Chapter One: Dividend Policy And Theories

TYPES OF DIVIDEND

Dividend theories

RELEVANCE THEORIES IRRELEVANT THEORIES

(i.e Which consider the dividend decision to be
(i.e Which consider the dividend decision to
irrelevant as it does not affect the value of the firm)
be relevant as it affect the value of the firm)

Modigliani and Traditional model

Walters’s model Gordon’s model
miller model

Assumption Assumption Assumptions

 The firm uses only
 Perfect capital market.
internal finance.  The firm is an all
 Investors are rational.
 The firm does not use equity firm.
debt or equity finance.  The firm has no  There are no taxes.
 The firm has constant external finance.  The firm has fixed
return and cost of capital.  Cost of capital and investment policy.
 The firm Irrelevant
has 100 recent return are constant.  No risk or uncertainty.
payout. Millar modiglia  The firm has
 The firm has constant EPS perpetual life.
and dividend.  There are no taxes.
 The firm has a very long
By: Daniel B. Page 1
life.
 𝐷1 + 𝑃1
po =
(1 + 𝐾𝑒)
Where
Po = Prevailing market price of a share
Ke =Cost of equity capital
D1 = Dividend to be received at the end of period one
P1 = Market price of the share at the end of period one P1 can be calculated with the help of the following
formula.
P1 = Po (1+Ke) – D1
Exercise 1
Shanan Gibe Ltd Company has 100000 shares outstanding the current market price of the shares
Br. 15 each. The company expects the net profit of Br. 490,000 during the year and it belongs to
a rich class for which the appropriate capitalization rate has been estimated to be 20%. The
company is considering dividend of Br. 2.50 per share for the current year and proposal for new
investment of Br. 720,000.
What will be the price of the share at the end of the year?
A) if the dividend is paid and
B) if the dividend is not paid.
𝐷1+𝑃1
Solution po = (1+𝐾𝑒)

A) If the dividend is paid Po = Br. 15

Ke = 20%
D1 = 2.5
P1 = ?
2.5 + 𝑃1
15 =
(1 + 20%)

2.5 + 𝑃1
15 =
1.2

2.5 + P1 = 15 × 1.2

P1 = 18 – 2.5

P1 = Br. 15.50

B) If the dividend is not paid Po = 15 Ke = 20% D1 = P1 =?

0 + 𝑃1
15 =
1.2
0 + P1 = 15 X 1.20
P1 = Br. 18

Walter has evolved a mathematical formula for determining the value of market share.

By: Daniel B. Page 2

 𝑟
𝐷 + 𝐾𝑒 (E − D)
P=
𝐾𝑒

Where, P = Market price of an equity share

D = Dividend per share
r = Internal rate of return
E = Earnings per share
Ke = Cost of equity capital

Exercise
From the following information supplied to you, ascertain whether the firm is following an
optional dividend policy as per Walter’s Model?
Total Earnings Br. 2,00,000
No. of equity shares (of Br. 100 each 20,000)
Dividend paid Br. 1,00,000
P/E Ratio 10
Return Investment 15%

The firm is expected to maintain its rate on return on fresh investments. Also find out what
should be the E/P ratio at which the dividend policy will have no effect on the value of the share?
Will your decision change if the P/E ratio is 7.25 and interest of 10%?

Solution
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 200000
EPS = 𝑛𝑜.𝑜𝑓shares = = 10 Br. i.e P/E ratio = 10
20000

1 1
Ke = P/E ratio = 10 = 0.1

𝑇𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑 100000

DPS = = = Br.5
𝑛𝑜.𝑜𝑓shares 20000

The value of the share as per Walter’s Model is

𝑟
𝐷+ (E−D)
𝐾𝑒
P=
𝐾𝑒

0.15
5+ (10−5)
0.10
P=
0.10

5+7.5
= = Br.125
0.10
𝐷𝑃𝑆 5
Dividend Payout = 𝐸𝑃𝑆 X 100 = 10
X 100 = 60%

r >Ke therefore by distributing 60% of earnings, the firm is not following an optional dividend
policy. In this case, the optional dividend policy for the firm would be to pay zero dividends and
the Market Price would be:

