Chapter 10

Chapter 10 Accounts Receivable and Inventory Management

After Studying Chapter 10, you should be able to: • List the key factors that can be varied in a firm's credit policy and understand the trade-off between profitability and costs involved. • Understand how the level of investment in accounts receivable is affected by the firm's credit policies. • Critically evaluate proposed changes in credit policy, including changes in credit standards, credit period, and cash discount. • Describe possible sources of information on credit applicants and how you might use the information to analyze a credit applicant. • Identify the various types of inventories and discuss the advantages and disadvantages of increasing/decreasing inventories • Describe, explain, and illustrate the key concepts and calculations necessary for effective inventory management and control, including classification, economic order quantity (EOQ), order point, safety stock, and just-in-time (JIT).

Accounts Receivable and Inventory Management • Credit and Collection Policies • Analyzing the Credit Applicant • Inventory Management and Control

Credit and Collection Policies of the Firm Quality of Trade Account Length of Credit Period (1) Average Collection Period (2) Bad-debt Losses Firm Collection Program Possible Cash Discount

Credit Standards • Credit Standards– The minimum quality of credit worthiness of a credit applicant that is acceptable to the firm. • Why lower the firm’s credit standards? The financial manager should continually lower the firm’s credit standards as long as profitability from the change exceeds the extra costs generated by the additional receivables.

Credit Standards • Costs arising from relaxing credit standards • A larger credit department • Additional clerical work • Servicing additional accounts • Bad-debt losses • Opportunity costs

Example of Relaxing Credit Standards Basket Wonders is not operating at full capacity and wants to determine if a relaxation of their credit standards will enhance profitability. • The firm is currently producing a single product with variable costs of $20 and selling price of $25. • Relaxing credit standards is not expected to affect current customer payment habits.

Example of Relaxing Credit Standards • Additional annual credit sales of $120,000 and an average collection period for new accounts of 3 months is expected. • The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%. Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax their credit standards?

Example of Relaxing Credit Standards Profitability of ($5 contribution) x (4,800 units) = additional sales $24,000 (120,000/25 = 4,800 units) Additional ($120,000 sales) / (4 Turns) = receivables $30,000 (120,000/(3/12) = 30,000) Investment in ($20/$25) x ($30,000) = add. receivables $24,000 Req. pre-tax return (20% opp. cost) x $24,000 = on add. investment $4,800 (20% of additional investment) Yes!Profits > Required pre-tax return

Average Collection Period • The average length of time from a sale on credit until the payment becomes usable funds for the firm. • Two parts: • Time from the sale until the customer mails the payment • Time from when the payment is mailed until the firm has received the cleared funds in its bank account.

Average Collection Period • Objective is to collect accounts receivable as quickly as possible without losing sales from high pressure collection procedures. This involves three key areas: • Credit Selection • Credit Terms • Credit Monitoring

Credit Terms • Credit Terms – Specify the length of time over which credit is extended to a customer and the discount, if any, given for early payment. For example, “2/10, net 30.” Credit Period– The total length of time over which credit is extended to a customer to pay a bill. For example, “net 30” requires full payment to the firm within 30 days from the invoice date.

Example of Relaxing the Credit Period Basket Wonders is considering changing its credit period from “net 30” (which has resulted in 12 A/R “Turns” per year) to “net 60” (which is expected to result in 6 A/R “Turns” per year). • The firm is currently producing a single product with variable costs of $20 and a selling price of $25. • Additional annual credit sales of $250,000 from new customers are forecasted, in addition to the current $2 million in annual credit sales.

Example of Relaxing the Credit Period • The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%. Ignoring any additional bad-debt losses that may arise, should Basket Wonders relax their credit period?

