1.

4 Management of Accounts Receivable

Consideration should be given to the company’s investment in accounts receivable since there is an opportunity cost associated with holding receivable balances. The major decision regarding accounts receivable
is the determination of the amount and terms of credit to extend to customers. The credit terms offered have a direct bearing on the associated costs and revenue to be generated from receivables. For example, if
credit terms are tight, there will be less of an investment in accounts receivable and less bad debt losses, but there will also be lower sales and reduced profits.

In evaluating a potential customer’s ability to pay, consideration should be given to the firm’s integrity, financial soundness, collateral to be pledged, and current economic conditions. A customer’s credit
soundness may be evaluated through quantitative techniques such as regression analysis. Such techniques are most useful when a large number of small customers are involved. Bad debt losses can be estimated
reliably when a company sells to many customers and when its credit policies have not changed for a long period of time.

The collection period for accounts receivable partly depends on the firm’s credit policy and economic conditions, such as a recessionary environment, a period of limited or tight credit, or both.

In managing accounts receivable, the following procedures are recommended. First, establish a credit policy:

1. A detailed review of a potential customer’s soundness should be made prior to extending credit. Procedures such as a careful review of the customer’s financial statements and credit rating, as well as a review
of financial service reports (e.g., CISA in the Philippines), are common.

2. As customer financial health changes, credit limits should be revised.

3. Marketing factors must be noted since an excessively restricted credit policy will lead to lost sales.

4. If seasonal datings are used, the firm may offer more liberal payments than usual during slow periods in order to stimulate business by selling to customers who are unable to pay until later in the season. This
policy is financially appropriate when the return on the additional sales plus the lowering in inventory costs is greater than the incremental cost associated with the additional investment in accounts receivable.

Second, establish a policy concerning billing:

1. Customer statements should be sent within 1 day subsequent to the close of the period.

2. Large sales should be billed immediately.

3. Customers should be invoiced for goods when the order is processed rather than when it is shipped.

4. Billing for services should be done on an interim basis or immediately prior to the actual services. The billing process will be more uniform if cycle billing is employed.

5. The use of seasonal datings should be considered. (See item 4, concerning credit policy.)

Finally, establish a policy concerning collection:

1. Accounts receivable should be aged in order to identify delinquent and high-risk customers. The aging should be compared to industry norms.

2. Collection efforts should be undertaken at the very first sign of customer financial unsoundness.

Example 1.8 
J Corporation sells on terms of net/60. Its accounts are on the average 30 days past due. Annual credit sales are P500,000. The investment in accounts receivable is: 
90/360 x P500,000 = P125,000 
Example 1.9 
The cost of a given product is 40 percent of selling price, and carrying cost is 12 percent of selling price. On average, accounts are paid 90 days subsequent to the sale date. Sales average P40,000 per month. The
investment in accounts receivable from this product is: 
Accounts receivable: 3 months $40,000 sales = P120,000 
Investment in accounts receivable: P120,000 x (0.40 + 0.12) = P 62,400 
Example 1.10 A company has accounts receivable of P700,000. The average manufacturing cost is 40 percent of the sales price. The before-tax profit margin is 10 percent. The carrying cost of inventory is 3
percent of selling price. The sales commission is 8 percent of sales. 
The investment in accounts receivable is: 
P700,000 x (0.40 + 0.03 + 0.08) = P700,000 x 0.51 = $357,000
Example 1.11 
If a company’s credit sales are P120,000, the collection period is 60 days, and the cost is 80 percent of sales price, what are (a) the average accounts receivable balance and (b) the average investment in accounts
receivable? 
(a) Accounts receivable turnover: 360/60 = 6 
Average accounts receivable = credit sales/turnover = P120,000/6 = P20,000
(b) Average investment in accounts receivable = P20,000 x 0.80 = P16,000 
It pays for a firm to give a discount for early payment by customers when the return on the funds received early is greater than the cost of the discount. 
Example 1.12 L Corporation provides the following data:
Current annual credit sales P12,000,000
Collection period 2 months
Terms net/30 
Rate of return 15% 
L proposes to offer a 3/10, net/30 discount. The corporation anticipates 25 percent of its customers will take advantage of the discount. As a result of the discount policy, the collection period will be reduced to 1
and 1/2 months. Should L offer the new terms? 
The discount policy is disadvantageous, as indicated below. 
Current average accounts receivable balance 
(P12,000,000/6)                                                                           = P2,000,000 
Average accounts receivable balance—
after policy change (P12,000,000/8)                                      = 1,500,000 
Reduction in average accounts receivable                         =   500,000
Rate of return                                                                                          x 0.15
Peso return earned                                                                     =     75,000 
Cost of discount (0.25 x P12,000,000 x 0.03)                          =  P 90,000
Disadvantage of discount policy (P90,000 - P75,000)       =  15,000 
A firm may consider offering credit to customers with a higher-than-normal risk rating. Here, the profitability on additional sales generated must be compared with the amount of additional bad debts expected,
higher investing and collection costs, and the opportunity cost of tying up funds in receivables for a longer period of time. When idle capacity exists, the additional profitability represents the incremental
contribution margin (sales less variable costs) since fixed costs remain the same. The incremental investment in receivables represents the average accounts receivable multiplied by the ratio of per-unit cost to
selling price. 