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 0.15
5+ (10−0) 5+15
0.10
P= = = Br.200
0.10 0.10
GORDON
𝐸(1+𝑏)
P=
𝐾𝑒−𝑏𝑟
Where,
P = Price of a share
E = Earnings per share
1 – b = D/p ratio (i.e., percentage of earnings distributed as dividends)
Ke = Capitalization rate
br = Growth rate = rate of return on investment of an all equity firm
Exercise 5
Raja company earns a rate of 12% on its total investment of Br. 6,00,000 in assets. It has
6,00,000 outstanding common shares at Br. 10 per share. Discount rate of the firm is 10% and it
has a policy of retaining 40% of the earnings. Determine the price of its share using Gordon’s
Model. What shall happen to the price of the share if the company has payout of 60% (or) 20%?
Solution
According to Gordon’s Model, the price of a share is:
𝐸(1−𝑏)
𝑃 = 𝐾𝑒−𝑏𝑟

Given: E = 12% of Br. 10=Br. 1.20

r = 12%=0.12
K = 10%=0.10
t = 10%=0.10
b = 40%=0.40
1.20(1−0.40) 1.20(0.6)
Put the values in formula 𝑃 = 0.10−(0.40 𝑋0.12) = 0.10−(0.048) = Br.13.85

FACTORS DETERMINING DIVIDEND POLICY

Profitable Legal Constrains Liquidity Sources of Growth Rate of

Position of Position Finance the Firm
the Firm
Uncertainty
of Future
Capital Market Uncertainty of
Income Conditions Future Income

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Chapter 2 : working capital
 Working capital management is concerned with management of current assets and current
liabilities, and the interrelationship that exists between these two groups
 The goal of the working capital management is to manage the firm’s current assets and liabilities
in such a way that a satisfactory level of working capital is maintained. This is because if the
firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and
may even be forced into bankruptcy.

 Concepts and Definitions of Working Capital

 There are two concepts of working capital. The concept lies on gross working capital and net
working capital. The term gross working capital is the total current assets of a firm.

Gross working capital = Total Current Assets

 The term net working capital can be defined in two ways. In the first place it is the difference
between current assets and current liabilities; and alternatively, it can be the portion of current
assets which is financed with long-term funds.

Net working capital = Current assets – Current liabilities

 Net working capital is commonly defined as the difference between current assets and current
liabilities. This definition is considered as the measure of liquidity by analysts.
 Need for Working Capital
 The need for gross working capital (current assets) is unquestionable for smooth
operation of firms. Given the objective of financial decision making to maximize the
shareholders’ wealth, it is necessary to generate sufficient profits.

Phase – RECEIVABLES

 Phase - 2
 CASH
 INVENTORY

Phase 1

To carry on business, a certain minimum level of working capital is necessary on a continuous

and uninterrupted basis
Phase - 1
Any amount over and above the permanent level of working capital is temporary, fluctuating or
variable working capital.

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 In the case of an expanding firm, the permanent working capital line may not be horizontal.

Determinants Factors for Amount of Working Capital

General Nature of the Business Production Cycle Credit Policy

The longer the time-span the larger The credit sales result in higher
 Manufacturing, service and will be the tied-up funds and, receivables. On the other hand, if
trade therefore, the larger is the working liberal credit terms are available from
capital needed and vice versa. the suppliers of goods the need for
working capital is less.

Business Cycle Growth and Expansion

Business fluctuations lead to cyclical and seasonal Other things constant, growth industries require more
changes which, in turn, cause a shift in the working working capital than those that are static.
capital position

Optimal Level of Current Assets and Financing Strategies

Under a flexible policy, the investment in current assets is high.

Carrying costs are mainly the cost of financing a higher level of current assets.
Shortage costs are mainly in the form of disorder in production schedule, loss of sales, and loss of customer
goodwill
The investment in current assets may be broken down as permanent current assets and temporary current assets. The
former represents what the firm requires even at the bottom of its sales cycles; the later reflects a variable component
that moves in line with seasonal fluctuations.

