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1. WORKING CAPITAL MANAGEMENT Discussion Points Introduction to Working Capital Management Determinants of Working Capital Financing Current Assets Cash Management Cash Management Techniques Cash Management Models Receivable Management Inventory management Objectives of Inventory Management Techniques of Inventory Management CHAPTER 4

2. INTRODUCTION TO WORKING CAPITAL MANAGEMENT Management of working capital is an important part of financial manager. The main objective of the working capital management is managing the current asset and current liabilities effectively and maintaining adequate amount of both current assets and c urrent liabilities. Meaning of Working Capital There are two concepts of working capital – gross and net (i) Gross Working C apital – refers to the firm’s investment in current assets. ASA - ADV. FM - JIMMA UNIVERSITY

3. … INTRODUCTION TO… CONT’D (ii) Net Working Capital – refers to the difference between current assets and current liabilities. Net working capital can be positive or negative . A positive net working capital will arise when current assets exceed current liabilities. A negative net working capital occurs when current liabilities are in excess of current assets. The gross working capital concept focuses attention on two aspects of current assets management: (a) how to optimize investment in current assets, and (b) how should current assets be financed? ASA - ADV. FM - JIMMA UNIVERSITY

4. The consideration of the level of investment in current assets should avoid two danger points – excessive and inadequate investments in current assets. Investment in current assets should be just adequate , not more or not less, to the needs of the business firm. Excessive investments in current assets should be avoided because it impairs the firm’s profitability, as idle investment earns nothing. Inversely, insufficient amount of working capital can threaten solvency of the firm because of its inability to meet its current obligations. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

5. It should be recognized that the working capital needs of the firm may be fluctuating with changing business activity . This may cause excess or shortage of working capital frequently. The management should be prompt to initiate an action and correct imbalances. … Cont’d … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

6. …Cont’d Whenever there is excess investments in current assets that may not be needed in the normal course of business, it should be invested in the appropriate investment vehicle to produce earnings. Inversely, whenever a need for working capital funds arises due to the increasing level of business activity or for any other reason, financing arrangement should be made quickly . Thus, the financial manager should have a knowledge of the sources of working capital funds as well as investment avenues where idle funds may be temporarily invested. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

7. …Cont’d Current assets should be sufficiently in excess of current liabilities to constitute a margin or cushion for maturing obligations within the ordinary operating cycle of a business. In order to protect their interests, short-term creditors always like a company to maintain current assets at a higher level than current liabilities. It is a conventional rule to maintain the level of current assets twice the level of current liabilities. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

8. …Cont’d However, the quality of current assets should be considered in determining the level of current assets vis-à-vis current liabilities. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe and unsound. A negative working capital means a negative liquidity , and may prove to be harmful for the company’s reputation. Excessive liquidity is also bad . It may be due to mismanagement of current assets. Hence, timely action must be taken by management to improve and correct the imbalances in the liquidity position of the firm. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

9. …Cont’d Working Capital Policy – refers to the firm’s basic policies regarding ( i )target levels for each categories of current asset, and (ii) how current assets are to be financed. Working Capital Management is an act of planning, organizing and controlling the components of working capital like cash, short-term investments, receivables, inventories, payables, overdrafts and short-term loans. Working capital management is concerned with the problems that arise in attempting to manage the current assets, current liabilities and the interrelationship that exist between them. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

10. …Cont’d Balanced Working Capital Position The firm should maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from the firm’s point of view. Excessive working capital means idle funds which earn no profits for the firm. Paucity of working capital not only impairs the firm’s profitability but also results in production interruptions and inefficiencies. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

11. …Cont’d ۩ Some of the dangers of maintaining excessive working capital are: a) It results in unnecessary accumulation of inventories. Thus, chances of inventory waste, theft and losses increase. b) It is an indication of defective credit policy and slack collection period. Consequently, higher incidence of bad debts results, which adversely affects profits. c) Excessive working capital makes management satisfied which degenerates into managerial inefficiency. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

12. …Cont’d ۩ Some of the Effects of inadequate working capital are: a) It stagnates growth. It becomes difficult for the firm to undertake profitable projects for non-availability of working capital funds b) It becomes difficult to implement operating plans and achieve the firm’s profit target. c) Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. d) Paucity of working capital funds render the firm unable to avail attractive credit opportunities, e) The firm loses its reputation when it is not in a position to honor its short-term obligations. As a result, the firm faces tight credit terms. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

