chapter 04 fund flow
TRANSCRIPT
33Chapt
er
Chapt
er The Fund Flow
Statement
Khursheed Ahmad BhatHODDepartment of Hospital Administration
2Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU
Chapter 3 – Why we prepare fund flow statement?
The balance sheet and income statement are the traditional basic financial
statement of a business enterprise. A serious limitation of these statements is
that they do not provide information regarding changes in the firm’s
financial position during a particular period of time. They fail to answer
following question
What funds were available during the accounting period and for what purpose
these funds were utilized?
Have long term sources been adequate to finance fixed asset purchase?
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU3
Chapter 3 – Why we prepare fund flow statement?
Permanent and Temporary Working Capital Maturity Matching Principle Financing Net working Capital Short-Term vs. Long-Term Financing Working Capital Policy
Does the firm possess adequate working capital? How much funds have been generated from operations? Why did the firm not pay dividend in spite of adequate
profit? The balance sheet is merely a static statement. It is
statement of asset and liabilities of the business as on particular date.
The fund flow statement overcomes these limitations of basic financial statement. Fund flow statement will provide us information about different sources of fund and their various uses in particular time.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU4
The term fund has a variety of meaning such as cash fund, capital fund and working capital fund.
1.Cash fund –In a narrow sense, fund means only cash. ‘Cash flow statement’ portrays net effect of the various business transactions on cash into account receipts & disbursement of cash.
This concept of preparing fund flow statement is not accepted, as there are many such transactions which do not affect cash but represent the flow of fund .
for example: purchase of furniture on credit does not affect cash but there is flow of fund.
Meaning Of Fund
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU5
Meaning Of Fund Continued……
2. Capital fund –Here fund means all financial resources used in the business, whether in the form of men, money, material, machine & others.
3.Net working capital -Net working capital means difference between current asset and current liabilities .funds generally refers to cash or cash equivalent or to working capital.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU6
Meaning Of Flow The term ‘flow’ refers to changes or transfer and therefore the ‘flow
of funds’ means transfer of economic values from one asset to another, from one liability to another, from one asset to liabilities or vice-versa or a combination of these. So flow of fund refers to increase or decrease in net working capital.
The increase or decrease in net working capital will take place only when one account, out of two accounts to be affected in a transaction ,is a current account i.e. current asset or current liabilities and the other account is non current account i.e. fixed asset or long term liability or capital.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU7
Meaning Of Flow (Continued)…………
When a change in non current account is followed by a change in another non current account, it does not amount to flow of fund. It is because, in such case, neither the working capital increase nor decrease
For exampleMachinery a/c Dr To share capital a/c(Machinery purchase in consideration of share) In the above transaction both accounts are non current accounts
which do not at all affect current asset and current liability. Therefore working capital will remain unaffected i.e. there will be no flow of fund.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU8
Meaning Of Flow (Continued)…………
When changes in one current account results in a changes in other current account ,it also does not affect working capital i.e. there is no flow of funds.
For example Cash a/c Dr To debtor a/c (Cash received from debtor) It represents an increase of cash –a current asset account and decrease
of debtor again a current asset account .thus there will be no net changes in the amount of working capital, although the composition of working capital will be affected .
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU9
Meaning Of Flow (Continued)…………
In the above figure the dotted line displays there will be no flow of fund & the dark line displays the flow of fund.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU10
Preparation of Fund Flow Statement
The changes which occurred in the current accounts as a result flow of fund are reflected in a statement known as ‘schedule of changes in working capital’ .
The similar changes in non current accounts are shown in ‘Fund Flow Statement’.
Therefore, following two statements under this techniques .1. Statement or Schedule of Changes in Working Capital.2. Statement of Sources and Uses of Funds or Funds Flow Statement.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU11
Preparation of Fund Flow Statement
Schedule of Changes in Working Capital It discloses the changes in individual item of current asset & current
liabilities between two period & there effect on working capital. Working capital will increase when there is an increase in current asset and decrease in current liabilities, whereas, working capital will decrease when there is a decrease in current asset & increase in current liabilities.
