CHAPTER 20

CREDIT AND INVENTORY MANAGEMENT

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LLC.
 LEARNING OBJECTIVES
• Explain how firms manage their receivable and the basic
components of a firm’s credit policies.
• Analyze a firm’s decision to grant credit.
• Define the types of inventory and inventory management
systems used by firms.
• Determine the costs of carrying inventory and the optimal
inventory level.

© McGraw Hill 20-2

 CHAPTER OUTLINE
• Credit and Receivables.
• Terms of the Sale.
• Analyzing Credit Policy.
• Optimal Credit Policy.
• Credit Analysis.
• Collection Policy.
• Inventory Management.
• Inventory Management Techniques.

© McGraw Hill 20-3

 CREDIT AND RECEIVABLES
When a firm sells goods and services, it can demand cash on or
before the delivery date, or it can extend credit to customers
and allow some delay in payment.
Why do firms grant credit?
• Offering credit is a way of stimulating sales, but there are costs
associated with granting credit:
1. Chance the customer will not pay.
2. Costs of carrying the receivables.

When credit is granted, an account receivable is created.

• Trade credit is credit granted to other firms.
• Consumer credit is credit granted to consumers.
© McGraw Hill 20-4
 COMPONENTS OF CREDIT POLICY
If a firm decides to grant credit to its customers, it will have to deal with the following
components of credit policy:
• Terms of sale are the conditions under which a firm sells its goods and services for cash or
credit.
• Credit analysis is the process of determining the probability that customers will not pay.
• Collection policy is the procedure followed by a firm in collecting accounts receivable.

Accounts receivable period involves several events:

© McGraw Hill
Access the text alternative for slide images.
20-5
 THE INVESTMENT IN RECEIVABLES
• Investment in accounts receivable for any firm depends on
the amount of credit sales and the average collection period.
• If a firm’s average collection period, ACP, is 30 days, then, at
any given time, there will be 30 days’ worth of sales
outstanding. If credit sales run $1,000 per day, the firm’s
accounts receivable will then be equal to 30 days × $1,000
per day = $30,000, on average.
• Firm’s receivables generally will be equal to its average daily
sales multiplied by its average collection period:

Accounts receivable = Average daily sales × ACP

© McGraw Hill 20-6

 TERMS OF THE SALE
Terms of a sale are made up of three distinct elements:
1. Period for which credit is granted (that is credit period).
2. Cash discount and the discount period.
3. Type of credit instrument.

Terms such as 2/10, net 60 are common.

• Customers have 60 days from the invoice date to pay full amount; but, if payment
is made within 10 days, a 2% cash discount applies.

Consider a buyer who places an order for $1,000, and assume that the terms
of the sale are 2/10, net 60.
• The buyer has the option of paying $1,000 × (1 − .02) = $980 in 10 days, or paying
the full $1,000 in 60 days.
• If terms are stated as net 30, customer has 30 days from invoice date to pay the
entire $1,000; no discount applies for early payment.
© McGraw Hill 20-7
 THE CREDIT PERIOD
Credit period is the length of time for which credit is granted.
• Varies across industries, but is usually between 30 and 120 days.

If a cash discount is offered, the credit period has two components:

• Net credit period is the length of time the customer must pay.
• Cash discount period is time during which the discount is available.

Invoice date is the beginning of the credit period.

• Invoice is a bill for goods or services provided by seller to purchaser.
• Terms of sale include the following:
• ROG, receipt of goods, means the credit period starts when the customer receives the order.
• With EOM dating, all sales made during a particular month are assumed to be made at the end of that
month.
• Terms of 2/10th, EOM tell the buyer to take a 2% discount if payment is made by the 10th of the
month; otherwise the full amount is due by the end of the month.
• Seasonal dating is sometimes used to encourage sales of seasonal products during the off-season.

