bre44380_ch30_787-812.indd 790 10/06/15 10:57 AM
790 Part Nine Financial Planning and Working Capital Management
out before they were replenished. But this simple model does capture some essential features
of inventory management:
∙ Optimal inventory levels involve a trade-off between carrying costs and order costs.
∙ Carrying costs include the cost of storing goods as well as the cost of capital tied up in
inventory.
∙ A firm can manage its inventories by waiting until they reach some minimum level and
then replenish them by ordering a predetermined quantity.^2
∙ When carrying costs are high and order costs are low, it makes sense to place more
frequent orders and maintain higher levels of inventory.
∙ Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal
inventory level rises, but less than proportionately.
It seems that carrying costs have been declining, for corporations today get by with lower
levels of inventory than they used to. One way that companies have reduced inventory lev-
els is by moving to a just-in-time approach. Just-in-time was pioneered by Toyota in Japan.
Toyota keeps inventories of auto parts to a minimum by ordering supplies only as they are
needed. Thus deliveries of components to its plants are made throughout the day at intervals
as short as one hour. Toyota is able to operate successfully with such low inventories only
because it has a set of plans to ensure that strikes, traffic snarl-ups, or other hazards don’t halt
the flow of components and bring production to a standstill.
Firms are finding that they can also reduce their inventories of finished goods by producing
their goods to order. For example, Dell Computer discovered that it did not need to keep a large
stock of finished machines. Its customers are able to use the Internet to specify what features
they want on their PCs. The computer is then assembled to order and shipped to the customer.^3(^3) These examples of just-in-time and build-to-order production are taken from T. Murphy, “JIT When ASAP Isn’t Good Enough,”
Ward’s Auto World (May 1999), pp. 67–73; R. Schreffler, “Alive and Well,” Ward’s Auto World (May 1999), pp. 73–77; “A Long
March: Mass Customization,” The Economist, July 14, 2001, pp. 63–65.
(^2) This is known as a reorder point (or two-bin) system. Some firms use instead a periodic review system, where the firm reviews inven-
tory levels periodically and tops the inventory up to the desired amount.
30-2 Credit Management
We continue our tour of current assets with the firm’s accounts receivable. When one com-
pany sells goods to another, it does not usually expect to be paid immediately. These unpaid
bills, or trade credit, compose the bulk of accounts receivable. The remainder is made up of
consumer credit, that is, bills that are awaiting payment by the final customer.
Management of trade credit requires answers to five sets of questions:
- How long are you going to give customers to pay their bills? Are you prepared to offer a
cash discount for prompt payment? - Do you require some formal IOU from the buyer or do you just ask him or her to sign a
receipt? - How do you determine which customers are likely to pay their bills?
- How much credit are you prepared to extend to each customer? Do you play it safe by
turning down any doubtful prospects? Or do you accept the risk of a few bad debts as
part of the cost of building a large regular clientele? - How do you collect the money when it becomes due? What do you do about reluctant
payers or deadbeats?
We discuss each of these topics in turn.