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(^260) Financial Management

6. The Storage Corporation currently carries Rs 25 million of inventory. The finance
   manager is considering whether to recommend a reduction in inventory costs at
   the following information about inventory costs at various levels. The company's
   after-tax discount rate that is used to evaluate current asset policies is 6 percent.
   The company earns a contribution margin of 20 percent on sales.

a. Would it be profitable for the company to reduce its inventory from Rs 25

million to Rs 23 million? (Calculate the change in after-tax income.)

b. Would it be profitable for the company to reduce its inventory to Rs 21 million?

(Calculate the change in after-tax income.)

Solution

a. Reducing inventory from Rs 25 to Rs 23 million causes net income to:

D Storage cost = (Rs 750,000 - Rs 725,000)(0.60) Rs 15,000

D Spoilage cost = (Rs 400,000 - Rs 375,000)(0.60) 15,000

D Financing cost = (Rs 2,000,000)(0.06) 120,000

D Profit on sales = (Rs 120,000-119,000)(365)(0.20)(0.60) (43,800)

D Net Profit Rs 106,200

b. To determine if it is profitable to reduce inventory to Rs 21 million, determine the

change in profits associated with reducing from Rs 23 million. That is, you know

that Rs 23 million is better than Rs 25 million and the decision is now whether to

reduce further to Rs 21 million. Remember that decisions depend on incremental

costs and benefits.

Reducing inventory from Rs 23 to Rs 21 million causes net income to:

D Storage cost = (Rs 725,000 - Rs 710,000)(0.60) Rs 9,000

D Spoilage cost = (Rs 375,000 - Rs 367,000)(0.60) 4,800

D Financing cost = (Rs 2,000,000)(0.06) 120,000

D Profit on sales = (Rs 119,000 - 114,500)(365)(0.20)(0.60) (197,100)

D Net Profit (Rs 63,300)

Given the choices, Rs 23 million is the most profitable level of inventory.

7. The Phil Company expects to sell 30,000 lamps per month or 360,000 lamps per
   year. The carrying cost is Rs 1.20 per lamp and the fixed reorder cost is Rs 375.

Rs 25 million Rs 23 million Rs 21 million

Storage costs

Spoilage costs

Daily sales

750,000

400,000

120,000

725,000

375,000

119,000

710,000

367,000

114,500