Net increase in working capital is treated as use of funds & the net decrease in working capital is treated as source of funds.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU12
•
Statement or Schedule of Changes in Working Capital
Item
(A) Current AssetsCash at bank Cash in handStock in tradeDebtorsBills receivableAdvance paymentShort term investmentPrepaid expenseAccrued incomeTotal (A) (B) Current Liabilities (1) Short term loans (2) Bank overdraft (3) Creditors (4) Bills payable (5) Outstanding expenses (6) Unclaim dividend Total (B)Net Working Capital (A-B)Incraese / Decrease in Working
Capital Total
Previous Year
Current Year
Effect on
Incraese Rs.
Working captialDecrease Rs.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU13
This statement reveals resources from which funds were obtain by the firm and the specific uses to which such funds were applied. The effectiveness of financial management in procuring funds from various sources & using them effectively for generating income without sacrificing the financial position of the firm is reflected in fund flow statement .
Meaning of fund flow statement :
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU14
Definitions of fund flow statement:
In the words of Foulke, R.A., “a statement of source and application of fund is a technical device design to analysis the changes in the financial condition of business enterprises between two dates”.
According to : Almond Coleman, “ The fund flow statement summarizing the significant financial changes which were occurred between the beginning & the end of a company’s accounting periods”.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU15
Definitions of fund flow statement:……..
This fund flow statement has two parts :1. Sources of fund2. Application of fund
The difference between these two parts that is sources & uses of funds represents net changes in working capital.
The excess of sources of funds over uses of fund is the net increase in working capital & excess of uses over sources of fund is net decrease in working capital.
The amount of net increase or decrease as shown in fund flow statement should be equal to the amount shown by schedule of working capital changes.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU16
The Fund Flow Statement
Sources of Fund Amount
Fund from operationIssue of shareIssue of debenturelong term loansSale of fixed assets / Investment Non trading receiptsDecrease in working capital (if any)
Uses Of Funds Amount
Loss from operationRedemption of preference sharesRedemption of debenturesRepayment of long term loansPurchase of fixed assets / InvestmentsPayment of dividend & taxesIncrease in working capital (if any)
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU17
Fund from operations :
The profit made by a firm through normal operations is a major source of funds. The amount of sales as shown in the P&L A/c is a source of
funds by way of increase in cash , debtor and B/R.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU18
Profit & loss Adjustment a\c
• Particular Amount
DepreciationLoss on sale of fixed assetsUnder writing commissionsDiscount on issue of shares & debenturesPreliminary expense written offDeferred revenue expenses Goodwill written off Patent or trademarkProvision for taxes (If treated non current)
Particular Amount
Profit or gain on sale of fixed assetDividend received Interest received ofinvestmentProfit on revaluation
of asset Fund from operation
19
Q-Comparative Balance sheet of Z Ltd. As on year 2000 and 2001 were as follow
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU
Liabilities 2000 2001 Assets 2000 2001
Account payableNotes payableLoan on MortgageCapital Sinking fundRetained EarningProvision for DDAccumulated Depreciation-Buildingfurniture
1500010000
40000500001600013950
1350
120003200161500
1800075000
40000450001200016275
1425
90002400151600
CashAccount receivable StockSinking fund investmentLandBuildingFurniture
11200
2130035000
1600010000600008000
161500
8500
2350030600
1200010000600007000
151600
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU20
Following information is given further
