Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VII. Short−Term Financial

Planning and Management

21. Credit and Inventory
    Management

© The McGraw−Hill^755

Companies, 2002

process produces a sawtooth pattern for inventory holdings; this pattern is illustrated in

Figure 21.5. As the figure shows, Eyssell always starts with 3,600 units in inventory and

ends up at zero. On average, then, inventory is half of 3,600, or 1,800 units.

The Carrying Costs As Figure 21.4 illustrates, carrying costs are normally assumed

to be directly proportional to inventory levels. Suppose we let Qbe the quantity of in-

ventory that Eyssell orders each time (3,600 units); we will call this the restocking quan-

tity. Average inventory would then just be Q/2, or 1,800 units. If we let CC be the

carrying cost per unit per year, Eyssell’s total carrying costs will be:

Total carrying costs Average inventory Carrying costs per unit

(Q/2) CC

[21.10]

In Eyssell’s case, if carrying costs were $.75 per unit per year, then total carrying costs

would be the average inventory of 1,800 multiplied by $.75, or $1,350 per year.

The Shortage Costs For now, we will focus only on the restocking costs. In essence,

we will assume that the firm never actually runs short on inventory, so that costs relat-

ing to safety reserves are not important. We will return to this issue later.

Restocking costs are normally assumed to be fixed. In other words, every time we

place an order, there are fixed costs associated with that order (remember that the cost

of the inventory itself is not considered here). Suppose we let Tbe the firm’s total unit

sales per year. If the firm orders Qunits each time, then it will need to place a total of

T/Qorders. For Eyssell, annual sales are 46,800, and the order size is 3,600. Eyssell thus

728 PART SEVEN Short-Term Financial Planning and Management

FIGURE 21.5

Weeks

Average inventory

Starting inventory:

Q = 3,600

Q/2 = 1,800

Ending inventory: 0

The Eyssell Corporation starts with inventory of 3,600 units. The quantity drops to zero by the

end of the fourth week. The average inventory is Q/2 = 3,600/2 = 1,800 over the period.

0 12345678

Inventory Holdings for the Eyssell Corporation