13. …Cont’d An enlightened management should, therefore, maintain the right amount of working capital on a continuous basis . Only then a proper functioning of business operations will be ensured. Sound financial and statistical techniques, supported by judgment, should be used to predict the quantum of working capital needed at different time period. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

14. …Cont’d Determinants of Working Capital There are no set rules or formulae to determine the working capital needs of firms. A large number of factors, each having a different importance, influence working capital needs of firms. Some of these factors are described below: 1) Nature of Business Working capital requirements of a firm are basically influenced by the nature of its business. For example, trading and financial firms have a very small investment in fixed assets, but require a large sum of money to be invested in working capital. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

15. …Cont’d Retail stores must carry large stocks of a variety of goods to satisfy varied and continuous demands for their customers. In contrast, public utilities have a very limited need for working capital and have to invest abundantly in fixed Assets. 2) Sales and Demand Conditions The working capital needs of a firm are related to its sales A growing firm may need to invest funds in fixed assets in order to sustain its growing production and sales. This will, in turn, increase investments in current assets to support the inflated scale of operations. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

16. …Cont’d 3) Technology and Manufacturing Cycle The manufacturing cycle ( or the inventory conversion cycle ) comprises of the purchase and use of raw materials and the production of finished goods. Longer the manufacturing cycle, larger will be the firm’s working capital requirements. For example, the manufacturing cycle in the case of a boiler, depending on its size, may range between six to twenty-four months. Inversely, the manufacturing cycle of products such as detergent powder, soaps, chocolate, etc. may be a few hours. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

17. …Cont’d An extended manufacturing time span means a larger tie-up of funds in inventories. Thus, if there are alternative technologies of manufacturing a product, the technological process with the shortest manufacturing cycle may be chosen. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

18. …Cont’d A high collection period will mean tie-up of large funds in receivables . Loose collection procedures can increase the chance of bad debts. In order to ensure unnecessary funds are not tied-up in receivables, the firm should follow a rationalized credit policy based on the credit standing of customers and other relevant factors. 4) Availability of Credit A firm which can get bank credit easily on favorable conditions, will operate with less working capital than a firm without such a facility. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

19. 5) Credit Policy The credit policy of the firm affects the working capital by influencing the level of debtors. A liberal credit policy, without rating the credit-worthiness of customers, will be detrimental to the firm and will create a problem of collecting funds later on. …Cont’d … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

20. …Cont’d 6) Operating Efficiency The firm may keep its investment in working capital at lower level if it is efficient in controlling operating costs and utilizing current assets . The use of working capital is improved and pace of cash conversion cycle is accelerated with operating efficiency. 7) Price Level Changes Generally, rising price levels will require a firm to maintain higher amount of working capital. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

21. …Cont’d Financing Current Assets A firm can adopt different financing policies vis-a-vis current assets. Three types of financing may be distinguished: (1) Long-term financing – The sources of long-term financing include: ♠ ordinary share capital, ♠ preference share capital, ♠ debentures, ♠ long-term borrowings from financial firms and ♠ reserves and surplus (retained earnings). … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

22. …Cont’d (2) Short-term financing – The short-term financing is obtained for a period less than one year . It can be obtained from banks and other suppliers of short-term finance in the money market. Short-term finances include working capital funds from banks, public deposits, commercial paper, factoring of receivables, etc. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

23. (3) Spontaneous financing – it refers to the automatic sources of short-term funds arising in the normal course of a business. Trade credit and outstanding expenses are examples of spontaneous financing. The firm is expected to utilize this sources of finances to the fullest extent. …Cont’d … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

24. …Cont’d Cash Management Business concerns needs cash to make payments for acquisition of resources and services for the normal conduct of business. Cash is one of the important and key parts of the current assets. Cash is the money which a business concern can disburse immediately without any restriction. The term cash includes coins, currency, checks held by the business and bank balance. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

