Inventory cost â€“ Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy

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Corporate Finance FIN 622

Lesson 30

INVENTORY MANAGEMENT

The following topics are being covered in this hand out.

Inventory cost Stock out cost

Economic Order Point

Just in time (JIT)

Debtors Management

Credit Control Policy

Stock outs

The situation when a firm runs out of stock which results in shutdown of slow down of production / sales.

This approach is designed to minimize the risk of stock outs at all costs. Particularly in manufacturing

environment stocks-outs can have a disastrous effect on the production process.

There are two concepts associated with stock out cost. First one is maximum stock levels, which is defined

as the sum of reorder level and reorder quantity and from this (minimum usage x minimum lead time) is

subtracted.

This stock level is a signal to the management that there should not be additional investment in stocks

because that is not needed and will be a useless. In other words, any investment over and above this level is

loss incurring.

The second is the minimum level of stock or also known as buffer stock. This level refers to a warning to

the management that stock level is approaching to such a low level that could result in a stock cost. We

compute this stock level as under:

Buffer stock = reorder level (average usage x average lead time)

In order to avoid stock out situation, a safety stock level should be procured and maintained.

Safety stock is the minimum inventory amount needed for an item, based on anticipated usage and expected

delivery time of materials.

This cushion guards against unpredicted surge in demand or delivery time.

Economic Order Point

Economic Order Point is the level of inventory that signals the time to place re-orders of materials using

economic order quantity amount. Safety stock is considered in the calculations.

We can calculate the EOP using the following formula:

EOP = SL + F √S x EOQ x L

Where

S= Consumption per Period

L= Lead Time

F= Stock out Acceptance Factor

EOQ = Economic Order Quantity

Just In Time (JIT)

The idea explains that inventories are kept near zero level. This means that inventory is acquired in such

quantity on daily basis that can support the daily production level. Therefore, there's no inventory lying in

store room rather all the inventory acquired move to production hall.

The philosophy is to pull inventory through the production processes on as "as-needed" basis rather than

pushing inventory through the processes on an "as-produces basis". This requires extreme accurate

estimates and there no chance of an error. For example, there's a high probability of running out of stock

and that could be disastrous.

JIT does not necessarily mean zero inventory level. The objective is to minimize the inventories but to

increase the productivity, quality and flexibility.

Before considering JIT as inventory management model, one should consider the following factors:

· JIT is possible only when vendors are located very close to business premises or production facility.

· This means that lead time is around couple of hours.

· Very sensitive issue. Greater probability of stock outs. May turn the overall benefits to losses.

· May not be feasible for every business. Some business may maintain some inventory items on JIT

and others on EOQ etc.

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Corporate Finance FIN 622

JIT & EOQ:

It might seem that JIT would be in a direct conflict with EOQ model. But certainly it is not the case. A JIT

system rejects the statement that ordering costs are necessarily fixed at the levels. JIT tries to push down all

the inventory related costs like ordering and set up on continuous basis.

By successfully reducing these ordering costs the firm is able to reduce the total cost. How close a company

comes to the JIT ideal depends on the type of production process and the nature of the supplier industries,

but it is a worthy objective for most companies.

Debtors Management

There are significant funds invested in accounts receivables and there must be some trade off between the

profitability and risk. The optimal level of investment should be based on the benefit resulting from a

specific level of investment in debtors. As you are well aware that investment in debtors influences the cash

operating cycle and therefore, debtors should be governed by a careful policy.

Extending credit to debtors is a matter to be analyzed carefully because it has two types of costs involved.

First, theirs is a chance of default of receiving payment and results in bad debts. Secondly, the amount to be

received from debtors is used to pay off creditors. If the amount is not received at the proper time then the

company has to settle creditors through loans and overdrafts, which carry a cost known as interest. The

company must have clear credit standards by defining the minimum quality of credit worthiness of debtors

that is acceptable to the firm.

Credit Control Policy:

The following section will shed light on credit control policy and its components.

a) Terms of sale

b) Credit analysis

c) Collection policy

Terms of sale refer to the conditions on which the company will sell its good to the customers on cash or

credit. The most important issues under these terms are the credit period and the discount level and

discount period.

In order to induce the debtors to settle their invoices at the earliest the company offers a discount or

reduction in the invoice amount. That discount is predominantly based on receiving the payment within a

very short period of time compared with normal credit period. For example, the normal terms representing

the period and discount are described as "3/10, net 45".

This means that the credit period is 10 days. The credit period is the length of time that is allowed to

debtors to pay off their bills. It will vary business to business and firm to firm. Normally this period is

between 30 to 60 days, however, 90 days credit is not very un-common. Credit period count runs from the

invoice date but can be the point of delivery of goods.

Length of credit period is influenced by several factors but the most important is the buyer's operating cycle

and inventory period. Before moving ahead, let's take up operating cycle concept.

Operating cycle can be divided into two parts:

1 Inventory period: the period of time it takes to procure, produce and sell the inventory.

In our example - inventory acquisition date Jan 01, 06 to march 01, 2006 60 days is known as

inventory period.

2 Accounts receivable period the time to recover the sales.

In our example, March 01 to April 15 45 days period is termed as accounts receivable period.

It should be noted that by extending credit to buyer, we finance a portion of buyer's operating cycle and

shorten buyer's cash cycle. And if seller's credit extension period exceeds the buyer's inventory period, then

seller is not only financing the buyer's inventory purchases but also a part of the receivable as well.

On the other side if seller's credit extension period exceeds the buyer's operating cycle, then seller is

effectively financing the buyer's need beyond the purchase and sale of seller's merchandise.

The other factors that influence the credit period decisions are:

Perish-ability of goods: if the shelve life of any good is short then it has low collateral value and attracts

short credit period compared to the goods having longer life.

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Corporate Finance FIN 622

Old vs. New products: A well established product may have shorter credit period limits. New products do

not have rapid turnover and often have longer credit periods associated with them. During off-season, the

credit period of well established products is extended to long periods.

Credit risk: If the buyer presumes greater risk he will extend short credit period.

Size of order: A large account order normally carries longer periods because of the turnover advantage. For

small orders the customers are not important.

Competition: If it is customary to extend large credit periods then all the sellers will be extending the same

level. This is because every seller has to attract the buyer in order to sell his product.

Customer type: corporate customers enjoy longer credit periods compared to individual customers due to

their business credibility.

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