CHAPTER

ACCOUNTS RECEIVABLE
.ANDJNVENTORY I •

MANAGEMENT

~f.Mrni"j ()ufco,n11 .

After studying c~apter 13, you should b_

e ·able to:

1. Understand the need to·manage ac~ounts

receivable.
2. Know the objectives of rec:eivable management.
' '

1' . 3. Explain the nature of credit policy and understand its · '
elements.
' . '

4. Know t~e costs assockated with the inves.t ment in

accounts receivable.
, 5. Understand .the cost-benefit re.lationship in credit,
and collecti~ll policies.
6. Analyze propos~d changes _in credit-policy. ··
7. Understand the need to rrionage inventories. .
8. Know t_
he objecti~e of inventory manageme~t.
9· Explain the functions of inventories.
Jo. ~den_tify th e cost assoc-iated with 'investment in
inventory. .
11 . Learn how fo determine
(<;]) Economic order quantity (EOQ}
(b) Reorder point .
12. Understand the d'ff . _
inventory contr ' etrent level monitoring and
0 1sys ems .

••••
 CHAP TER 13

ACCO UNTS RECE IVAB LE ,

AND INVE NTOR Y MANA GEME NT

ACCOUNTS RECEIVABLE MANAGEMENT

I

INTRODUCTION

Althou_gh some sales are made for cash, today the vast majority of sales· are on
credit. Thus in typical ·si~uation, goods are shipped, inventories are reduced and an
·account receivable is created.

Accounts receivable consists of money owed to a firm for goods and services sold
on credit. This type of credit basically takes two forms:

1. Trade or commercial credit. Credit which the firm extends to other

firms. '
2. Consumer or retail credit. Credit which the .firm extents· to its final
customers. •

OBJECTIVES. OF ACCOUN
. TS RECEIVABLE MANAGEMENT ·
The goal of accoun~s receivable management is to ensure that the firm's investment
. in accounts receivable is appropriate and contributes to shareholder wealth.
maximization. It is therefore the responsibility of the finance officer to evaluate
the pertinent co~s and benefits related to credit extension, to finance the firm's
investment in accounts receivable, implement the firm's credit policy and to
en~orce collection. ·
• CREDIT POLICY

Credit policy is
a set of guidelines for ·extending credit to c~stomers. The success
or failure of a business depends primarily on the demand for its producfs - as a
rule, the higher its sales·, the larger its profits ~d the higher ~e Value of its st~ck.
Sales, in turn, d_epend on a number of factors, .some exogenous but others under
the control of the firm. Tp~ major controllable variables which affect demand are
sales prices, product quality, advertising and the firm's credit policy.
310 Chapter /3
I
.-
Credit policy generally covers the following variables:

1. Credit Standards

Credit standards refer to tho mini'muin financial strength of acceptable credit

customer and the amount available to different customer. Credit policy can
have a significant influence upon sales. If credit policy is relaxe~; while sales
may increase, the quality of accounts receivable ~ay s~ffer: This ma~ result
into longer average collection period. An ~Pfimal credit f!ol,cy would .'~volve_
extending trade credit more liberally until the marginal profitab1hty on
additional sales ~uals the required return on the additional investment in
receivables. Or it is a trade-off between the profits on sales that give rise to
receivables on one hand and the .cost of.carrying th,ese receivables plus bad-
debt losses qn the other. Setting credit standards implicitly requires a .
measurement of credit quality, whi.ch- is defined in terms of the probability of
a customer's default. The probability estimate fo~ agiven customer is for the
most part a subjective judgment. Nevertheless, credit eval_uation is a well-
established practice, and a good credit manager can make reasonably accurate
judgments of the probability of default by different classes of_ customers.

To measure credit quality and customer's ·credit worthiness, the following

areas are generally evaluated: ·

a. Character-which refers to the probability· that the customers will pay

their debts or obligations. Credit reports provide backgrQund
infonnation on people and firms' past perfonnances from a firms'
bankers, their other suppliers, their. customers, and even their
competitors.
b. -Capacitywhich is the judgment of cust~mers' abilities to pay. It is ,J
determined in part by the customers' past records and business
methods. It may he supplemented-by physical observation of their
plants o~ stores.. Again, credit analysts will obtain judgmental ,
mformat1on on this.factor from a variety of sources. . ·

-c~ Ctipital which is·measured by the general financial condition of a finn

as indi~at_ed _by an analrsis o: its financial stat~m~nts. Special ,
emphasis 1s g1Ven to the nsk ratios - the debt/assets ratio the current
ratio, and the times-interest-earned ratio. '

d. Coll°!er~I which is rep~sented by assets that customers may offer as

secunty m order to obtam credit. ·

• I
I

'◄
 Accounl.f Receivable and Inventory Managemdit 311

e. , Conditions wh!ch refer both to general economic trends.and to special

developmen~ m certam geographic regions or sectors of the economy
that n_ught affect customers' abilities to m~t their obligations.
2. Credit Terms

Credit tenns involve both the.length of the credit period and the discount given.
Credit period is tlJe l~gth of time buyers are given to pay for their purchases.
Discounts are p_rice reductions for early payment. The discqunt specifies what
the percentage reduction is and when payment must be made to be eligible for ..
the.discount. The terms "2/l 0, net 30" mean that a 2% discount is given if the
bill is paid on or·before the tenth day after ~e date of invoice; payme}lt is due
by the thirtieth day: The credit _period, then, is thirty days. Although the
customs of the industry frequently dictate the terms given, the credit perioq if
lengthened generally results to _an increased product demand and vice versa.

