CHAPTER 15  

  Working Capital and Current Assets Management 703

so the firm benefits by minimizing their use in supporting operating assets. In

other words, to maximize shareholder wealth, managers should work to mini-
mize the length of the cash conversion cycle (subject to a variety of constraints
mentioned below), which minimizes the need for costly financing. Managers can
achieve this goal by implementing a combination of the following strategies:
1. Turn over inventory as quickly as possible without stockouts that result in
lost sales.
2. Collect accounts receivable as quickly as possible without losing sales from
high-pressure collection techniques or from credit terms that are not com-
petitive in the market.
3. Manage mail, processing, and clearing time to reduce them when collecting
from customers and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible without damaging the firm’s
credit rating or its relationships with suppliers.
Techniques for implementing these four strategies are the focus of the remainder
of this chapter and the following chapter.

➔ REVIEW QUESTIONS  MyLab Finance Solutions

15–4 What is the difference between the firm’s operating cycle and its cash
conversion cycle?
15–5 Why is it helpful to divide the funding needs of a seasonal business into
its permanent and seasonal funding requirements when developing a
funding strategy?
15–6 What are the benefits, costs, and risks of an aggressive funding strategy
and of a conservative funding strategy? Under which strategy is the
borrowing often in excess of the actual need?
15–7 Why is it important for a firm to minimize the length of its cash con-
version cycle?

LG 3 15.3 Inventory Management

The first component of the cash conversion cycle is the average age of inventory.
The objective for managing inventory, as noted earlier, is to turn over inventory as
quickly as possible (or equivalently, to minimize the average age of inventory) with-
out losing sales from stockouts. The financial manager tends to act as an advisor or
“watchdog” in matters concerning inventory. He or she does not have direct con-
trol over inventory but does provide input to the inventory management process.

DIFFERING VIEWPOINTS ABOUT INVENTORY LEVEL

Viewpoints about appropriate inventory levels commonly differ among a firm’s
finance, marketing, manufacturing, and purchasing managers. Each views inven-
tory levels in light of his or her own objectives. The financial manager’s general
disposition toward inventory levels is to keep them low, to ensure that the firm’s
money is not being unwisely invested in excess resources. The marketing man-
ager, in contrast, would like to have large inventories of the firm’s finished prod-
ucts. This would ensure that all orders could be filled quickly, eliminating the
need for backorders due to stockouts.

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 704 PART SEVEN   Short-Term Financial Decisions

The manufacturing manager’s major responsibility is to implement the pro-

duction plan so that it results in the desired amount of finished goods of acceptable
quality available on time at a low cost. In fulfilling this role, the manufacturing
manager would keep raw materials inventories high to avoid production delays.
He or she also would favor large production runs for the sake of lower unit pro-
duction costs, which would result in high finished goods inventories.
The purchasing manager is concerned solely with the raw materials invento-
ries. He or she must have on hand, in the correct quantities at the desired times
and at a favorable price, whatever raw materials are required by production.
Without proper control, in an effort to get quantity discounts or in anticipation
of rising prices or a shortage of certain materials, the purchasing manager may
purchase larger quantities of resources than are actually needed at the time.

COMMON TECHNIQUES FOR MANAGING INVENTORY

Numerous techniques are available for effectively managing the firm’s inventory.
Here we briefly consider four commonly used techniques.

ABC System
ABC inventory system A firm using the ABC inventory system divides its inventory into three groups: A,
Inventory management tech- B, and C. The A group includes those items with the largest dollar investment.
nique that divides inventory into Typically, this group consists of 20% of the firm’s inventory items but 80% of its
three groups—A, B, and C, in investment in inventory. The B group consists of items that account for the next
descending order of impor-
largest investment in inventory. The C group comprises a large number of items
tance and level of monitoring—
on the basis of the dollar that require a relatively small investment.
investment in each. The inventory group of each item determines the item’s level of monitoring.
The A group items receive the most intense monitoring because of the high dollar
investment. Typically, managers track A group items on a perpetual inventory
system that allows daily verification of each item’s inventory level. B group items
are frequently controlled through periodic, perhaps weekly, checking of their lev-
els. Managers monitor C group items with unsophisticated techniques, such as
two-bin method
the two-bin method. With the two-bin method, the item is stored in two bins. As
Unsophisticated inventory-­
an item is needed, inventory is removed from the first bin. When that bin is
monitoring technique that is
typically applied to C group empty, an order is placed to refill the first bin while inventory is drawn from the
items and involves reordering second bin. The second bin is used until empty, and so on.
inventory when one of two bins The large dollar investment in A and B group items suggests the need for a
is empty. better method of inventory management than the ABC system. The EOQ model,
economic order quantity discussed next, is an appropriate model for managing A and B group items.
(EOQ) model
Inventory management tech- Economic Order Quantity (EOQ) Model
nique for determining an item’s
optimal order size, which is the
One technique for determining the optimal order size for inventory items is the
size that minimizes the total of economic order quantity (EOQ) model. The EOQ model considers various costs
its order costs and carrying of inventory and then determines what order size minimizes total inventory cost.
costs. The EOQ model works by trading off two categories of inventory costs:
order costs order costs and carrying costs. Order costs include the fixed clerical costs of plac-
The fixed clerical costs of plac- ing and receiving orders: the cost of writing a purchase order, of processing the
ing and receiving an inventory resulting paperwork, and of receiving an order and checking it against the
order. invoice. The more orders a firm places, the higher are order costs. In the EOQ
carrying costs model, we measure order costs in dollars per order. Carrying costs are the vari-
The variable costs per unit of able costs per unit of holding an item of inventory for a specific period of time.
holding an item in inventory for Carrying costs include storage costs, insurance costs, the costs of deterioration
a specific period of time. and obsolescence, and the opportunity cost of investing funds in inventory rather

