Question

Brian Kelly is the founder and CEO of Kelly’s Barbecue and Grill (KBG).  KBG is a local retailer of outdoor cooking equipment, ranging from small portable gas grills to competition grade barbecue grills and smokers.  Kelly has operated his business profitably for nearly 15 years.  In recent years, sales revenues and profits have been stagnant.  As an old-fashioned type, Kelly has always operated his business on a cash-only basis.  After consulting with his accountant, Josh Adams CPA, Kelly believes that his sales policy has left little room for additional growth.  

Kelly is considering offering 30-day credit to customers in an effort to drive increased sales.  Initially, he plans to only offer credit on his high-end propane grill model before extending this new policy to his full inventory.  His luxury gas grill model, the Caliber Cross Flame Pro retails for $12,590 and costs Kelly $10,470 per unit from his supplier.  There should be no change to his cost per unit, but Kelly believes that he might be able to mark-up his retail price to $13,000 since he will be offering more flexible payment terms.  

KBG currently sells an average of 15 units of the Caliber model each month.  Kelly thinks that he may be able to sell up to an average of 22 units per month if he begins offering the proposed 30-day credit terms.  Kelly has further decided that a 3% per month required return would be appropriate for evaluating the proposed credit policy change.  

1. Calculate the net present value (NPV) of switching from the cash-only policy to the 30-day credit terms.

2. Determine the minimum increase, or maximum decrease, in monthly sales volume for Kelly to deem the switch appropriate.

         

Kelly currently places a monthly order of 15 units of the Caliber model from his supplier.  It costs him $50 to place each order and he estimates that it costs him about $23 to store each grill in inventory for a year.

3. Under his current ordering system, with monthly sales of 15 units;
   1. What is the average inventory balance (in units) for the Caliber model, assuming the grills are sold evenly throughout the month?

2. How much does Kelly pay per year in ordering costs?

3. How much does Kelly pay per year in storage costs?

4. How much money would Kelly save per year if he were to optimize his order size?  

5. Assuming his goal would be to minimize the total costs incurred for ordering/storing inventory, how many units of the Caliber model should Kelly order each time he places an order when his monthly sales volume is 22 units?  

Answer 1

Details	Cash sale	30 days credit sale
Sales Price/Unit	$                    12,590	$              13,000
Purchase cost/Unit	$                    10,470	$              10,470
Contribution/ Unit	$                       2,120	$                2,530
Units sold /month	15	22
Contribution/ Month	$                    31,800	$              55,660
Required raturn/month	3%	3%

NPV Calculation of switch from cash to Credit Policy
Incremental cash inflow / month =$55660-$31800	$                    23,860
Required rate of return =3% per month
PV of Incremental cash inflows =23860/3%=	$             795,333.33
Cost of Switching
1. Loss of one months cash revenue =15*12590=	$                  188,850
Additional purchase cost of (22-15) 7 units @10470=	$                    73,290
Total Cost of Switch =	$                  262,140
NPV of Switching =$795,333.33-$262,140=	$            533,193.33

Keely's current Inventory System
Average order & sales per month	15	Units
Average Inventory Balance =15/2=	7.5	Units
No of orders in a year =	12
cost per order =	$                            50
Annual Ordering cost =12*50=	$                          600
Average inventry holding =	7.5	units
Inventory holding cost/year=	$23
Per year storage cost =7.5*23=	$172.50
EOQ for Kelly
Details
Annual usgae units	264
Cost pr Order	$                            50
Carrying cost per unit =	$                      23.00
EOQ = Sq Root of [(2*Order cost*Annual usage)/(Annual Holding cost per unit]
EOQ = Sq Root of [(2*264*50/23]
EOQ =33.88=34 approx
So Kelly should place order of 34 units to minimize the ordering and holding cost.