Profitability vs Liquidity
Conservative Strategy (A) Long – term financing source is used to meet fixed asset
requirement as well as peak working capital requirement. implies greater liquidity and lower

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risk. low investment in current assets, high amount of liquidity assets, reduced risk of insolvency
and less amount of profitability.

Aggressive (B) Long – term financing is used to meet fixed asset requirement and permanent
working capital requirement. An aggressive policy indicates higher risk and poor liquidity. high
investment in current assets, increased profitability, reduced liquidity and increased risk of
insolvency
Moderate (C) Long- term financing is used to meet fixed asset requirements, permanent
working capital requirement, and a portion of fluctuating working capital requirement.
Estimation of Working Capital Amounts
Examples suppose the following data for Astedu Company for the year 2008 shows the
following information. Raw material cost of Br. 248,000, total conversion cost of Br. 194,400,
total production cost of Br.968,000, annual sales of Br. 1,448,000, and fixed investment of Br.
1,600,000.
Astedu wants to use one of the three approaches to determine the amount of working capital
required and has the following additional information to do so. With regard to the first approach,
inventory is one month’s supply of each of the raw materials, semi-finished goods (fully
completed material and half completed conversion cost) and finished goods. Receivables are one
month’s of sales. And operating cash is to be one month’s total cost.
Under the second approach, the amount of working capital required is to be 25 – 35 percent of
annual sales And the third approach considers a 10-20 percent of fixed capital investment. Show
the result of the three approaches for the total working capital needed.
Solutions
Raw materials for one month’s supply = 248,000/ 12 = Br. 20,667
Semi-finished or work-in-process (WIP) inventory for one month’s supply = [Br. 20,667 +
194,400 / 12 = Br. 36,867.
Finished goods inventory for one month’s supply = 968,000/ 12 = Br. 80,666
So that the total inventory needed by Astedu Company is Br. 20,667 + Br.36, 867 + Br.
80,666 = Br. 138,200.
Receivables one month’s of total sales forecasted = Br. 1,448,000/ 12 = Br. 120,667
Operating cash need as one month’s of total cost = Br. 968,000/12 = Br. 80,667
Thus the total working capital needed is Br. 138,200 +Br.120,667+Br.80,667 = Br.339,533
Under the second approach:
The average ratio can be taken to determine the amount (i.e., (25+35)/ 2 =30 percent) of
working capital needed. Therefore, 0.3 X Br. 1,448,000 = Br.434,400
The last method results in working capital of 240,000 (i.e., 1,600,000 x 0.15). The rate 15
percent is the average of 10- 20 percent. (10+20)/2 = 15 percent
CHAPTER 3: CASH AND LIQUIDITY MANAGEMENT

Concepts of Cash Management and Motives for Holding Cash

 It involves managing money of a firm to avoid shortage; to minimize cash availability;
and to get return on any idle cash.
Motive of holding cash
 Transaction Motive: Transaction motive also called cash for transaction
 Precautionary Motive: transactions are often quite uncertain; emergencies may arise for
which the firm needs immediate cash

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  Speculative Motive: cash for opportunities is the desire of a firm to take advantage of
opportunities.
 Compensating Motive: Compensating balances are minimum checking account levels
that the firm agrees to maintain at the bank.

Benefits of Holding Sufficient Cash Balance

Objectives of Cash Management

The basic objective of cash management, therefore, can be categorized as:
i) meeting payment
ii) minimizing funds committed to cash balances.
Factor determining cash needs
A short costs, (B) excess cash balance, (C) procurement and management, (D)
uncertainty and (E) compensating balance.
Plans for Cash and Cash Budget
Cash planning is potential to resolve the problems of handling excess cash and
suffers from cash shortage The two commonly used methods of forecasting both at the short
or long-term basis are:
i) the receipt and disbursement method and ii) the adjusted net income method.
The Adjusted Net Income Method This method of cash forecasting involves the tracing of
working capital flows. It is sometimes called the sources and uses approach
Illustration on Preparation of Cash Budget
XYZ Textile Share Company wishes to arrange overdraft facilities with its bankers during the
period April – June 2008 when it will be manufacturing mostly for stores. Prepare a cash budget
for the above period from the following data; indicating the extent of the bank facilities the
company will require at the end of each period.
Period Sales (in Br.) Purchases (in Br.) Wages (in Br.)
February 182,000 124,000 12,000
March 192,000 144,000 14,000
April 108,000 243,000 12,000
May 176,000 244,000 11,000
June 126,000 268,000 16,000

