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.

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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. D 11. D 11. D 31. D

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

Supporting Computations:

1. Cash conversion cycle = Inventory conversion period + Receivables

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

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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:
P2,000,000
Old credit policy: (ACP) (Sales360
per day) (Variable cost ratio)

(40) ( ) (0.6) = P133,333.

P1,750,000
360
New credit policy: (ACP) (Sales per day) (Variable cost ratio)

(30) ( ) (0.6) = P87,500.

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

P45,833.

7.
Income Income
Statement Statement
under Current Effect of under New
Policy Change Policy
Sales P2,000,000 (P250,000) P1,750,000
Less discounts
Net sales
Production costs 1,200,000 150,000 1,050,000
Gross profit before
credit costs P 800,000 (P100,000) P 700,000
Credit related costs:
Cost of carrying
receivables 16,000 5,500 10,500
Collection expenses
Bad debt losses 100,000 65,000 35,000
Gross profit P 684,000 (P 29,500) P 654,500
Tax (40%) 273,600 11,800 261,800
Net income P 410,400 (P 17,700) P 392,700

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8.

  
EOQ = 2 (F) (S) = 2 (P600) (120,000) = P144,000,000
(C) (P) 0.20 (P500) 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
120,000 units per year
11. 1,200 units per order

= 100 orders per year

360 days per year
100 orders per order

= 3.60 days

The firm must place one order every 3.60 days.

(F) (S)
12. Q

TIC= (C) (P) (Q/2) + P600 (120,000)

1,200

= 0.2 (P500) (1,200 / 2) +

= P60,000 + P60,000 = P120,000

Note that total carrying costs equal total ordering costs at the EOQ.
P600 (120,000)
13. Now, the average inventory is EOQ/2 + Safety stock = 1,100 units rather
1,200
than EOQ/2 = 600 units.
TIC= 0.2 (P500) (1,100) +

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= P110,000 + P60,000 = P170,000

Note that a safety stock increases the cost of carrying inventories.

14.
Average inventory with turnover of
nine times is (P90,000,000  9) P10,000,000
Average inventory with turnover of
12 times is (P90,000,000  12) 7,500,000
Reduction in inventory P 2,500,000
Savings (P2,500,000 x .10) P 250,000

III. Problems

PROBLEM 1 (MACAPUNO INDUSTRIES)

(1) C* = 45,000
(2) 22,500
(3) 100

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 firm’s 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

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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 Income
Statement Statement
under Current Effect of under New
Policy Change Policy
Gross sales P10,000,000 +P1,000,000 P11,000,000
Less discounts 0 + 0 0
Net sales P10,000,000 +P1,000,000 P11,000,000
Production costs (80%) 8,000,000 + 800,000 8,800,000
Profit before credit
costs and taxes P 2,000,000 + P200,000 P 2,200,000
Credit-related costs
Cost of carrying
receivables 106,667 + 69,333 176,000
Collection expenses 50,000 + 0 50,000
Bad debt losses 200,000 + 40,000 240,000
Profit before
taxes P 1,643,333 +P 90,667 P 1,734,000
Tax rate (40%) 657,333 + 36,267 693,600
Net income P 986,000 +P 54,400 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.

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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.

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 Income
Statement Statement
under Current Effect of under New
Policy Change Policy
Gross sales P10,000,000 (P1,000,000) P9,000,000
Less discounts 0 0 0
Net sales P10,000,000 (P1,000,000) P9,000,000
Production costs (80%) 8,000,000 ( 800,000) 7,200,000
Profit before credit
costs and taxes P 2,000,000 ( P200,000) P 1,800,000
Credit-related costs
Cost of carrying
receivables 106,667 ( 36,267) 70,400
Collection expenses 50,000 0 50,000
Bad debt losses 200,000 ( 110,000) 90,000
Profit before
taxes P 1,643,333 (P 53,733) P 1,589,600
Tax rate (40%) 657,333 ( 21,493) 635,840
Net income P 986,000 (P 32,240) 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.

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PROBLEM 3 (STRAWBERRY BREAD COMPANY)

(1)


EOQ = 2 (F) (S)
(C) (P)


= 2 (P5,000) (2,600,000)
(0.02) (P5.00)

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

Reorder point = 6 weeks’ sales + Safety stock

= 6 (50,000) + 200,000
= 300,000 + 200,000
= 500,000 bushels.

(3) Total inventory costs:

TIC= CP Q+ F S + CP (Safety stock)

2 Q

= (0.02) (P5) 510,000 + (P5,000) 2,600,000

2 510,000
+ (0.02) (P5) (200,000)

= P25,500 + P25,490.20 + P20,000

= P70,990.20

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(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:

650,000 2,600,000
TIC= (0.02) (P5) 2 + (P1,500) 650,000

+ (0.02) (P5) (200,000)

= P32,500 + P6,000 + P20,000

= P58,500.

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.)

PROBLEM 4 (MAG CORP.)

a. Contribution margin of lost sales (20,000 units)

Revenue P 12.00
Variable costs
Cost of sales P 4.50
Selling and administration 1.00
Total variable costs P 5.50
Unit contribution margin 6.50
Volume of lost sales x 20,000
Total contribution margin of lost sales P(130,000)
Overtime premiums (overtime cost is less than the
additional contribution margin of lost sales:
15,000 x P6.50 = P97,500 > P40,000 P( 40,000)
Rental savings 60,000
Rental income from owned warehouse
(12,0000 x .75 x P1.50) 13,500
Elimination of insurance and property taxes 14,000

Opportunity costs of funds released from

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inventory investment
Investment in inventory 600,000

Interest before tax .20 120,000

.12
1  .40
Estimated before-tax peso savings 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.

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