3. Collection Policy
!

'· Collection policy refers.to the procedures the firm follows to co11ect past-due
accounts. For example, a letter may be sent to customers when a bill is 10 days
. \ past due; a more severe letter, followed by a telephone call, may_be used_if
• I
payment is not received within 30 days; and the account may be turned over
to a· collection agency after 90 days. Credit analysis is instrumental in
determining the amount of credit risk to be accept~. In tum, the amount of
risk accepted affects the slowness of receivables and the resulting investment·
in receivables, as well as the amount of bad-debt losses. Collection procedures
affect these factors. Within a reasonable range, the greater the relative amount
of
spent on collection procedures, the.lower the proportion bad-debt losses and
· t~e shorte·r the average collection period, all other things remaining the san1e.
So a balance ·must be struck between the costs and benefits of different
collection policies.

4. Delinquency and Default

Whatever credit policies a bu~iness firm may adopt, there will be some·
customers who will delay and others who will default entirely, thereby
increasing the total accounts receivable costs. Again, the optimal credit policy
that should be adopted is-the one \hat provides the greatest marginal benefit.
r
 y

~3~12~iC?!:_n~ap~t~er~l!J3~_ _ _ _ _ _ _ _
COSTS ASSOCIATED WITH -INVESTMENT IN ACCOUNTS
_:_~---~~==~~-
RECEIVABLE .
.
I . Credit analysis, accounting and collection costs

If the finn is extending credit in anticipation of a~cting more business, it

·
mcurs th e .cost · · a credi·t manager plus· . assistants
· ·of hinng . . and bookkeepers
w1"th'm th e finance department", of acquiring. crecht mfonnat1on
· d sources and·· of
generally maintaining and operating a credit and collection epartment. ·
~. .
2. Capital costs

Once the tinn extends credit, it must· raise funds in order to·finance it. The ·
interest to be paid if the funds are -borrowed or the opportunity cost of e9uity
capital will constitute the cost of funds that ~ill be tied up in the receivables.
.
3. Delinquency costs
. • I
These co~ are iricurre~ when tf:te customer is late in paying. This delay adds
collection costs above those associated with a normal'collection. Delinquency
also creates an opportunity cost for any additional time the funds are tied up
after the normal collection period. · · ·.

4. Default cos~ (Bad \tebts)

The firm incurs default costs when the.customer fails to pay at all. In addition
to ~he collection 'costs, capitarcosts· and delinquency costs incurred up to this.
po1~t, the firm loses the cost of goods sold not_paid for. It nas to write off the ·
entire sales once it decides the ~elinquent account has defaulted and is no
longer collectible. '
 Accounts Receivab/ d
e an Inventory Management 313
SUMMARY OF TRADE-OFFS IN CRE
POUC ES : on AND COLLECllON !..,

Shown below is a summary of the cost-ben . . ·

application of factors affecting the c~ d. defit rela!! 0 nsh1p that will result upon
• · · e It an collection policies: ,
1,

Trade-offs
Benefit
I. Relaxation of Cost
a. Increase in sales and
credit total contribution a. Increase in credit
standard.s margin. processing costs.
b. Increase. in collection
costs.
c. Higher default costs
(bad debts). ·
d. ijigher capital costs
2. Lengthening·of a. increase in sales (opportunity costs).
and a. Highei capital costs
credit period total contribution. (QJjportunity cost of
margin. higher investment in ·
~ivabl es).
3. Granting·cash . a. Increase ii:- sales and I '

discount a. Lesser profit.

total contribution
margin.
b. Opportunity income
on lower i'nvestment in
receivable.
4. Intensified a. Lower default costs a. · Higher collection
collection (bad debts) expenses. . 1
efforts '-
b. Lower opportunity b. Lower sales.
cost or capital costs.

ANALYZING PROPOSED. CHANGES IN CREDIT POLICY

. '

If a business enterprise eases its .credit policy either by way of lengthening ~e

credit period, relaxing credit standards and collection policy, or offering cash
discounts, then its sales should increase. Cost wil1 also rise be~ause of .increase in
production costs. Likewise, _additional investment in accounts receivable will
increase carrying costs and bad debt and/or discount expenses may also rise.
 314 Chapt er /3

MARGINAL OR INCREMENTAL ANALYSXS Of CREDIT POUCIES

~e
Marg,lnal analysis is perfonned in tenns of a ~ystematic compai:ison of
increm ental returns and the incremerNal costs resulting from a chang e m the firm
s
the
credit policy. Whenever the' incremental or profit fro~ a proposed .c~ange in
mana geme nt of accounts receivable exceeds the required return or mcremental
costs of the additional investment the change should be implemented. All things
being equal, the decision concern{ng the change in credit policy is made usi'ng the
following rules:

If: Incremental then accep t the

I) locremental profit >
cost chanQe in credit policy.
contribution

lncrementa.l then reject the chang e

2) Incremental profit < in credit policy
contribution cost

then be indifferent to
Incremental profit Incremental
3) = cost
the chang e in credit
contribution policy

Illustrative Case I. Relaxation of Credit Policy

. .