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 CHAPTER 15    Working Capital and Current Assets Management 705

than in other assets that earn a return. A firm can push carrying costs down by
placing many small orders rather than a few large ones. In the EOQ model, we
measure carrying costs in dollars per unit per period.
Order costs decrease as the size of the order increases and the number of
orders falls. Carrying costs, however, increase with increases in the order size.
The EOQ model analyzes the tradeoff between order costs and carrying costs to
determine the order quantity that minimizes the total inventory cost.

Mathematical Development of EOQ  A formula can be developed for

determining the firm’s EOQ for a given inventory item, where
S = usage in units per period
O = cost per order
Q = order quantity in units
C = carrying cost per unit per period
The first step is to derive the cost functions for order cost and carrying cost.
Total order cost equals the cost per order (O) times the number of orders. The
number of orders equals S , Q, the usage in units per period (S) divided by the
order quantity in units (Q), so the order cost equals

Order cost = O * (S , Q)   (15.4)

The carrying cost is the cost of carrying a unit of inventory per period (C) multi-
plied by the firm’s average inventory. The average inventory is Q , 2 because
EOQ model assumes that a firm’s inventory is drawn down at a steady rate
between orders. That is, the average inventory is the order quantity (Q) divided
by 2. Thus, carrying cost equals

Carrying cost = C * (Q , 2)   (15.5)

total cost of inventory The firm’s total cost of inventory equals the sum of the order cost and the
The sum of order costs and car- carrying cost. Thus, the total cost function is
rying costs of inventory.

Total cost = 3 O * (S , Q)4 + 3 C * (Q , 2)4   (15.6)

Because the EOQ is the order quantity that minimizes the total cost function, we
must solve the total cost function for the EOQ.3 The resulting equation is

2 * S * O
EOQ =   (15.7)
A C

3. In this simple model, the EOQ occurs at the point where the order cost 3 O * (S , Q)4 just equals the carrying
cost 3 C * (Q , 2)4 . To demonstrate, we set the two costs equal and solve for Q:
3 O * (S , Q)4 = 3 C * (Q , 2)4
Then cross-multiplying, we get
2 * O * S = C * Q2
Dividing both sides by C, we get
Q 2 = (2 * O * S) , C
so
Q = 2(2 * O * S) , C

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 706 PART SEVEN   Short-Term Financial Decisions

Remember that the EOQ as defined by Equation 15.7 is simply the size of
the order that the firm should place to minimize costs. Think intuitively about
what Equation 15.7 says regarding the optimal order quantity. If the rate at
which the firm uses inventory, S, increases, then the order quantity should be
higher. That makes sense because if a firm uses inventory very rapidly and if it
places small orders, it will have to place many of them and order costs will be
very high. Similarly, Equation 15.7 says that if the carrying cost per unit (C) is
high, the order quantity should be smaller. That makes sense, too, because if
inventory is costly to hold (perhaps because it spoils or because its value
declines rapidly), a firm does not want to hold a large inventory balance.

P E RS ON A L F IN A N C E E X A M P L E 1 5 . 4 Individuals sometimes are confronted with personal finance

decisions involving cost tradeoffs similar to the tradeoff
between the fixed order costs and variable carrying costs of inventory that corpo-
rations face. Take the case of the von Dammes, who supplement the income they
earn from their primary jobs by painting houses in their spare time.
The von Dammes estimate that over the course of a year they will buy 250 gal-
lons of paint at an average cost of $20 per gallon. For every trip they make to the
paint store, the von Dammes spend about $10 in fuel and other costs related to the
wear and tear on their personal vehicle. They store the paint in a self-storage unit
and estimate that they spend about $2 per gallon of paint in storage costs. How of-
ten should they visit the paint store, and how much paint should they purchase on
each visit?
Applying the EOQ model to this problem, we have:
S = 250 gallons per year O = $10 per order C = $2 per gallon

2 * 250 * $10
EOQ = = 50
A $2

The von Dammes should purchase 50 gallons of paint each time they visit the store.
Given their annual use of 250 gallons, they will make 5 trips to the store per year.