25. …Cont’d Cash management involves identifying sources of cash flows, identifying various avenues to invest surplus cash effectively, and being prepared to meet any cash contingencies. A Cash crises can be pre-empted by preparing a cash budget. This involves short-term cash forecasting (weekly, monthly, and annually) to help manage daily cash; and long-term (annual, 3 – 5 years) cash flow projections to develop the necessary capital strategy to meet business needs. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

26. …Cont’d Motives for Holding Cash 1. Transaction Motive It is a motive for holding cash or near cash to meet routine cash requirements to finance transaction in the normal course of business. Cash is needed to make purchases of raw materials, pay expenses, taxes, dividends etc. 2. Precautionary Motive It is the motive for holding cash or near cash as a cushion to meet unexpected contingencies . Cash is needed to meet the unexpected situation like, floods, strikes etc. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

27. …Cont’d 3. Speculative Motive It is the motive for holding cash to quickly take advantage of opportunities typically outside the normal course of business. Certain amount of cash is needed to meet an opportunity to purchase raw materials at a reduced price or make purchase at favorable prices. This is to tap profits from opportunities arising from fluctuations in commodity prices, security prices, interest rates, etc. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

28. …Cont’d 4. Compensating Motive It is a motive for holding cash to compensate banks for providing certain services or loans. Banks provide variety of services to the business concern, such as clearance of check, transfer of funds etc. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

29. …Cont’d Cash Management Techniques To minimize the firm’s financing requirements ; financial managers use two techniques viz., (1) speedy cash collections and (2) slowing disbursements. Speedy Cash Collections A business must concentrate in the field of speedy cash collections from customers. For the purpose, the firm should prepare systematic plan and refined techniques . Customers are encouraged to pay their bills as quickly as possible without delay. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

30. …Cont’d (1) Some of the Speedy Cash Collection techniques applied by the firm are as below: Prompt payment by customers A business should encourage the customer to pay promptly with the help of offering discounts, special offer etc. It helps to reduce delaying payment of customers and the firm can avoid delays from the customers. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

31. …Cont’d (b) Early Conversion of Payments into Cash A business should take careful action regarding the quick conversion of the payment into cash. For this purpose the firm may use some of the techniques like postal float , processing float and clearing float . … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

32. …Cont’d (c) Concentration Banking It is a collection procedure in which payments are made to regionally dispersed collection centers , and deposited in local banks for quick clearing . It is a system of decentralized billing and multiple collection points . This system has the advantage of placing collection centers close to the customers thereby reducing mail float. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

33. …Cont’d (d) Lockbox System It is a collection procedure in which payers send their payment or checks to a nearby post box that is cleared by the firm’s bank. Several times that the bank deposit the check in the firms account. Under the lockbox system , businesses hire a post office box at important collection centers where the customers remit payments. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

34. …Cont’d (e) Direct Send A collection procedure in which the pay presents payment checks directly to the banks on which they are drawn, thus reducing clearing float. (f) Wire Transfer Transfer of money electronically could minimize or eliminate floats. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

35. …Cont’d (2) Slowing Disbursement An effective cash management is not only in the part of speedy collection of its cash and receivables but also it should concentrate to slowing their disbursement of cash to the customers or suppliers. Slowing disbursement of cash does not mean delaying the payment or avoiding the payment. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

36. …Cont’d Slowing disbursement of cash is possible with the help of the following methods: (1) Avoiding the Early Payment of Cash The firm should pay its payable only on the last day of the payment. If the firm avoids early payment of cash, the firm can retain the cash with it and that can be used for other purposes. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

37. …Cont’d (2) Centralized Disbursement System Decentralized collection system will provide the speedy cash collections. Centralized disbursement of cash system takes time for collection from our accounts as well as we can pay on the date. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

38. …Cont’d Cash Management Models Cash management models analyze methods which provide certain framework as to how cash management is conducted in the firm. Cash management models are the development of the theoretical concepts into analytical approaches with the mathematical applications. There are two cash management models which are very popular in the field of finance. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

39. …Cont’d (1) Baumol Model It is a model that provides for → cost efficient transactional balances, →assumes that the demand for cash can be predicted with certainty, and → determines the optimal conversion size . That is, the optimum amount of cash that should be transferred from marketable securities to cash each time a conversion is made. This model assumes that the firm’s cash inflows and outflows are known with certainty. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