ABC Corpo ration 's products sells for PJO a unit of which P7 repres ents variab
le
are
costs before taxes including credit department cost. Current annual credit sales
P2.4 miJJion. The firm is considering a more liberal extension of credit ,'whic h will
s.
result in a slowi ng in the average collection ·perrod froln one month to two month
·
The relaxation in credit standards is expected to produce a 25% increase in sales.-
Assum e that the firm's required rate of return on investment is 20% before taxes.
Bad debts losses ·will be 5% of incremental sales and -~o11ection expen ses will
increa se by P20,0 00.

· REQUIRED: Shoul d the company liberalize its credit policy?

d
 Accounts Receivable and Inventory Management, 31S
Solution:
_.. ,.
Incr eme ntal_contribution margin from
addi tion al unit s (60,000 x P3) -
Les~: Bad debt s (P600,000 x 5%) P18 0,00 0
Coll ectio n expe nses · 30,0 00
Tota l 20,0 00
Net incr eme ntal profit P 50,0 00
-.· P130,000.
Req uire d retu rn on additional investment:
Pres ent level of receivables
(P2. 4 mill ion/ 12 mos.)
P20 0,00 0
Lev el of receivables after change in
. cred it poli cy (P3 million"/ 6 mos.)
500, 000
Add ition al receivables
Add ition al investment in-receivables P300,000
(P30 0,00 0 x 70% )
P21 0,00 0
Mul tiply by: Required return 20°/c,
Req uire d retu rn on additional investment
·p 42,000 • I

Conclusion:
· ·
In as muc h as the profit on additional sale s of
P13 0,00 0, exce eds the
requ ired retu rn on the additional investment of P42
,000 , the firm wou ld b~
well -adv ised to rela x i~ cred it standards.

Illustrative Case Il. Change in C~ it Terms

The Rom an Sha des Com pany has 12% opportun

ity cost of capi tal and curr entl y
sells on term s n/20 . It has curr ent annu al sales of
Pl0 Mill ion, 80% ofw hic~ are
on cred it. Cur reot aver age coliection period is 60
days. It is now cons ider ing tp
offe r term s of 2/10 , n/30 in orde r to redu ce the colle
ction period. It expe cts 69o/o
of its cust ome rs to take advantage of the disc ount
and the coll ectio n peri od to be
redu ced to 40 days . · · ' ·

REQ~IRED: Sho uld the com ~any chan ge its term s from
n/2~ to 2/10, n/30 ?
 \
316 Chapter /3 · -
Solution: Present Proposed

Opportunity cost .
(Return on investment x
Average Receivables)
Pt60,000
Present ( J2% x P J.~33 M) PI06,667 ·
Proposed ( J2% x P0.888M)
Sales discount . , I
· 96,000
(P8M x· 60% x 2%)
Total _ PI60,000 P202,66Z . I.
•.

, l -
Conclusion: . .
The company would be better•off by main~ining the pr~sent ~redit terms
and policy of not granting c~h discount becal!se of the lesser costs
involved as shown above. ·

INVENTORY MANAGEMENT
INTRODUCTION
Inventories are an essential part of virtually all business operations and must be
acquire4 ahead of sales. The main.classifications of inve~tories are:

For manufacturing fiTJ11s For trading firms

a. Raw materials . ' ·a. Merchandise
b. Goods-in-process
c. Finished goods
d. Factory suppJies

Inventory management is important as it is difficult. ·The necessity of forecasting

sales before establishing target inventory -level makes inventory management a
difficult task. Furthermore, erroneous establishment of inventory levels.could lead
to eithe~ lost sales or to excessive carrying costs. ·

OBJECTIVE OF INVENTORY MANAGEMENT

Inventory is the stockpile of the product the finn is offering for· sale and the ' .
components that make u·p the product. It is the responsibility of the financial
officer to maintain a sufficient amQunt of inventory to insure.the. smooth operation
of the firm's production and marketing functions and at the same time avoid tying
up funds in excessive·and slow-moving inventory. · · -

\·
r Accounts Receivable and Inventory Management 317

FUNCTIONS OF INVENTORIES

Jnv~ntories, ~ t~ey in the fonn of raw materials, parts and components, work in
process, or fimshed goods may appr~priately He considered as the life-blood of the
prod~cti?n_ - distribut_ion s~st~m. Within this system of l)roduction and
distnbut1on, the followmg functions and use~ of inventories can be identified:

1. Pipeline or transit inventories

. .
These are inv~ntori.es ~hich are being ·moved or transported from one
location to another and they fill the supply pipelines betw~ stages.of the
entire prod~ction-distribution system.