Reorder Point  Once the firm has determined its economic order quantity, it
reorder point must determine when to place an order. The reorder point reflects the number of
The point at which to reorder days of lead time the firm needs to place and receive an order and the firm’s daily
inventory, expressed as days of usage of the inventory item. Assuming that the firm uses inventory at a constant
lead time * daily usage. rate, the formula for the reorder point is

Reorder point = Days of lead time * Daily usage (15.8)

For example, if a firm knows it takes 3 days to place and receive an order
and if it uses 15 units per day of the inventory item, the reorder point is 45 units
of inventory (3 days * 15 units/day). Thus, as soon as the item’s inventory level
falls to the reorder point (45 units, in this case), the firm places an order for the
safety stock
item’s EOQ. If the estimates of lead time and usage are correct, the order will
Extra inventory that is held to arrive exactly as the inventory level reaches zero. However, lead times and usage
prevent stockouts of important rates are not precise, so most firms hold safety stock (extra inventory) to prevent
items. stockouts of important items.

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 CHAPTER 15    Working Capital and Current Assets Management 707

E XAM P L E 1 5 . 5 MAX Company, a producer of dinnerware, has an A group inventory item

that is vital to the production process. This item costs $1,500, and MAX
MyLab Finance Solution uses 1,100 units of the item per year. MAX wants to determine its optimal
Video order strategy for the item. To calculate the EOQ, we need the following
inputs:

Order cost per order = $150

Carrying cost per unit per year = $200

Substituting into Equation 15.7, we get

2 * 1,100 * $150
EOQ = ≈ 41 units
A $200
The reorder point for MAX depends on the number of days MAX oper-
ates per year. Assuming that MAX operates 250 days per year and uses 1,100
units of this item, its daily usage is 4.4 units (1,100 , 250). If its lead time is
2 days and MAX wants to maintain a safety stock of 4 units, the reorder
point for this item is 3 (2 * 4.4) + 4 4 , or 12.8 units. However, orders are
made only in whole units, so MAX places the order when the inventory falls
to 13 units.

The firm’s goal for inventory is to turn it over as quickly as possible without
stockouts. Inventory turnover is best calculated by dividing cost of goods sold by
average inventory. The EOQ model determines the optimal order size and, indi-
rectly, through the assumption of constant usage, the average inventory. Thus,
the EOQ model determines the firm’s optimal inventory turnover rate, given the
firm’s specific costs of inventory.

Just-in-Time (JIT) System

just-in-time (JIT) system Firms use the just-in-time (JIT) system to minimize inventory investment.
Inventory management tech- The philosophy is that materials should arrive at exactly the time they are
nique that minimizes inventory needed for production. Ideally, the firm would have only work-in-process
investment by having materials inventory. Because its objective is to minimize inventory investment, a JIT
arrive at exactly the time they
system uses no (or very little) safety stock. Extensive coordination among the
are needed for production.
firm’s employees, its suppliers, and shipping companies must exist to ensure
that material inputs arrive on time. Failure of materials to arrive on time
results in a shutdown of the production line until the materials do arrive.
Likewise, a JIT system requires high-quality parts from suppliers. When
quality problems arise, production must be stopped until the problems are
resolved.
The goal of the JIT system is manufacturing efficiency. It uses inventory as a
tool for attaining efficiency by emphasizing quality of the materials used and
their timely delivery. When JIT is working properly, it forces process inefficien-
cies to surface.
Knowing the level of inventory is, of course, an important part of any inven-
tory management system. As described in the Focus on Practice box, radio fre-
quency identification technology may be the “next new thing” in improving
inventory and supply chain management.

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 708 PART SEVEN   Short-Term Financial Decisions

FOCUS ON PRACTICE in practice

In Bed with RFID
When you think about a company’s managers use radio frequency identi- allows the hotel to track every item to
inventory, you may envision pallets fication (RFID) technology to do just and from its laundry. Making sure that
full of boxes stacked high in a ware- that. The hotel installed a system cre- it has just the right amount of linen in
house. But for high-end hotels, an ated by InvoTech Systems that tracks stock helps LUMA hold down costs
important inventory category is the each of the hotel’s 15,000 linen items while delighting its guests.
high-thread-count linens in every using RFID-enabled laundry carts. The
guest room. Luxury bedding can cost system allows LUMA to eliminate the What problem might occur with
hundreds of dollars, so hotel manag- daily task of sorting and hand count- the full implementation of RFID
ers need to closely track every sheet ing all the different types of linens. technology in retail industries?
and pillowcase. At the recently Each piece of linen the hotel orders ­Specifically, consider the amount
opened LUMA Hotel Times Square, comes with a washable RFID tag that of data that might be collected.