40. A portfolio of marketable securities acts as a reservoir for replenishing transactional cash balances . The firm manages this cash on the basis of the cost of converting marketable securities into cash ( the conversion cost ) and the cost of holding cash rather than marketable securities ( opportunity cost ). Opportunity cost is the interest earnings per birr given up during a specified time period as a result of holding funds in cash account instead of investing them in marketable securities. Thus, the firm incurs a holding cost for maintaining the cash balance. …Cont’d … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

41. …Cont’d Opportunity cost - can be calculated with the help of the following formula; i = where, i = interest rate earned C/2 = Average cash balance Conversion Cost (transaction cost) – is a cost incurred by the firm while converting its marketable securities into cash . It is stated as birr per conversion . ASA - ADV. FM - JIMMA UNIVERSITY

42. The total conversion cost per period can be calculated with the help of the following formula: t = where, T = Total transaction cash needs for the period b = Cost per conversion C = Value of marketable securities …Cont’d … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

43. …Cont’d Optimal cash conversion can be calculated with the help of the following formula; C = where, C = optimal conversion amount b = cost of conversion into cash per lot or transaction T = projected cash requirement i = interest rate earned … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

44. …Cont’d The objective of the Baumol model is to determine the economic conversion quantity (ECQ ) of cash that minimizes total cost. Cash transfer that are larger than or smaller than ECQ result in higher total cost . The optimum cash balance (C) or the economic conversion quantity (ECQ), is the cost minimizing quantity of cash to be converted from marketable securities to cash. The optimum cash balance, C is obtained when the total cost is minimum . … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

45. …Cont’d Example: The management of ABC Company, a small distributor of sporting goods, anticipates Birr 1,500,000 cash outlays (demand) during the coming year. A recent study indicates that it costs Birr 30 to convert marketable securities to cash. The marketable securities portfolio currently earns an 8 percent annual rate of return. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

46. …Cont’d Required: Compute (1) the optimum cash conversion balance (C) or the Economic conversion quantity (ECQ)? (2) the number of conversion during the year to replenish the account (3) The average cash balance (4) The total cost Solution: (1) C = C = C = C = Birr 33, 541 … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

47. …Cont’d (2) The number of conversions during the year to replenish the account: = T/C = 1,500,000/33,541 = 45 (3) The average cash balance: = C/2 = Birr 33,541/2 = Birr 16, 770.50 … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

48. …Cont’d (4) The total cost of managing the cash: = i (Average cash balance) + (cost per conversion x no. of conversions) = i (C/2) + c(T/C) = 0.08 (Birr 16,770.50) + (Birr 30 x 45) = Birr 2692.00 … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

49. …Cont’d Exercise Continuing with the above illustration, determine the amount of conversion cost, opportunity cost and total cost, assuming that, based on the rule of thumb, the firm set the conversion amount at: (a) Birr 40,000 (b) Birr 30,000 (c) Which costs increase and decrease as the cash balance rises above the optimum cash balance? Consider case (a) for example. (d) Which costs increase and decrease as the cash balance falls below the optimum cash balance? Consider case (b) for example. … INTRODUCTION TO… CONT’D ASA - ADV. FM - JIMMA UNIVERSITY

50. …Cont’d (2) Miller–Orr Model Most firms don’t use their cash flows uniformly and also cannot predict their daily cash inflows and outflows. The Miller–Orr Model helps them by allowing daily cash flow variation. The objective of this model is to determine the optimum cash balance level which minimizes the cost of management of cash. Under this model, the firm allows the cash balance to fluctuate between the upper control limit and the lower control limit , making a purchase and sale of marketable securities only when one of these limits is reached. ASA - ADV. FM - JIMMA UNIVERSITY

51. …Cont’d This is the method that provides for cost efficient transactional cash balances. It assumes uncertain cash flows and determines an upper limit (i.e., the maximum amount) and return point for cash balances. The return point represents the level at which the cash balance is set , either when cash is converted to marketable securities or vice versa. Cash balances are allowed to fluctuate between the upper limit and a zero balance. ASA - ADV. FM - JIMMA UNIVERSITY

