Page 283 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes
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Case Study Inventory Levels

he Storage Corporation currently carries 25 million of inventory. The finance
manager is considering whether to recommend a reduction in inventory costs at
Tthe following information about inventory costs at various levels. The company’s
after-tax discount rate that is used to evaluate current asset policies is 6%. The company
earns a contribution margin of 20% on sales.

25 million 23 million 21 million
Storage costs 7,50,000 7,25,000 7,10,000
Spoilage costs 4,00,000 3,75,000 3,67,000
Daily sales 1,20,000 1,19,000 1,14,500

(a) Would it be profitable for the company to reduce its inventory from 25 million to
23 million? (Calculate the change in after-tax income).
(b) Would it be profitable for the company to reduce its inventory to 21 million?
(Calculate the change in after-tax income.)
(a) Reducing inventory from 25 to 23 million causes net income to:
DStorage cost = ( 7,50,000 – 7,25,000)(0.60) = 15,000
DSpoilage cost = ( 4,00,000 – 3,75,000)(0.60) = 15,000

DFinancing cost = ( 20,00,000)(0.06) = 1,20,000
DProfit on sales = ( 1,20,000 – 1,19,000)(365)(0.20)(0.60) = (43,800)
DNet Profit = 1,06,200

(b) To determine if it is profitable to reduce inventory to 21 million, determine the
change in profits associated with reducing from 23 million. That is, you know that
23 million is better than 25 million and the decision is now whether to reduce it
further to 21 million. Remember that decisions depend on incremental costs and
benefits.
DFinancing cost = ( 20,00,000)(0.06) = 1,20,000
DStorage cost = ( 7,25,000 – 7,10,000)(0.60) = 9,000
DSpoilage cost = ( 3,75,000 – 3,67,000)(0.60) = 4,800
DFinancing cost = ( 20,00,000)(0.06) = 1,20,000

DProfit on sales = ( 1,19,000 – 1,14,500)(365)(0.20)(0.60) = (1,97,100)
DNet Profit = ( 63,300)
Given the choices, 23 million is the most profitable level of inventory.

Question
Fabrication Company requires steel for its fabrication work. The probability distributions
of the daily usage rate and the lead time for procurement are given below:

Contd...

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