• Net profit for the year 2001 amounted 6675.• Dividend amounted to Rs.5000 was paid during the year.• Prepare a statement of sources and uses of fund.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU 21
Schedule of Changes in Working Capital
Items
CURRENR ASSETS:-CashAccount receivable StockTOTAL of CA (A)CUURENT LIABILITIES:-Account payableNote payableProvision for D DTOTAL of CL (B)Difference b/w (A-B)Decrease in W C
2000Amount
11200213003500067500
150001000013502635041150
41150
2001Amount
8500235003060062600
18000750014252692535675547541150
Change in
Increase
2200
2500
5475 10175
Working capitalDecrease
2700
4400
3000
75
10175
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU22
Fund flow statement
Sources of fund
Sale of sinking fund investmentFund from operation Decrease in working capital
Amount
4000525
5475
10000
Application of fundRedemption of share capitalDividend paid
Amount
50005000
10000
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU23
Difference between permanent & temporary working capital-2
Variable Working Capital• • Amount • of • Working• Capital • Permanent
Working Capital
• • Time•
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU24
Financing needs over time
• Fixed Assets
• Permanent Current Assets
• Total Assets
• Fluctuating Current Assets
• Time
• $
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU25
Matching approach to asset financing
• Fixed Assets
• Permanent Current Assets
• Total Assets
• Fluctuating Current Assets
• Time
• $
• Short-term• Debt
• Long-term• Debt +• Equity• Capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU26
Conservative approach to asset financing
• Fixed Assets
• Permanent Current Assets
• Total Assets
• Fluctuating Current Assets
• Time
• $
• Short-term• Debt
• Long-term• Debt +• Equity• capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU27
• Fixed Assets
• Permanent Current Assets
• Total Assets
• Fluctuating Current Assets
• Time
• $
• Short-term• Debt
• Long-term• Debt +• Equity• capital
Aggressive approach to asset financing
FACTORS DETERMINING WORKING CAPITAL
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU28
1. Nature of the Industry2. Demand of Industry3. Cash requirements4. Nature of the Business5. Manufacturing time6. Volume of Sales7. Terms of Purchase and Sales8. Inventory Turnover9. Business Turnover10. Business Cycle11. Current Assets requirements12. Production Cycle
• 13. Credit control14. Inflation or Price level changes15. Profit planning and control16. Repayment ability17. Cash reserves18. Operation efficiency19. Change in Technology20. Firm’s finance and dividend policy
21. Attitude towards Risk
EXCESS OR INADEQUATE WORKING CAPITAL
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU29
Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital.
Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the firm.
Disadvantages of Redundant or Excess Working Capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU30
Idle funds, non-profitable for business, poor ROIUnnecessary purchasing & accumulation of inventories
over required level Excessive debtors and defective credit policy, higher
incidence of B/D.Overall inefficiency in the organization.When there is excessive working capital, Credit
worthiness suffersDue to low rate of return on investments, the market
value of shares may fall
Disadvantages of Inadequate Working Capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU31
Can’t pay off its short-term liabilities in time. Economies of scale are not possible. Difficult for the firm to exploit favourable market situations Day-to-day liquidity worsens Improper utilization the fixed assets and ROA/ROI falls sharply
Management Of Working Capital ( WCM )
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU32
Management of working capital is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the inter-relationship that exists between them. In other words, it refers to all aspects of administration of CA and CL.
Working Capital Management Policies of a firm have a great effect on its profitability, liquidity and structural health of the organization.