_2. Org~nizational_or decoupling inventories

These are inventories that. are maintained to provide each link in the
productio·n-distribution chain a certain degree of independence from the
others. These will also take care 'Of random fluctuations in demand and/or
supply. . ,.
' . I.

3. Seasonal or anticipation stock

These are butli up in anticipation of the· heavy selling season · or in
ant~~~pation of price increase or as p.art of promotional sales campaign._

4. Batch or,lot~size inventories

These are inventories that are maintained whenever the user makes or buys
· m~terial in larger lots than are needed for his immediat~purposes.
I -
5.. Safety or b•uffer stock
These . inventories ar.e maintained to protect the company from
uncertainties such ~ unexpected customer demand, de~ays _in delivery of
goods ordered, etc. · '·
' ••'
COST ASSOCIATED WITH INVESTMENT
' .
IN INVENTORY

To provide the inventories required to sustain operations. at the low~st possible

: cost, it is necessary to identify all the costs involved in acquiring and maintaining
invent(?ry. T1'e following are ,ge~er~lly th~ ~osts ~s~ciated wi~ inventories which
could vary from finn to firm, from item to item and also over time.
 l~~l!B~c~n~a':trp~te!,.!_IJ~_.!--_ _ _ __:_~------~--""7'-
.~
I. Canying costs - . .
Cost of capital tied up in inventory
Storage and handling co5t
Insurance
Property taxes .
Depreciation and obsolescence .
· Administrative costs (e.g., accountmg, etc.)

u. Ordering, shipping and_recei~ing coSlS .

Cost of placing orders mcludmg production and-setup costs
Shipping and handling costs

Ill.. Costs of running short

Loss of sales·.· ;
Loss of customer goodwill
- I .Description of production schedules

INVENTORY MANAGEMENT TECHNIQUES

INVENTORY PLANNING

Inventory planning involves the determinatioo of what inventory quality, quantity,

timing, and location should be in order to.-meet ruture business requirements.
. ' -
The approach and mathematical techniques that may be used in determining
inventory order si:ze, timing, etc. incl~~e EOQ model, Reorder point

lri using the Inventory_Economic Order Quantity, the following formulas are
followed: . ~ . ·

·Annual Costs
J. Economic Order 2 x demand x 'per
Quantity (EOQ) in units order
Carrying costs per unit

Total Total
a) Total inventory costs -
.Ordering + Canying
Costs Costs
b) Annual derna d · ·ts · 0rdering
Total ordering costs _ --==~__;_:-=:.:n=..:m:.:..=u.::.n::•:. x C ts per
EOQ or order size :~der

--
 Accounts Receivable and Inventory Management 319

c) Total carrying costs Average

= Inve · Carrying
ntory - x . Costs per
unit
d) Average Inventory _ EOQ or order size ·
2

2. Reorder point - · Lead Time + Safety

Usage I Stock_

Illustrative Cas e m. Economic Order Quantity Determin

ation
Assume that a local gift shop is attempting to determine how
many sets of wine
glass to order. .The store feels it will sell approximately 800
sets in the next year
at a price of P18 per set: _The wholesale price that the store
pays per set is P12.
Costs of carrying one set of wine glasses are estimated at
Pl .50 per year while
ordering costs are estimated at P2S.

' a. Determine the economic order quantity for the sets of . '
wine glasses.
Answer:
. '
EOQ - J 2 x 800 x P2S
Pl.SO
' I

t 63- units per order

.
.
· b. Determin~ the ann~a\ 'invent~ry costs for the firm if it
orders in this quantity·

Tomi inventory·co~ ~ [ ( ~~~) Gs) + 2

e~ }~1.s~]
3

= ~244.95

• r

,, .
' I
 320 Chapter J3
-===---=~-~~ --__:__::...:_ __:__;__----- --.:..---
Dlustrative Case IV. EOQ, Reorder point Determinatif;m

The following inventory infonnation and relationships for the Baguio Corporation
are available:

I.· Orders can be placed only in multiples of 100 units.

2. Annual unit usage is )00,000. (Assume a SO-week year in your
calculations.) , ·
or
3. The carrying cost is 30 percent of_the purchase price the goods.
4. The purchase price is PIO per unit.
5. The ordering cost i~ PS0 per order.
6. The desired safety stock is 1,000 units. (This does not include d~livery-
time stock.)
7. Delivery time is two weeks.

Given this information:

a. What _is the optimal EOQ level? .

· b. How many orders will be placed annually?
c. At what inventory level should a reorder be made?

Solution:

J
EOQ -
J 2 x 300,000 x PS0
IO x 0.3'0
' .
- , 3. 16~ un~ts bu_t since . orders must be placed in
multiples of J00 units, the effectfve EOQ becomes
3,200.