50% of credit sales are realized in the month following the sales and the remaining 50% in the
second month following. Creditors are paid in the month following the month of purchase. Cash
at the bank on 1st April 2008 is Br. 30,000. Wages are paid at beginning of following month of
accrual.

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Solution Cash budget for a period April – June
Months April May June
Cash inflows:
Collection of receivable
Following moth of sale Br. 96,000 Br. 54,000 Br. 88,000
Second month of sale 91,000 96,000 54,000
Total cash inflow (A) Br. 187,000 Br.150,000 Br.142,000
Cash outflows:
Payment for purchase Br. 144,000 Br. 243,000 Br. 244,000
Wages payment 14,000 12,000 11,000
Total cash outflow (B) Br. 158,000 Br. 255,000 Br. 255,000
Cash surplus (Deficit) (A-B) Br. 29,000 (Br. 105,000) (Br. 113,000)
Balance at Beginning 30,000 59,000 (46,000)
Ending Balance Br. 59,000 (Br. 46,000) (Br.159,000)

Bank facilities required by the firm are Br. 46,000 and Br. 159,000 for May and June
respectively.
Cash Management Strategies
Cash management strategies are intended to minimize the operating cash balance requirement.
The basic strategies that can be employed include:
A. Stretching accounting payables
B. Efficient inventory-production management
C. Speedy collection of accounts receivables, and
D. Combined cash management strategies

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Investment opportunities for Idle Cash

The most know marketable securities are: treasury bills, negotiable certificate of deposits,
commercial papers, bankers’ acceptance, repurchase agreements and inter-corporate deposits.
Chapter four: RECEIVABLES MANAGEMENT
Meaning and Objective of Receivables Management

As it is stated above, receivables are a direct result of credit sales.

Achieving Growth in Sales and Increasing

Meeting Competition

4.3 Benefits and costs of Receivables, and Receivable management

Benefits There are two pronounced benefits of credit provisions: expansion of sales and retention
of existing customers.

Costs The major categories of costs associated with the extension of credit and account
receivable are:
Capital Costs
Collection Costs
Delinquency costs The cost arises out of the failure of the customers meet their obligations
when payments on credit sales become due after the expiry of the credit period.
Default Costs Finally, the firm may not be able to recover the over dues because of the inability
of the customers.

4.4 Factors Affecting the Size of Receivables

Level of Sales

Credit Policies The term credit policy refers to those decisions variables that influence the
amount of trade credit i.e., the investment of receivables. These variables include the quality of
accounts receivables, trade accounts to be accepted, the length of the credit period to be
extended, cash discounts to be given and any special term to be offered depending upon
particular circumstances of the firm and the customers.

Terms of Credit The size of receivables is also affected by the terms of trade offered by the
firm. The two important components of the credit terms are credit period and cash discount.
Credit Period is in terms of the duration of time for which trade credit is extended and over due
amount to be paid by the customers. Cash discount which the customer can take advantage of
the discount given and the overdue amount will be reduced by this amount.

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4.5 Basic Decisions in Receivable Management

The management of receivables involves three crucial decisions in three areas: i) Credit policies
ii) Credit terms iii) collection policies

Effect of Relaxation of Credit Standards

Items Direction of Change Effect on Profits

Sales Volume Increase Increase (Positive)

Average Collection period Increase Decrease (Negative)

Uncollectible Expenses Increase Decrease (Negative)

The effect of tighten credit standards is likely to have an opposite effect.