52. …Cont’d The value of the return point depends on: (1) conversion costs (2) the daily opportunity cost of funds, and (3) the variance of daily cash flows. The variance is estimated by using daily net cash flows (inflows minus outflows for the day). Return point = ASA - ADV. FM - JIMMA UNIVERSITY

53. …Cont’d Upper limit: the upper limit for the cash balance is three times the return point . When the cash balance falls to zero , the amount converted from marketable securities to cash is the amount represented by the return point . Marketable Securities Converted to Cash = Return Point – Zero Balance When the cash balance reaches the upper limit, an amount equal to the upper limit minus the return point is converted to marketable securities. Cash Converted to Marketable Securities = Upper Limit – Return Point ASA - ADV. FM - JIMMA UNIVERSITY

54. …Cont’d   ASA - ADV. FM - JIMMA UNIVERSITY

55. …Cont’d   ASA - ADV. FM - JIMMA UNIVERSITY

56. …Cont’d Note: The Miller–Orr Model is more realistic as it allows variations in cash balance within the lower and upper limits. The lower limit can be set according to the firm’s liquidity requirement. ASA - ADV. FM - JIMMA UNIVERSITY

57. …Cont’d Receivable Management The term receivables is defined as debt owed to the concern by customers arising from sale of goods or services in the ordinary course of business. Receivables are also one of the major parts of current assets of the business concerns. It arises only due to credit sales to customers, hence, it is also known as Accounts Receivables or Bills Receivables . Most credit sales are made on open account , without any formal acknowledgement of debt obligation through a financial instrument. ASA - ADV. FM - JIMMA UNIVERSITY

58. …Cont’d Management of accounts receivable is defined as the process of making decision resulting to the investment of funds in these assets which will result in maximizing the overall return on the investment of the firm. Credit Terms Credit terms are specifications of the conditions under which the firm extends credit to its customers. The credit terms consists of two parts: the credit period and any cash discount terms offered. ASA - ADV. FM - JIMMA UNIVERSITY

59. …Cont’d Account receivables represent the extension of credit by the firm to its customers. The extension of credit to customers by most manufacturers is a cost of doing business. By keeping its money tied-up in accounts receivable, the firm loses the time value of the money and runs the risk of non-payment by its customers. In return for incurring these costs, the firm can be competitive, attract and retain customers, and improve and maintain sales and profits. ASA - ADV. FM - JIMMA UNIVERSITY

60. …Cont’d Factors Determining the Receivable Size Receivables size of the business concern depends upon various factors. Some of the important factors are described below: a) Sales Level Sales level is one of the important factors which determines the size of receivable of the firm. If the firm wants to increase the sales level, it has to liberalize its credit policy and terms and conditions. When the firm maintains more sales, there will be a possibility of large size of receivable. ASA - ADV. FM - JIMMA UNIVERSITY

61. …Cont’d b) Credit Policy Credit policy is the determination of credit standards and analysis. It may vary from firm to firm or even sometimes product to product in the same industry. Liberal credit policy leads to increase the sales volume and also increases the size of receivable. Stringent credit policy reduces the size of the receivables. ASA - ADV. FM - JIMMA UNIVERSITY

62. …Cont’d c) Credit Terms Credit terms specify the repayment terms required of credit receivables, depend upon the credit terms, size of the receivables may increase or decrease. Hence, credit term is one of the factors which affects the size of the receivable. d) Credit Period It is the time for which trade credit is extended to customers in the case of credit sales. Normally, it is expressed in terms of “ Net days ”. ASA - ADV. FM - JIMMA UNIVERSITY

63. …Cont’d e) Cash Discount Cash discount is the incentive to the customers to make early payment of the due date. A special discount will be provided to the customer for his/her payment before the due date. f) Management of Receivable It is also one of the factors which affects the size of receivable in the firm. When the management involves systematic approaches to the receivable, the firm can reduce the size of receivable. ASA - ADV. FM - JIMMA UNIVERSITY

64. …Cont’d Benefits of Extending Trade Credit The firm grants trade credit because it expects the investment in receivables to be profitable. The immediate impact of granting trade credit is in the firm’s sales level; and the motivation for investment in receivables may be oriented toward either sales expansion or sales retention. Sales expansion refers to granting more trade credit (i) to increase sales to existing customers and/or (ii) to attract new customers. ASA - ADV. FM - JIMMA UNIVERSITY