© McGraw Hill 20-8

 LENGTH OF THE CREDIT PERIOD
Buyer’s inventory period and operating cycle influence length of credit period; the
shorter these are, the shorter the credit period.
Several other factors influence the credit period:
• Perishability and collateral value: Perishable items have relatively rapid turnover and
relatively low collateral value; credit periods are shorter for such goods.
• Consumer demand: Products that are well established generally have more rapi. turnover,
while newer or slow-moving products will often have longer credit periods to entice buyers.
• Cost, profitability, and standardization: Relatively inexpensive goods tend to have shorter
credit periods.
• Credit risk: The greater the credit risk of the buyer, the shorter the credit period is likely to
be.
• Size of the account: Small accounts may have shorter credit periods.
• Competition: In a highly competitive market, longer credit periods may be offered as a way
of attracting customers.
• Customer type: Wholesale/retail customers may have different terms.
© McGraw Hill 20-9
 CASH DISCOUNTS
Cash discounts (that is sales discounts) are given to induce prompt payment.
• When a cash discount is offered, the credit is essentially free during the discount
period.

Cash discounts also serve as a way of charging higher prices to customers

that have had credit extended to them.
Suppose an order is for $1,000. The buyer can pay $980 in 10 days or wait
another 20 days and pay $1,000. It’s obvious that the buyer is effectively
borrowing $980 for 20 days and that the buyer pays $20 in interest on the
“loan.” What’s the interest rate?
• With $20 in interest on $980 borrowed, the rate is $20/$980 = .020408, or
2.0408% per 20-day period.
• There are 365/20 = 18.25 such periods in a year; so, by not taking the discount,
the buyer is paying an effective annual rate (EAR) of:
EAR = 1.02040818.25 − 1 = .4459, or 44.59%.
© McGraw Hill 20-10
 TRADE DISCOUNTS AND
THE CASH DISCOUNT AND THE ACP
Sometimes the discount is not an early payment incentive, but rather a trade
discount, a discount routinely given to some type of buyer.
To the extent that a cash discount encourages customers to pay early, it will shorten
the receivables period and, all other things being equal, reduce the firm’s investment
in receivables.
Suppose a firm currently has terms of net 30 and an ACP of 30 days. If it offers terms
of 2/10, net 30, then perhaps 50% of its customers (in terms of volume of purchases)
will pay in 10 days. The remaining customers will still take an average of 30 days to
pay. What will the new ACP be? If the firm’s annual sales are $15 million (before
discounts), what will happen to the investment in receivables?
• If half of the customers take 10 days to pay and half take 30, the new average collection
period is: .50 × 10 days + .50 × 30 days = 20 days.
• ACP falls from 30 days to 20 days.
• Average daily sales are $15 million/365 = $41,096 per day, so receivables will fall by $41,096
× 10 = $410,959.

© McGraw Hill 20-11

 CREDIT INSTRUMENTS
The credit instrument is the basic evidence of indebtedness.
Most trade credit is offered on open account, where the only formal instrument of
credit is the invoice, which is sent with the shipment of goods and which the
customer signs as evidence that the goods have been received.
• Afterward, the firm and its customers record the exchange on their books of account.

Firm may require the customer sign a promissory note, a basic I OU.
• Could be used with large orders, when there is no cash discount involved, or when the firm
anticipates a problem in collections.

Promissory notes are signed after delivery of the goods.

• Firm can obtain a credit commitment from a customer before the goods are delivered by
arranging a commercial draft.
• When draft is presented and buyer “accepts” it, it is called a trade acceptance is sent back to
the selling firm.
• If a bank accepts the draft, meaning that the bank is guaranteeing payment, then the draft
becomes a banker’s acceptance.
© McGraw Hill 20-12
 ANALYZING CREDIT POLICY
Granting credit makes sense only if NPV from doing so is positive.
In evaluating credit policy, there are five basic factors to consider:
1. Revenue effects: If the firm grants credit, then there will be a delay in
revenue collections as some customers take advantage of the credit
offered and pay later.
2. Cost effects: Although the firm may experience delayed revenues if it
grants credit, it will still incur the costs of sales immediately.
3. The cost of debt: When the firm grants credit, it must arrange to finance
the resulting receivables.
4. The probability of nonpayment: If the firm grants credit, some
percentage of the credit buyers will not pay.
5. The cash discount: When the firm offers a cash discount as part of its
credit terms, some customers will choose to pay early to take advantage
of the discount.
© McGraw Hill 20-13
 EVALUATING A PROPOSED CREDIT
POLICY
Locust Software has been in existence for two years, and it is one of
several successful firms that develop computer programs.
Currently, Locust sells for cash only.
Locust is evaluating a request from some major customers to change
its current policy to net one month (30 days).
To analyze this proposal, we define the following:
• P = Price per unit.
• v = Variable cost per unit.
• Q = Current quantity sold per month.
• Q′ = Quantity sold under new policy.
• R = Monthly required return.