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU33
3D Nature of Working Capital Management
• Dimension I• Profitability,
• Risk, & Liquidity
• Dimension I• Profitability,
• Risk, & Liquidity
• Dimension II
• Composition & Level
• of CA
• Dimension II
• Composition & Level
• of CA
• Dimension III
• Composition & Level • of CL
• Dimension III
• Composition & Level • of CL
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU34
Principles Of Working Capital Management
• PRINCIPLES OF WORKING CAPITAL
MANAGEMENT
• Principle of Risk
Variation
• Principle of Cost
of Capital
• Principle of Equity Position
• Principle of Maturity of
Payment
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU35
Maturity Matching Principle
• Maturity (due date) of financing should roughly match duration (life) of asset being financed Then financing /asset combination becomes self-
liquidating• Cash inflows from asset can be used to pay off loan
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU36
Financing Net Working Capital
• According to maturity matching principle Temporary (seasonal) should be financed with short-
term borrowing Permanent working capital should be financed with
long-term sources, such as long-term debt and/or equity
• In practice, firms may use more or less short-term funds to finance working capital
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU37
Figure 3.7(a):
Working Capital Financing Policies
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU38
Figure 3.7(b):
Working Capital Financing Policies
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU39
Short-Term vs. Long-Term Financing
• The mix of short- or long-term working capital financing is a matter of policy
Use of long-term funds is a conservative policy Use of short-term funds is an aggressive policy
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU40
Short-Term vs. Long-Term Financing
• Short-term financing Cheap but risky
• Cheap—short-term rates generally lower than long-term rates
• Risky—because you are continually entering marketplace to borrow
• Borrower will face changing conditions (ex; higher interest rates and tight money)
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU41
Short-Term vs. Long-Term Financing
• Long-term financing Safe but expensive
• Safe—you can secure the required capital
• Expensive—long-term rates generally higher than short-term rates
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU42
Working Capital Policy
• Firm must set policy on following issues: How much working capital is used Extent to which working capital is supported by short-
vs. long-term financing How each component of working capital is managed The nature/source of any short-term financing used
Thank You
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU43
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU44
Cash Management
• Cash management—determining: Optimal size of firm’s liquid asset balance Appropriate types and amounts of
short-term investments Most efficient methods of controlling
collection and disbursement of cash
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU45
Cash Management
• Why have cash on hand? Transactions demand: need money to pay bills
(employees, suppliers, utility/phone, etc.)
Precautionary demand: to handle emergencies (unforeseen expenses)
Speculative demand: to take advantage of unexpected opportunities (purchase of raw materials that are on sale)
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU46
Objectives of Cash Management
• Cash doesn’t earn a return• Want to maintain liquidity
Take cash discounts Maintain firm’s credit rating Minimize interest costs Avoid insolvency
• Good cash management implies maintaining adequate liquidity with minimum cash in bank Can place portion of cash balance into marketable
securities (AKA: near cash or cash equivalents)
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU47
Marketable Securities
• Liquid investments that can be held instead of cash and earn a modest return
Examples include Treasury bills, commercial paper, bankers’ acceptances
Many are bought and sold at a discount in money market
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU48
Examples of Marketable Securities
• Treasury Bills Short-term government notes issued at a
discount with principal repaid at maturity
• Commercial Paper Short-term unsecured promissory notes
issued by corporations with good credit
• Bankers’ Acceptances Short-term promissory notes issued by a firm
and accepted (or guaranteed) by a bank
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU49
Yield on a Discounted Money Market Security
• Annualized yield 100 – P 365
P d
where P = Discounted price as a percentage of maturity value
d = Number of days to maturity r = Annualized yield
×r =
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU50
Components of Float
• Mail Float delay between when cheque is sent to a payee and
is received by payee
• Processing Float time between receipt of payment by a payee and the
deposit of the payment in the payee’s account
• Clearing Float time between depositing a cheque and having
available spendable funds
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU51
Cheque Disbursement and the Cheque Clearing Process• When you pay a bill,
You write cheque and mail to payee (2-3 days of mail float)
Payee receives cheque and performs internal processing (1 day of processing float)
Payee deposits cheque in its own bank (1 day of processing float)
Payee’s bank sends cheque into interbank clearing system which processes cheque (2 days of clearing float)
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU52
Figure 4.5: The Cheque-Clearing Process
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU53
Accelerating Cash Receipts
• Lock-box systems Post office box(es) located near customers in
order to shorten mail and processing float• Local bank empties the box, deposits payments
into firm’s account, and reports payments to firm
May involve significant fees
More cost-effective if small number of larger deposits
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU54
Figure 4.6: A Lock Box System in the Cheque-Clearing Process
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU55
Accelerating Cash Receipts
• Concentration Banking Customers send cheques sent to firm’s local
collection centres, where they are deposited
Local deposits are transferred electronically into one central concentration account
Reduces mail float
Funds available for paying loans or investing in marketable securities
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU56
Electronic Funds Transfer
• Electronic funds transfer mechanisms are reducing the importance of float management techniques for many companies
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU57
Electronic Funds Transfer
• Wire Transfers Transferring money electronically
• Preauthorized Cheques Customer gives payee signed cheque-like
documents in advance When payee ships product, it deposits
preauthorized cheque in its bank account• Eliminates mail float • Payee must trust payer
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU58
Managing Cash Outflow
• Zero balance accounts (ZBAs) Decentralization of cash payments can lead to large
number of cash balances around the country
Divisions write cheques on ZBAs—funded from central account only when cheques are cleared
Solves problem of idle cash in decentralized bank accounts
• Remote disbursing Using bank in remote location for disbursement
chequing account• Increases mail float
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU59
Evaluating Cash Management Services
• Evaluation involves comparison of costs versus benefits of faster collection
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU60
Example 4.1: Evaluating Cash Management Services
Q: Kelso Systems Inc. has customers in British Columbia that remit about 500 cheques a year. The average cheque is for $10,000. West coast cheques currently take an average of eight days from the time they are mailed to clear into Kelso’s east coast account. A British Columbia bank has offered Kelso a lock box system for $1,000 a year plus $0.20 per cheque. The system can be expected to reduce the clearing time to six days.
