WORKING CAPITAL MANAGEMENT

Overview of working capital management; Cash and marketable securities management;

Accounts receivable and inventory; Short term financing

Working capital is a measure of both a company's operational efficiency and its short-term
financial health. The working capital ratio (current assets/current liabilities), or current ratio,
indicates whether a company has enough short-term assets to cover its short-term debt. A good
working capital ratio is considered anything between 1.2 and 2.0. A ratio of less than 1.0
indicates negative working capital, with potential liquidity problems, while a ratio above 2.0
might indicate that a company is not using its excess assets effectively to generate maximum
possible revenue.
If a company's current assets do not exceed its current liabilities, then it may have trouble paying
back creditors or go bankrupt. A declining working capital ratio is a red flag for financial
analysts. They might also look at the quick ratio, which is more of an acid test of short-term
liquidity because it only includes cash and cash-equivalents, marketable investments and
accounts receivable.
Capital is another word for money and working capital is the money available to fund a
company’s day-to-day operations – essentially, what you have to work with.
In financial speak, working capital is the difference between current assets and current liabilities.
Current assets is the money you have in the bank as well as any assets you can quickly convert to
cash if you needed it. Current liabilities are debts that you will repay within the year. So,
working capital is what’s left over when you subtract your current liabilities from what you have
in the bank.
In broader terms, working capital is also a gauge of a company’s financial health. The larger the
difference between what you own and what you owe short-term, the healthier the business.
Unless, of course, what you owe far exceeds what you own. Then you have negative working
capital and are close to being out of business.

Generally, the following are the major considerations that should be taken into account when dealing on
the level of working capital.

 Nature of business; various firms have varying nature of intensity and hence require varying levels
of working capital. E.g. a legal firm or law chambers just requires a few stationery in form of Manila
paper files, a ream of papers, carbon papers, a computer, printer, fax machine and other stationery
like staple. Therefore, for such a firm of low nature of low intensity, do not require a lot of working
capital compared to other businesses of high intensity like factories, institutions and hospitals.
 Size of the firm; vast business firms generally require more working capital than small ones. This is
mainly because, big firms have a lot of operations and capacity which require to be sustained with a
lot of working capital compared to small firms.
 Credit policy; this refers to a number of written guidelines and procedures followed by a firm when
dealing with debt sales. This influences the level of book debts. The firms need to be discretionary in
giving debts to its customers depending on the trust they have in them and should be prompt in

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 collecting the debts but if a firm has a loose credit policy, then it means , it will have very many
debtors which calls for more working capital
 The length of the cash cycle; this refers to the period it takes from the acquisition of inputs, their
processing into finished goods and services and final selling them and collecting the proceeds
therefrom. if a firm has a longer cash cycle, then the more it will require working capital as regular
collections cannot be relied upon to meet shorter obligations as they follow due and vice versa.
 Manufacturing cycle; this start with the purchase and use of raw materials and ends up with the
production of finished goods and services. The long the cycle, the large the amount of working
capital required. Thus if they are alternative ways of purchasing the one of short period should be
undertaken otherwise any delay in the production process could increase the need for working
capital.
 Stability of revenues/sales; in case a firm has a stable revenues/sales that can easily be predicted,
then there is no need for keeping large volumes of working capital. If on the other hand the pattern
is unstable and unpredictable, then high levels of working capital will be needed to offset or
smoothen the effects of this uncertainty.
 Price level changes; an increasing price level will require a firm to keep high amounts of working
capital, but if the firm is able to adjust its prices for the products with the increasing price level ,
then they will need less investments in working capital. On the other hand, if the suppliers increase
the factor price inputs, then this will require the firm maintain high levels of working capital and vice
versa.
 Business fluctuations; this is a microeconomic indicator of the performance of a given country in
terms of economic activities and it is best explained illustrated using the business cycle.

Diagram

LEVEL OF ACTIVITY

BOOM/PEAK

DEPRESSION

DEPRESSION

During the peak period in the economy, sales will increase and the firm’s needs for inventory increase.
Additionally assets may be bought to increase the productivity capacity of the firm, therefore, these calls
for more working capital to sustain the increased capacity and the reverse in time of depression in fewer
activities.

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  The risk/return preferences of the financial manager; the level of working capital to be
maintained by a particular firm may be determined depending on the risk/return preferences of
financial managers- a risk averse manager will tend to hold high levels of working capital since
he/she makes the firm able to meet its shorter obligations, however a risk seeker will maintain a
low level of working capital and invest most of the remaining resources in viable investments/
projects which yield profitability.

Types of working capital

There are 2 major types of working capital that is permanent and temporary working capital

Permanent working capital; this refers to the amount of short term assets that are required to support
the normal business activity. This type of working capital will naturally grow as the business activity
grows. The need for the permanent working capital exists because; the operative cycle is a continuous
process therefore the need for current resources is there constantly. There is always a minimum level of
current assets which is continuously required by the firm to carry on business activities. This is called
fixed or permanent working capital.

Temporary working capital; these are shorter term assets needed to meet a temporary surge business
activity. The extent of working capital will depend on seasonal fluctuations in the business operations.
E.g. it is common to have demand for business products increasing dramatically in seasons like
charismas, Easter, idrefitre, when schools open etc. therefore the working capital needed to meet these
seasonal adjustments is what is referred to as temporary working capital.