© McGraw Hill 20-14

 NPV OF SWITCHING POLICIES 1

Suppose we have the following for Locust:

• P = $49, v = $20, Q = 100, and Q  110.
If required return, R, is 2% per month, should Locust make the switch?
• Currently, Locust has monthly sales of P × Q = $4,900. Variable costs each month
are v × Q = $2,000, so the monthly cash flow from this activity is.
Cash flow with old policy   P  v  Q
 $49  20  100
 $2,900
• If Locust does switch to net 30 days on sales, the quantity sold will rise to Q  110.
Monthly revenues will increase to P  Q, and costs will be v  Q. The monthly cash
flow under the new policy will be:
Cash flow with new policy   P  v  Q
 $49  20  110
© McGraw Hill  $3,190. 20-15
 NPV OF SWITCHING POLICIES 2

Relevant incremental cash flow is the difference between the new and old cash
flows:
Incremental cash inflow   P  v Q   Q 
 $49  20   110  100   $290.
Present value of the future incremental cash flows is:
PV   P – v  Q – Q  R
• For Locust, this PV works out to be: PV  $29  10  .02  $14,500

Cost of switching involves two components:

1. Locust will have to produce Q  Q more units at a cost of
v Q  Q   $20  110  100   $200.
2. Sales that would have been collected this month under the current policy
 P  Q  $4,900  will not be collected.
Cost of switching  PQ  v  Q  Q 
• For Locust, this cost would be $4,900 + 200 = $5,100.
© McGraw Hill 20-16
 NPV OF SWITCHING POLICIES 3

• Putting it all together, we see that the NPV of the switch is:
NPV of switching    PQ  v Q ' Q    P  v Q  Q  R

• As we saw earlier, the benefit is $290 per month forever. At

2% per month, the NPV is:
NPV  $5,100  $290 .02
 $5,100  14,500
 $9, 400.
• Therefore, the switch is profitable.

© McGraw Hill 20-17

 WE’D RATHER FIGHT THAN SWITCH
Suppose a company is considering a switch from all cash to net
30, but the quantity sold is not expected to change. What is the
NPV of the switch? Explain.

In this case, Q  Q is zero, so the NPV is −PQ. What this says is

that the effect of the switch is to postpone one month’s
collections forever, with no benefit from doing so.

© McGraw Hill 20-18

 A BREAK-EVEN APPLICATION
Key variable for Locust is Q  Q the increase in unit sales.
• Projected increase of 10 units is only an estimate, so there is some forecasting risk.

What increase in unit sales is necessary to break even?

Earlier, the NPV of the switch was defined as:
• NPV    PQ  v Q  Q    P  v Q  Q  R
Calculate the break-even point explicitly by setting the NPV equal to zero and
solving for Q  Q :
NPV  0    PQ  v Q  Q    P  v Q  Q  R
Q  Q  PQ  P  v  R  v 

For Locust, the break-even sales increase is:

Q  Q  $4,900 $29 .02  $20 
 3.43 units
© McGraw Hill 20-19
 THE TOTAL CREDIT COST CURVE
Trade-off between granting credit and not granting credit isn’t hard to identify, but it
is difficult to quantify precisely.
Carrying costs associated with granting credit come in three forms.
1. Required return on receivables.
2. Losses from bad debts.
3. Costs of managing credit and credit collections.

If a firm has a very restrictive credit policy, all the associated costs will be low, the
firm will have a “shortage” of credit, and there will be an opportunity cost.
• Opportunity cost is the extra potential profit from credit sales that are lost because credit is
refused, and it comes from two sources:
1. Increase in quantity sold, Q minus Q.

2. (Potentially) a higher price.