Effect of Increase in Credit Period

Items Direction of Change Effect on Profits

Sales Volume Increases Increases (Positive)

Average Collection period Increases Decreases (Negative)

Uncollectible Expenses Increases Decreases (Negative)

A reduction in the credit period is likely to have an opposite effect.

Summary of Effect of Increase in Cash Discounts

Items Direction of Change Effect on Profits

Sales Volume Increases Increases (Positive)

Average Collection period Decreases Increases (Positive)

Uncollectible Expenses Decreases Increases (Positive)

Profit Per Unit Decreases Decreases (Negative)

Decease in cash discount is likely to have an opposite effect.

Summary of Effect of Tight (Rigid) Collection Policies

Items Direction of Change Effect on Profits

Sales Volume Decrease Decreases (Negative)

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Average Collection period Decrease Increase (Positive)

Uncollectible Expenses Decrease Increase (Positive)

Collection Expenditure Increase Decrease (Negative)

The effect of lenient Collection Policy will be just the opposite effect.

FACTORING RECEIVABLES

The basic functions of a factor include finding the customer, and collects sales proceeds and
remit the same to the client. Other secondary functions of factor includes:

 Sales ledger administration: Full credit services are provided by factor to client, like
advising about credit extension or reduction, maintenance of accounts receivables,
information related to market trends, competitors, and so on.

 Credit collection and protection: a factor performs all the actions related to the collection
of debts. In additions too the collection, factor also provides protection from debts like
partial or full protection from bad debts.

Financial assistance: A factor has provides facilities like advancing the debts to the clients. Thus
factor provides various services like managing debts and financing them

 for a return called as factor service commission with or without reserve commission to
cover bad debts losses.

The factoring facilities can be broadly classified into two groups. They are (1) full service
non-recourse factoring and (2) full service recourse factoring.

Illustration 3: A firm has annual sales of $ 20 millions. 80 percent of sales are on 60-day credit.
Average collection period is given as 75 days. Based on the past performance bad debts costs
are estimated as 1 percent on credit sales. The firm has credit collection cost of $ 75,000 per
annum. A factor offers 1.75 % service charges for collection of receivables. Factor also
provides finance facility of 80 percent of amount sold to him within 10 days of sale. Interest cost
on borrowings is given to you as 6 %. Should the firm go for factoring service?

Sol:

Existing credit collection (without factoring)

Bad debts expenses @ 1 % on credit sales

1 % of ($20,000,000 X 80%) $ 160,000

Collection charges per annum (given) 75,000

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Interest on receivables investment

Receivables X interest cost

[16000,000 X 75 days) / 360 days] X 6 % 200,000

Total expenses $ 435,000

Factoring Services as an alternative of own collection policy:

Factor commission

[$16,000,000 X 1.75%] $ 280,000

Bad debts expenses 160,000

Interest expenses (same as above) 200,000

Total expenses $ 640,000

Less: savings on factoring service

Collection charges (not required) (75,000)

Interest saved on cash advance received from

Factor after 10 days of sale

[$16000,000 X 65days) / 360 days] X 6 % (173,333)

Net expenses after benefits $ 391,667

It can be concluded that the total expenses with factoring services is lower than the expenses
with own collection policy, therefore it advisable to the firm to go for factor service for
collection of receivables.

Chapter 5: INVENTORY MANAGEMENT

Introduction
5.1 Nature of Inventories
The various forms that inventories exist in a manufacturing company are normally classified into
three categories. The first category is raw material. The second type of inventory is work-in-
progress, The third final type of inventory is finished goods, that is, products ready for shipment
or for sale. They are completely manufactured products.
A merchandizing enterprise will have a very high level of finished goods inventory and no raw
material and work- in- process inventory.