2. Number of orders - 300,000

3,200
- 93.75 o~ers per year
3. Reorder point - Lead Time Safety
Usage +
Stock

- (300,000
·so . X
2) + J,000

- lJ,000 units
I

d
 Accounts Receivable and Inventory Mahagement 321
Illustrative Case V. Costs associated with Safety Stoc
k , I •

Hard Hat Inc. operates a chain of hardware stores in Met

ro Manila. The controller
wants to· detennine the optimum safety stock levels
for an air purifier unit. The
inventory manager has comp_iled the following data.
· <

,• The annual carrying cost of inventory approximates

. investment in inventory. . . 20 percent of the
·
• The inyent~ry investment per unit average PSO.
• The stockout cost i~ estimated to be PS per unit.
.
.
• The company orders inventory on the average often
times per year.
• To~I co~t = carrying cost + expected stockout cost
.
• The probabilities of a stbc~out per order cycle with vary
ing levels·o f safety
stock ·are·as follows:

Units
· Safety Stock · Stockout Probability ·
200 0 0%
·100 100 15
1
0 100 15
0 200 12
What is the tot~I cos fof safety stoc~ on an an~ual basi
s with a safety sto~k level
of 100 units?

Solution:
• •
I
Annual carrying cost (100 x PlO). Pl ,000
Annul stockout cost [( 100 x 15%) (S) ( 1O)] 750
Total -Pl,750

• I
 ~3~22~~C;.!}_h~ap~t~er~/~J~----.- - - - - - - - - - - - - - : -
LEVEL MO~ITORING AND INVENTORY CONTROL SYSTEMS '

Inventory control is the regulation of inventory. within predetermined · limits.

Effective inventory management should provide ad~u~te st~cks to meet .the
' requirements of the business, while . at the same t~me keepmg th e required
investment to· a minimum. Various systems and techniques have been developed
to pro~ide effective con~I over inventories.

Some of the more generally-known inventory control systems are as follows:

I . Fixed Order Quantity System

This is a systerp wherein each ·time. the inventory goes down to a '
predetermined level known as the reorde~ point, an order for .a fixed
quantity is placed. This system requires the use of perpetual inventory -\
records or the continuous monitoring of the inventory level: Example of
' the application of this type of controt is the two-bin .system under which .
reorder is placed when the contents of the first bin are used up. ·

Another approach used in determining the reorder point i~ by addi~g the ',
average demand during lead time and buffer ~tock.

2. . Fixed Reorder Cycle System ·

This is also known as the periodic revie~ or the replacement system where
orders are made_after a review of inventory levels has been done at regular
intervals. An order-is placed if at the time of the revi_e w the inventory level ,
had gone down since the precediJ)g review. The quantity ordered under
·this system is variable depending on usage or demand during the revie~ ~
period.. · · • , · · .

Replenishment level is computed by the following f~rmula:

\ .
M = 8 + D(R + L)
where: M = Replenishment level in units ✓

8 = Buffer stock in. units

D = Average demand p~r day
R - Time interval in days, between reviews ·
L = Lead time in days .,
- >
 I

Accounts Receivable and Inventory Management ,, 323

3. Optional Replenishment System

This s~stem represents a combination of the important control

mech~msms of t~e other two systems described above. Replenishment
level 1s computed by the use of the following equation: ·
p = B + D(L + R/2)

where: P Reorder point in units

B Buffer stock in units
D Average daily demand in units
L Lead time in days
R = Tif1!e between review in days
4. ABC Classification System
·Under this system, segregation of materials for selective"c~ntrol is made.
Inventories are classified into "A" or high-value items, "B" or medium
cost items and "C" or •low cost items. Control may be exercised on these
items as follows: · -
1. A items - highest possible controls, including ,most complete,
accurate records, regular review by top supervisor, blanket orders
with frequent deliveries from vendor, close follow-up through the
factory deliveries from vendor, close follow-up through the
fac~ory to reduce lead time, etc. Careful accurate d~tennination
of order quantities and order point with frequent review to reduce,
if possible.
2. B items - normal controls involving good records and regular
attention; good analysis for EOQ and order point but reviewed
quarterly only or when major changes occur.
-
3. C items ·_ simplest possible controls such as peri~ ic review of
physical· inventory-with no records or only the simplest notations
that replenishment stocks have been ordered; no EOQ or order
point calculations.
' 324 Chapter Jj -
REVIEW QUESTIONS AND PROB_LEMS ,

\ I •

Questions ' I ,

h · f sh and marketable securitie~, why should the

I. n. t e managemebnt ~ ca ~ety and liquidity rather than maximization of
1
pnmary concern e ,or sa,,
profi~ I I

2. Why does ,float exist and what e,ffect would elec!ronic ·funds transfer
· systems have on float?
3. Ho~ can a firm operate with a negative cash balance on its ·corpor~te
books?

4. Why ~ould a financi.al manager want' to s!ow down disbursements?

' .

5. What are three quantitative measures that can be aP,plied to the collection ·
policy o~the firm? ,

6. In what form is trade credit most commoniy offered? What is the credit ,
\
I

fn·strument in this case?.

,7. What costs· are associated with carrying receivables? What costs are
associated with not granting credit? What d() we call the sum of the costs _
for different levels of receivables?

8. What are the fiye Cs of credit? EX;plain why each is ~mportant?

· 9. What are some of the factors that determine the length of the credit period?
Why is the length of the buyer,s operating cycle o~en considered an upper
bound on the length of the credit period?

