Question

Taizhou Products uses 800 units of a product per year n a continuous basis. The product has carrying costs of $50 per unit per year and order costs of 300$ per order. It takes 30 days to receive a shipment after an order is placed and the firm requires a safety dock of 5 days usage in inventory. Further, the operation director would need to increase the firm liquidity in short run. a)Determine the reorder point. (Assume a 360-day year) b)Advise Taizhou on the credit standard can be applied to improve the firm liquidity. c)Write a memo to operation director, indicate the short term sources of financing to Taizhou in order to increase firm liquidity. Different in spontaneous and non-spontaneous financing) d)Explain the funding strategies which can be explained to Taizhou

Answer 1

Reorder level = Average daily usage rate x lead-time in days
= 800/360 * (30+5)
77.78
=78 units

Based on this reorder level the firm will place 800/78= 11 orders in a year. Since the order cost is $300, the total cost of ordering in a year is $3300. The average inventory is ((5*800/360)+78)/2= 44.55.
The carrying cost is $50. Hence, the carrying cost of the year is 50*44.55= ~$2228.
The company could possible lower the inventory levels and try to maintain more cash in hand to improve its credit levels. Alternatively, it can try to improve its supply chain to that the lead time for ordering is reduced from 30 days.
The company could use multiple short term financing sources such as- standing credit facility with the bank, longer credit repayment cycle/ facility with the suppliers, shorter collection cycles and so on.
It can also issue commercial papers to raise short term capital from the market. This is generally the more expensive way of raising short term finance. Having an overnight borrowing facility is not an option for every firm but it can be a very low cost source of short term funds.
The easiest and least costly way to increase liquidity of the firm is to shorten the credit sales collection period and at the same time, extending the credit cycle with the suppliers. The standing credit facility with the banks has a cost of borrowing which is generally high. Raising funds from market through commercial papers etc. has an initial transaction cost as well as high interest rate.