Example 1.13 J Corporation, which has idle capacity, provides the following data: 
Selling price per unit   P80 
Variable cost per unit P50 
Fixed cost per unit       P10 
Annual credit sales     300,000 units 
Collection period         2 months
Rate of return               16% 
The corporation is considering a change in policy that will relax its credit standards. The following information applies to the proposal:
 1. Sales will increase by 20 percent. 
2. Collection period will go to 3 months. 
3. Bad debt losses are expected to be 3 percent of the increased sales. 
4. Collection costs are expected to increase by P20,000. 
The analysis of its proposed credit policy change follows: 
Concerning incremental profitability: 
          Increased unit sales (300,000 x 0.20)         60,000 
          Per-unit contribution margin (P80-P50) =   x P30
          Incremental profit                                            P1,800,000 
Concerning additional bad debts:
          Incremental dollar sales (60,000 x P80) P4,800,000
          Bad debt percentage                                         x   0.03 
          Additional bad debts                                   P 144,000 
New average unit cost is:
                                             Units     Unit Cost     Total Cost 
Current                           300,000           P60       P18,000,000 
Increment                        60,000           P50a         3,000,000 
Total                                 360,000                        P21,000,000 
New average unit cost = P21,000,000/360,000 = P58.33 
a Since idle capacity exists, the per-unit cost on the incremental sales is solely the variable cost of P50. 
Additional cost of higher investment in average accounts receivable is:
Investment in average accounts 
          receivable after the change in policy   P5,249,700a 
Current investment in average accounts 
                      receivable                                        3,000,000b
Incremental investment in average 
                  accounts receivable                        P2,249,700
 Rate of return                                                                 x 0.16 
Additional cost                                                     P   359,952 
a Credit sales/turnover x unit cost/selling price = P28,800,000/4 x P58.33/P80:00 =       P5,249,700 
b P24,000,000/6 x P60/P80 = P3,000,000
The net advantage/disadvantage is: 
Incremental profitability                                               P1,800,000 
Less: Additional bad debts              P144,000 
          Additional collection costs        20,000 
          Opportunity cost                        359,952                523,952  
Net advantage/disadvantage                                   P1,276,048
Since the net advantage is considerable, J Corporation should relax its credit policy.

 Example 1.14 
W Corporation is considering liberalizing its credit policy to encourage more customers to purchase on credit. Currently, 80 percent of sales are on credit and there is a gross margin of 30 percent. Other relevant
data are: 
                                                 Currently                Proposal 
Sales                                      P300,000                   P450,000 
Credit sales                          P240,000                   P360,000
Collection expenses         4% of credit sales     5% of credit sales 
Accounts receivable turnover 4.5                      3 
An analysis of the proposal yields the following results: 
Average accounts receivable balance (credit sales/accounts receivable turnover) Expected average accounts receivable      (P360,000/3)                P120,000 
Current average accounts receivable         (P240,000/4.5)             P53,333
Increase                                                                                                       P66,667
Gross profit 
      Expected increase in credit sales (P360,000-P240,000)            P120,000 
Gross profit rate                                                                                                 0.30 
Increase                                                                                                       P 36,000
Collection expenses 
     Expected collection expenses (0.05 x P360,000)                          P 18,000
     Current collection expenses (0.04 x P240,000)                                  9,600
 Increase                                                                                                     P 8,400 
W Corporation would benefit from a more liberal credit policy. When a company is considering initiating a sales campaign in order to improve income, incremental profitability is compared to the cost of the
discount and the opportunity cost associated with the higher investment in accounts receivable. 

Example 1.15

D Company is planning a sales campaign, during which Drake will offer credit terms of 4/20, net/60. Drake anticipates its collection period will rise from 70 days to 90 days. Data for the contemplated campaign
are:

Percentage of Sales Percentage of Sales Prior to Campaign During Campaign

Cash sales 30 20

Payment from

1–20 50 45

21–100 20 35
The proposed sales strategy will likely increase sales from P6 million to P7 million. The gross profit rate is 20 percent, and the rate of return is 12 percent. Sales discounts are given on cash sales.