65. …Cont’d The second motivation, sales retention , refers to granting trade credit to protect the firm’s sales from competition. For example, if a competitor offers customers better credit terms, the firm may choose to match these terms in an effort to protect its sales. ASA - ADV. FM - JIMMA UNIVERSITY

66. …Cont’d Costs of Extending Trade Credit In general, trade credit involves about five types of costs. These are: i) Production, selling, and administrative costs ii) Cash discounts iii) Bad debt losses iv) Taxes v) Opportunity cost. ASA - ADV. FM - JIMMA UNIVERSITY

67. …Cont’d Inventory Management Inventories constitute the most significant part of current assets of the business concern. They are also essential for the smooth running of the business concern. A proper planning of raw material, handling, storing and recording is to be considered as a part of inventory management. Inventory management means, management of raw materials and related items. Inventory management also involves what to purchase, how to purchase, how much to purchase, from where to purchase, where to store and when to use for production etc. ASA - ADV. FM - JIMMA UNIVERSITY

68. …Cont’d Kinds of Inventories Inventories can be classified into five major categories: A. Raw Materials Inventory – goods not committed to production. B. Work-In Process Inventory – committed in the production process but not yet completed. C. Consumables – materials needed to smooth running of the manufacturing process. D. Finished Goods Inventory – are the final output of the production process. E. Spares – include small spares and parts. ASA - ADV. FM - JIMMA UNIVERSITY

69. …Cont’d Objectives of Inventory Management Inventory occupy 30 – 80% of the total current assets of the business concern. It is also very essential part not only in the field of Financial Management but also it is closely associated with production management. Hence, in any working capital decision regarding the inventories, it will affect both financial and production functions of the concern. Hence, efficient management of inventories is an essential part of any kind of manufacturing process. ASA - ADV. FM - JIMMA UNIVERSITY

70. …Cont’d The major objectives of inventory management are as follows: 1) to efficient and smooth production process. 2) to maintain optimum inventory to maximize the profitability. 3) to meet the seasonal demand of the product. 4) to avoid price increase in future. 5) to ensure the level and site of inventories required. 6) to plan when to purchase and where to purchase. 7) to avoid both over stock and under stock of inventory. ASA - ADV. FM - JIMMA UNIVERSITY

71. …Cont’d Techniques of Inventory Management Inventory management consists of effective control and administration of inventories. Inventory control refers to a system which ensures supply of required quantity and quality of inventories at the required time and at the same time prevent unnecessary investment in inventories. Inventory management techniques may be classified into various types: ASA - ADV. FM - JIMMA UNIVERSITY

72. …Cont’d Techniques based on Order Quantity of Inventories Order quantity of inventories can be determined with the help of the following techniques: Stock level: Stock level is the level of stock maintained by the business concern at all times. Thus, the business concern should maintain optimum level of stock to smooth running of the business process. Minimum Level: The business concern must maintain minimum level of stock at all times. If the stocks are less than the minimum level, then the work will stop due to shortage of materials. ASA - ADV. FM - JIMMA UNIVERSITY

73. …Cont’d Re-order Level: Re-ordering level is fixed between minimum level and maximum level. Re-order level is the level when the business concern makes fresh order at this level. Re-order level = Max. Consumption x Max. Re-order period Maximum Level: It is the maximum limit of the quantity of inventories, the business concern must maintain. If the quantity exceeds maximum level limit then it will be overstocking. Maximum level = Re-order level + Re-order quantity – (Min. consumption x Min. delivery period) ASA - ADV. FM - JIMMA UNIVERSITY

74. …Cont’d Danger Level: It is the level below the minimum level. it leads to stoppage of the production process. Danger level = Average consumption x Max. Re-order period for emergency purchase. Average Stock Level: It is calculated as, Average Stock level = Min. stock level + ½ of re-order quantity max. level ASA - ADV. FM - JIMMA UNIVERSITY

75. …Cont’d Lead Time: Lead time is the time normally taken in receiving delivery after placing orders with suppliers. The time taken in processing the order and then executing it is known as lead time. Safety Stock: Safety stock implies extra inventories that can be drawn down when actual lead time and/or usage rates are greater than expected. ASA - ADV. FM - JIMMA UNIVERSITY

