FIN302

• Cash budget


  An important management control tool especially during recession
• Cash budget


  • Indicates forecasts of receipts (cash inflows) & payments (cash outflows) during the budget period
  • Incorporates both revenues & capital items
  • Forecasts of cash receipts & payments are tabulated to reflect the forecast cash bal at certain intervals
• Importance

  • Reflects the cash-effect of the budgetary plans
  • Can lead to adjustments in other budgets if it indicates insufficient cash resources
  • Indicates to mgt problems that are likely to arise
• Possible cash positions & mitigation measures by mgt


  • Short-term deficit: increasing creditors/increasing payables deferral period, reducing debtors/reducing receivables collection period, arrange an overdraft
  • Short-term surplus: reduce payables deferral period/make early payments to creditors & enjoy discounts, increase debtors/increase receivables collection period, invest in short-term securities
  • Long-term deficit: raise long-term finance e.g. through issuing shares, disinvest/shutdown
  • Long-term surplus: invest in long-term securities, expand the business, diversify, update/replace fixed assets
• Profit made ≠ Cash position
• Reasons


  • Some cash receipts do not affect income statement e.g. cash received in advance
  • Some cash payments have no effect on the profit made e.g. prepayments
  • Non-cash items such as depreciation & provision for bad debts do influence profit but not cash position
  • The incurrence of costs/expenses & the realisation of income (recorded in the income statement) may not coincide with the timing of receipts & payments (recorded in the cash budget / in cashflow statement)
• For mgt, the cash budget is a better financial planning tool than the income statement in ensuring sufficient cash balance in the company
• Rolling Budget


  This is a cash budget involving continuous budgeting i.e. regularly adding to the existing budget a new future period whilst removing the earliest period. Thus, the budget needs to constantly revised so as to reflect the most recent / up to date company position.
• Management of Other Current Assets

  Concerned with the management of non-cash working capital particularly inventory management
• Inventory management


  • Involves the application of quantitative models in establishing the optimum investment in inventory (stocks)
  • Inventory constitutes raw materials, work-in-progress &/or finished goods
• For most firms inventory is a major investment asset i.e. investment in inventory constitute a relatively significantly large proportion of the firm's total investment
• Management must ensure that stocks are sufficient to meet production & sales requirements
• The firm must also avoid holding excess/surplus stocks unnecessarily
• Surplus stocks may result in risk of obsolescence or deterioration of stocks( out of used/out dated)
• The optimum level of stock lies somewhere between the two extremes of insufficient and excess stock
• 3 Reasons for holding stocks

  • Transaction motive
  • Precautionary motive
  • Speculative motive
• Transaction motive


  Emanates from the need to hold stocks to meet production & sales requirements
• Precautionary motive


  • Arises from the need to cover for the possibility that the firm may have underestimated its future production & sales requirements
  • Alternatively it may be a result of unreliable supply of raw materials due to uncertain events affecting the supply side of raw materials
• Speculative motive


  • If input prices are expected to rise in future, the firm can increase the level of stock so as to avoid possible losses arising from higher future prices
  • Equally if prices are anticipated to fall the firm can reduce its stock levels so as to benefit from future lower prices
• Relevant Costs for Quantitative Models

  • Holding costs
  • Ordering costs
• Holding Costs


  • Opportunity cost of investing in stocks e.g. lost required return
  • Incremental insurance costs(theft,damage during storage)
  • Incremental warehouse & storage costs(rent)
  • Cost of obsolescence & deterioration of stocks
  • Only costs that vary with the level of stock are relevant costs in quantitative models
• Ordering Costs


  • Costs of preparing a purchase order
  • Costs of receiving deliveries
  • Costs of paying invoices
  • Only incremental costs of placing an order are used in formulating quantitative models
  • Ordering costs that are common to all stock decisions are not relevant
• Economic Order Quantity (EOQ)


  • Under 'certainty' assumption, the optimum order is determined by costs which are in turn influenced by either the quantity of stocks held or the number of orders placed
  • If more units are ordered at a time, fewer orders will be required per annum, hence a reduction in ordering costs
• There is a trade off between ordering costs & holding costs
• Economic Order Quantity (EOQ)


  • The optimum order size is what is referred to as the 'economic order quantity' (EOQ)
  • The EOQ can be determined by using a formula, graphical representation, or tabulating total costs of various order quantities
• Using a formula to determine EOQ

  1. Number of orders for a period = Total demand for that item of stock for the period (D) / Quantity ordered in units (Q)

  2. Total ordering costs = No. of orders for a period x ordering costs per order (O) = (D/Q) x O = DO/Q

  3. Total holding costs for a period = Average stock for the period x Holding costs per unit = (Q/2) x H = QH/2

  4. Total relevant costs (TC) = DO/Q + QH/2

  5. Differentiating the total cost function with respect to Q and setting the derivative equal to zero to determine the minimum point, gives the EOQ formula: Q=EOQ = √(2DO/H)
• Graphical Representation of EOQ

  • When order quantity increases, average stock increases & total annual holding cost increases
  • When order quantity increases, the no. of orders decreases & the total no. of annual reorder costs decreases
  • The point at which costs are minimised is the EOQ
• The EOQ Graph shows the relationship between holding costs, ordering costs, and total costs
• The EOQ is the point where total costs are minimised
• The model assumes that holding costs are constant, but this is only true for items like funds invested in stocks, as other costs like storage may vary with stock levels
• The assumption that average balance of stock is equal to half of the order quantity only holds if a constant amount of stock is used per day, but seasonal and cyclical factors often result in uneven usage
• Economic Order Quantity Model Extension

  Dealing with Uncertainty and Safety Stocks
• In the real world there is uncertainty in the demand or usage of inventory, the placement of an order, and the delivery of stocks
• A firm needs to protect itself from 'uncertainty' conditions by maintaining a level of 'safety stocks' for raw materials, work in progress & finished goods
• Safety Stocks


  Amounts of stocks in excess of the anticipated usage during the 'time lead' to cushion against stock shortages due to demand fluctuations
• If the cost of holding the excess stock (safety stock) is more than the cost associated with stock shortages, the firm may not maintain high safety of stocks
• An acceptable level of stocks must be set where the cost of a stock-out plus the cost of holding the safety stocks are minimised
• Stock-Out Costs


  Opportunity costs of running out of stocks, e.g. loss of contribution if customers take their business elsewhere, discounted value of lost contribution on future sales for regular customers permanently lost due to failure to meet delivery, stoppage in production and resultant inefficiencies
• Safety stock levels


  • 1000 units
  • 1500 units
  • 1800 units
  • 2000 units
• Safety stock


  1000 units