Is the bank’s proposal a good deal for Kelso if it borrows at 8%?
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Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU61
Example 4.1: Evaluating Cash Management Services
A: The cheques represent revenue of: 500 × $10,000 = $5,000,000 per year. The average amount tied up in the cheque clearing process is: 8/365 x $5,000,000 = $109,589.
The proposed lockbox system will reduce this to: 6/365 x $5,000,000 = $82,192, thus freeing up $27,397 of cash. Kelso will be able to borrow $27,397 less, thus saving: $27,397 x 0.08 = $2,192 in interestThe system is expected to cost: $1,000 + ($0.20 x 500) = $1,100.The net saving is: $2,192 - $1,100 = $1,092 The bank’s proposal should be accepted
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Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU62
Managing Accounts Receivable
• Generally firms like as little money as possible tied up in receivables Reduces costs (firm has to borrow to support the
receivable level) Minimizes bad debt exposure
• But, having good relationships with customers is important Increases sales
• Firm needs to strike a balance on these issues
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU63
Trade-offs in Receivable Management
Liberal Management More sales and gross margin, but
More bad debtsHigher collection costsMore discount expensesHigher receivablesLonger collectionsMore interest expense
Strict ManagementLess sales and gross margin, but
Less bad debtsLower collection costsLess discount expensesLower receivablesShorter collectionsLess interest expense
Trade-offs in Managing Accounts Receivable
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU64
Managing Accounts Receivable
• Policy Decisions Influencing Accounts Receivable Credit Policy
• Criteria used to screen credit applications• Controls quality of accounts to which credit is extended
Terms of Sale• Terms and conditions under which credit extended must be
repaid Collections Policy
• Methods employed to collect payment on past due accounts
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU65
Credit Policy
• Must examine creditworthiness of potential credit customers Credit report Customer’s financial statements Bank references Customer’s reputation among other vendors
• Conflicts often arise between sales and credit departments Sales department’s job to generate sales Credit department may refuse credit to high risk
accounts
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU66
Terms of Sale
• Credit sales are made according to specified terms of sale Example: 2/10, net 30 means customer
receives 2% discount if payment is made within 10 days, otherwise entire amount is due by 30 days
Customers pay quickly to save money Firm’s terms of sale generally follow industry
practice
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU67
Collections Policy• Firm’s collection policy—manner and aggressiveness
with which firm pursues payment from delinquent customers Being overly aggressive can damage customer relations
• Function of collections department— to follow up on overdue receivables (called dunning) Mail polite letter Follow up with additional dunning letters Phone calls Collection agency Lawsuit
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU68
Inventory Management
• Inventory management— establishes a balance between carrying enough inventory to meet sales or production requirements while minimizing inventory costs
• Inventory usually managed by manufacturing or operations However, finance department has an oversight
responsibility • Monitor level of lost or obsolete inventory• Supervise periodic physical inventories
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU69
Benefits and Costs of Carrying Adequate Inventory• Benefits
Reduces stockouts and backorders Makes operations run more smoothly, improves customer
relations and increases sales
• Carrying Costs Interest on funds used to acquire inventory Storage and security Insurance Taxes Shrinkage Spoilage Breakage Obsolescence
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU70
Inventory Ordering Costs
• Inventory ordering costs Expenses of placing orders with suppliers,
receiving shipments, and processing materials into inventory • Excludes vendor charges
Relate to the number of orders placed rather than to the amount of inventory held