10~ .In each of the following pairings, indicate which-firm would probably have I •
a longer credi~ period and explain your reasoning. ·
a. F~nn A sells ~ ~ira~le cure for baldness; Firm B sells toupees.
b. Finn A spectaltzes m products for landlords· Firm B specializes -.
in products for renters. '
c. F!rm A sells to customers with an inventory turnover of IO times;-
F~nn B sells to customers with an inventory turnover of 20 times. ,
d. F~rm A sells fres~ fruit; Firm B sells canned fruit. .
e. Finn A sells and installs carpeting; Firm 8 sells rugs.
 Accounts Receivable and /nv~ntory Management 325
, 11. What are the d_ifferent inventory types? How do the types differ? Why are
some types said to have dependent demand whereas other types are said
· . to have mdependent- demand?

12. If a comp~ ny, moves to a JIT inventory management system, what ~ill
: . . . happe~ !o inventory turnover? What will happen to total asset turnov er?
What wall happen t~ return on equity (ROE)?
I •
.,-• • > ""

13. If a compa ny's inventory carrying costs are PS million per year and its
-fixed order costs are P8 million per year, do you think the firm keeps too
much i~ventocy on. hand or too little? Why?

14. At least part of Apple' s corporate profits can be traced to 'its inventory
manag ement. Using just-in-time inventory, Apple typically maintains aw
invento ry of three to four days' sales. Competitors such as Hewlett- · ·
P~ckar d and IBM haye attempted to match Apple' s inventory polici~s, but
I • lag far behind . In an industry where the price of PC compo nents continu es
to decline , Ap_ple clearly has a competitive advantage. Why would you say
that it 'is to Apple' s· advantage t<;> have ~uch a short inventory period? If
doing this is· valuable,' why don't all other PC manufacturers switch t9
Apple 's approa ch?

Problems

ProblemI 1

Davis Compa ny sells ori terms of net 45. Its annual credit sales are P912,5 00 and
·its accoun ts receiva ble average ·IS days overdue. Assume a 365-da y year': What is
Davis' investm ent in receivables?

Problem 2

Tyron Inc., has credit sales of P600,000 and 'an avera~ e collect ion period of 25
days. The fimi; s •variabl e cost ratio is 80 percent. The opportunity cost of funds
·invest ed in accounts-receivable is 15 percent. Assume.a 365--day year. ·

Required:
a. What is the accoun ts receivabl~ tu~ove r for Tyron Inc.? . .
b. What is the averag e investmen~ in a~coun~ receiva ble for Tyron Inc.? .·
l.
 ~3~26~-: _iC~n ~ap~ t'!!_e r~/~J ~----- ------ ~-~-- ----

Problem 3
n credit and amount to P750,000 a year.
8 II O
Butterfly Company's current saJes are
000 and variable costs o
f 85 f
~ercent ·o sales.
The fi nn has fi1xed costs of PI 00, · . ·• d J w1·thout
sa es
·ty hich would penmt 1t to expan t red" ·
Butterf1y has excess capact ,w .. I · t
· add"mon
·mcurnng · aJ fi1xed costs.· One means of expand mg sa
.· es ts o
• ~ c 1t of
.
.
th
net 90 days to applicants who h·ave been turned d<?wn. m e past The .~red1t
manager has prepared sev~ral estimates for each of three risk.classes of appl 1cants.

Additional · BadDebl Required Pretax

Tota/Sales Sales Loss Ratio Rate ofReturn
Risk Closs 20%
A P800,000 PS0,000 5%
40,000 ·s 24
- B
C
· 840,000
860,000 20,000 · 12 30

Required:
a. What are the marginal pretax profits for each risk·class?
b. Which risk classes, if any, should B_utterfly accept as new credit customers?

Problem 4

Jazz Auto Supply is not satisfied with its present credit policy. A proposal under
consideration is to change the credit terms from _1/J 0, net 30 to 2/10, net _30. The
firm's current average collection period is 42.days but it is expected to decline to _ ~

38 days. The percentage of credit customers who take the discount is expected to
increase from 45 percent- to 60 percent under the new policy. Credit sales are
anticipated to remain P400,000 with a contribution margin of 25 percent. The bad
debt losses are forecasted to decrease from 3.0 percent of~redit sales to 2~5 percent.
The finn 's opportunity co_st for investing in additional receivables is I8 perceot.
Should Jaz.z adopt th is change in policy? · ·

Problem 5

Dairy IceCrea~ sells J2,000 gallons of ice cream each month ·from its central
storage facility. Monthly carrying costs ·are PO.JO per gallon and ordering costs are
PSO per order. Ignore potential stockout co_sts and assume a 30-day month.
Required·
. '
a. ~hat is the economic order quantity (EOQ) for the ice cream?
b. What is the average inventory? , ' ,
c. .What is the total inventory cost for the month?
 Accounts Receivab/~ and JnvenJory Management 327

d. Whf\_t is the optimal length of the· inventory cycle?

e. How many orders will be placed per month?

problem 6

Fruitcake Specialists sells 36,000 fruit cakes annually. Annual carrying costi, are
PS per fruit cake and the ordering costs are P 100 per order., The firm has decided
to maintain a safety stock of one month's sales or 3,000 fruitcakes. The delivery
time per order is 5 days. Ass.ume a 365-day year.

