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Financial Management

Q.1 Examine the reasons for holding inventories by a firm & also discuss the techniques ofinventory control.

Whether a business is in retailing or manufacturing, there are several cogent reasonsfor holding inventory. Businesses may hold stocks of raw materials, spare parts formachinery, work in progress or finished goods. Given that there are costs involved withpurchases, orders and carriage inwards, a firm might want to minimize its order costsand utilize storage space efficiently. While a business would incur holding costs whenstoring inventory, these costs can be offset if there are good business reasons for sodoing.

Purpose of inventory

The purpose of holding inventory is to achieve efficiency through cost reduction andincreased sales volume. Figure 1.1 displays various purposes involved in holdinginventories:

Figure 13.3: Purpose for holding inventory

Sales

Customers place orders for goods only when they need it. But when customersapproach the firm with orders the firms must have adequate inventory of finished goodsto execute it. This is possible only when firms maintain ready stock of finished goods inanticipation of orders from the customers.

If a firm suffers from constant customer complaints about the product being out of stock,customers may migrate to other producers. This will affect the firms customers base,customer loyalty and market share.

Purpose

sales To avail

quantity

discount

Reduce risk of

production

stoppages

Reducing ordering

costs and time


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To avail quantity discounts

Suppliers give discounts for bulk purchases. Such discounts decrease the cost per unitof inventory purchased. Such cost reduction increase firms profits. Firms may go in fororders of large quantity to avail themselves of the benefit of quantity discounts.

Reduce risk of production stoppages

Manufacturing firms require a lot of raw materials and spares and tools for productionand maintenance of machines. Non availability of any vital item can stop the productionprocess. Production stoppage has serious consequences. Loss of customers onaccount of the failure to execute their orders will affect the firms profitability. To avoidsuch situations, firms maintain inventories as hedge against production stoppages

Reducing ordering costs and time

Every time a firm places an order it incurs cost of procuring it. It also involves a leadtime in procurement. In some cases the uncertainty in supply due to certainadministrative problems of the supplier of the product will affect the productionschedules of the organisation. Therefore, firms maintain higher levels of inventory toavoid the risks of lengthening the lead time in procurement.

Therefore, to save on time and costs, firms may place orders for large quantities.

Therefore, it can be concluded that the motives for holding inventories are

Transaction motive: For making available inventories to facilitate smooth

production and sales Precautionary motive: For guarding against the risk of unexpected changes in

demand and supply

Speculative motive: To take benefit out of the changes in prices, firms increaseor decrease in the inventory levels

1. To meet expected demand

A business must ensure that it has adequate supplies to meet expected demand for its

goods, regardless of whether it is a retailing or production environment. Particularlywhere a business has a high demand and rapid turnover, having stock in storage

ensures that the firm can comfortably meet anticipated demand.

2. To guard against shortages

Holding inventory can act as insurance against future shortages. Unexpected shortages

in the supply of raw materials or finished goods can affect the production run of a


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business or its ability to meet demand. Holding inventories allows a degree of continuity

for the activities of an enterprise.

3. To benefit from discounts

Suppliers often offer trade discounts for bulk purchases, once those purchases areabove a certain amount. A business can reduce the unit cost of materials and its

ordering costs (delivery, import duties) by purchasing a large amount of goods/ raw

materials to hold in stock.

4. To deal with variations in usage or demand

"Usage" refers to production consumption in a manufacturing process. Increased usage

can increase the demand for materials. This is the result of either increased inefficiency

or increased production levels. Sometimes a business might cater for special orders or

have high seasonal demand that it must address, requiring additional stock to facilitate

such occurrences.

5. To facilitate the production process

Stock can allow the manufacturing process to flow smoothly and help the business to

respond quickly and effectively to contingencies.

6. In times of high inflation/ supply shortages

Holding vast supplies of inventories can be a deliberate strategy in response to unusual

or difficult economic circumstances. In times of high inflation, a business might not wish

to purchase stock at increasingly higher prices. Once the business determines that it is

feasible to hold additional inventory beyond the usual levels, this is a very sensible

strategy.

