Question

Q1. (a) Sudajaya Berhad is contemplating making several changes in its working
capital management. Firstly, Sudajaya Berhad is considering the change of its
current ordering policy to the economic order quantity model (EOQ). The
demand for its products is forecasted to be 160,000 units in the coming year
and it has traditionally ordered 10% of its annual demand per order. The
ordering cost is expected to be RM400 per order while the holding cost is
expected to be RM5.12 per unit per year. A buffer inventory of 5,000 units
will be maintained, whether orders are made by the traditional method or the
EOQ model. Secondly, on its receivables management, Sudajaya Berhad is
evaluating the introduction of an early settlement discount of 2% for
customers who pay within 30 days with a maximum average payment period
of 60 days for credit customers who do not take up the discount. It is expected
that 25% of credit customers will take up the discount if it were offered.
Moreover, it is forecasted that administration and operating cost savings of
RM753,000 per year will be made after improving operational procedures and
introducing the early settlement discount. Credit sales of Sudajaya Berhad are
currently RM87.6 million per year and trade receivables are currently RM18
million. Credit sales are not expected to change as a result of the changes in
receivables management. The company has a cost of short-term finance of
5.5% per year.

Required:
(i) Compare and contrast the cost of the current ordering policy and the
cost of the proposed ordering policy using the EOQ model. Appraise
whether the EOQ model should be adopted.

(ii) Evaluate the feasibility of the proposed changes in receivables
management. Assuming that only 25% of customers take up the early
settlement discount, determine the maximum early settlement discount
that could be offered.

(b) Working capital management inadvertently involves trade-off between
profitability and liquidity. Justify why striking a balance between profitability
and liquidity is crucial in managing an efficient working capital.

Answer 1

i) Under EOQ model

EOQ²= 2AO/i

Where, A= annual demand

I= holding period fee

O= order or set up cost

Thus, EOQ= 2*160000*400/5.12

                    = (2500000)^1/2

                           = 5000 units

Thus, the Economic order qty is 5000 units,

· Holding cost= (Q/2)*I

        =( 5000/2)*5.12= 2500*5.12= Rs. 12800/-

· Set up/ ordering cost = (160000/5000)*400per order

         =Rs. 12800/-

Thus, total cost = 12800+12800= Rs. 25600/-

Under Traditional system

Order Qty= 10%*160000= 16000

· Thus, Holding cost= (Q/2)*I

        =( 16000/2)*5.12= 8000*5.12= Rs. 40960/-

· Set up/ ordering cost = (160000/16000)*400per order

         =Rs. 4000/-

Thus, total cost = 40960+4000= Rs. 44960/-

Thus, EOQ system is preferable.

Note: Since buffer stock is to be maintained under both the options, it becomes irrelevant in comparison.