An analysis of the proposed sales campaign is as follows:

Sales Campaign

Without Campaign With Campaign

Gross profit P1,200,000 P1,400,000

Sales subject to discount

0.8 x P6,000,000 P4,800,000

0.65 x P7,000,000 P4,550,000

Sales discount x 0.4 192,000 x 0.04 182,000

Investment in average

accounts receivable

70/360 x P6,000,000 x 0.8 P 933,333

90/360 x P7,000,000 x 0.8 P1,400,000

Rate of return x 0.12 112,000 x 0.12 168,000 Net profit P896,000 P1,050,000

D should initiate the sales program since it will generate an additional profit of P154,000.

A business may wish to evaluate a credit policy that would extend credit to currently limited-credit or no-credit customers. Full credit should only be given to a customer category if net earnings ensue.
Example 1.15

D Company is planning a sales campaign, during which Drake will offer credit terms of 4/20, net/60. Drake anticipates its collection period will rise from 70 days to 90 days. Data for the contemplated campaign
are:

Percentage of Sales Percentage of Sales Prior to Campaign During Campaign

Cash sales 30 20

Payment from

1–20 50 45

21–100 20 35

The proposed sales strategy will likely increase sales from P6 million to P7 million. The gross profit rate is 20 percent, and the rate of return is 12 percent. Sales discounts are given on cash sales.

An analysis of the proposed sales campaign is as follows:

Sales Campaign

Without Campaign With Campaign

Gross profit P1,200,000 P1,400,000

Sales subject to discount

0.8 x P6,000,000 P4,800,000

0.65 x P7,000,000 P4,550,000

Sales discount x 0.4 192,000 x 0.04 182,000

Investment in average

accounts receivable

70/360 x P6,000,000 x 0.8 P 933,333

90/360 x P7,000,000 x 0.8 P1,400,000

Rate of return x 0.12 112,000 x 0.12 168,000 Net profit P896,000 P1,050,000
D should initiate the sales program since it will generate an additional profit of P154,000.

A business may wish to evaluate a credit policy that would extend credit to currently limited-credit or no-credit customers. Full credit should only be given to a customer category if net earnings ensue.

EXAMPLE 1.16

T Corporation has three credit categories (X, Y, Z) and is considering changing its credit policy for categories Y and Z. The pertinent data are:

Category Bad Debt (%) Collection Credit Terms Additional Annual Period(days) Sales if Credit
Restrictions Are Eased

X 2 30 Full P100,000

Y 5 50 Restricted P400,000

Z 13 80 No credit P900,000

Gross profit approximates 15 percent of sales. The rate of return is 16 percent. Analysis of the data yields the following results:

Category Y Category Z

Gross profit

P400,000 x 0.15 P60,000

P900,000 x 0.15 P135,000

Increment in bad debts

P400,000 x 0.05 20,000

P900,000 x 0.13 117,000

Incremental average in accounts receivable

50/360 x 0.85 x P400,000 P47,222

80/360 x 0.85 x P900,000 P170,000

Rate of return x 0.16 x 0.16

Additional cost 7,556 27,200

Net profitability P32,444 P9,200

Credit should be eased only for category Y.

Extending credit to category Z is likely to incur a loss for the company.

1.5 Inventory Management

—
The three types of inventory are: (1) raw materials, which are materials acquired from a supplier that will be used in the manufacture of goods; (2) work-in-process, which is partially completed goods at the end of
the accounting period; and (3) finished goods, which are completed goods awaiting sale.

Inventory management involves a trade-off between the costs associated with keeping inventory versus the benefits of holding inventory. Higher inventory levels result in increased costs from storage, insurance,
spoilage, and interest on borrowed funds needed to finance inventory acquisition. However, an increase in inventory lowers the possibility of lost sales from stockouts and the incidence of production slowdowns
from inadequate inventory. Further, large volume purchases will result in greater purchase discounts. Inventory levels are also influenced by short-term interest rates. For example, as short-term interest rates
increase, the optimum level of holding inventory will be reduced.

Inventory should be counted at regular, cyclic intervals because this provides the ability to check inventory on an ongoing basis as well as to reconcile the book and physical amounts. Cyclic counting has the
following advantages:

1. It allows for an efficient use of a few full-time experienced counters throughout the year.

2. It enables the timely detection and correction of the causes of inventory error.

3. It does not require a plant shutdown, as does a year-end count.

4. It facilitates the modification of computer inventory programs if needed.

A quantity discount may be received when purchasing large orders. The discount serves as a reduction of the acquisition cost of materials.