Required:
a. What is the economic order quantity (EOQ)?
b. What is the average inventory?
c. How many orders should be placed each year?
d. What is the total inventory cost?
.. e. What is the r~rder ·point?

Problem 7

Dama de Noche Corporation is considering a change in credit policy. The current

policy is cash only, and sales per period_ are 2,000 units at a price of P 110. If credit ·
is·offered, the new·price will be P120 per unit, and the credit will be extended for
one period. Unit sales as:e not expected to change, and all customers are expected
to take credit. Dama de :Noche anticipates that' 4 percent of its customers will
default If the required retu~ is 2 percent per pei:iod, is the change a good idea?
What if only half the customers ·take the offered credit?

Problem 8

Heidi Company is in the _process of considering a change in its terms of sale_. The
current policy is cash only; the new policy will involve o~e period's credit. Sales
are 40,0qo units per period at ~ p~ice of PS 10 per unit. If credit is offered, the new
price will be P537. Unit sales are not expected to change and all c~stomers are
expected to take the credit. Heidi estimates that 3 ~rcent of credit sales will be
uncollectible. If the required return i6 2.5 percent per period, is the change a good
idea? · · · ·
 328 Chapter 13

Problem 9 / I ,
1 • f running shoes per month at a cash price
O
Happy Feet C:ompany sel~s 3,30~ pa~rs olic that involves 30 days' credit
of P90 per pair. The firm 1s considermg a n~w p ereYd.tI ·sales • The cash price w·111
. . . p91 84 per pair on The
an d an mcrease m prrce to . . . d affect the. quantity sold.
remain at P90, and the new polrcy ,s ~ot expecte to. per. .month.
. . d w1.11 be 15 .days. The •required
· return 1s I percent
.
d1scount per10

Require d:
a. How would the new credit tenns be quoted? I '

b. What investment in receivables is required under the new policy?

c. Explain why the variable c.ost of manufacturiAg the shoes is not .relevant here.
d. If the default rate is anticipated to be J J ·percent, should the switch be made?
What is the break-even credit price? What is _the break-even cash di~count?

Problem 10

Silicon Wafers Inc., is debating whether or not to ·extend credit to ~ particular

customer. Silicon's prQducts, primarily used in the ma_nufacture of
semiconductors, currently sell for PI, 140, per unit: The variable cost is P760 per
unit. The order under consideration is for.15 units today; payment is promised in
30 days. ·

Require d.·
I

. a. a
Ir'there is . 20· percent"chance of default, should Silicon fill the order? The.
required return is 2 percent per month. This is a one-time sale and the customer
will not buy if credit is not extended .
b. What is the break-even probability in (a)?
c. In ge~eral t~s, how do you think you~ answer to (a) will be affected if th~ • I

customer will purchase the merchandise for cash if the credit is refused? The
c~h price is PI ,090 per unit.
 A~counts Receivable and /nven{ory Management 329
problem 11
/

c ·o nsider the followin g information about two alternative credit strategie~:

Refused Credit Grant Credit

Price per unit .P.71 P75
Cost per unit P32 P33
Quantit y sold per quarter 6,200 6,900
Probabi lity of paymen t 1.0 .90

The higher eost-per unit reflects the expense.associated with credit orders, and the
higher price per unit reflects .the existence of a cash discount. The ci:edit period
will be 90 days, ancl the cQst of debt is .75 percent permon th. -

Require d:
a. Based on this i'nformation, should credit be granted?
b. ·In (a), what does·the credit p1:ice per unit have to be a break even?
-c. In (a), suppose we can obtain a credit report for Pl .50 per custome r. Assumi ng
that each custome r buys one uhit and that the credit report correctl y identifie s
all ·custom ers who will not pay, should credit be extende d?

Multiple Choice Questions

1. Barbie ~ompan y, a·retail"store, is considering foregoing sales discoun ts

in order ·to dela)' using its cash. Supplier credi~ terms are·2/10, net 3 0.
1
Assumi ng a 360-day year, what is the annual cost of credit if the cash
discoun t is not taken and Barbie pays net 30?
a. 24:0o/o C. 36.0%-
b. 24.5% d. 36.7% .
2. The s"a les manage r at R~ineee Company feels confide nt that, if the
credit policy at Rainee's were changed, sales ·would . increase and,
consequ ently, the company :would utilize excess capacity . The two
are
cre~it ~roposais bei~g CO!)Sidered" as follows: .
Proposal A Proposa/B
Increase in sales PS00,OOD. P600,000
-Con~b ution margin 20% . 20%
Bad debt percentage So/a 5%
Increase in operating profits P75,000 P90,900
Desired return on sales 15% 15%
~3~30~~C:_!_h~apre_t~er~IJ!___ _ _ _ _ _
.
----=~-===-=====-=--
Currently, payment terms are
net 30. The.proposed paymen! tenns for
et 45 and net 90, respectively. An
· Proposal A and Proposal 8 areronposals for the change
• to in credit Polic"
anaIys1s com pare theser. two P·ngfactors except t he J
would include all of the •0 11ow•
a. Cost of funds for Rainee,
b Current bad debt experience. d· · ·
c.· Impact on the current customer base of exten mg tenns to only
.
certain customers.
d. Bank loan covenants on days' sal~s outstandmg. ·

