderExample of When to Order
10.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
0 0 18 20 38 40 18 20 38 40LeadLeadTimeTime
200200
20002000
OrderOrderPointPointU
NIT
SU
NIT
S
DAYSDAYS
Economic Order Quantity (Q*)Economic Order Quantity (Q*)
Example of When to OrderExample of When to Order
10.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Our previous example assumed certain demand and lead time. When demand and/or lead time are
uncertain, then the order point is:
Order PointOrder Point =
(Avg. lead time x Avg. daily usage) + Safety stockSafety stock
Safety StockSafety Stock – Inventory stock held in reserve as a cushion against uncertain demand (or
usage) and replenishment lead time.
Safety StockSafety Stock
10.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
0 18 20 380 18 20 38
400400
20002000
OrderOrderPointPoint
UN
ITS
UN
ITS
DAYSDAYS
22002200
Safety StockSafety Stock200200
Order Point Order Point with Safety Stockwith Safety Stock
10.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
UN
ITS
UN
ITS
DAYSDAYS
Safety StockSafety Stock
Actual leadActual leadtime is 3 days!time is 3 days!
(at day 21)(at day 21)
22002200
20002000
OrderOrderPointPoint
400400
200200
0 18 210 18 21
The firm “dips”The firm “dips”into the safety stockinto the safety stock
Order Point Order Point with Safety Stockwith Safety Stock
10.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Amount of uncertainty in inventory demand
• Amount of uncertainty in the lead time
• Cost of running out of inventory
• Cost of carrying inventory
What is the proper amount of What is the proper amount of safety stock?safety stock?
Depends on theDepends on the::
How Much Safety Stock?How Much Safety Stock?
10.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• A very accurate production and inventory information system
• Highly efficient purchasing• Reliable suppliers• Efficient inventory-handling system
Just-in-TimeJust-in-Time – An approach to inventory management and control in which inventories are acquired and inserted in production at the
exact times they are needed.
Requirements of applying this approachRequirements of applying this approach::
Just-in-TimeJust-in-Time
10.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• JIT inventory control is one link in SCM.• The internet has enhanced SCM and
allows for many business-to-business (B2B) transactions
• Competition through B2B auctions helps reduce firm costs – especially standardized items
Supply Chain Management (SCM)Supply Chain Management (SCM) – Managing the process of moving goods, services, and
information from suppliers to end customers.
Supply Chain ManagementSupply Chain Management