• Credit cost curve is a graphical representation of the sum of the carrying costs and
the opportunity costs of a credit policy.
© McGraw Hill 20-20
 CREDIT COST CURVE
There is a point in the credit cost
curve where the total credit cost
is minimized.
• This point corresponds to the
optimal amount of credit or,
equivalently, the optimal
investment in receivables.

All other things being equal, it is

likely that firms with the
following characteristics will
extend credit more liberally than
other firms:
• Excess capacity.
• Low variable operating costs..
• Repeat customers.

© McGraw Hill Access the text alternative for slide images. 20-21
 ORGANIZING THE CREDIT FUNCTION
Firms that grant credit have the expense of running a credit department,
though many choose to contract out all or part of the credit function to a
factor, an insurer, or a captive finance company.
Firms that manage internal credit operations are self-insured against default.
• Alternative is to buy credit insurance through an insurance company, where the
insurance company offers coverage up to a preset dollar limit for each account.

Large firms often extend credit through a captive finance company, a wholly
owned subsidiary that handles the credit function for the parent company.
Why would a firm choose to set up a separate company to handle the credit
function?
• Primarily, to separate the production and financing of the firm’s products for
management, financing, and reporting.

© McGraw Hill 20-22

 CREDIT ANALYSIS: A ONE-TIME SALE 1

Credit analysis refers to the process of deciding whether to extend credit to

a particular customer, and it usually involves two steps:
1. Gathering relevant information.
2. Determining creditworthiness.

One-time sale example:

• Assume a new customer wishes to buy one unit on credit at a price of P per unit.
• If credit is refused, the customer will not make the purchase.
• If credit is granted, then, in one month, the customer will either pay up or default.
• Probability of default is π and can be interpreted as the percentage of new customers
who will not pay
• Our business does not have repeat customers; this is a one-time sale.
• Required return on receivables is R per month, and the variable cost is v per unit.

© McGraw Hill 20-23

 CREDIT ANALYSIS: A ONE-TIME SALE 2

If the firm grants credit, it spends v (variable cost) this month and expects to
collect (1 − π)P next month.
NPV of granting credit is: NPV = −v + (1 − π)P/(1 − R).
• For Locust Software, this NPV is: NPV = −$20 + (1 − π) × $49/1.02.
• With a 20% rate of default, NPV = −$20 + .80 × $49/1.02 = $18.43.
In granting credit to a new customer, a firm risks its variable cost (v). It
stands to gain the full price (P). For a new customer, then, credit may be
granted even if the default probability is high.
• Beak-even probability can be determined by setting NPV equal to zero and solving
for π:
NPV = 0 = −$20 + (1 − π) × $49/1.02.
1 − π = $20/$49 × 1.02.
π = .584, or 58.4%.
Locust should extend credit as long as there is a 1 − .584 = .416, or 41.6% chance or
better of collecting.
© McGraw Hill 20-24
 CREDIT ANALYSIS: REPEAT BUSINESS 1

Repeat business example.

• Important assumption: A new customer who does not default the
first time around will remain a customer forever and never default.
If the firm grants credit, it spends v this month.
Next month, it gets nothing if the customer defaults, or it gets P
if the customer pays.
• If the customer pays, then the customer will buy another unit on
credit and the firm will spend v again.
The net cash inflow for the month is P − v.
In every subsequent month, this same P − v will occur as the
customer pays for the previous month’s order and places a new
one.
© McGraw Hill 20-25
 CREDIT ANALYSIS: REPEAT BUSINESS 2

In one month, the firm will receive $0 with probability π.