Financing of working capital

If a business is to invest in working capital, then it needs to decide on how these investors are to be
funded or financed, i.e. are you going to use short term or long sources of funds. The challenge in
financing working capital is to ensure that the benefits from investments in short term assets covers the
financing obligations a rising out the financing source employed.

Approaches to financing working capital; there are two major approaches for financing working capital
i.e. the traditional and modern approach.

Traditional approach; traditionally, current assets were financed by short term credit while fixed assets
where financed by long term funds (long term debt or equity)

Diagram

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 CURRENT ASSETS(Short term finance/funds

FIXED ASSETS/LONG TERM FINANCE OF FUNDS

Under this approach, a firm can adopt a financial plan which involves the marching of the expected life
of the assets with expected life of funds raised to finance it. E.g. an investment that is to last for 8 years
can be financed using an eight years loan, but a six month loan can be used to finance materials to be
paid for within six months and this also known as a marching or hedging approach. In other words, it is
important to decide on financing sources for working capital to avoid a mismatch between the life of the
asset and the maturity of the source of funding to avoid difficulties for a firm. Thus when the firm
follows this approach, long financing will be used to finance long working capital and short sources for
temporary working capital as summarized in the figure below.

Diagram

Temporary working capital (short term source of funds

Permanent working capital (short term and long term sources of funds

Fixed assets (long term source of funds)

In order to march the assets to the funding sources, the fixed assets should always be financed by
equally long term sources of funds

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Permanent working capital can be financed by long term sources of funds as these assets will always be
available as long as the business continues to operate. In addition, short sources of funding can also be
used to finance those assets however, temporary

Temporary working capital; is seasonal and it is normally needed for short term periods. It should be
therefore be financed by short term sources of funds.

The modern approach working capital

Given the permanent nature of large proportion of current assets, it is generally felt prudent to fund a
proportion of net current assets with long term finance. The question here is to what extent does such
funding occur?

The possibilities will either be to finance some permanent current assets by short term sources of funds
or all permanent and some fluctuating current assets being financed by long term credit.

Diagrams options 1

Temporary working capital (short term source of funds

Long term/short term funds

Fixed assets (long term funds)

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Diagrams option 2

Temporary working capital (short term source of funds

Permanent working capital (long funds

Fixed assets (long term funds)

The above options are only two of the many e.g. the use of short term funds could be extended to
finance a proportion of fixed assets or alternatively all the firm’s activities could be funded by long term
finance. Therefore, the choice is a matter of material judgment, but tradeoff between the benefits and
risks of short term credit must be considered.

Note; in order for a firm to achieve an optimal objective of investing in working capital, detailed policies
are required in managing the individual components of net working capital. The firm should therefore
establish the cash, debtors, and stock (inventory) management policies that are consistent with the
overall objective of profitability and liquidity. Thus the firm in its working capital management can follow
the following working capital policies

1. Aggressive working capital policy; a firm following an aggressive working capital policy combines
low levels of current assets with high levels of long term assets. In other, the ratio of current assets
to total assets (CA: TA) is low and therefore under this policy, the emphasis is placed on profitability
at the expense of liquidity.
2. Conservative working capital policy; a firm following this working policy combines a high level of
current assets with a high level of short term financing. A firm finances part of short term assets
using long term sources of funding. This is more costly and less profitable since the firm will have to
continue paying interest during periods when the funds have not been used. Therefore, in this case,
the ratio of current assets to total assets is high, hence under this policy, the firm emphasizes
liquidity at the expense of profitability
3. Moderate working capital policy; here a firm uses combinations of long term and short term assets
in equal proportions i.e. the ratio of current assets is nether to high nor too low. It is evident that
this is a policy that balances the tween objectives of profitability and liquidity simultaneously and it’s
the most ideal policy that managers should strive for when investing in working capital.

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Management of cash resources

Cash is the most liquid short term assets which is usually hold as money in currents accounts. It is
extremely important for the financial managers to efficiently manage cash since it is the best input of
production through I does not go directly into the production process. This means that it is through cash
resources that inputs and information are acquired in the firm. On the other hand, cash is also the most
expected output by the investors and other stakeholders of the firm.

The importance of cash resource; it is essential to keep some of the resources for an organization in the
cash form due to the following generally recognized motives for holding cash by a business unit

(i) Transaction motive; this recognizes the fact that business has to carry out daily transactions,
e.g. cash is needed to pay labor, materials, suppliers, utilities etc. which form part of the
transactions of business on a daily basis.
(ii) Precautionary motive; cash is needed to cushion /hedge the business against unforeseen
problems like a breakdown in equipment and machinery, failure of electricity, water system and
emergency work force problems like strikes
(iii) Speculative motive; the business maintains cash balances in order to take advantage of any
profitable ventures that might unexpectedly come up like a sudden decrease in the prices of
factory’s inputs.

The cash management problem

The managerial question facing the financial manager is not whether to keep cash or not. This is simply
answered by the fact that cash is required according to the motives of keeping cash. However the main
problem faced by financial managers is how much cash should be maintained by the business. The ideal
answer to this question directly touches on tween objectives of profitability and liquidity that have to be
observed when controlling investments in current assets. This means that we have to look into risk
preferences of the financial manager.