Example of Relaxing the Credit Period Profitability of ($5 contribution)x(10,000 units) = additional sales $50,000 (250,000/25 = 10,000) Additional ($250,000 sales) / (6 Turns) = receivables $41,667 Investment in add. ($20/$25) x ($41,667) = receivables (new sales) $33,334 Previous ($2,000,000 sales) / (12 Turns) = receivable level $166,667

Example of Relaxing the Credit Period New ($2,000,000 sales) / (6 Turns) = receivable level $333,333 Investment in $333,333 - $166,667 = add. receivables $166,666 (original sales) Total investment in $33,334 + $166,666 = add. receivables $200,000 Req. pre-tax return (20% opp. cost) x $200,000 = on add. investment $40,000 Yes! Profits > Required pre-tax return

Changing credit standards • Li Hong Company is currently selling a product for $10 per unit. Sales (all on credit) for last year were 60,000 units. The variable cost per unit is $6. The firm’s total fixed costs are $120,000. • The firm is considering a relaxation of credit standards that is expected to result in the following: a 5% increase in unit sales to 63,000 units; an increase in the average collection period from 30 days (its current level) to 45 days; an increase in bad-debt expenses from 1% of sales (the current level) to 2%. The firm’s required return on equal-risk investments, which is the opportunity cost of tying up funds in accounts receivable, is 15%.

Changing credit standards • Need to calculate the effect on the firm’s additional profit contribution from sales, the cost of the marginal investment in accounts receivable and the cost of marginal bad debts. • Additional profit contribution from sales • Fixed costs are ‘sunk’ and thereby unaffected by a change in the sales level. • Variable cost is the only cost relevant to a change in sales. Sales are expected to increase by 5%, or 3,000 units. The profit contribution per unit equals the difference between the sale price per unit ($10) and the variable cost per unit ($6) and so the profit contribution per unit will be $4. • Thus, the total additional profit contribution from sales will be $12,000 (3,000 units × $4 per unit).

Changing credit standards • Cost of the marginal investment in accounts receivable • To determine the cost of the marginal investment in accounts receivable, Peng Xi must find the difference between the cost of carrying receivables before and after the introduction of the relaxed credit standards. We are only concerned about the out-of-pocket costs so the relevant cost in this analysis is the variable cost. • The average investment in accounts receivable can be calculated using the following formula: • Average investment in accounts receivable = total variable cost of annual sales/ turnover of accounts receivable • where • Turnover of accounts receivable = 365/average collection period

Changing credit standards • The total variable cost of annual sales, using the variable cost per unit of $6 are, • Total variable cost of annual sales: • Under present plan: ($6 × 60,000 units) = $360,000 • Under proposed plan: ($6 × 63,000 units) = $378,000 • The proposed plan increases total variable cost of sales by $18,000. • The turnover of accounts receivable shows the number of times each year that accounts receivable are turned into cash. It is found by dividing the average collection period into 365. • Turnover of accounts receivable (rounded): • Under present plan: 365/30 = 12.2 • Under proposed plan: 365/45 = 8.1

Changing credit standards • Substitute the cost and turnover data just calculated to get the following average investments in accounts receivable: • Average investment in accounts receivable: • Under present plan: $360,000/12.2 = $29,508 • Under proposed plan: $378,000/8.1 = $46,667 • The marginal investment in accounts receivable, and its cost, are calculated as follows: • Cost of marginal investment in accounts receivable (A/R): • Average investment under proposed plan $46,667 • – Average investment under present plan 29,508 • Marginal investment in accounts receivable $17,159 • × Required return on investment 0.15 • Cost of marginal investment in A/R $2,574

Changing credit standards • The value of $2,574 is a cost because it represents the maximum amount that could have been earned on the $17,159 had it been placed in the best equal-risk investment alternative available at the firm’s required return on investment of 15%. • Cost of marginal bad debts • The cost of marginal bad debts is the difference between the level of bad debts before and after the relaxation of credit standards: • Cost of marginal bad debts: • Under proposed plan: 0.02 × $10 × 63,000 units = 12,600 • Under present plan: 0.01 × $10 × 60,000 units = 6,000 • Cost of marginal bad debts $6,600

Changing credit standards • Bad debts costs are calculated by using the sale price per unit ($10) to identify not just the true loss of variable (or out-of-pocket) cost ($6) that results when a customer fails to pay its account, but also the profit contribution per unit—in this case, $4 ($10 sales prices – $6 variable cost)—that is included in the ‘additional profit contribution from sales’. Thus, the resulting cost of marginal bad debts is $6,600. • To decide whether the firm should relax its credit standards, the additional profit contribution from sales must be compared with the sum of the cost of the marginal investment in accounts receivable and the cost of marginal bad debts. If the additional profit contribution is greater than marginal costs, credit standards should be relaxed.