7. Some processes require holding work in progress

Inventory can also include work in progress. Some products might have longer

production cycles than others (like wine or cheese for instance). It is necessary to hold a

high volume of inventory to cater for the inherent nature of production in some businesscontexts.

Naturally, there are restrictions on how much inventory a business could or should hold.

The nature of the product, regulations and maximum storage capacity are some

elements that limit or deter a business from holding too much inventory. Once a


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business decides to hold inventory, then a proper inventory management and control

system is necessary to optimize both the stock levels and inventory costs.

Inventory Control

Inventory control is concerned with the acquisition, storage, handling and use ofinventories so as to ensure the availability of inventory whenever needed, providingadequate provision for contingencies, deriving maximum economy and minimizingwastage and losses. Hence Inventory control refers to a system, which ensures thesupply of required quantity and quality of inventory at the required time and at the same

time prevent unnecessary investment in inventories.

Inventories Control Techniques

What are the main Techniques of InventoryMaterial Control?

SIMRANJOT

Inventory consists of stock of raw materials, work-in-progress, spare pa consumables for productionand finished goods for sale. Thus, inventory com includes control over raw materials, spare parts,consumables, partly finished goods, and finished goods. The following are the common techniques ofinventory control:

1. Determination of various levels of materials

2. Economic Order Quantity

3. ABC Analysis

4. Perpetual Inventory System

1. Determination of Various Levels of Materials

The store-keeper plays an important role in deciding upon the various levels materials. In order toensure that the optimum quantity of materials is purchased stocked neither less nor more, the storekeeper applies scientific techniques of material management. Fixing of certain levels for each item ofmaterials in one of techniques.

These levels are not permanent but require revision according to the change in the factors whichdetermine these levels. The following levels are generally fixed.

(a) Re-order Level

(b) Maximum Level

(c) Minimum Level

(d) Average Level

(e) Danger Level

(a) Re-order Level:


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This level is that level of material at which it is necessary to initiate purchase requisition for freshsupplies. This is normally the point lying between the maximum and the minimum levels. Freshorders must be placed before the actual stocks touch the minimum level.

This level is fixed in such a manner that the quantity of materials represented by the differencebetween the re-order level and the minimum level will be sufficient to meet the requirement of

production till such time as the order materialises and materials are delivered. The following factorsare taken into account for fixing the Re-order level:

(i) Rate of consumption of material

(ii) Lead time, i.e., time required to receive the delivery of fresh purchase.

(iii) Re-order quantity

(iv) Minimum level

Re-order level can be calculated by applying the following formula:

Re-order level = Minimum level + consumption during period required to get fresh delivery

Another formula for Re-order level is:

Re-order level = Maximum consumption x Maximum Re-order Period Illustration-1

Calculate Re-order level for a material from the following information: Minimum level - 1,000 unitsMaximum level - 6,000 units Time required to get fresh delivery - 15 days. Daily consumption of thematerial - 100 units.

Solution:

Re-order level = Minimum Level + Consumption during the period required to get fresh delivery

= 1,000 units + (100 x 15) = 2,500 units.

Calculate Re-order Level from the following particulars: Minimum consumption - 80 units'Maximum consumption - 120 units Re-order period - 10-12 days

Solution:

Re-order Level = Maximum consumption x maximum Re-order period = 120 units x 12 = 1,440 units

(b) Maximum Level:

The maximum level is that level of stock which can be held at any time. In other words, it is the levelbeyond which stock should not be maintained. The purpose is to avoid over-stocking and thereby

using working capital in a proper way. This level is fixed after taking into account the followingfactors:

(i) Rate of consumption

(ii) Lead time

(iii) Availability of capital


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(iv) Storage capacity

(v) Cost of maintaining stores including insurance cost

(vi) Nature of commodity

(vii) Possibility of price fluctuation

(viii) Possibility of change in fashion, habit, etc.