Source: https://www.hospitalitynet.org/news/4082782.html

materials requirement
planning (MRP) system Computerized Systems for Resource Control
Inventory management tech- Today, a number of systems are available for controlling inventory and other
nique that applies EOQ con- resources. One of the most basic is the materials requirement planning (MRP)
cepts and uses a computer to system. Firms use that system to determine what materials to order and when
compare production needs to
to order them. MRP applies EOQ concepts to determine how much to order.
available inventory balances
and determine when orders Using a computer, MRP simulates each product’s bill of materials, inventory
should be placed for various status, and manufacturing process. The bill of materials is simply a list of all
items on a product’s bill of parts and materials that go into making the finished product. For a given pro-
materials. duction plan, the computer simulates material requirements by comparing pro-
manufacturing resource duction needs to available inventory balances. On the basis of the time it takes
planning II (MRP II) for a product that is in process to move through the various production stages
An extension of MRP that uses a and the lead time to get materials, the MRP system determines when orders
sophisticated computerized sys- should be placed for various items on the bill of materials. The objective of this
tem to integrate data from system is to lower the firm’s inventory investment without impairing produc-
numerous areas such as finance,
tion. If the firm’s pretax cost of capital for investments of equal risk is 10%,
accounting, marketing, engi-
neering, and manufacturing and
every dollar of investment released from inventory will increase before-tax
generate production plans as profits by $0.10.
well as numerous financial and An extension of MRP is manufacturing resource planning II (MRP II), which
management reports. integrates data from numerous areas such as finance, accounting, marketing,
enterprise resource engineering, and manufacturing, using a sophisticated computer system. This
planning (ERP) system generates production plans as well as numerous financial and manage-
A computerized system that ment reports. In essence, it models the firm’s processes so that the firm can assess
electronically integrates external and monitor the effects of changes in one area of operations on other areas. For
information about the firm’s sup- example, the MRP II system would allow the firm to determine the effect of an
pliers and customers with the increase in labor costs on sales and profits.
firm’s departmental data so that
Whereas MRP and MRP II tend to focus on internal operations, enter-
information on all available
resources—human and mate-
prise resource planning (ERP) systems expand the focus to the external envi-
rial—can be instantly obtained in ronment by including information about suppliers and customers. ERP
a fashion that eliminates produc- electronically integrates all of a firm’s departments so that, for example, pro-
tion delays and controls costs. duction can call up sales information and immediately know how much must

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 CHAPTER 15    Working Capital and Current Assets Management 709

be produced to fill customer orders. Because all available resources—human

and material—are known, the system can eliminate production delays and
control costs. ERP systems automatically note changes, such as a supplier’s
inability to meet a scheduled delivery date, so that production can make nec-
essary adjustments.

INTERNATIONAL INVENTORY MANAGEMENT

International inventory management is typically much more complicated for
exporters in general, and for multinational companies in particular, than for
purely domestic firms. The production and manufacturing economies of scale
that might be expected from selling products globally may prove elusive if prod-
ucts must be tailored for individual local markets, as frequently happens, or if
actual production takes place in factories around the world. When raw materi-
als, intermediate goods, or finished products must be transported over long
distances—particularly by ocean shipping—there will be more delays, confusion,
damage, and theft than occur in a one-country operation. The international
inventory manager therefore puts a premium on flexibility. He or she is usually
less concerned about ordering the economically optimal quantity of inventory
than about making sure that sufficient quantities of inventory are delivered
where they are needed, when they are needed, and in a condition to be used as
planned.

➔ REVIEW QUESTIONS  MyLab Finance Solutions

15–8 What are likely to be the viewpoints of each of the following
managers about the levels of the various types of inventory: finance,
marketing, manufacturing, and purchasing? Why is inventory an
investment?
15–9 Briefly describe the following techniques for managing inventory:
(1) ABC system, economic order quantity (EOQ) model, (2) just-in-
time (JIT) system, and (3) three computerized systems for resource
control, MRP, MRP II, and ERP.
15–10 What factors make managing inventory more difficult for exporters
and multinational companies?

LG 4 LG 5 15.4 Accounts Receivable Management

The second component of the cash conversion cycle is the average collection
period. This period is the average length of time from a sale on credit until
the payment becomes usable funds for the firm. The average collection period
has two parts. The first part is the time from the sale until the customer mails
the payment. The second part is the time from when the payment is mailed
until the firm has the collected funds in its bank account. The first part of the
average collection period involves managing the credit available to the firm’s
customers, and the second part involves collecting and processing payments.
This section of the chapter discusses the firm’s accounts receivable credit
management.

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