With probability (1 − π), the firm will have a permanent new customer,
where the value of a new customer is equal to the present value of (P − v)
every month forever:
• PV = (P − v)/R.
NPV of extending credit is: NPV = −v + (1 − π)(P − v)/R
For Locust, this is:
NPV = −$20 + (1 − π) × ($49 − 20)/.02
= −$20 + (1 − π) × $1,450
Even if the probability of default is 90%, the NPV is:
NPV = −$20 + .10 × $1,450 = $125.
Locust should extend credit unless default is a virtual certainty.
• It costs only $20 to find out who is a good customer and who is not.
© McGraw Hill 20-26
 CREDIT INFORMATION
Information sources commonly used to assess creditworthiness
include the following:
1. Financial statements: A firm can ask a customer to supply financial
statements such as balance sheets and income statements
2. Credit reports about the customer’s payment history with other firms:
Quite a few organizations sell information about the credit strength and
credit history of business firms
3. Banks: Banks will generally provide some assistance to their business
customers in acquiring information about the creditworthiness of other
firms
4. The customer’s payment history with the firm: The most obvious way to
obtain information about the likelihood of customers not paying is to
examine whether they have settled past obligations (and how quickly)
© McGraw Hill 20-27
 CREDIT EVALUATION AND SCORING
Five Cs of credit are the five basic credit factors to be evaluated
in assessing the probability a customer will not pay:
1. Character: Customer’s willingness to meet credit obligations.
2. Capacity: Customer’s ability to meet credit obligations out of operating
cash flows.
3. Capital: Customer’s financial reserves.
4. Collateral: An asset pledged in the case of default.
5. Conditions: General economic conditions in the customer’s line of
business.
Credit scoring is the process of quantifying the probability of default when
granting consumer credit.
• Because credit-scoring models and procedures determine who is and who is not
creditworthy, it is not surprising that they have been the subject of government
regulation.
© McGraw Hill 20-28
 COLLECTION POLICY:
MONITORING RECEIVABLES
To keep track of payments by customers, most firms will monitor outstanding
accounts.
• Firm will normally keep track of its ACP through time.
Aging schedule is a compilation of accounts receivable by the age of each account.
• To prepare, the credit department classifies accounts by age.

Suppose a firm has $100,000 in receivables. Some are only a few days old, but others
have been outstanding for quite some time.
• If firm has a credit period of 60 days, then 25% of accounts are late.
Aging Schedule.
Age of Account Amount Percentage of Total Value of Accounts Receivable
0-10 days $50,000 50%
11-60 days 25,000 25
61-80 20,000 20
Over 80 days 5,000 5
$100,000 100%

© McGraw Hill 20-29

 COLLECTION EFFORT
A firm usually goes through the following sequence of procedures for
customers whose payments are overdue:
1. Sends out a delinquency letter informing the customer of the past-due status of
the account.
2. Makes a telephone call to the customer.
3. Employs a collection agency.
4. Takes legal action against the customer.

Firm may refuse to grant additional credit to customers until arrearages are
cleared up.
When the customer files for bankruptcy, the credit-granting firm is just
another unsecured creditor.
• The firm can wait, or it can sell its receivable.

© McGraw Hill 20-30

 INVENTORY MANAGEMENT
Financial manager of a firm will not normally have primary control over
inventory management.
• Other functional areas (for example purchasing, production, and marketing) will
usually share decision-making authority regarding inventory.
For a manufacturer, inventory is normally classified into one of three
categories:
1. Raw material is whatever the firm uses as a starting point in its production
process.
2. Work-in-progress is unfinished products.
3. Finished goods are products ready to ship or sell.

Keep in mind three things concerning inventory types:

• Names for different types of inventory can be misleading because one company’s
raw materials can be another’s finished goods.
• Various types of inventory can be different in terms of liquidity.
• Derived (or dependent demand) items versus independent items.
© McGraw Hill 20-31
 INVENTORY COSTS
Carrying costs represent all the direct and opportunity costs of keeping inventory on
hand and include:
1. Storage and tracking costs.
2. Insurance and taxes.
3. Losses due to obsolescence, deterioration, or theft.
4. The opportunity cost of capital on the invested amount.

Shortage costs are associated with having inventory on hand and consist of two
components:.
1. Restocking or order costs are either the costs of placing an order with suppliers or the costs
of setting up a production run.
2. Costs related to safety reserves are opportunity costs such as lost sales and loss of
customer goodwill that result from having inadequate inventory.

Basic trade-off exists in inventory management because carrying costs increase with
inventory levels, whereas shortage or restocking costs decline with inventory levels.
© McGraw Hill 20-32
 INVENTORY MANAGEMENT TECHNIQUES:
ABC APPROACH
Basic idea is to divide inventory into three (or
more) groups.
• Underlying rationale is that a small portion of
inventory in terms of quantity might represent a
large portion in terms of inventory value.