5.2 Objectives of Inventory Management

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In the context of inventory management, a firm may be challenged with the problem of meeting
two conflicting needs: i) to minimize investment in inventory and ii) to meet a demand for a
product by efficiently organizing the production and sales operations. These two conflicting
objectives of inventory management can also be expressed in terms of cost and benefit associated
with inventory. The firm should minimize investment in inventory implies that maintaining
inventory involves cost, such that the smaller is the inventory, the lower is the cost. But
inventory also provide benefits to the extent that they facilitate the smooth functioning of the
firm: the larger the inventory, the better it is from this viewpoint. An optimal level of inventory
should be determined on the basis of the trade-off between costs and benefits associated with the
level of inventory.
5.3 Costs of Holding Inventory
the cost associated with inventory fall into two basic categories.
Ordering Costs This category of cost is associated with the acquisition of or ordering of
inventory.
Carrying Costs These costs are involved in maintaining storing and carrying inventory.
Included in carrying costs can be categorized as:

5.4 Benefits of Holding Inventory

.
Since inventory enables uncoupling (flexible) the key activities of a firm, each of them can be
operated at the most efficient rate. This has several beneficial effects on the firm’s operations. In
other words, the three types of inventories, raw materials, work- in- process and finished goods,
perform certain useful functions. Alternatively, rigid tying (coupling) of purchase and production
to sales schedules is undesirable in the short run as it will deprive the firms of certain benefits.
5.5 Inventory Management Techniques
The following are some simple production – oriented methods of inventory control to indicate a
broad framework for managing inventories efficiently in conformity with the goal of wealth
maximization. The major problem areas that comprise the heart of inventory control and
techniques for respective problem are indicated below:
Inventory Control Problem Area Inventory Management Techniques
The classification problem to determine the The A B C Approach
type of control required
The Order Quantity Problem The Economic Order Quantity Model
(EOQ model) to remove over and under
stocking
Safety Stock Problem Safety Stock Estimation
The Order Point Problem Reorder Points Estimation

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The formula used for determining EOQ is as follows:

2 AxR
Q = EOQ  CC

Where, A = Total annual requirement or consumption (in units)

R = Cost of Ordering per Order (Restocking costs per order)

CC = Carrying Costs per Unit.

Q = Economic Order Quantity (EOQ)

limitations of EOQ Model The EOQ Model is limited from the following angles.
 The assumption of constant consumption and the instantaneous replenishment of
inventories are of doubtful validity.
 There may be an unusual and unexpected demand for stocks. To meet such
contingencies, firms have to keep additional, inventories which are known as Safety
Stocks.
 Another weakness of EOQ model is that the assumption of a known annual demand
for inventories is doubtful.
 In additional to above all, there are some computational problems involved.
Illustration
The following details are available in respect of Elen Company
1) Annual requirement of inventory is 40,000 units
2) Cost per unit (other than carrying and ordering costs) is Br. 16
3) Carrying costs are likely to be 15per cent of cost per unit per year
4) Cost of placing order is Br. 480 per order
What is the Economic Order Quantity level of Elen Company?
Solution
2 x 40,000x 480
 4,000 units
EOQ= 2.4
C = Br.16 x 0.15 = 2.40
Stock Levels
Stock levels should be fixed in such a way that there is no over-stocking, so the loss due to
damage, deterioration in quality, risk of obsolescence, etc is minimum and capital is not blocked
or interest on borrowed funds is not paid unnecessarily. Again, there shall not be under-stocking
or stock-out situation which may cause production hold-ups and loss of sale and profit.
The production planning and control or material control department controls stock by fixing
maximum, minimum, reordering level and reorder quantity for each stock item. These levels
are noted in the bin card and the storekeeper sends requisition to the purchases department for

By: Daniel B. Page 15

replenishment of stock as and when the quantity of an item touches the re-order level. These
levels are not permanent and revised when the consumption of material, availability of fund, etc,
change. Production and sales department wants more stocks and finance department wants low
stocks.
Reorder Stock Level The EOQ technique determines the size of an order to acquire inventory
so as to minimize the carrying as well as the ordering costs. Another important concept in
inventory management is when to place an order of procurement. This aspect of inventory
management is covered under the reorder point problem.
The reorder point can be defined as the level of inventory when fresh order should be placed
with suppliers for procuring additional inventory equal to the economic order quantity.