A risk adverse manager will tend to keep a lot of cash to avoid a risk of failing to honor the firm’s short
term obligations. It should be noted that by doing so this manager is emphasizing the liquid objective at
the expense of profitability since this money by just being banked on a current account simply attracts a
very low or no interest. on the other hand, a risk seeker will always seek to increase profitability by
investing in high profit generating investments implying that the firm will maintain low cash balances as
the other will have been invested .however, a risk taking manager will suppress the liquidity position of
a firm hence the failure to meet the firm’s short term obligations as they fall due.

In conclusion, the manager must ensure that cash balances maintained are neither too high nor too low,
i.e. the cash balance must be optimal to allow the attainment for both objectives of profitability and
liquidity simultaneously.

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Designing a cash management policy

A cash management policy is a set of guidelines or procedures established by the business to ensure
that it has the optimal cash balances at any time. In other words a firm should seek to march the cash
receipts and disbursements (payments) to avoid idle cash resources or deficits. I.e. the business should
seek a position where it has a zero balance after the cash inflows have covered these cash out flows.
However, this is a very difficult task since cash inflows and out flows rarely march, but the following cash
management action can guide to achieve such a position.

 Efficient management of cash flows

 Cash planning
 Investment of the surplus cash to yield a return or planning of the deficits.

Efficient management of cash flows.

In any period, the business will have both cash receipts and cash disbursements/payments with a net
cash balance either as a surplus or as deficit. Therefore, to ensure that that cash receipts and
disbursements are synchronized and zero net balances realized, the manager should design measures to
accelerate the cash receipts into the firm or delay disbursements of cash out of the firm. I.e. cash
collections should be sped up while cash disbursement is tightly controlled. However the delay of
disbursements should not lead the organization into jeopardy.

Management of cash inflows

In order to speed up the collections of cash, the following methods can be used.

 Improving the efficiency of the internal process for preparing and dispatching customer’s invoices.
E.g. invoices can be enclosed within the other shipping documents or even sent before shipment to
demand advance payment if possible.
 Motivate the clients to settle their bills quickly. This can be done by adapting a prompt billing system
so that clients pay on the due date.
 Adapting automatic settlement systems/methods. Here the firm can encourage the clients to inform
the organization that they are interested in buying on credit, and then the firm arranges for an
automatic settlement with bankers of a client such that on a due date the firm automatically gets its
payment.
 Reducing the collection float. The collection float is the total time it takes a cheque to reach a
business from the time when actually cash becomes available for use in a firm. This will be affected
by the time the cheque spends in transit (mailing float). The time it takes the business to process the
cheque (processing float) and the time it takes in the clearing process of the banking system
(availability float). Therefore, the business should be aware of these times and arrange the efficient
handling of these processes. This can be achieved through.

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 Building up multiple collection locations in form of lock box networks, which are maintained at the
general post office or any other convenient spot and used as receiving points to customer’s
remittances. The cheques in these boxes are then collected by the bank and directly deposited on
the firm’s account instead of going through the entire collection float.
 Improving the process of concentrating the cash receipts into a single central account. Cash
concentration is improved by ensuring timely transfers between the banks where the business holds
accounts and this can be done through the use of wire transfer facilities where available e.g. (west
union in Uganda). However, these steps will work well if there is a developed banking system with
modern communication facilities.

MANAGEMENT OF CASH OUT FLOWS

Cash flow management is the process of monitoring, analyzing, and adjusting your business'
cash flows.
For small businesses, the most important aspect of cash flow management is avoiding extended
cash shortages, caused by having too great a gap between cash inflows and outflows. You won't
be able to stay in business if you can't pay your bills for any extended length of time!
Therefore, you need to perform a cash flow analysis on a regular basis, and use cash flow
forecasting so you can take the steps necessary to head off cash flow problems. Much software

Accounting programs have built-in reporting features that make cash flow analysis easy. This is
the first step of cash flow management.
In this case, cash disbursement should be delayed as much as possible without hurting the
corporate image of the firm or defaulting obligations of the business. The principle here is that
cash will be paid out at the moment where delay is no longer possible and beneficial. The
following are some of the ways of delaying disbursements.
 Predicting the banking habits of the work force and pay out the wage or amount accordingly.
The wages should not be paid in advance when the workers are willing to accept delayed
payments. In the same way, payments should be by cheque as bank clearance will always
delay by some days (however today, because of technological advancement, many methods
are used like SWIFT TRANSFER, DRAFT, EFT, RTGS ETC)
 You should take advantage of all credit facilities so that suppliers are not paid in advance and
if it pays, extend a credit by a few days.
 Maximizing the disbursement float through selecting geographical optimal disbursement
bank. These banks should be such that the cheques drawn on them will maximize the days
the cheques remain uncollected.

Management of surplus cash balances

In this case, if a firm is able to remain with a cash surplus, then it must look for viable
investments on projects which will maximize the profitability of the business. However, these
projects or investments should have the following feature.
(i) They should be safe so that the search for profitability does not increase the risk of a
firm.
(ii) They should be marketable i.e. they should be easily sold to the customers.

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 (iii) They should have shorter maturity period.

