MANAGEMENT CONSULTANCY - Solutions Manual

CHAPTER 16 MANAGEMENT OF CURRENT ASSETS

I. Questions 1. Cash and marketable securities are generally used to meet the transaction needs of the firm and for contingency purposes. Because the funds must be available when needed, the primary concern should be with safety and liquidity rather than the maximum profits. 2. Float exists because of the delay time in check processing. Electronic funds transfer, or the electronic movement of funds between computer terminals, would eliminate the need for checks and thus eliminate float. 3. A firm could operate with a negative balance on the corporate books knowing float will carry them through at the bank. Checks written on the corporate books may not clear until many days later at the bank. For this reason, a negative account balance on the corporate books of P100,000 may still represent a positive balance at the bank. 4. By slowing down disbursements or the processing of checks against the corporate account, the firm is able to increase float and also to provide a source of short-term financing. 5. The average collection period, the ratio of bad debts to credit sales and the aging of accounts receivable. 6. The EOQ or economic order point tells us at what size order point we will minimize the overall inventory costs to the firm, with specific attention to inventory ordering costs and inventory carrying costs. It does not directly tell us the average size of inventory on hand and we must determine this as a separate calculation. It is generally assumed, however, that inventory will be used up at a constant rate over time, going from the order size to zero and then back again. Thus, average inventory is half the order size. 7. A safety stock protects against the risk of losing sales to competitors due to being out of an item. A safety stock will guard against late deliveries due to weather, production delays, equipment breakdowns and many other things that can go wrong between the placement of an order and its delivery. With more inventory on hand, the carrying cost of inventory will go up. 8. A just-in-time inventory system usually means there will be fewer suppliers, and they will be more closely located to the manufacturer they supply.

II. Multiple Choice 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. D A C D B D C D D B 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. D C A D A A C C D B 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. D B D A D C D C B D 31. D 32. D 33. D

Supporting Computations: 1. Cash conversion cycle = Inventory conversion period + Receivables 16-1

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conversion period - Payables deferral period = 60 days + 35 days - 28 days = 67 days 2. Average sales per day = P972,000 / 360 = P2,700.

Average investment in receivables = P2,700 (35) = P94,500 3. Currently, Francisco has 4(P250,000) = P1,000,000 in unavailable collections. If lockboxes were used, this could be reduced to P750,000. Thus, P250,000 would be available to invest at 8 percent, resulting in an annual return of 0.08(P250,000) = P20,000. If the system costs P25,000, Francisco would lose P5,000 per year by adopting the system. 4. 0.3(10 days) + 0.4(30 days) + 0.3(40 days) = 27 days 5. Receivables = (ACP) (Sales/360) = 27(P1,200,000/360) = P90,000 6. The incremental change in receivables investment would be calculated as follows: Old credit policy: (ACP) (Sales per day) (Variable cost ratio) (40) ( ) (0.6) = P133,333.

New credit policy: (ACP) (Sales per day) (Variable cost ratio) (30) (
P2,000,000 ) (0.6) = P87,500. 360

The incremental change in receivables is P87,500 - P133,333 = -P45,833.

7. P1,750,000 360 Income
Statement under Current Policy Effect of Change Income Statement under New Policy

Sales Less discounts Net sales Production costs Gross profit before credit costs Credit related costs: Cost of carrying receivables Collection expenses Bad debt losses Gross profit Tax (40%) Net income 8. EOQ = =

P2,000,000 1,200,000 P 800,000 16,000 100,000 P 684,000 273,600 P 410,400

(P250,000) 150,000 (P100,000) 5,500 65,000 (P 29,500) 11,800 (P 17,700)

P1,750,000 1,050,000 P 700,000 10,500 35,000 P 654,500 261,800 P 392,700

2 (F) (S) (C) (P)

2 (P600) (120,000) 0.20 (P500)

P144,000,000 P100

1,200 units

9. Maximum inventory = EOQ + Safety stock = 1,200 + 500 = 1,700 units 10. Average inventory = EOQ/2 + Safety stock = 600 + 500 = 1,100 units 16-2

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11. = 100 orders per year

(F) (S) Q

3.60 days

The firm must place one order every 3.60 days. 12. TIC = = = (C) (P) (Q/2) + 0.2 (P500) (1,200 / 2) + P60,000 + P60,000 (120,000) P600 = P120,000
1,200 P600 (120,000)

Note that total carrying costs equal total ordering costs at the EOQ. 13. Now, the average inventory is EOQ/2 + Safety stock = 1,200 units rather than EOQ/2 = 600 units. 1,100 TIC = = 0.2 (P500) (1,100) + P110,000 + P60,000 = P170,000 120,000 units per year 1,200 units per order 360 days per year 100 orders per order

Note that a safety stock increases the cost of carrying inventories. 14. Average inventory with turnover of nine times is (P90,000,000 9) Average inventory with turnover of 12 times is (P90,000,000 12) Reduction in inventory Savings (P2,500,000 x .10) P10,000,000 7,500,000 P 2,500,000 P 250,000

III. Problems PROBLEM 1 (MACAPUNO INDUSTRIES) (1) C* = 45,000 (2) 22,500 (3) 100 16-3

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PROBLEM 2 (UBE COMPANY) Under the current credit policy, the Ube Company has no discounts, has collection expenses of P50,000, has bad debt losses of (0.02) (P10,000,000) = P200,000, and has average accounts receivable of (DSO) (Average sales per day) = (30) (P10,000,000/360) = P833,333. The firms cost of carrying these receivables is (Variable cost ratio) (A/R) (Cost of capital) = (0.80) (P833,333) (0.16) = P106,667. It is necessary to multiply by the variable cost ratio because the actual investment in receivables is less than the peso amount of the receivables. Proposal 1: Lengthen the credit period to net 30 so that 1. Sales increase by P1 million. 2. Discounts = P0. 3. Bad debts losses = (0.02) (P10,000,000) + (0.04) (P1,000,000) = P200,000 + P40,000 = P240,000 4. DSO = 45 days on all sales 5. New average receivables = (45) (P11,000,000/360) = P1,375,000. 6. Cost of carrying receivables = (v) (k) (Average accounts receivable) = (0.80) (0.16) (P1,375,000) = P176,000 7. Collection expenses = P50,000 Analysis of proposed change:
Income Statement under Current Policy Income Statement under New Policy