(ix) Restrictions imposed by Govt., local authority or trade associations

(x) Re-order level it

(xi) Re-order quantity

Maximum level can be calculated by applying the following formula:

Maximum Level = Re-order level + Re-order Quantity - (Minimum consumption x Minimum Re-order period)

(c) Minimum Level:

This is the level below which the stock of an item should not fall. This is known as safety or bufferstock. An enterprise must maintain minimum quantity of stock so that the production is nothampered due to non-availability of materials. This level is fixed after considering the followingfactors:

(i) Re-order level

(ii) Lead time

(iii) Rate of consumption

The formula for calculating minimum level is:

Minimum level = Re-order level - (Normal consumption x Normal Re-order period)

(d) Average Level:

Average level can be calculated by applying the following formula:

Maximum level + Minimum level Average level = ---------------------------------------------- -

Or Average level = Minimum level + of Re-order Quantity.

(e) Danger Level:

Usually stock should not be lower than the minimum level. But if for any reason, stock comes downbelow the minimum level, it is called danger level. When the stock reaches danger level, it isnecessary to take urgent action on the part of the management for immediate replenishment of stockto prevent stock-out situation. The danger level can be calculated by applying the following formula:

Danger Level = Average consumption x Maximum Re-order period for emergency purchases


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From the following particulars, calculate the maximum level, minimum level, re-order level andaverage level:

Normal consumption - 300 units per day Maximum consumption - 420 units per day Minimumconsumption - 240 units per day Re-order quantity - 3,600 units

Re-order period - 10-12 days

2. Economic Order Quantity (EOQ)

The economic order quantity, known as EOQ, represents the most favorable quantity to be orderedeach time fresh orders are placed.

The quantity to be ordered is called economic order quantity because the purchase of this size ofmaterial is most economical. It is helpful to determine in advance as to how much should one buy

when the stock level reaches the re-order level. If large quantities arc purchased, the carrying costswould be large.

On the other hand, if small quantities are purchased at frequent intervals the ordering costs would be

high. The economic order quantity is fixed at such a level as to minimise the cost of ordering andcarrying the stock. It is the size of the order which produces the lowest cost of material ordered.

While determining the economic order quantity, the following three cost factors are taken intoconsideration:

(i) The cost of the material

(ii) The inventory carrying cost

(iii) The ordering cost

Carrying costs are the costs of holding the inventory in the stores. These are:

(i) Rent for the storage space.

(ii) Salaries and wages of the employees engaged in store keeping department.

(iii) Loss due to pilferage and deterioration.

(iv) Insurance charges.

(v) Stationery used in the stores.

(vi) Loss of interest on the capital locked up in materials.

Ordering costs are the costs of placing orders for the purchase of materials. These are:

(i) Salaries and wages of the employees engaged in purchasing department.

(ii) Stationary, postage, telephone expenses, etc. of the purchasing department.

(iii) Depreciation on equipments and furniture used by the purchasing department.

(iv) Rent for the space used by the purchasing department.


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While placing orders for purchasing materials, the total cost to be incurred is kept in view. Asdiscussed earlier, if an order is placed for a large quantity at a time, the ordering cost is less but thecarrying cost would be more.

On the other hand, if orders are placed for small quantities, the ordering cost is more but thecarrying cost would be less; thus the economic order quantity is determined at a point when the

ordering costs and the carrying costs are equal. Only at this stage the total of ordering cost andcarrying cost is minimum.

Determination of Economic Order Quantity: The economic order quantity is determined by using thefollowing formula:

Where, EOQ = Economic order quantity.

C = Annual consumption or usage of material in units.

0 = Cost of placing one feeder including the cost of receiving the goods.

1 = Cost of carrying one unit of inventory for one year.

Assumptions in the Calculation of Economic Order Quantity:

The economic order quantity is based on the following assumptions:

Quantity of the item to be consumed during a particular period is known with certainty.