Management of deficit cash balances

This is a situation where by the firm realizes cash inflows or receipts less than the cash outflows
or disbursements and the best way to manage these balances is what called cash planning.
Cash planning refers to the preparation of forecasts of cash receipts and payments so as to give
an idea of the business feature financial requirements.
Cash planning helps the manager to have an insight into the future financial needs of the
business, formulate policies to deal with cash balances and evaluate the impact of future
business decisions on liquidity positions of the business. Therefore, the results of cash planning
are the cash budget or a statement of forecasted cash receipts and payments.

MANAGEMENT OF DEBTORS

Managing debtors is often referred to as credit management, and includes:

 collecting debts on time

 setting credit limits and payment terms
 making credit applications and credit checks
 enforcing a clear credit policy
 Considering debtor finance.
Debt management also involves keeping debtor records - this is a legal tax requirement.
There are also laws governing how you are allowed to follow up debts with your
customers.
Receivables (debtors) are book debts in the firm which it expects to collect in the near future.
This is money that is owed to the business for a short period of time. The investment
receivables will arise when there is a gap or time lag between the point of delivery of the goods
or services and when payment is received from the customer and such a customer is called a
trade debtor and she /he represents a firm’s claim on assets.
Trade credit is very important to a firm since it helps it to protect its sales from being eroded
by competitions and it also attracts potential customers. The following are justifications for
investment in debtors

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 It is used as a marketing tool especially when a company has just launched its products.
 Trade credits can be used in maintaining market share in a declining market. On the other, it
keeps increasing the market share in a growing market
 It is used as a competitive tool i.e. firms give credit to counter the effects of competition
from competitors.
 It is used for building customer goodwill. Credit is extended so as to build long term
relationship with the buyers or as a reward for their loyalty.
 It is used for meeting the buyers’ needs or requirements since some buyers can hardly
operate without credit being extended to them.
 It may be an industrial practice to give credit such that new entrants to the industry may
find it difficult to offer their goods or services on credit. Hence it is a barrier to new
entrants.

Costs associated with trade credit

As much as extending trade credit is important, there are costs which the firm has to meet in
the management of debtors and these include;
 Collection costs; these are costs incurred at a time of collecting debtors/receivables. They
include; meetings, telephone calls/mobile, sending remainders and even advertising in the
press
 Bad debt losses; these refer to customers who may fail to honor their credit obligations
hence leading to some receivables uncollectable and this may ultimately lead to debts being
written off.
 Administrative costs. These are normally incurred in supervising and investigating receivable
accounts. They arise in form of processing costs, clerical works etc.
 Opportunity costs. If a firm invests in debtors/receivables, then it is very clear that funds are
tied up in debts meaning that some business opportunities such as expansion are foregone
during the time the funds are tied up.
 Implied costs. These are unseen costs which may come up as a result of chasing a debtor-
they range from quarrels, beatings and other inconveniences which in most cases spoil the
relationship between the firm and the debtors.

As long as there is competition in the industry, selling on credit cannot be avoided and this is
mainly because, the firm is most likely protecting its customers from other competitors in the
industry who offer credit to its customers. Since the investments in debts has both benefits and
costs, the major issue then becomes whether it is important to invest in debtors and how much
should this investment be?

To answer this question effectively, the financial manager should take into consideration the
two major objectives of profitability and liquidity. Higher levels of investments in debtors
enhance the liquidity position of the firm but at the expense of profitability and vice versa. It is
therefore recommended that the financial manager invests in an optimal level of debtors which
will ensure that the twin objectives of liquidity and profitability are achieved at the same time.
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However, to achieve this optimal level, we should look at the factors which determine the level
of investment in debtors and these include;

 Level of sales. In most cases the higher the sales, the higher the investment in credit and
vice versa. This is mainly because of the availability of some factors that are not usually in
the control of the financial managers and these factors are micro economics in nature
which affect the market demand greatly.
 Collection period. This refers to the lapse of time between when the credit is extended to
the customer and when he/she is expected to pay the debt. Therefore a short collection
period will tend to yield a higher level of investment in debtors and vice versa.
 Credit policy of the firm. These are the guidelines or procedures that are followed in the
management of credit in the business. It includes the credit terms/standards and the
collection efforts. If the policy of the firm is lenient then there will be more investments in
debtors. The more credit is granted for longer periods to customers whose credit
worthiness is not fully known and the reverse is true for a stringent credit policy.

Credit management policy

A credit policy is already defined as a set of guidelines or procedures designed to minimize the
costs associated with credit while maximizing the benefit from it. Therefore the objective of a
credit policy is to have an optimal investment in debtors. There are two types of credit policies
i.e. lenient and stringent investments credit policy.
Lenient policy; Lenient credit policy tends to give credit to customers on very liberal /soft
terms/standards. On the other hand a stringent credit policy gives credit on a highly selective
basis only to those customers whose creditworthiness has been ascertained and who are
financially strong.
Note. The above policy alternatives are the extreme and undesirable. In normal circumstances,
firms follow credit policies ranging in between the two, hence there is need to formulate a
credit policy which is optimal.
Elements of credit policy
There are three credit policies usually used
A credit policy is based on three main controllable variables i.e. credit standards, credit terms
and the collection procedures.
Credit standard, this is the criteria that the client should meet if she /he is to qualify for credit.
The purpose of this standard is to enable the firm select clients who have the ability and
willingness to payback the debts and these standards can be set basing on the 5 Cs. i.e. capital,
capacity, collateral, character and condition.
Character, Here the firm attempts to evaluate the traits of the applicants which gives an
indicator as to whether such a client has the willingness to meet his/her obligations. In making
this analysis, the following 8 aspects can be evaluated.
 Bank references
 Marital status i.e. that it may be more secure to grant credit a married couple because they
tend to be more stable and settling in permanent places unlike the unmarried ones.
Attachment to government agencies, like ministries and other public places, public