Example 1.17

A company purchases 1,000 units of an item having a list price of P10 each. The quantity discount is 5 percent. The net cost of the item is:

Acquisition cost (1,000 x P10) P10,000

Less: Discount (0.05 x P10,000) 500

Net cost P 9,500

The average investment in inventory should be considered.

Example 1.18

Savon Corporation places an order for 5,000 units at the beginning of the year. Each unit costs P10. The average investment is:

Average inventorya 2,500 units

Unit cost, P P10

Average investment P25,000

a Quantity(Q) / 2 = 5,000/2

The more frequently a company places an order, the lower will be the average investment.

Carrying and Ordering Costs

Inventory carrying costs include those for warehousing, handling, insurance, and property taxes. A provisional cost for spoilage and obsolescence should also be included in an analysis of inventory. In addition,
the opportunity cost of holding inventory balances must be considered. Assuming that the carrying cost per unit is constant, then

Carrying cost = Q/2 x C

where Q/2 represents average quantity and C is the carrying cost per unit.

Inventory order costs are the costs of placing an order and receiving the merchandise. They include freight charges and the clerical costs to place an order. In the case of produced items, they also include the
scheduling cost. The ordering cost per unit is assumed to be constant.

Ordering cost = S/Q x P

where S = total usage Q = quantity per order P = cost of placing an order

The total inventory cost is therefore:

QC/2 + SP/C

A trade-off exists between ordering and carrying costs. A greater order quantity will increase carrying costs but lower ordering costs.

Economic Order Quantity (EOQ)

The economic order quantity (EOQ) is the optimum amount of goods to order each time an order is placed so that total inventory costs are minimized.
EOQ = √ 2SP/C

The number of orders to be made for a period is the usage (S) divided by the EOQ.

Example 1.19

W Corporation needs to know how frequently to place their orders. They provide the following information:

S =500 units per month

P = P40 per order

C = P4 per unit

EOQ = 100 units (Check if you will arrive at this answer using the EOQ formula)

The number of orders required each month is:

S/EOQ = 500/100 = 5

Therefore, an order should be placed about every 6 days (31/5).

Example 1.20 A Appliance Store is determining its frequency of orders for toasters. Each toaster costs $15. The annual carrying costs are approximated at $200. The ordering cost is $10. A expects to sell 500
toasters each month. Its desired average inventory level is 40.

S = 50 x 12 = 600

P = $10

C = (purchase price x carrying cost)/average investment = (P15 x P200)/(40 x P15) = P5 EOQ = √2SP/C = √2(600x10)/5 = 49 rounded

The number of orders per year is: S/EOQ = 600/49 = 12 orders (rounded)

A Appliance should place an order about every 30 days (365/12).

During periods of inflation and tight credit, a company should be flexible in its inventory management policies. For example, its EOQ model will have to be modified to reflect rising costs.

Stockouts

Stockout of raw materials or work-in-process can result in a shutdown or slowdown in the production process. In order to avoid a stockout situation, a safety stock level should be maintained. Safety stock is the
minimum inventory amount needed for an item, based on anticipated usage and the expected delivery time of materials. This cushion guards against unusual product demand or unexpected delivery problems.

Example 1.21
Winston Corporation places an order when its inventory level reaches 210 rather than 180 units. Its safety stock is 30 units. In other words, the company expects to be stocked with 30 units when the new order is
received. The optimum safety stock level is the point where the increased carrying cost equals the opportunity cost associated with a potential stockout. The increased carrying cost is equal to the carrying cost per
unit multiplied by the safety stock.

Stockout cost = number of orders (usage/order quantity) x stockout units x unit stockout cost x probability of a stockout

Example 1.22 Tri Corporation uses 100,000 units annually. Each order placed is for 10,000 units. Stockout is 1,000 units; this amount is the difference between the maximum daily usage during the lead time less
the reorder point, ignoring a safety stock factor. The stockout probability management wishes to take is 30 percent. The per-unit stockout cost is P2.30. The carrying cost per unit is P5. The inventory manager
must determine (a) the stockout cost and (b) the amount of safety stock to keep on hand.

(a) Stockout cost = usage/order quantity x stockout units x unit stockout cost x probability of a stockout = 100,000/10,000 x 1,000 x P2.30 x 0.3 = P6,900

(b) Let X = safety stock

Stockout cost = carrying cost of safety stock

P6,900 = P5X

1,380 units = X

Economic Order Point (EOP)

The economic order point is the inventory level that signals the time to reorder merchandise at the EOQ amount. Safety stock is provided for in the computation.