3. Genes1s· o·st
1 r·b
1 utors. sells to retail store
. s·. on credit terms of 2/lO
. , .net
30. Daily sales average 1SO units at a pric e of P300 each .. Assun11ng _
that all sales are on credit and 60% of customers take the
dascoun~ and
pay on day Io while the rest of the customers pay on day
30, the amount
of Genesis' accounts receivable is · ,
a. . Pl ,350,000.. · c. P900,000.
b. P990,000. d. P8 I0,000.
4. A change in credit policy has caused an increase in _sa~es
, an increase
in discounts taken, a .decrease in the amount of bad
debts, and a
decrease in the investment in accounts receivable. Bas
ed upon this
information, the company's
a. Average collection period has decreased.
b. _Percentage discount offered has decreased.
c. Accounts receivable turnover has d~reased ..
d. Working ~J>•tal has increased.
,/

5. Blue Computers believes that its collection costs cou

ld be reduced
through modification of collection procedures. This acti
on is expected '
to result in a lengthening of the average collection period
from 28 days
to 34 days; howeve~, there will be no change in uncolle
ctible accounts.
The company's budgeted credit sales · for the com
ing year ~
P27,000,000, and short-tenn interest rates are expected
to average 8%.
T~ ~ake the. chan_ges in ~llection procedures cost
beneficial, t~e
mm1.mum savmgs m collection costs (using a 360-day
com mg year would have to be year) for the
a. P30,000. .
b. P360,000.
c. Pl80,000.
d. P36,000.

/
111111"'
Account, Receivable and Inventory Managemenl 331

6. .A company p~s to tighten its credit policy. The new policy will
decrease the average number of days in collection from 75 to'50 days
and will reduce the ratio of credit sales to total revenue from 700/o to
60%. The company estimates that projected sales will be 5% less if the
proposed new credit policy is implemented . If projected sales for the
coming years are PSO million, calculate the peso impact on accounts
receivable of this proposed change in credit policy. Assume a 360-day
year.
a. PJ,819,445 decrease. c. P3~)3,334 decrease.
b. P6,500,~0 decrease. d. Pl 8,749,778 inc_rease.

7. A ·company with P4.8 million in credit sales per year plans to relax its
credit · s~ndards, projecting that this will increase credit sales by
P720,000. The company' s average collection per:od for new
customers is expected to be 75 days, and the payment behavior of the.
e~isting custome~-is not expected to change: Variable costs are 80%
of sales. The firm's opportunity cost is 200/o before taxes. Assuming
a 360-day year,' what is-the company' s benefit (loss) on the planned
change in credit terms?
a. PO c. P144,000
b. P28,800 · d. P120,000
8. Which of the .following represenfs a finn:s average gross receivables
balance?

1. Days' sales in receivables x, accounts teceivable turnover.

-II. Average daily sales x · average collection period.
I11. Net sales + average gross receivables.

a. I on·ly. c. II only.
b. I and II only. d. U and III only.

9. A firm averages P4,000 in sales per day and is paid, on an average,

within 30 days of the sale. After they receive their invoice, 55% of the
customers pay by check, while the remaining 45% pay by credit card.
Approximat ely how much would the company show in accounts
receivable on its statement of financial position on any giv~n date?
.a. . P4,000
b. P120,000
c. ·. P48,000
d. P54,000

1111
 332 Chapter J3'
.IO. The high cost of Short-term fi_n~ricing has r~cently caused a.com pan
---
· ,to reevaluate
, the terms
. of credit 1t e_xtends tob its customers.
t h The
. . . cu rrentY
policy. is J/10, net 60: · lf'customers can orrow a t e pnme rat
I ..
· ·what prime rate must the ccimj'.lany c~ange its _terms of <;redit in o:dat
lo avoid an undesirable extension in 1ts-eollect1on of receivables? er
a, 2°/o ;
I .c, 7%
b. 5% ~ . .. ·d. - ·8%
- .
Whic~ one o_f ~e following ·woU Id· not be considered a carrying cost
11.
associated with mventory? . ·
a. Insurance costs. ·
b. . Co~t of capital irlvested in ·the inventory .. . ·
c: · · Cost of obsolescence. · , · ·· . ·
d. Shipping costs:· .· ··. ·, .. ·
, \ . ' I • - I

12. An·~xample of a carJ)'ing cost is ·

a. .· . Qisruption of production schedules. I

b. · Quantity discounts·lost. ··
c. Handli~g costs. -
d. Spoilage. , ·

· .13. The result of the economic order . ·

a. -. Annual quantity of · qu~~t•ty. formula indicates the
-b A mventory to be carried . . , . ..
• S nnual
ti usage
. . of materta· 1s during
. the year · .· . .-
c. . . a _ety_ s~o,ck plus estimated invent . . .
d. Qµanttcy of each individual . d. ory_ for t_he year.
. . . . or_e.r durmg th~ year.

. ''

\
• I

I I

I• • '.