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 parastatal bodies, levels of education, the previous dealing with the firm and the
occupational stability contact of addressee- mobile phone etc.
Capacity, this is the ability of the customer to pay the credit advanced to him or her. In
analyzing the capacity of a client, we should look at financial statements, previous experience
with the firm, the amount and purpose of the credit.
Capital, this is the contribution or interest of the customer in his business or her business and
this is shown by the accounting equation C=A-L, C is capital A is assets and L is liability.
Therefore it is undesirable to grant credit to persons who have got little capital since by looking
at their capital structure, you are determining a stake of the person in /her business.
Collateral, this is the security which the lender will turn to in case the borrower defaults.
However, this security should be good and safe and can easily turn into cash and easily
marketable.
Conditions- This refers to the prevailing economic and other conditions which may fail the
customers’ ability to pay back e.g. inflation huge transportation costs and political factors.

INVENTORY MANAGEMENT
Inventory management is the process of efficiently overseeing the constant flow of units into
and out of an existing inventory. This process usually involves controlling the transfer in of units
in order to prevent the inventory from becoming too high, or dwindling to levels that could put
the operation of the company into jeopardy. Competent inventory management also seeks to
control the costs associated with the inventory, both from the perspective of the total value of
the goods included and the tax burden generated by the cumulative value of the inventory
Successful inventory management involves creating a purchasing plan that will ensure that
items are available when they are needed (but that neither too much nor too little is
purchased) and keeping track of existing inventory and its use. Two common inventory-
management strategies are the just-in-time method, where companies plan to receive items
as they are needed rather than maintaining high inventory levels, and materials requirement
planning, which schedules material deliveries based on sales forecasts.
 Clerical costs of preparing purchase orders
 Some spent finding suppliers and expediting orders
Ordering Cost  Transportation costs
 Receiving costs (E.g. unloading and inspection)
 Costs of storage space (E.g. warehouse depreciation)
 Security
Holding Costs  Insurance
 Forgone interest on working capital tied up in inventory
 Deterioration, theft, spoilage, or obsolescence
 Disrupted production when raw materials are unavailable :
Idle workers
Shortage Costs Extra machinery setups
 Lost sales resulting in dissatisfied customers
 Loss of quantity discounts on purchases

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Inventory management, or inventory control, is an attempt to balance inventory needs
and requirements with the need to minimize costs resulting from obtaining and holding
inventory. There are several schools of thought that view inventory and its function
differently. These will be addressed later, but first we present a foundation to facilitate
the reader's understanding of inventory and its function.

MANAGEMENT OF INVENTORIES
The term inventory refers to the goods or materials used by a firm for the purpose of production
and sale. It also includes the items, which are used as supportive materials to facilitate
production.
There are three basic types of inventory:
 Raw materials,
 Work-in-progress
 And finished goods.
 Raw materials are the items purchased by firms for use in production of finished product.
 Work-in-progress consists of all items currently in the process of production. These are
actually partly manufactured products.
 Finished goods consist of those items, which have already been produced but not yet sold.
Inventory constitutes one of the important items of current assets, which permits smooth
operation of production and sale process of a firm. Inventory management is that aspect of
current assets management, which is concerned with maintaining optimum investment in
inventory and applying effective control system so as to minimize the total inventory cost

Purpose of inventory management

Inventory management is important from the view point that it enables to address two important
issues:

 The firm has to maintain adequate inventory for smooth production and selling activities.
 It has to minimize the investment in inventory to enhance firm's profitability.
 Investment in inventory should neither be excessive nor inadequate. It should just be
optimum.
 Maintaining optimum level of inventory is the main aim of inventory management.
 Excessive investment in inventory results into more cost of fund being tied up so that it
reduces the profitability, inventories may be misused, lost, damaged and hold costs in terms
of large space and others.
 At the same time, insufficient investment in inventory creates stock-out problems,
interruption in production and selling operation.
 Therefore, the firm may lose the customers as they shift to the competitors. Financial
manager, as he involves in inventory management, should always try to put neither excessive
nor inadequate investment in inventory. The importance or significance of inventory
management could be specified as below:

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 Inventory management helps in maintaining a tradeoff between carrying costs and ordering
costs which results into minimizing the total cost of inventory.

 Inventory management facilitates maintaining adequate inventory for smooth production and
sales operations.

 Inventory management avoids the stock-out problem that a firm otherwise would face in the
lack of proper inventory management.

 Inventory management suggests the proper inventory control system to be applied by a firm
to avoid losses, damages and misuses.