76. …Cont’d Safety stocks are determined by opportunity cost and carrying cost of inventories. If the business concern maintain low level of safety stock, it will lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying costs. ASA - ADV. FM - JIMMA UNIVERSITY

77. …Cont’d Illustration: From the following information calculate, (1) Re-order level (2) Maximum level (3) Minimum level (4) Average level. Normal usage: 100 units per week Maximum usage: 150 units per week Minimum level: 50 units per week Re-order quantity (EOQ) 500 units Log in time: 5 to 7 weeks ASA - ADV. FM - JIMMA UNIVERSITY

78. …Cont’d Solution: (1) Re-order Level: = Max. consumption x Max. re-order period = 150 x 7 = = 1050 units (2) Maximum Level: = Re-order level + Re-order quantity – (Min. consumption x Min. delivery period) = 1050 + 500 – (50 x 5) = 1300 units ASA - ADV. FM - JIMMA UNIVERSITY

79. …Cont’d   ASA - ADV. FM - JIMMA UNIVERSITY

80. …Cont’d Economic Order Quantity (EOQ): EOQ refers to the level of inventory at which the total cost of inventory comprising ordering cost and carrying cost. Determining an optimum level involves two types of cost such as ordering cost and carrying cost . The EOQ is that inventory level that minimizes the total ordering and carrying costs. ASA - ADV. FM - JIMMA UNIVERSITY

81. …Cont’d Total Costs: The carrying cost of inventory is the carrying cost per unit times the average number of units of inventory, or CQ/2. The total number of orders for a period of time is simply the total usage (in units) of an item of inventory for that period , S, divided by Q. Consequently, total ordering costs are represented by the ordering cost per order times the number of orders, or SO/Q. Total inventory costs , then, are the carrying costs plus ordering costs, or ASA - ADV. FM - JIMMA UNIVERSITY

82. …Cont’d We see from Equation that the higher the order quantity, Q, the higher the carrying costs but the lower the total ordering costs. The lower the order quantity, the lower the carrying costs but the higher the total ordering costs. We are concerned with the trade-off between the economies of increased order size and the added cost of carrying additional inventory. ASA - ADV. FM - JIMMA UNIVERSITY

83. …Cont’d   ASA - ADV. FM - JIMMA UNIVERSITY

84. …Cont’d Minimum Total Cost X Order Size (Q) Fig: Economic Order Quantity Relationship ASA - ADV. FM - JIMMA UNIVERSITY

85. …Cont’d Illustration of EOQ: To illustrate its use, suppose that usage of an inventory item is 2 ,000 units during a 100-day period, ordering costs are Birr 100 an order, and the carrying costs are Birr 10 per unit per 100 days. The optimal economic order quantity, then , is ASA - ADV. FM - JIMMA UNIVERSITY

86. …Cont’d   ASA - ADV. FM - JIMMA UNIVERSITY

87. …Cont’d With an order quantity of 200 units, the firm would order (2,000/200), or 10 times , during the period under consideration, or every 10 days . We see from the Equation that Q* varies directly with total usage, S , and order cost, , and inversely with the carrying cost, C . The relationship is dampened by the square root sign in both cases. As usage increases, the optimal order size and the average level of inventory increase by a lesser percentage. In other words, economies of scale are possible. ASA - ADV. FM - JIMMA UNIVERSITY

88. …Cont’d B. Techniques based on the Classification of Inventories A-B-C Analysis: It is the inventory management technique that divide inventory into three categories based on the value and volume of the inventories; 10% of the inventor’s item contribute to 70% of value of consumption and this category is known as A category . About 20% of the inventory item contribute about 20% of the value of consumption and this category is called Category B and 70% of inventory item contributes only 10% of the value of consumption and this category is called C category . ASA - ADV. FM - JIMMA UNIVERSITY

89. …Cont’d Category Volume (%) Value (%) A 10 70 B 20 20 C 70 10 Total 100 100 Inventory Breakdown Between Value and Volume ASA - ADV. FM - JIMMA UNIVERSITY

90. ASA - ADV. FM - JIMMA UNIVERSITY END OF CHAPTER EIGHT I think this signals end of the course. So when is the Exam ???