Effect of Change

Gross sales Less discounts Net sales Production costs (80%) Profit before credit costs and taxes Credit-related costs Cost of carrying receivables Collection expenses Bad debt losses Profit before taxes Tax rate (40%) Net income

P10,000,000 0 P10,000,000 8,000,000 P 2,000,000 106,667 50,000 200,000 P 1,643,333 657,333 P 986,000

+P1,000,000 + 0 +P1,000,000 + 800,000 + P200,000 + + + +P + +P 69,333 0 40,000 90,667 36,267 54,400

P11,000,000 0 P11,000,000 8,800,000 P 2,200,000 176,000 50,000 240,000 P 1,734,000 693,600 P 1,040,400

The proposed change appears to be a good one, assuming the assumptions are correct. Proposal 2: Shorten the credit period to net 20 so that 1. Sales decrease by P1 million. 2. Discounts = P0. 3. Bad debts losses = (0.01) (P9,000,000) = P90,000 4. DSO = 22 days 5. New average receivables = (22) (P9,000,000/360) = P550,000. 16-4

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6. Cost of carrying receivables = (v) (k) (Average accounts receivable) = (0.80) (0.16) (P550,000) = P70,400 7. Collection expenses = P50,000 Analysis of proposed change:
Income Statement under Current Policy Income Statement under New Policy

Q Gross sales 2 Less discounts Net sales Production costs (80%) Profit before credit costs and taxes Credit-related costs Cost of carrying receivables Collection expenses Bad debt losses Profit before taxes Tax rate (40%) Net income

S P10,000,000 Q 0 P10,000,000 8,000,000 510,000 2 P 2,000,000 106,667 50,000 200,000 P 1,643,333 657,333 P 986,000

Effect of Change

(P1,000,000) P9,000,000 0 0 (P1,000,000) P9,000,000 ( 800,000) 2,600,000 7,200,000 510,000 ( P200,000) P 1,800,000 ( ( (P ( (P 36,267) 0 110,000) 53,733) 21,493) 32,240) 70,400 50,000 90,000 P 1,589,600 635,840 P 953,760

This change reduces net income, so it should be rejected. Ube will increase profits by accepting Proposal 1 to lengthen the credit period from 25 days to 30 days, assuming all assumptions are correct. This may or may not be the optimal, or profit-maximizing, credit policy, but it does appear to be a movement in the right direction. PROBLEM 3 (STRAWBERRY BREAD COMPANY) (1) EOQ = = = 509,902 bushels.

Because the firm must order in multiples of 2,000 bushels, it should order in quantities of 510,000 bushels. (2) Average weekly sales Reorder point = = = =
2 (F) (S) (C) (P) 6 weeks sales + Safety stock

6 (50,000) + 200,000 2 + 200,000 300,000(P5,000) (2,600,000) (0.02) 500,000 bushels.(P5.00)

= =

2,600,000 / 52 50,000 bushels.

(3) Total inventory costs: 16-5

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TIC

CP

+ F

+ CP (Safety stock) + (P5,000)

=(0.02) (P5)

+ (0.02) (P5) (200,000) = = P25,500 + P25,490.20 + P20,000 P70,990.20

(4) Ordering costs would be reduced by P3,500 to P1,500. By ordering 650,000 bushels at a time, the firm can bring its total inventory cost to P58,500: TIC = (0.02) (P5) + (0.02) (P5) (200,000) = = P32,500 + P6,000 + P20,000 P58,500. + (P1,500)

Because the firm can reduce its total inventory costs by ordering 650,000 bushels at a time, it should accept the offer and place larger orders. (Incidentally, this same type of analysis is used to consider any quantity discount offer.)

650,000 2

2,600,000 650,000

PROBLEM 4 (MAG CORP.) a. Contribution margin of lost sales (20,000 units) Revenue Variable costs Cost of sales Selling and administration Total variable costs Unit contribution margin Volume of lost sales Total contribution margin of lost sales Overtime premiums (overtime cost is less than the additional contribution margin of lost sales: 15,000 x P6.50 = P97,500 > P40,000 Rental savings 16-6 P 12.00 4.50 1.00 P 5.50 6.50 x 20,000 P(130,000) P( 40,000) 60,000 P

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Rental income from owned warehouse (12,0000 x .75 x P1.50) Elimination of insurance and property taxes Opportunity costs of funds released from inventory investment Investment in inventory 600,000 Interest before tax Estimated before-tax peso savings .20

13,500 14,000

120,000 P 37,500

b. Conditions that should exist in order for a company to install just-in-time inventory successfully include the following. Top management must be committed and provide the necessary leadership support in order to ensure a company-wide, coordinated effort. A detailed system for integrating the sequential operations of the manufacturing process needs to be developed and implemented. Raw materials must arrive when needed for each subassembly so that the production process functions smoothly. Accurate sales forecasts are needed for effective finished goods planning and production scheduling. Products should be designed to use standardized parts to reduce manufacturing time and reduce costs. Reliable vendors who can deliver quality raw materials on time with minimum lead time must be obtained.
.12 1 .40

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