It is a point between the maximum level and the minimum level of stock holding at which the
storekeeper initiates purchases requisition for fresh supplies of materials. The reorder level is
slightly more than the minimum level of stock to guard against possible disruption in suppliers,
increase in consumption due to changing demand and other factors. This level depends upon
various factors, e.g., maximum consumption during lead time, unexpected delay in receiving
fresh supply, cost of placing order, cost of storage, EOQ; minimum level and so on. In case of
abnormal delay, the stock should not reach zero level. Lead time means the time required to
obtain delivery of material from date of order. The formula which is generally used to calculate
reorder level is given below:

Reorder Stock Level = Maximum Usage X Maximum delivery time

Maximum Stock Level It represents that quantity of material beyond which the stock of any
items should not generally be allowed to exceed. The main objective of fixing this level is to
ensure that working capital is not blocked unnecessarily in stock. It is computed by the
following formula:

Maximum Stock Level = [Reorder Stock level + Reorder Quantity] – Minimum

usage x Minimum delivery time]
Minimum Stock Level It is that level of stock below which the stock of any item should not
normally be allowed to fall. It is that level which the stocks will reach with fresh delivery of
material provided that delivery is made within the reorder period and consumption is normal
during the period.

Minimum Stock Level = Reorder Stock Level – (Normal Usage x Average

delivery or reorder time

Average Stock Level This is the average of the maximum and the minimum. It is computed by
using the formula:

Average Stock Level = ½ (Minimum Stock Level+ Maximum Stock Level

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Illustration: Two components, A and B are, used as follows:
Normal usage 50 units each per week
Minimum usage25 units each per week
Maximum usage 75 units each per week
Re-order quantity A: 300 units; B: 500 units
Re-order period A: 4 to 6 weeks; B: 2 to 4 weeks
Calculate for each component: (a) Reorder level, (b) Minimum Level, (c) Maximum Level and (d)
Average Stock Level.

Solution
a) Reorder level = maximum usage x maximum reorder period
For component A: 75x 6 = 450 units
For component B: 75x 4 = 300 units
b) Minimum level = reorder level – (Normal usage x average reorder period)
For component A: 450 units – (50 units x 5 weeks) = 200 units
For component B: 300 unit – (50 units x 3 weeks) = 150 units
c) Maximum level = Reorder level + reorder quantity – (minimum usage x minimum
reorder period)
For component A: 450 units + 300 units– (25units x 4 weeks) = 650 units
For component B: 300 unit + 500unit – (25 units x 2 weeks) = 750 units
d) Average Stock Level = Minimum Stock Level + ½ (Reorder quantity)
For component A: ½(200+ 650) = 425 units
For component B: ½(150+ 750) = 450 units

Safety Stock
The economic order quantity and the reorder point are explained with assumptions like constant/
fixed requirement of inventory and instantaneous replenishment of inventory. These assumptions
are, however, of questionable validity in actual situations. For instance, the demand for inventory
is likely to fluctuate from time to time. In particular, at certain point of time the demand may
exceed the anticipated level. Similarly, the receipt of inventory from suppliers may be delayed
beyond the expected lead time. The delay may arise from strikes, floods, transportation, and
other bottlenecks.

Thus, a firm would come across situations in which the actual usage of inventory is higher than
the anticipated level and/or the delivery of the inventory from suppliers is delayed.

The effect of slower delivery may be a shortage of inventory. That is the firm would face stock-
out situations. This in turn would disrupt the production schedule and alienate the customers. The
firm would, therefore, have to keep a sufficient safety margin by having additional inventory to
guard against stock-out situations. Such stocks are called safety stocks. Safety stocks are the
minimum additional inventory to serve as a safety margin or buffer to meet unanticipated
increase in usage resulting from an unusually high demand and/or an uncontrollable late receipt
of incoming inventory (Khan and Jain, 2000).

By: Daniel B. Page 17

Establishment of a safety stock needs the consideration of a stock-out cost on one side and the
carrying cost on the other. Stock-out cost and the carrying cost are counterbalancing. A financial
manger’s responsibility would, therefore, be to determine the safety stock with minimum stock-
out and carrying costs.

By: Daniel B. Page 18