Reasons to Hold Inventory

Most businesses hold inventory for many reasons. Among them are:
Meeting unexpected demands; the chain of supply and demand really comes into
consideration here. Business people know that consumers expect goods and services when
they need them. Thus, businesses usually stock up their inventories to meet these unexpected
demands. These demands may result in overcrowding of inventories because we never know
when the storm strikes and consumers would flock to buy the items.

Smoothing seasonal demands; with the comings and goings of major events and the changing
seasons, most businesses have inventories at hand to smoothen the seasonal demands. For
example, Christmas is just round the corner. With the coming season, retail outlets as well as
other businesses are busy meeting and stabilizing the upcoming Christmas demands of
consumers. If they do not have any inventory, how can they meet these demands?

Taking advantage of price discounts; when a business purchase goods from the manufacturers
and suppliers, they usually get price discounts if they buy in bigger bulks. Manufacturers and
suppliers give these discounts to attract and maintain regular buyers. Taking advantage of price
discounts is helpful at times but one must always remember not to overstock the inventory
because inefficient buying may cause failure of the business.

Hedging against price increase; Businesses usually hold inventory to avoid from the ever
fluctuating market price of inventories. Thus, by having efficient and good inventory system,
businesses can control their inventory cost.

Getting quality discounts; when businesses have inventory in store, they can get quality discounts
because they know which goods and services to buy from the suppliers and manufacturers. It helps to
learn where to get better deals than no deal at all.

Furthermore, why firms need inventories

The solution to this question can be derived from the nature of the production process i.e. input-
process-out put which also correspond to the functions of procurement, purchasing, production and
marketing respectively. Procurement can be disrupted by external factors e.g. unrealistic supplies or

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internal factors (inefficiencies in the procurement function through bureaucracies). These factors imply
that the production function will be disrupted due to lack of inputs to transform (inventories-raw
materials). Therefore this means that, if you have a problem with procurement, you will not run out of
production. Hence the raw materials are said to decouple the purchasing function from the operations
resulting into a smooth flow of activities.
Secondary, the production function is in stages with one stage feeding the other. If there is a
break down at one stage, the transformation process will be at a standstill position. Therefore,
keeping inventories or WIP, facilitates continuous production flow. Hence inventories of WIP
decouple the operations of the different stages of production which also ensures a smooth flow
of operations.

Finally, marketing is not predictable. There are may be an increase in demand for the firm’s
products which will require the firm to have inventories off finished products to meet this
demand. Therefore finished products decouple the marketing function from production.

Managerial issues in inventory management

Inventories are an essential investment with clear benefits; hence the business cannot afford to
ignore them. However, investment in inventories involves costs and carrying costs.

Ordering costs; these are expenses in form of administrative costs involved in preparing and
dispatching orders, communication with suppliers and other costs related to placing orders.
These costs are incurred right from the time the orders on inventories are placed to when the
order is actually received and placed in business premises. Naturally, ordering costs per order
decrease the bigger the size of the order and vice versa.
Carrying costs; Carrying costs are expenses incurred to keep the inventories in the business
from the time of receipt to the time they enter the production or marketing functions. Such
cost will include the risk of inventories becoming obsolete while in storage. Storage or
warehousing charges, opportunity costs of the funds tied up in the inventories and other costs
like lighting, security, insurance heating and other charges are required to maintain the value of
inventories. In this case, carrying costs normally increase as more inventories are maintained.
High levels of inventories do ensure liquidity but at the expense of profitability and vice versa.
Therefore, an optimal level of investment in inventories must be sought which maximizes the
benefits of liquidity while minimizing the total costs of carrying and ordering inventories in the
firm
In summary, the benefits or importance of inventory control is listed in following points:
1. Inventory control protects a company from fluctuations in demand of its products.
2. It enables a company to provide better services to its customers.
3. It keeps a smooth flow of raw-materials and aids in continuing production operations.
4. It checks and maintains the right stock and reduces the risk of loss.

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5. It helps to minimize administrative workload, manpower requirement and even labor cost.
6. It tries to protect fluctuation in output.
7. It makes effective use of working capital by avoiding over-stocking.
8. It helps to maintain a check on loss of materials due to carelessness or pilferage (stealing).
9. It facilitates cost accounting activities.
10. It avoids duplication in ordering of stock.

INVENTORY METHODS MANAGEMENT METHODS

1) JUST IN TIME (JIT)
Just-in-time (JIT) is an inventory strategy companies employ to increase efficiency and decrease
waste by receiving goods only as they are needed in the production process, thereby reducing
inventory costs. This method requires producers to forecast demand accurately.

Just-in-time (JIT) inventory control reduces the amount of inventory that a company maintains.
The concept is based on a cluster of lean manufacturing activities that are designed to only
manufacture enough products to meet customer demand. This control system does so by pulling
demand through a production facility, where each step in the production process is only
authorized to produce a limited amount of inventory.