Changing credit standards • The effect of Li Hong’s credit relaxation policy:

Credit Terms • Cash Discount Period – The period of time during which a cash discount can be taken for early payment. For example, “2/10” allows a cash discount in the first 10 days from the invoice date. Cash Discount – A percent (%) reduction in sales or purchase price allowed for early payment of invoices. For example, “2/10” allows the customer to take a 2% cash discount during the cash discount period.

Credit Terms • The terms of sale for customers who have been extended credit by the firm. • E.g. ‘net 30’ means the customer has 30 days from the beginning of the credit period to pay the full invoice amount. • Some firms offer cash discounts as percentage discounts from the purchase price for full payment without a specified time. • E.g. ‘2/10 net 30’ means the customer can take a 2% discount from the amount payable if payment is made within the first 10 days of the credit period, or pay the full amount of the amount payable within 30 days of the beginning of the credit period.

Credit Terms • Any discounts for early payment should only be offered after a cost benefit analysis. • Are reflective of the type of business the firm operates. E.g. seasonal, perishable goods etc • Should be reflective of industry standards at a firm level, but reflective of customer riskiness at an individual customer level.

Credit Terms • Li Hong Company has an average collection period of 40 days (turnover = 365/40 = 9.1). The firm’s credit terms are net 30, so this period is divided into 32 days until the customers place their payments in the mail (not everyone pays within 30 days) and 8 days to receive, process and collect payments once they are mailed. Li Hong is considering changing its credit terms from net 30 to 2/10 net 30. This change is expected to reduce the amount of time until the payments are placed in the mail, resulting in an average collection period of 25 days (turnover = 365/25 = 14.6). • As shown in the EOQ example (slide 74), Li Hong has a raw material with current annual usage of 1,100 units. Each finished product produced requires one unit of this raw material at a variable cost of $1,500 per unit, incurs another $800 of variable cost in the production process and sells for $3,000 on terms of net 30. Li Hong estimates that 80% of its customers will take the 2% discount and that offering the discount will increase sales of the finished product by 50 units (from 1,100 to 1,150 units) per year but will not alter its bad-debt percentage. Li Hong’s opportunity cost of funds invested in accounts receivable is 14%. Should Li Hong offer the proposed cash discount?

Credit Terms • Analysis of initiating a cash discount for Li Hong Company • c Li Hong’s opportunity cost of funds is 14%

Example of Introducing a Cash Discount A competing firm of Basket Wonders is considering changing the credit period from “net 60” (which has resulted in 6 A/R “Turns” per year) to “2/10, net 60.” • Current annual credit sales of $5 million are expected to be maintained. • The firm expects 30% of its credit customers (in dollar volume) to take the cash discount and thus increase A/R “Turns” to 8. • (30% x 10 days + 70% x 60 days = 3 + 42 days = 45 days • 360 days per year / 45 days = 8 turns per year

Example of Introducing a Cash Discount • The before-tax opportunity cost for each dollar of funds “tied-up” in additional receivables is 20%. Ignoring any additional bad-debt losses that may arise, should the competing firm introduce a cash discount?

Example of Using the Cash Discount Receivable level ($5,000,000 sales) / (6 Turns) = (Original) $833,333 Receivable level ($5,000,000 sales) / (8 Turns) = (New) $625,000 Reduction of $833,333 - $625,000 = investment in A/R $208,333

Example of Using the Cash Discount Pre-tax cost of 0.02 x 0.3 x $5,000,000 = the cash discount $30,000. Pre-tax opp. savings (20% opp. cost) x $208,333 = on reduction in A/R $41,667. Yes! Savings > Costs The benefits derived from released accounts receivable exceed the costs of providing the discount to the firm’s customers.