As Figure 20.2 shows, A Group comprises only

10% of inventory by item count, but represents
more than half of the value of inventory.
• Items monitored closely; inventory levels are kept
relatively low.

C Group are basic inventory items (for example

nuts and bolds); crucial and inexpensive, so large
quantities are ordered and kept on hand.
• B Group consists of in-between items.

Access the text alternative for slide images.

© McGraw Hill 20-33
 INVENTORY MANAGEMENT TECHNIQUES:
ECONOMIC ORDER QUANTITY (EOQ) MODEL
Best-known approach for explicitly
establishing an optimal inventory level.
Basic idea illustrated in Figure 20.3, which
plots various costs associated with
holding inventory against inventory levels.
With the EOQ model, we will attempt to
specifically locate the minimum total cost
point,
Q *.

Keep in mind is the cost of the inventory

itself is not included.
• This is because the total amount of
inventory the firm needs in a given year is
dictated by sales.

Access the text alternative for slide images.

© McGraw Hill 20-34
 EOQ MODEL: INVENTORY DEPLETION
To develop the EOQ, we will assume that the firm’s inventory is sold at a
steady rate until it hits zero.
• At that point, firm restocks its inventory back to some optimal level.

Suppose the Eyssell Corporation starts out today with 3,600 units of a particular item
in inventory. Annual sales of this item are 46,800 units, which is about 900 per week.
If Eyssell sells off 900 units of inventory each week, then all the available inventory
will be sold after four weeks, and Eyssell will restock by ordering (or manufacturing)
another 3,600 units and start over.
This selling and restocking process produces a sawtooth pattern for inventory
holdings.
Eyssell always starts with 3,600 units and ends up at zero.
• On average, then, inventory is half of 3,600, or 1,800 unit .

© McGraw Hill 20-35

 EOQ MODEL: THE CARRYING COSTS
Carrying costs are normally assumed to be directly proportional to inventory
levels.
Suppose we let Q be the quantity of inventory that Eyssell orders each time
(3,600 units); we will call this the restocking quantity.
• Average inventory would then be Q/2, or 1,800 units.

If we let CC be the carrying cost per unit per year, Eyssell’s total carrying
costs will be:
Total carrying costs = Average inventory × Carrying cost per unit
= (Q/2) × CC
In Eyssell’s case, if carrying costs were $.75 per unit per year, total carrying
costs would be the average inventory of 1,800 units multiplied by $.75, or
$1,350 per year.
© McGraw Hill 20-36
 EOQ MODEL: THE RESTOCKING COSTS
Restocking costs are normally assumed to be fixed.
Suppose we let T be the firm’s total unit sales per year.
If the firm orders Q units each time, then it will need to place a total of T/Q
orders.
For Eyssell, annual sales are 46,800, and the order size is 3,600.
• Eyssell places a total of 46,800/3,600 = 13 orders per year.

If the fixed cost per order is F, the total restocking cost for the year would be:
Total restocking cost = Fixed cost per order × Number of orders
= F × (T/Q)
For Eyssell, order costs might be $50 per order, so the total restocking cost
for 13 orders would be $50 × 13 = $650 per year.
© McGraw Hill 20-37
 EOQ MODEL: THE TOTAL COSTS 1

Total costs associated with holding inventory are the sum of the carrying costs and
the restocking costs:
Total costs = Carrying costs + Restocking costs
= (Q/2) × CC + F × (T/Q)
Our goal is to find the value of Q, the restocking quantity, that minimizes this cost.
• For Eyssell, carrying costs (CC) were $.75 per unit per year, fixed costs (F) were $50 per
order, and total unit sales (T) were 46,800 units.
• With these numbers, here are some possible total costs:
Restocking Quantity Carrying Cost + Restocking Costs = Total
(Q) (Q/2 CC (F T/Q) Costs
500 $187.5 $4,680.0 $4,867.5
1,000 375.0 2,340.0 2,715.0
1,500 562.5 1,560.0 2,122.5
2,000 750.0 1,170.0 1,920.0
2,500 937.5 936.0 1,873.5
3,000 1,125.0 780.0 1,905.0
3,500 1,312.5 668.6 1,981.1