The pattern of consumption of material is constant and uniform throughout the period.

Cost per unit is constant and known and quantity discount is not involved.

Ordering cost and carrying cost are known and they are fixed per unit and will remain constantthroughout the period.

IlIustration-4

From the following information, calculate the economic order quantity: Annual consumption -10,000 units Cost of material per unit - Rs.10 Cost of placing and receiving one order - Rs.50 Annualcarrying cost of one unit - 10% of inventory value.

Solution:

Where, C = Annual consumption of materials in units = 10,000 units

O = Cost of placing one order including the cost of receiving = Rs.50 I = Carrying cost per unit perannum = 10% of Rs.10 = Re.1.

Economic order quantity can also be calculated by using the tabular method. A comparison of totalcosts at different order sizes is made to determine the economic order quantity. The order sizehaving the least total cost is accepted as economic order quantity. At this point, both carrying costsand ordering costs would be equal.

Taking the figures from the illustration 4, calculate the economic order quantity by using the tabularmethod.

Solution:


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The above table reveals that the cost of placing order for materials and the carrying costs are exactlyequal when the order quantity is 1,000 units. At this point, the total cost is also the least. Hence, theeconomic order quantity is 1,000 units and the number of orders per year would be 10.

3. ABC Analysis

This technique of inventory control is also known as Always Better Control technique. ABC analysisis an analytical method of control which aims at concentrating efforts on those areas where attentionis needed most.

This is a principle of selective control. The emphasis of ABC analysis technique is that themanagement should concentrate its energy in controlling those items that mostly affect theorganisational objects. Manufacturing concerns find it useful to group the materials into threeclasses on the basis of investment involved.

Materials having higher values but constitute small percentage of total items, are grouped in 'A'category. On the other hand, a large percentage of items of materials which represent a smallerpercentage of the values, are grouped in 'C' category. Items of materials having moderate value 'andmoderate size are grouped in 'B' category. On the basis of physical quantities and value of arterials

used, the following table illustrates the above classification:

After the items of materials are classified into A, B and C category, control can be exercised in aselective manner as follows:

(i) Greater care and strict control should be exercised on the items of category 'A' as any loss orbreakage or wastage of any item of this category many prove to be very costly. Economic orderquantity and re-order level should be carefully fixed for such category of items.

(ii) Moderate and relaxed control is required for the items of category 'B'.

(iii) There is not much need for exercising control over the items of category 'C' Periodic or annualverification is required for this category of materials.

The graphical representation of ABC analysis is given below:

Advantages of ABC Analysis:

The advantages of ABC analysis are given below:'

Close and strict control of costly items is ensured.

Investment in inventory can be regulated and funds can be utilised in the, best possible way.

Economy is achieved in respect of stock carrying cost.

It helps to keep enough safely stock for 'C' category items.

Clerical cost can be reduced and inventory is maintained at optimum level.

Scientific and selective control helps in maintenance of high stock turnover rate.


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There are many techniques of management of inventory. Some of them are as shown in the

figure 1.2

Figure 1.2: Inventory management techniques

1. ABC Analysis of InventoriesThe ABC inventory control technique is based on the principle that a small portion of theitems may typically represent the bulk of money value of the total inventory used in the

production process, while a relatively large number of items may from a small part of themoney value of stores. The money value is ascertained by multiplying the quantity ofmaterial of each item by its unit price.

According to this approach to inventory control high value items are more closelycontrolled than low value items. Each item of inventory is given A, B or C denominationdepending upon the amount spent for that particular item. A or the highest value itemsshould be under the tight control and under responsibility of the most experiencedpersonnel, while C or the lowest value may be under simple physical control.It may also be clear with the help of the following examples:A Category 5% to 10% of the items represent 70% to 75% of the money value.B Category 15% to 20% of the items represent 15% to 20% of the money.