Seasonal Dating • Seasonal Dating– Credit terms that encourage the buyer of seasonal products to take delivery before the peak sales period and to defer payment until after the peak sales period. • Avoids carrying excess inventory and the associated carrying costs. • Accept dating if warehousing costs plus the required return on investment in inventory exceeds the required return on additional receivables.

Default Risk and Bad-Debt Losses (see p. 251 for details) Present Policy Policy A Policy B Demand $2,400,000 $3,000,000 $3,300,000 Incremental sales $ 600,000 $ 300,000 Default losses Original sales 2% Incremental Sales 10% 18% Avg. Collection Pd. Original sales 1 month Incremental Sales 12 times 2 months 3 months per year 6 times 4 times

Default Risk and Bad-Debt Losses Policy A Policy B 1. Additional sales $600,000 $300,000 2. Profitability: (20% contribution) x (1) 120,000 60,000 3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000 4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000 5. Inv. in add. receivables: (.80) x (4) 80,000 60,000 6. Required before-tax return on additional investment: (5) x (20%) 16,000 12,000 7. Additional bad-debt losses + additional required return: (3) + (6) 76,000 66,000 8. Incremental profitability: (2) - (7) 44,000 (6,000) Adopt Policy A but not Policy B.

Collection Policy and Procedures • Collection Procedures • Letters • Phone calls • Personal visits • Legal action The firm should increase collection expenditures until the marginal reduction in bad-debt losses equals the marginal outlay to collect. As an account becomes more overdue, the collection effort becomes more personal and more intense, until a resolution achieved. Saturation Point Bad-Debt Losses Collection Expenditures

Analyzing the Credit Applicant • Obtaining information on the credit applicant • Analyzing this information to determine the applicant’s creditworthiness • Making the credit decision

Sources of Information The company must weigh the amount of information needed versus the time and expense required. • Financial statements • Credit ratings and reports • Bank checking • Trade checking • Company’s own experience

Credit Analysis A credit analyst is likely to utilize information regarding: • the financial statements of the firm (ratio analysis) • the character of the company • the character of management • the financial strength of the firm • other individual issues specific to the firm

Sequential Investigation Process The cost of investigation (determining the type and amount of information collected) is balanced against the expected profit from an order. An example is provided in the following three slides 10-45 through 10-48.

Sample Investigation Process Flow Chart (Part A) Pending Order * For previous customers only a Dun & Bradstreet reference book check. Bad past credit experience Stage 1 $5 Cost No Yes Reject No prior experience whatsoever Stage 2 $5 - $15 Cost Dun & Bradstreet report analysis*

Sample Investigation Process Flow Chart (Part B) Credit rating “limited” and/or other damaging information unearthed? Yes Reject No Credit rating “fair” and/or other close to maximum “line of credit”? No Accept Yes

Sample Investigation Process Flow Chart (Part C) ** That is, the credit of a bank is substituted for customer’s credit. Bank, creditor, and financial statement analysis Stage 3 $30 Cost Good Fair Poor Accept Reject Accept, only upon domestic irrevocable letter of credit (L/C)**

Other Credit Decision Issues • Credit-scoring System – A system used to decide whether to grant credit by assigning numerical scores to various characteristics related to creditworthiness. Line of Credit– A limit to the amount of credit extended to an account. Purchaser can buy on credit up to that limit. • Streamlines the procedure for shipping goods.

Other Credit Decision Issues • Outsourcing Credit and Collections • The entire credit and/or collection function(s) are outsourced to a third-party company. • Credit decisions are made • Ledger accounts maintained • Payments processed • Collections initiated Decision based on the core competencies of the firm.

Inventory Management and Control • Inventories form a link between production and sale of a product. • Inventory types: • Raw-materials inventory • Work-in-process inventory • In-transit inventory • Finished-goods inventory

Chapter 10

Chapter 10

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Chapter 10

Chapter 10

Chapter 10

Chapter 10

Chapter 10

Chapter 10

Chapter 10

Chapter 10

Chapter 10

CHAPTER 10

CHAPTER 10

Chapter 10

Chapter 10

Chapter 10

Chapter 10

Chapter 10

10~Chapter 10

CHAPTER 10

Chapter 10

Chapter 10

Chapter 10

Chapter 10