© McGraw Hill 20-38

 EOQ MODEL: THE TOTAL COSTS 2

We can find the minimum point by setting carrying costs equal restocking
costs and solving for Q*:
Carrying costs  Restocking costs
Q * 2   CC  F  T Q *

With a little algebra, we get:

Q *2   2T  F  CC
Economic order quantity (EOQ) is the restocking quantity that minimizes the total
inventory costs.
2T  F
Q* 
CC
(2  46,800)  $50

$.75
 6, 240,000
 2, 498 units
© McGraw Hill 20-39
 CARRYING COSTS AND RESTOCKING
COSTS
Carrying Costs
Thiewes Shoes begins each period with 100 pairs of hiking boots in stock. This stock is
depleted each period and reordered. If the carrying cost per pair of boots per year is
$3, what are the total carrying costs for the hiking boots?
Inventories always start at 100 items and end up at zero, so average inventory is 50
items. At an annual cost of $3 per item, total carrying costs are $150.

Restocking Costs
In Example 20.2, suppose Thiewes sells a total of 600 pairs of boots in a year. How
many times per year does Thiewes restock? Suppose the restocking cost is $20 per
order. What are total restocking costs?
Thiewes orders 100 items each time. Total sales are 600 items per year, so Thiewes
restocks six times per year, or about once every two months. The restocking costs
would be 6 orders × $20 per order = $120.
© McGraw Hill 20-40
 THE EOQ
Based on our previous two examples, what size orders should Thiewes place to
minimize costs? How often will Thiewes restock? What are the total carrying and
restocking costs? The total costs?
We know that the total number of pairs of boots ordered for the year (T) is 600. The
restocking cost (F) is $20 per order, and the carrying cost (CC) is $3. We can calculate
the EOQ for Thiewes as follows:
2T  F
EOQ 
CC
(2  600)  $20

$3
 8,000  89.44 units

Because Thiewes sells 600 pairs per year, it will restock 600/89.44 = 6.71 times. The
total restocking costs will be $20 × 6.71 = $134.16. Average inventory will be 89.44/2
= 44.72. The carrying costs will be $3 × 44.72 = $134.16, the same as the restocking
costs. The total costs are $268.33.
© McGraw Hill 20-41
 EXTENSIONS TO THE EOQ MODEL
We have assumed a company will let its inventory run down to zero and
then reorder, but a company will wish to reorder before its inventory goes to
zero for two reasons:
1. By always having some inventory on hand, firm minimizes risk of a stockout (and
resulting losses of sales and customers).
2. When a firm does reorder, there will be some time lag before the inventory
arrives.
Safety stock is minimum level of inventory a firm keeps on hand.
• Inventories are reordered whenever the level of inventory falls to the safety stock
level.
To allow for delivery time, a firm will place orders before inventories reach a
critical level.
• Reorder points are the times at which the firm will actually place its inventory
orders.
© McGraw Hill 20-42
 MANAGING DERIVED-DEMAND
INVENTORIES
Materials requirement planning (MRP) is a set of procedures used to
determine inventory levels for demand-dependent inventory types, such as
work-in-progress and raw materials.
• Basic idea behind MRP is that, once finished goods inventory levels are set, it is
possible to determine what levels of work-in-progress inventories must exist to
meet the need for finished goods.
• Particularly important for complicated products for which a variety of components
are needed to create the finished product.

Just-in-time inventory is a system for managing demand-dependent

inventories that minimizes inventory holdings c.
• Goal is to minimize inventories, thereby maximizing turnover.
• Began in Japan and is a fundamental part of Japanese manufacturing philosophy.
• Result is that inventories are reordered and restocked frequently.

© McGraw Hill 20-43

 SELECTED CONCEPT QUESTIONS
• What are the basic components of credit policy?
• Explain what terms of “3/45, net 90” mean. What is the
effective interest rate?
• What are the important effects to consider in a decision to
offer credit?
• What is a captive finance company?
• What is credit analysis?
• What is an aging schedule?
• What are the different types of inventory?
• Which cost component of the EOQ model does the JIT
inventory system minimize?
© McGraw Hill 20-44
 END OF CHAPTER
CHAPTER 20

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