Tend to vary inversely with carrying costs
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU71
Economic Order Quantity (EOQ) Model
• EOQ model recognizes trade-offs between carrying costs and ordering costs Carrying costs increase with amount of inventory
held ( from larger orders) Ordering costs increase with the number of orders
placed (from more orders)
• EOQ minimizes total of sum of ordering and carrying costs
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU72
Inventory Costs and the EOQ
Q (Order Size)
Cost ($) Total
Cost
EOQ
Carrying Cost
Ordering Cost
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU73
Economic Order Quantity (EOQ) Model
• EOQ model is:
whereQ= order size in unitsD= annual quantity used in unitsF= cost of placing one orderC= annual cost of carrying one unit in stock
½ denotes square root
c
2FDQ
½
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU74
Figure 4.7: Inventory on Hand for a Steadily Used Item
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU75
Economic Order Quantity (EOQ) Model • Other Inventory Formulas
Average Inventory = Total Carrying Cost: =
Number of Orders =
Total Ordering Cost = FN =
Total Ordering and Carrying Cost =
2
Q
Qc
2
DN =
QD
FQ
Q DTC = c +F
2 Q
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU76
Example 4.3: Economic Order Quantity
Exa
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Q: The Galbraith Corp. buys a part that costs $5. The carrying cost of inventory is approximately 20% of the part’s dollar value per year. It costs $50 to place, process and receive an order. The firm uses 900 of the $5 parts per year.
What ordering quantity minimizes inventory costs?How many orders will be placed each year if that order quantity is used? What inventory costs are incurred for the part with this ordering quantity?
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU77
Example 4.3: Economic Order Quantity
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A: Annual carrying cost per unit is 20% x $5 = $1
EOQ = 300 units The annual number of reorders is 900 300 = 3Ordering costs are $50 x 3 = $150 per yearAverage inventory is 300 2 = 150 units Carrying costs are 150 x $1 = $150 a yearTotal inventory cost of the part is $300
1
900502Q
½
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU78
Safety Stocks, Reorder Points and Lead Times• Safety stock provides insurance against
unexpectedly rapid use or delayed delivery Additional supply of inventory that is carried
at all times to be used when normal working stocks run out
Rarely advisable to carry so much safety stock that stockouts never happen• Carrying costs would be excessive
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU79
Safety Stocks, Reorder Points and Lead Times
• Ordering lead time—advance notice needed so that an order placed will arrive when required Usually estimated by item’s supplier
• Reorder point—level of inventory at which order is placed
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU80
Figure 4.9: Inventory on Hand Including Safety Stock
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU81
Economic Order Quantity (EOQ) Model • Other Inventory Formulas (with Safety
Stock) • Average Inventory =
• Total Carrying Cost: =
• Total Ordering and Carrying Cost =
StockSafety 2
Q
Qc Safety Stock
2
Q DTC = c SafetyStock +F
2 Q
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU82
Tracking Inventories—The ABC System• Some inventory items (A items) require great
deal of attention Very expensive Critical to firm’s processes or to those of customers
• Some inventory items do not require great deal of attention (C items) Commonplace, easy to obtain
• B items fall between items A & C
• ABC system segregates items by value and places tighter control on higher cost (value) pieces
Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU83
Just In Time (JIT) Inventory System
• Inventory supplied At exactly the right time In exactly the right quantities
• Theoretically eliminates the need for factory inventory Shortens operating cycle Reduces costs Eliminate wasteful procedures But: late delivery can stop factory’s entire production line
• Works best with large manufacturers who are powerful with respect to supplier Supplier is willing to do almost anything to keep the
manufacturer’s business