EOP = SL + z √ S(EOQ)(L)

where L = the lead time

z= the stockout acceptance factor

Example 1.23 B Corporation provides the following data:

S = 2,000 units per month

EOQ = 75 units

L = 1/4 of a month

z = 1.29; which represents the acceptable stockout level of 10 percent (from normal probability distribution table )

EOP = SL + z√S(EOQ)(L) = 2,000(1/4) + 1.29√(2,000)(75)(1/4) = 750

The financial manager should attempt to determine the inventory level that results in the greatest savings.

Example 1.24 Frost Corporation is thinking of revising its inventory policy. The current inventory turnover is 16 times. Variable costs are 70 percent of sales. If inventory levels are increased, Frost anticipates
additional sales generated and less of an incidence of inventory stockouts. The rate of return is 17 percent. Actual and estimated sales and inventory turnover are as follows:

Sales (P) Turnover

700,000 16

780,000 14

850,000 11

940,000 7

Frost’s financial manager can now compute the inventory level that will result in the highest net savings.

a Incremental average inventory balance 0.17 (the rate of return).

b Incremental sales 0.30 (contribution margin).

The best inventory level is 55,714 units, since the greatest savings result at this point.

ABC Inventory Control Method

The ABC method of inventory control requires the classification of inventory into one of three groups, A, B, or C. Group A items are most expensive, group B less expensive, and group C the least expensive. The
higher the value of the inventory items, the more control should be exercised over them. Inventory should be analyzed frequently when using the ABC method. The procedure for constructing an ABC analysis
follows:

1. Separate each type of inventory, such as finished goods, work-in-process, and raw materials.

2. Calculate the annual dollar usage for each type of inventory by multiplying the unit cost times the expected future annual usage.
3. Rank each inventory type from high to low, based on annual dollar usage.

4. Classify the inventory as A, B, or C, based on the top 20 percent, the next 30 percent, and the last 50 percent valuation, respectively.

5. Tag the inventory with ABC classifications and record those classifications in the item inventory master records.

Inventory Classification Population (%) $ Usage (%)

A 20 80

B 30 15

C 50 5

Figure 4-1 illustrates the ABC distribution.

The ABC analysis become a tool with the materials manger checks the accuracy of his or her records. More time is spent checking A category items than B and C items. The financial manager should establish an
audit program for those records and items that have the greatest impact on profitability based on the ABC analysis.

Managing Dependent-Demand Inventories

Many types of businesses such as make-to-stock manufacturers, hospitals, wholesale distributors, and retail businesses must keep independent-demand items on hand. On the other hand, many manufacturers deal
with dependent-demand inventories. Dependent-demand (or derived-demand) items are those components that are assembled to become part of some parent item or in some similar way become part of a set of
components. Dependent-demand inventories typically are consumed within the production system, not by some outside demand. Materials requirements planning (MRP) and just-in-time (JIT) inventory
management are two methods for managing derived-demand inventories.

Material Requirements Planning (MRP). MRP is a system that works backwards from the scheduled quantities and need dates for end items specified in a master production schedule (MPS) to determine the
requirements for components needed to meet the MPS.

Just-in-Time (JIT) Inventory. The primary goal of JIT is to reduce inventories to insignificant or zero levels. In traditional manufacturing, inventories result whenever production exceeds demand. Inventories are
needed as a buffer when production does not meet expected demand. With JIT, parts and materials arrive just in time to be used in production.
REVIEW LESSON
The Management of Working Capital
The main objectives of working capital management include maintaining the working capital operating cycle and ensuring its ordered operation, minimizing the cost of capital spent on the working capital,
and maximizing the return on current asset investments.

QUESTIONS;
 X Company has the following selected asset and liabilities:
Cash P100,000 
Accounts receivable P300,000
Inventory P420,000 
Machinery P900,000 
Long-term investments P360,000
Intangible assets - Patent P40,000 
Accounts payable P120,000 
Taxes payable P30,000 
Accrued expenses payable P50,000 
Bonds payable P500,000 
Common stock P700,00
How much is the net working capital?
=620,000

 As you can observe in the Philippines, from households to businesses, what are the tools being used to accelerate cash inflows? List them down, describe and give an example of the use of each tool.  
 X Corporation obtains average cash receipts of P200,000 per day. It usually takes 5 days from the time a check is mailed to its availability for use. What is the amount tied up by the delay?
-1000000

 The opportunity cost of not taking a discount when the terms are 3/15, net/60 is computed is? Answer in one decimal places only.
-24.7