C Category The remaining number of the items represent 5% to 10% of the moneyvalue.The relative position of these items show that items of category A should be under themaximum control, items of category B may not be given that much attention and item Cmay be under a loose control.

Methods of Inventory Control

The following are the primary stock control methods that are often used by companies

in their production operations. All these methods are well established and have been

used in production industry for quite a long period of time.

Min-Max Plan
http://resources.smude.edu.in/slm/wp-content/uploads/2010/02/clip-image01020.gif


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In min-max plan, the cost accountant who is in charge of the inventory control,

establishes two levels, the minimum and maximum level of stock. When the

items/materials/units, reach the minimum level, the order to replenish the stock is

placed. The maximum level is the level that the stock quantity should not exceed, as it

will put a considerable strain on the finances of the company and will also create

problems such as storage, wastage and over consumption.

Two Bin System

The two bin system is used to establish a connection between the order and reorder

procedures. As mentioned above, from the point of view of a producer, uneven supply

of stock and odd consumption is not very healthy. Such unevenness is sorted by two-

bin system. In such a system, the stock is sorted into two bins, or piles. The first stock

(bin 1), is the larger of the two and is used up between the time period that lasts frompurchase of stock till the reorder. The second stock (bin 2), can be used from the time

when the reorder is placed till the order is actually received. The second stock, has a

considerable amount of stand by that can be used for emergencies.

Order Cycling System

This system is based upon a review timetable. According to this system, a review of the

entire inventory is done at regular intervals, such as 30 days, 60 days or 90 days. After

the review is done, the cost accountant views stock items with low quantities that will

not last up to the next review interval. The purchase order for such a stock item is

placed immediately. The order cycling system is not exactly foolproof and one requires

a rather experienced cost accountant to efficiently conduct it.

ABC Analysis

Any stock is segregated into different sections. These items are classified into 3

sections, A, B and C. The logic of segregating these items into sections is that section A

consists of limited number of items that are very expensive. Section B has items that

are not expensive and the number of units that is to be ordered is also not very large.The section C consists of numerous items, that have a low monetary value. The logic

behind such segregation is that every section is viewed differently by the cost

accountant, due the difference in order time, reorder time and delivery period. For

example, though the unites in section A are less, their monetary value is also high and

so is their delivery period. The ABC analysis is a simple and probably the most effective

of all stock control methods.


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There are many other methods such as FIFO and LIFO (issuance inventory valuation

methods) that are considered to be very effective in controlling inventory. In addition to

that, you might also refer to some established mathematical formulas such as economic

ordering quantity.

Q.2 a.) A bond of Rs. 1000 value carries a coupon rate of 10% and has a maturity period of 6years. Interest is payable semi-annually. If the required rate of return is 12%, calculate the

value of the bond. ( 5marks)

b.) A bond whose par value is Rs. 500 bearing a coupon rate of 10% and has a maturity of 3

years. The required rate of return is 8%. What should be the price of the bond? ( 5marks)

Q.3 Examine the features & evaluation of decision-tree approaches.

Q.4 If the EPS is Rs.5, dividend pay-out ratio is 50%, cost of equity is 20% and growth rate in

the ROI is 15%. What is the value of the stock as per Gordons Dividend Equalisation Model?

Q.5 Critically examine the pay-back period as a technique of approval of projects.

Q.6 Two companies are identical in all aspects except in the debt-equity profile. Company X has 14%

debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn

20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40% and

cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach.


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Q3. Two companies are identical in all respects except in the debt equity profile. Company X

has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both

companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming

a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X

and Y using NOI approach?

Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

Answer:

S= 1000,000/.22 =4545454.5

B=25,00,000

=K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22

0.0496+.142 =.1915 or 19.15%

V = 5000000/0.1915 = 26,109,660.57

* Critical assumption is ko remains constant.

* An increase in cheaper debt funds is exactly offset by an increase in the required rate of

return on equity.

* As long as ki is constant, ke is a linear function of..

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