Just in time inventory system is one of the recently development inventory management
concepts, which assumes that the purchase of inventory has to be just in time of use. JIT refers to
process of acquiring material (inventory) as they are needed. JIT reduces inventory by
purchasing and storing lower quantities of inventories as much as possible. The objective of JIT
is to maintain inventory as low as possible. Sometimes, it may even be at zero level. Thus, under
JIT, the inventories are received in time or purchased in time of use. It is only possible when the
supplier can be relied from making the delivery of goods on time without compromising the
quality. Generally, in developed countries where communication and transportation system are
very efficient, the use of JIT is common.
Advantages of Just in time inventory management
 Companies like to use JIT as it is seen as a more cost efficient method of holding stock. Its
purpose is to minimize the amount of goods you hold at any one time, and this has numerous
advantages:
 Less space needed: With a faster turnaround of stock, you don’t need as much warehouse or
storage space to store goods. This reduces the amount of storage an organisation needs to rent
or buy, freeing up funds for other parts of the business.
 Waste reduction: A faster turnaround of stock prevents goods becoming damaged or
obsolete while sitting in storage, reducing waste. This again saves money by preventing
investment in unnecessary stock, and reducing the need to replace old stock.
 Smaller investments: JIT inventory management is ideal for smaller companies that don’t
have the funds available to purchase huge amounts of stock at once. Ordering stock as and
when it’s needed helps to maintain a healthy cash flow.
 All of these advantages will save the company money.
Benefits of JIT Manufacturing System

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The main benefits of JIT have been well famous within the literature. A carefully planned
implementation of JIT can directly provide increased teamwork and employee involvement, as
the organization works together to find areas of waste to target and work out ways to reduce
waste in that area (Slack, Chambers, & Johnston, 2007). This results in a simplification of the
inventory management system, as well as business processes involved in inventory management.
Supplier relationships and data regarding the business are used to identify specific areas where
inventory improvements are required.
 Lower stock holding means a reduction in storage space which saves rent and insurance costs
 Areas previously used, to store inventories can be used for other more productive uses.
 As stock is only obtained when it is needed, less working capital is tied up in stock.
 Funds that were tied up in inventories can be used elsewhere.
 Throughput time is reduced, resulting in greater potential output and quicker response to
customers.
 There is less likelihood of stock perishing, becoming obsolete or out of date
 Avoids the build-up of unsold finished product that can occur with sudden changes in
demand.
 Defect rates are reduced, resulting in less waste and greater customer satisfaction.
 Less time is spent on checking and re-working the product of others as the emphasis is on
getting the work right first time.
Disadvantages of just in time inventory management
JIT unfortunately comes with a number of potential disadvantages, which can have a significant
impact on the company if they occur.
 Risk of running out of stock: By not carrying much stock, it is imperative you have the
correct procedures in place to ensure stock can become readily available, and quickly. To do
this, you need to have a good relationship with your supplier(s). You may need to form an
exclusive agreement with suppliers that specifies supplying goods within a certain time
frame, prioritizing your company. JIT means that you become extremely reliant on the
consistency of your supply chain. What if your supplier struggles with your requirements, or
goes out of business? Can you get the products quickly from somewhere else?
 Lack of control over time frame: Having to rely on the timeliness of suppliers for each
order puts you at risk of delaying your customers’ receipt of goods. If you don’t meet your
customers’ expectations, they could take their business elsewhere, which would have a huge
impact on your business if this occurs often.
 More planning required: With JIT inventory management, it’s imperative that companies
understand their sales trends and variances in close detail. Most companies have seasonal
sales periods, meaning a number of products will need a higher stock level at certain times of
the year due to higher demand. Therefore, you need to factor that into planning for inventory
levels, ensuring suppliers are able to meet different volume requirements at different times.
2) ABC Analysis

ABC analysis is a way of categorizing the material on the basis of the quantity of consumption
and their relative values. Some material might be consumed in lower quantities but their period
may be very high. Such materials are kept in group "A". Similarly, some material may be
consumed in large quantities but their values may be lower. Such materials are kept in group 'C'.
In between these two, some materials may be consumption in moderate quantity with the
moderated price. Such materials are kept in group 'B' under ABC analysis very close control is

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exercised over the material in group 'A' whereas a very little control is exercise is exercised over
the material in group 'C'.
Purpose of ABC Analysis:
The object of carrying our ABC analysis is to develop policy guidelines for selective controls.
Normally, once analysis has been done, the following broad policy guidelines can be established
in respect of each category:
 ‘A’ items merit a tightly controlled inventory system with constant attention by the purchase
manager and stores management.
 ‘B’ items formalized inventory system with periodic attention by purchase and stores
management.
 ‘C’ items use a simpler system designed to cause the least trouble for the purchase and stores
department.
CLASSIFICATION OF ITEMS IN CATEGORIES A,B and C
A items: High consumptions value
1) Very strict control
2) No safety stock
3) Frequent ordering
4) Weekly control statements
5) As many sources as possible for each item
6) Rigorous value analysis
7) Accurate forecast in materials planning
8) Minimization of waste obsolete and surplus
9) Maximum efforts to reduce lead time.
B items: Moderate value
1) Moderate control
2) Low safety stock
3) Once in 3 weeks
4) Monthly control reports
5) Two or more reliable sources
6) Moderate value analyses
7) Estimate based on past data on present plans
8) Quarterly control over surplus and obsolete items
9) Moderate efforts.
C items: Low consumptions value
Low control
2) High safety stock
3) Bulk ordering once in 6 months
4) Quarterly control reports
5) Two reliable sources for each item
6) Minimum value analysis
7) Rough estimates for planning
8) Annual review over surplus and obsolete materials
9) Minimum clerical efforts
The advantages of ABC analysis are as follows:

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 Reduction in investment: under ABC analysis, the materials from group 'A' are purchased in
lower quantities as much as possible. With this, the effort to reduce the delivery period is also
made. These in turn help to reduce the investment in material.
 Strict control: under ABC analysis, strict control can be exercised to the materials in group
'A' that have higher value.
 Minimum storage cost: since, the ,material from group 'A' are purchased in lower quantities
as much as possible, it reduces the storage cost as well.
 Saving in time: since a signification effort is made for management of the material from
group 'A', it helps to save time as well.
 Economy: this method is economical, since equal time and labor is not needed for all types
of materials.
 Close and strict control is facilitated on the most important items which help in overall
inventory valuation or overall material consumption.
 Proper regulation of investment in inventory which will ensure optimum utilization of
available funds.
 Helps in maintaining a high inventory turnover rates

Disadvantage of ABC analysis

 ABC analysis will not be effective if the materials are not classified into the groups properly.
 It is not suitable for the organization where the costs of materials do not vary significantly.
 There is no any scientific base for the classification of material under ABC analysis.
 The classification of the materials into different groups may lead to extra cost. Hence, it may
not be suitable for small organization.

3) ECONOMIC ORDER QUANTITY (EOQ)

The Economic Order Quantity (EOQ) is the number of units that a company should add to
inventory with each order to minimize the total costs of inventory—such as holding
costs, order costs, and shortage costs.

Economic order quantity (EOQ) is the order quantity of inventory that minimizes the total cost of
inventory management.
Two most important categories of inventory costs are:
 ordering costs
 And carrying costs.
Ordering costs are costs that are incurred on obtaining additional inventories. They include costs
incurred on communicating the order, transportation cost, etc.
Carrying costs represent the costs incurred on holding inventory in hand. They include the
opportunity cost of money held up in inventories, storage costs, spoilage costs, electricity, rent,
insurance, opportunity etc.
Ordering costs and carrying costs are quite opposite to each other. If we need to minimize
carrying costs we have to place small order which increases the ordering costs. If we want

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minimize our ordering costs we have to place few orders in a year and this requires placing large
orders which in turn increases the total carrying costs for the period.
We need to minimize the total inventory costs and EOQ model helps us just do that.
Total inventory costs = Ordering costs + Holding costs
The most used approach in attaining the goals of inventory management is the economic order
quantity (EOQ) analysis. This uses the EOQ model to determine the optimal amount of
inventories to order and keep an amount that minimize the cost of inventory while assuring
liquidity to the business.
The EOQ Model makes the following assumptions:
(i) The rate of usage (demand) of the product over the planning period is known with certainty
and is constant. For example, a dealer in goat roasting will know for sure that a fixed number of
120 goats will be demanded in a year.
(ii) The inventories are replenished periodically over time. Such replenishment is instantaneous
and there is no lead time between the ordering and receipt of inventories in the business
(iii) Ordering costs per order are known with certainty and fixed
(iv) Carrying costs per unit of inventory are known with certainty and are fixed.

ECONOMIC ORDER QUANTITY (EOQ) MODEL

The economic order quantity (EOQ) is the order quantity that minimizes total holding and
ordering costs for the year. Even if all the assumptions don’t hold exactly, the EOQ gives us a
good indication of whether or not current order quantities are reasonable.

Where annual usage in units is= total demand (TD)

Order cost = (OC)

Annual carrying cost per unit = (CC)

The Advantages & Disadvantages of Economic Order Quantity (EOQ)

The Economic Order Quantity model solves the "how much" and "when" aspects of ordering
inventory. When inventory reaches the zero point, you order just enough to replenish your stock

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back to its original level. You repeat this cycle throughout the year, never having to decide when
to order or how much to order. The decisions are based on preset levels. While this model offers
some positive guidelines, you must watch for pitfalls as well.

Assumptions
The EOQ model assumes that demand remains steady throughout the year and that inventory
gets used at a fixed rate. If those assumptions hold true, you can order at the same time each
month or quarter. However, if demand fluctuates, you may run out of inventory sooner than you
anticipate. You also may have to order more than you usually do to meet higher demand, or
lower the order to adjust to declining demand. That means you would temporarily have to
temporarily abandon the EOQ model when demand fluctuates.

Lead Time; When you run out of stock, you can expect a waiting period until your new stock
arrives, even if you order immediately. As a result, the EOQ model can take lead time into
consideration and move the reorder date to just before stock runs out. This works well in most
cases. However, the model assumes the lead time remains the same for each order. In reality,
your supplier could experience delays. Since you carry the minimum amount of inventory if you
use EOQ, you could run out during a supplier delay. The solution is to establish reorder dates
that take into account your suppliers' reliability.

REFERENCES:
1. ACCA Reading text (Paper 9) on Financial Management 2007-2008
2. Pandey M. (2002): Financial Management. Eight edition, Vikas Publishing House
3. Van Horne, J (2001): Financial management and Policy. 12th edition Prentice Hall
4. Brigham, E.F and E HRHARDT, M.C. (2007) Financial Management: Theory &Practice
(with Thomson one-business school 1-year printed access card
5. Blocks, S.B. and Hirt, G.A (2008) foundations of financial management
6. Petty, J.W (2004) Study Guide for Financial Management: Principles and applications

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